[Federal Register Volume 72, Number 235 (Friday, December 7, 2007)]
[Rules and Regulations]
[Pages 69288-69445]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 07-5729]
[[Page 69287]]
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Part II
Department of the Treasury
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Office of the Comptroller of the Currency
12 CFR Part 3
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Federal Reserve System
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12 CFR Parts 208 and 225
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Federal Deposit Insurance Corporation
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12 CFR Part 325
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Department of the Treasury
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Office of Thrift Supervision
12 CFR Parts 559, 560, 563, and 567
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Risk-Based Capital Standards: Advanced Capital Adequacy Framework--
Basel II; Final Rule
Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 /
Rules and Regulations
[[Page 69288]]
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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 3
[Docket No. OCC-2007-0018]
RIN 1557-AC91
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[Regulations H and Y; Docket No. R-1261]
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 325
RIN 3064-AC73
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
12 CFR Parts 559, 560, 563, and 567
RIN 1550-AB56; Docket No. OTS 2007-0021
Risk-Based Capital Standards: Advanced Capital Adequacy Framework
-- Basel II
AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of
Governors of the Federal Reserve System; Federal Deposit Insurance
Corporation; and Office of Thrift Supervision, Treasury.
ACTION: Final rule.
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SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board
of Governors of the Federal Reserve System (Board), the Federal Deposit
Insurance Corporation (FDIC), and the Office of Thrift Supervision
(OTS) (collectively, the agencies) are adopting a new risk-based
capital adequacy framework that requires some and permits other
qualifying banks \1\ to use an internal ratings-based approach to
calculate regulatory credit risk capital requirements and advanced
measurement approaches to calculate regulatory operational risk capital
requirements. The final rule describes the qualifying criteria for
banks required or seeking to operate under the new framework and the
applicable risk-based capital requirements for banks that operate under
the framework.
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\1\ For simplicity, and unless otherwise indicated, this final
rule uses the term ``bank'' to include banks, savings associations,
and bank holding companies (BHCs). The terms ``bank holding
company'' and ``BHC'' refer only to bank holding companies regulated
by the Board and do not include savings and loan holding companies
regulated by the OTS.
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DATES: This final rule is effective April 1, 2008.
FOR FURTHER INFORMATION CONTACT:
OCC: Mark Ginsberg, Risk Expert, Capital Policy (202-927-4580) or
Ron Shimabukuro, Senior Counsel, Legislative and Regulatory Activities
Division (202-874-5090). Office of the Comptroller of the Currency, 250
E Street, SW., Washington, DC 20219.
Board: Barbara Bouchard, Deputy Associate Director (202-452-3072 or
[email protected]) or Anna Lee Hewko, Senior Supervisory
Financial Analyst (202-530-6260 or [email protected]), Division of
Banking Supervision and Regulation; or Mark E. Van Der Weide, Senior
Counsel (202-452-2263 or [email protected]), Legal Division. For
users of Telecommunications Device for the Deaf (``TDD'') only, contact
202-263-4869.
FDIC: Jason C. Cave, Associate Director, Capital Markets Branch,
(202) 898-3548, Bobby R. Bean, Chief, Policy Section, Capital Markets
Branch, (202) 898-3575, Kenton Fox, Senior Policy Analyst, Capital
Markets Branch, (202) 898-7119, Division of Supervision and Consumer
Protection; or Michael B. Phillips, Counsel, (202) 898-3581,
Supervision and Legislation Branch, Legal Division, Federal Deposit
Insurance Corporation, 550 17th Street, NW., Washington, DC 20429.
OTS: Michael D. Solomon, Director, Capital Policy, Supervision
Policy (202) 906-5654; David W. Riley, Senior Analyst, Capital Policy
(202) 906-6669; Austin Hong, Senior Analyst, Capital Policy (202) 906-
6389; or Karen Osterloh, Special Counsel, Regulations and Legislation
Division (202) 906-6639, Office of Thrift Supervision, 1700 G Street,
NW., Washington, DC 20552.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Executive Summary of the Final Rule
B. Conceptual Overview
1. The IRB Approach for Credit Risk
2. The AMA for Operational Risk
C. Overview of Final Rule
D. Structure of Final Rule
E. Overall Capital Objectives
F. Competitive Considerations
II. Scope
A. Core and Opt-In Banks
B. U.S. Subsidiaries of Foreign Banks
C. Reservation of Authority
D. Principle of Conservatism
III. Qualification
A. The Qualification Process
1. In General
2. Parallel Run and Transitional Floor Periods
B. Qualification Requirements
1. Process and Systems Requirements
2. Risk rating and Segmentation Systems for Wholesale and Retail
Exposures
Wholesale Exposures
Retail Exposures
Rating Philosophy
Rating and Segmentation Reviews and Updates
3. Quantification of Risk Parameters for Wholesale and Retail
Exposures
Probability of Default (PD)
Loss Given Default (LGD)
Expected Loss Given Default (ELGD)
Economic Loss and Post-Default Extensions of Credit
Economic Downturn Conditions
Supervisory Mapping Function
Pre-default Reductions in Exposure
Exposure at Default (EAD)
General Quantification Principles
Portfolios With Limited Data or Limited Defaults
4. Optional Approaches That Require Prior Supervisory Approval
5. Operational Risk
Operational Risk Data and Assessment System
Operational risk Quantification System
6. Data management and maintenance
7. Control and oversight mechanisms
Validation
Internal Audit
Stress Testing
8. Documentation
C. Ongoing Qualification
D. Merger and Acquisition Transition Provisions
IV. Calculation of Tier 1 Capital and Total Qualifying Capital
V. Calculation of Risk-Weighted Assets
A. Categorization of Exposures
1. Wholesale Exposures
2. Retail Exposures
3. Securitization Exposures
4. Equity Exposures
5. Boundary Between Operational Risk and Other Risks
6. Boundary Between the Final Rule and the Market Risk Rule
B. Risk-Weighted Assets for General Credit Risk (Wholesale
Exposures, Retail Exposures, On-Balance Sheet Assets that Are Not
Defined by Exposure Category, and Immaterial Credit Exposures)
1. Phase 1 -- Categorization of Exposures
2. Phase 2 -- Assignment of Wholesale Obligors and Exposures to
Rating Grades and retail exposures to segments
Purchased Wholesale Exposures
Wholesale Lease Residuals
3. Phase 3 -- Assignment of risk Parameters to Wholesale
Obligors and Exposures and Retail Segments
4. Phase 4 -- Calculation of Risk-Weighted Assets
5. Statutory Provisions on the Regulatory Capital Treatment of
Certain Mortgage Loans
C. Credit Risk Mitigation (CRM) Techniques
1. Collateral
2. Counterparty Credit Risk of Repo-Style Transactions, Eligible
Margin Loans, and OTC Derivative Contracts
Qualifying master netting agreement
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EAD for Repo-Style Transactions and Eligible Margin Loans
Collateral Haircut Approach
Simple VaR Methodology
3. EAD for OTC derivative Contracts
Current Exposure Methodology
4. Internal Models Methodology
Maturity Under the Internal Models Methodology
Collateral Agreements Under the Internal Models Methodology
Alternative Methods
5. Guarantees and Credit Derivatives That Cover Wholesale
Exposures
Eligible Guarantees and Eligible Credit Derivatives
PD Substitution Approach
LGD Adjustment Approach
Maturity Mismatch Haircut
Restructuring Haircut
Currency Mismatch Haircut
Example
Multiple Credit Risk Mitigants
Double Default Treatment
6. Guarantees and Credit Derivatives That Cover Retail Exposures
D. Unsettled Securities, Foreign Exchange, and Commodity
Transactions
E. Securitization Exposures
1. Hierarchy of Approaches
Gains-on-Sale and CEIOs
The Ratings-Based Approach (RBA)
The Internal Assessment Approach (IAA)
The Supervisory Formula Approach (SFA)
Deduction
Exceptions to the General Hierarchy of Approaches
Servicer Cash Advances
Amount of a Securitization Exposure
Implicit Support
Operational Requirements for Traditional Securitizations
Clean-Up Calls
Additional Supervisory Guidance
2. Ratings-Based Approach (RBA)
3. Internal Assessment Approach (IAA)
4. Supervisory Formula Approach (SFA)
General Requirements
Inputs to the SFA Formula
5. Eligible Disruption Liquidity Facilities
6. CRM for Securitization Exposures
7. Synthetic Securitizations
Background
Operational Requirements for Synthetic Securitizations
First-Loss Tranches
Mezzanine Tranches
Super-Senior Tranches
8. Nth-to-Default Credit Derivatives
9. Early Amortization Provisions
Background
Controlled Early Amortization
Non-Controlled Early Amortization
Securitization of Revolving Residential Mortgage Exposures
F. Equity Exposures
1. Introduction and Exposure Measurement
Hedge Transactions
Measures of Hedge Effectiveness
2. Simple Risk-Weight Approach (SRWA)
Non-Significant Equity Exposures
3. Internal Models Approach (IMA)
IMA Qualification
Risk-Weighted Assets Under the IMA
4. Equity Exposures to Investment Funds
Full Look-Through Approach
Simple Modified Look-Through Approach
Alternative modified look-through approach
VI. Operational Risk
VII. Disclosure
1. Overview
Comments on the Proposed Rule
2. General Requirements
Frequency/Timeliness
Location of Disclosures and Audit/Attestation Requirements
Proprietary and Confidential Information
3. Summary of Specific Public Disclosure Requirements
4. Regulatory Reporting
I. Introduction
A. Executive Summary of the Final Rule
On September 25, 2006, the agencies issued a joint notice of
proposed rulemaking (proposed rule or proposal) (71 FR 55830) seeking
public comment on a new risk-based regulatory capital framework for
banks.\2\ The agencies previously issued an advance notice of proposed
rulemaking (ANPR) related to the new risk-based regulatory capital
framework (68 FR 45900, August 4, 2003). The proposed rule was based on
a series of releases from the Basel Committee on Banking Supervision
(BCBS), culminating in the BCBS's comprehensive June 2006 release
entitled ``International Convergence of Capital Measurement and Capital
Standards: A Revised Framework'' (New Accord).\3\ The New Accord sets
forth a ``three pillar'' framework encompassing risk-based capital
requirements for credit risk, market risk, and operational risk (Pillar
1); supervisory review of capital adequacy (Pillar 2); and market
discipline through enhanced public disclosures (Pillar 3). The New
Accord includes several methodologies for determining a bank's risk-
based capital requirements for credit, market, and operational risk.
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\2\ The agencies also issued proposed changes to the risk-based
capital rule for market risk in a separate notice of proposed
rulemaking (71 FR 55958, September 25, 2006). A final rule on that
proposal is under development and will be issued in the near future.
\3\ The BCBS is a committee of banking supervisory authorities
established by the central bank governors of the G-10 countries in
1975. The BCBS issued the New Accord to modernize its first capital
Accord, which was endorsed by the BCBS members in 1988 and
implemented by the agencies in 1989. The New Accord, the 1988
Accord, and other documents issued by the BCBS are available through
the Bank for International Settlements' Web site at http://www.bis.org.
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The proposed rule included the advanced capital methodologies from
the New Accord, including the advanced internal ratings-based (IRB)
approach for credit risk and the advanced measurement approaches (AMA)
for operational risk (together, the advanced approaches). The IRB
approach uses risk parameters determined by a bank's internal systems
in the calculation of the bank's credit risk capital requirements. The
AMA relies on a bank's internal estimates of its operational risks to
generate an operational risk capital requirement for the bank.\4\
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\4\ The agencies issued draft guidance on the advanced
approaches. See 72 FR 9084 (February 28, 2007).
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The agencies now are adopting this final rule implementing a new
risk-based regulatory capital framework, based on the New Accord, that
is mandatory for some U.S. banks and optional for others. While the New
Accord includes several methodologies for determining risk-based
capital requirements, the agencies are adopting only the advanced
approaches at this time.
The agencies received approximately 90 public comments on the
proposed rule from banking organizations, trade associations
representing the banking or financial services industry, supervisory
authorities, and other interested parties. This section of the preamble
highlights several fundamental issues that commenters raised about the
agencies' proposal and briefly describes how the agencies have
responded to those issues in the final rule. More detail is provided in
the preamble sections below. Overall, commenters supported the
development of the framework and the move to more risk-sensitive
capital requirements. One overarching issue, however, was the areas
where the proposal differed from the New Accord. Commenters said the
divergences generally created competitive problems, raised home-host
issues, entailed extra cost and regulatory burden, and did not
necessarily improve the overall safety and soundness of banks subject
to the rule.
Commenters also generally disagreed with the agencies' proposal to
adopt only the advanced approaches from the New Accord. Further,
commenters objected to the agencies' retention of the leverage ratio,
the transitional arrangements in the proposal, and the 10 percent
numerical benchmark for identifying material aggregate reductions in
risk-based capital requirements to be used for evaluating and
responding to capital outcomes during the parallel run and transitional
floor periods (discussed below). Commenters also noted numerous
technical issues with the proposed rule.
As noted in an interagency press release issued July 20, 2007
(Banking Agencies Reach Agreement on Basel II Implementation), the
agencies have agreed to eliminate the language from
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the preamble concerning a 10 percent limitation on aggregate reductions
in risk-based capital requirements. The press release also stated that
the agencies are retaining intact the transitional floor periods (see
preamble sections I.E. and III.A.2.). In addition, while not
specifically mentioned in the press release, the agencies are retaining
the leverage ratio and the prompt corrective action (PCA) regulations
without modification.
The final rule adopts without change the proposed criteria for
identifying core banks (banks required to apply the advanced
approaches) and continues to permit other banks (opt-in banks) to adopt
the advanced approaches if they meet the applicable qualification
requirements. Core banks are those with consolidated total assets
(excluding assets held by an insurance underwriting subsidiary of a
bank holding company) of $250 billion or more or with consolidated
total on-balance-sheet foreign exposure of $10 billion or more. A
depository institution (DI) also is a core bank if it is a subsidiary
of another DI or bank holding company that uses the advanced
approaches. The final rule also provides that a bank's primary Federal
supervisor may determine that application of the final rule is not
appropriate in light of the bank's asset size, level of complexity,
risk profile, or scope of operations (see preamble sections II.A. and
B.).
As noted above, the final rule includes only the advanced
approaches. The July 2007 interagency press release stated that the
agencies have agreed to issue a proposed rule that would provide non-
core banks with the option to adopt an approach consistent with the
standardized approach included in the New Accord. This new proposal
(the standardized proposal) will replace the earlier proposal to adopt
the so-called Basel IA option (Basel 1A proposal).\5\ The press release
also noted the agencies' intention to finalize the standardized
proposal before core banks begin the first transitional floor period
under this final rule.
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\5\ 71 FR 77445 (Dec. 26, 2006).
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In response to commenters' concerns that some aspects of the
proposed rule would result in excessive regulatory burden without
commensurate safety and soundness enhancements, the agencies included a
principle of conservatism in the final rule. In general, under this
principle, in limited situations, a bank may choose not to apply a
provision of the rule to one or more exposures if the bank can
demonstrate on an ongoing basis to the satisfaction of its primary
Federal supervisor that not applying the provision would, in all
circumstances, unambiguously generate a risk-based capital requirement
for each such exposure that is greater than that which would otherwise
be required under the regulation, and the bank meets other specified
requirements (see preamble section II.D.).
In the proposal, the agencies modified the definition of default
for wholesale exposures from that in the New Accord to address issues
commenters had raised on the ANPR. Commenters objected to the agencies'
modified definition of default for wholesale exposures, however,
asserting that a definition different from the New Accord would result
in competitive inequities and significant implementation burden without
associated supervisory benefit. In response to these concerns, the
agencies have adopted a definition of default for wholesale exposures
that is consistent with the New Accord (see preamble section III.B.2.).
For retail exposures, the final rule retains the proposed definition of
default and clarifies that, subject to certain considerations, a
foreign subsidiary of a U.S. bank may, in its consolidated risk-based
capital calculations, use the applicable host jurisdiction definition
of default for retail exposures of the foreign subsidiary in that
jurisdiction (see preamble section III.B.2.).
Another concept introduced in the proposal that was not in the New
Accord was the expected loss given default (ELGD) risk parameter. ELGD
had four functions in the proposed rule--as a component of the
calculation of expected credit loss (ECL) in the numerator of the risk-
based capital ratios; in the expected loss (EL) component of the IRB
risk-based capital formulas; as a floor on the value of the loss given
default (LGD) risk parameter; and as an input into a supervisory
mapping function. Many commenters objected to the inclusion of ELGD as
a departure from the New Accord that would create regulatory burden and
competitive inequity. Many commenters also objected to the supervisory
mapping function, which the agencies intended as an alternative for
banks that were not able to estimate reliably the LGD risk parameter.
The agencies have eliminated ELGD from the final rule. Banks are
required to estimate only the LGD risk parameter, which reflects
economic downturn conditions (see preamble section III.B.3.). The
supervisory mapping function also has been eliminated from the rule.
Commenters also objected to the agencies' decision not to include a
distinct risk weight function for exposures to small- and medium-size
enterprises (SMEs) as provided in the New Accord. In the proposal, the
agencies noted they were not aware of compelling evidence that smaller
firms with the same probability of default (PD) and LGD as larger firms
are subject to less systemic risk than is already reflected in the
wholesale risk-based capital functions. The agencies continue to
believe an SME-specific risk weight function is not supported by
sufficient evidence and might give rise to competitive inequities
across U.S. banks, and have not adopted such a function in the final
rule (see preamble section V.A.1.)
With regard to the proposed treatment for securitization exposures,
commenters raised a number of technical issues. Many objected to the
proposed definition of a securitization exposure, which included
exposures to investment funds with material liabilities (including
exposures to hedge funds). The agencies agree with commenters that the
proposed definition for securitization exposures was quite broad and
captured some exposures that would more appropriately be treated under
the wholesale or equity frameworks. To limit the scope of the IRB
securitization framework, the agencies have modified the definition of
traditional securitization in the final rule as described in preamble
section V.A.3. Technical issues related to securitization exposures are
discussed in preamble sections V.A.3. and V.E.
For equity exposures, commenters focused on the proposal's lack of
a grandfathering period. The New Accord provides national discretion
for each implementing jurisdiction to adopt a grandfather period for
equity exposures. Commenters asserted that this omission would result
in competitive inequity for U.S. banks as compared to other
internationally active institutions. The agencies believe that,
overall, the proposal's approach to equity exposures results in a
competitive risk-based capital requirement. The final rule does not
include a grandfathering provision, and the agencies have adopted the
proposed treatment for equity exposures without significant change (see
preamble section V.F.).
A number of commenters raised issues related to operational risk.
Most significantly, commenters noted that activities besides securities
processing and credit card fraud have highly predictable and reasonably
stable losses and should be considered for operational risk offsets.
The agencies believe that the proposed definition of
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eligible operational risk offsets allows for the consideration of other
activities in a flexible and prudent manner and, thus, are retaining
the proposed definition in the final rule. Commenters also noted that
the proposal appeared to place limits on the use of operational risk
mitigants. The agencies have provided flexibility in this regard and
under the final rule will take into consideration whether a particular
operational risk mitigant covers potential operational losses in a
manner equivalent to holding regulatory capital (see preamble sections
III.B.5. and V.I.).
Many commenters expressed concern that the proposed public
disclosures were excessive and would hinder, rather than facilitate,
market discipline by requiring banks to disclose information that would
not be well understood by or useful to the market. Commenters also
expressed concern about possible disclosure of proprietary information.
The agencies believe that it is important to retain the vast majority
of the proposed disclosures, which are consistent with the New Accord.
These disclosures will enable market participants to gain key insights
regarding a bank's capital structure, risk exposures, risk assessment
processes, and, ultimately, capital adequacy. The agencies have
modified the final rule to provide flexibility regarding proprietary
information.
B. Conceptual Overview
This final rule is intended to produce risk-based capital
requirements that are more risk-sensitive than those produced under the
agencies' existing risk-based capital rules (general risk-based capital
rules). In particular, the IRB approach requires banks to assign risk
parameters to wholesale exposures and retail segments and provides
specific risk-based capital formulas that must be used to transform
these risk parameters into risk-based capital requirements.
The framework is based on ``value-at-risk'' (VaR) modeling
techniques that measure credit risk and operational risk. Because bank
risk measurement practices are both continually evolving and subject to
uncertainty, the framework should be viewed as an effort to improve the
risk sensitivity of the risk-based capital requirements for banks,
rather than as an effort to produce a statistically precise measurement
of risk.
The framework's conceptual foundation is based on the view that
risk can be quantified through the estimation of specific
characteristics of the probability distribution of potential losses
over a given time horizon. This approach assumes that a suitable
estimate of that probability distribution, or at least of the specific
characteristics to be measured, can be produced. Figure 1 illustrates
some of the key concepts associated with the framework. The figure
shows a probability distribution of potential losses associated with
some time horizon (for example, one year). It could reflect, for
example, credit losses, operational losses, or other types of losses.
[GRAPHIC] [TIFF OMITTED] TR07DE07.000
The area under the curve to the right of a particular loss amount
is the probability of experiencing losses exceeding this amount within
a given time horizon. The figure also shows the statistical mean of the
loss distribution, which is equivalent to the amount of loss that is
``expected'' over the time horizon. The concept of ``expected loss''
(EL) is distinguished from that of ``unexpected loss'' (UL), which
represents potential losses over and above the EL amount. A given level
of UL can be defined by reference to a particular percentile threshold
of the probability distribution. For example, in the figure UL is
measured at the 99.9th percentile level and thus is equal to the value
of the loss distribution corresponding to the 99.9th percentile, less
the amount of EL. This is shown graphically at the bottom of the
figure.
The particular percentile level chosen for the measurement of UL is
referred to as the ``confidence level'' or the ``soundness standard''
associated with the measurement. If capital is available to cover
losses up to and including this percentile level, then the bank should
remain solvent in the face of actual losses of that magnitude.
Typically, the choice of confidence level or soundness standard
reflects a very high percentile level, so that there is a very low
estimated probability that actual losses would exceed the UL amount
associated with that confidence level or soundness standard.
Assessing risk and assigning regulatory capital requirements by
reference to a specific percentile of a probability distribution of
potential losses is commonly referred to as a VaR approach. Such an
approach was adopted by the FDIC, Board, and OCC for assessing a bank's
risk-based capital requirements for market risk in 1996 (market risk
rule). Under the market risk
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rule, a bank's own internal models are used to estimate the 99th
percentile of the bank's market risk loss distribution over a ten-
business-day horizon. The bank's market risk capital requirement is
based on this VaR estimate, generally multiplied by a factor of three.
The agencies implemented this multiplication factor to provide a
prudential buffer for market volatility and modeling uncertainty.
1. The IRB Approach for Credit Risk
The conceptual foundation of this final rule's approach to credit
risk capital requirements is similar to the market risk rule's approach
to market risk capital requirements, in the sense that each is VaR-
oriented. Nevertheless, there are important differences between the IRB
approach and the market risk rule. The current market risk rule
specifies a nominal confidence level of 99.0 percent and a ten-
business-day horizon, but otherwise provides banks with substantial
modeling flexibility in determining their market risk loss distribution
and capital requirements. In contrast, the IRB approach for assessing
credit risk capital requirements is based on a 99.9 percent nominal
confidence level, a one-year horizon, and a supervisory model of credit
losses embodying particular assumptions about the underlying drivers of
portfolio credit risk, including loss correlations among different
asset types.\6\
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\6\ The theoretical underpinnings for the supervisory model of
credit risk underlying the IRB approach are provided in a paper by
Michael Gordy, ``A Risk-Factor Model Foundation for Ratings-Based
Bank Capital Rules,'' Journal of Financial Intermediation, July
2003. The IRB formulas are derived as an application of these
results to a single-factor CreditMetricsTM-style model.
For mathematical details on this model, see Michael Gordy, ``A
Comparative Anatomy of Credit Risk Models,'' Journal of Banking and
Finance, January 2000, or H.U. Koyluogu and A. Hickman,
``Reconcilable Differences,'' Risk, October 1998. For a less
technical overview of the IRB formulas, see the BCBS's ``An
Explanatory Note on the Basel II Risk Weight Functions,'' July 2005
(BCBS Explanatory Note). The document can be found on the Bank for
International Settlements Web site at http://www.bis.org.
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The IRB approach is broadly similar to the credit VaR approaches
used by a number of banks as the basis for their internal assessment of
the economic capital necessary to cover credit risk. It is common for a
bank's internal credit risk models to consider a one-year loss horizon
and to focus on a high loss threshold confidence level. As with the
internal credit VaR models used by banks, the output of the risk-based
capital formulas in the IRB approach is an estimate of the amount of
credit losses above ECL over a one-year horizon that would only be
exceeded a small percentage of the time. The agencies believe that a
one-year horizon is appropriate because it balances the difficulty of
easily or rapidly exiting non-trading positions against the possibility
that in many cases a bank can cover credit losses by raising additional
capital should the underlying credit problems manifest themselves
gradually. The nominal confidence level of the IRB risk-based capital
formulas (99.9 percent) means that if all the assumptions in the IRB
supervisory model for credit risk were correct for a bank, there would
be less than a 0.1 percent probability that credit losses at the bank
in any year would exceed the IRB risk-based capital requirement.\7\
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\7\ Banks' internal economic capital models typically focus on
measures of equity capital, whereas the total regulatory capital
measure underlying this rule includes not only equity capital, but
also certain debt and hybrid instruments, such as subordinated debt.
Thus, the 99.9 percent nominal confidence level embodied in the IRB
approach is not directly compatable to the nominal solvency
standards underpinning banks' economic capital models.
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As noted above, the supervisory model of credit risk underlying the
IRB approach embodies specific assumptions about the economic drivers
of portfolio credit risk at banks. As with any modeling approach, these
assumptions represent simplifications of very complex real-world
phenomena and, at best, are only an approximation of the actual credit
risks at any bank. If these assumptions (described in greater detail
below) are incorrect or otherwise do not characterize a given bank
precisely, the actual confidence level implied by the IRB risk-based
capital formulas may exceed or fall short of a true 99.9 percent
confidence level.
In combination with other supervisory assumptions and parameters
underlying the IRB approach, the approach's 99.9 percent nominal
confidence level reflects a judgmental pooling of available
information, including supervisory experience. The framework underlying
this final rule reflects a desire on the part of the agencies to
achieve (i) risk-based capital requirements that are reflective of
relative risk across different assets and that are broadly consistent
with maintaining at least an investment-grade rating (for example, at
least BBB) on the liabilities funding those assets, even in periods of
economic adversity; and (ii) for the U.S. banking system as a whole,
aggregate minimum regulatory capital requirements that are not a
material reduction from the aggregate minimum regulatory capital
requirements under the general risk-based capital rules.
A number of important explicit general assumptions and specific
parameters are built into the IRB approach to make the framework
applicable to a range of banks and to obtain tractable information for
calculating risk-based capital requirements. Chief among the
assumptions embodied in the IRB approach are: (i) Assumptions that a
bank's credit portfolio is infinitely granular; (ii) assumptions that
loan defaults at a bank are driven by a single, systematic risk factor;
(iii) assumptions that systematic and non-systematic risk factors are
log-normal random variables; and (iv) assumptions regarding
correlations among credit losses on various types of assets.
The specific risk-based capital formulas in this final rule require
the bank to estimate certain risk parameters for its wholesale and
retail exposures, which the bank may do using a variety of techniques.
These risk parameters are PD, LGD, exposure at default (EAD), and, for
wholesale exposures, effective remaining maturity (M). The proposed
rule included an additional risk parameter, ELGD. As discussed in
section III.B.3. of the preamble, the agencies have eliminated the ELGD
risk parameter from the final rule. The risk-based capital formulas
into which the estimated risk parameters are inserted are simpler than
the economic capital methodologies typically employed by banks, which
often require complex computer simulations. In particular, an important
property of the IRB risk-based capital formulas is portfolio
invariance. That is, the risk-based capital requirement for a
particular exposure generally does not depend on the other exposures
held by the bank. Like the general risk-based capital rules, the total
credit risk capital requirement for a bank's wholesale and retail
exposures is the sum of the credit risk capital requirements on
individual wholesale exposures and segments of retail exposures.
The IRB risk-based capital formulas contain supervisory asset value
correlation (AVC) factors, which have a significant impact on the
capital requirements generated by the formulas. The AVC assigned to a
given portfolio of exposures is an estimate of the degree to which any
unanticipated changes in the financial conditions of the underlying
obligors of the exposures are correlated (that is, would likely move up
and down together). High correlation of exposures in a period of
economic downturn conditions is an area of supervisory concern. For a
portfolio of exposures having the same risk parameters, a larger AVC
implies less
[[Page 69293]]
diversification within the portfolio, greater overall systematic risk,
and, hence, a higher risk-based capital requirement.\8\ For example, a
15 percent AVC for a portfolio of residential mortgage exposures would
result in a lower risk-based capital requirement than a 20 percent AVC
and a higher risk-based capital requirement than a 10 percent AVC.
---------------------------------------------------------------------------
\8\ See BCBS Explanatory Note.
---------------------------------------------------------------------------
The AVCs that appear in the IRB risk-based capital formulas for
wholesale exposures decline with increasing PD; that is, the IRB risk-
based capital formulas generally imply that a group of low-PD wholesale
exposures are more correlated than a group of high-PD wholesale
exposures. Thus, under the rule, a low-PD wholesale exposure would have
a higher relative risk-based capital requirement than that implied by
its PD were the AVC in the IRB risk-based capital formulas for
wholesale exposures fixed rather than a decreasing function of PD. The
AVCs included in the IRB risk-based capital formulas for both wholesale
and retail exposures reflect a combination of supervisory judgment and
empirical evidence.\9\ However, the historical data available for
estimating correlations among retail exposures, particularly for non-
mortgage retail exposures, was more limited than was the case with
wholesale exposures. As a result, supervisory judgment played a greater
role. Moreover, the flat 15 percent AVC for residential mortgage
exposures is based largely on supervisory experience with and analysis
of traditional long-term, fixed-rate mortgages.
---------------------------------------------------------------------------
\9\ See BCBS Explanatory Note, section 5.3.
---------------------------------------------------------------------------
Several commenters stated that the proposed AVCs for wholesale
exposures were too high in general, and a few claimed that, in
particular, the AVCs for multi-family residential real estate exposures
should be lower. Other commenters suggested that the AVCs of wholesale
exposures should be a function of obligor size rather than PD.
Similarly, several commenters maintained that the proposed AVCs for
retail exposures were too high. Some of these commenters suggested that
the AVCs for qualifying revolving exposures (QREs), such as credit
cards, should be in the range of 1 to 2 percent, not 4 percent as
proposed. Similarly, some of those commenters opposed the proposed flat
15 percent AVC for residential mortgage exposures; one commenter
suggested that the agencies should consider employing lower AVCs for
home equity loans and lines of credit (HELOCs) to take into account
their shorter maturity relative to traditional mortgage exposures.
However, most commenters recognized that the proposed AVCs were
consistent with those in the New Accord and recommended that the
agencies use the AVCs contained in the New Accord to avoid
international competitive inequity and unnecessary burden. Several
commenters suggested that the agencies should reconsider the AVCs going
forward, working with the BCBS.
The agencies agree with the prevailing view of the commenters that
using the AVCs in the New Accord alleviates a potential source of
international inconsistency and implementation burden. The final rule
therefore maintains the proposed AVCs. As the agencies gain more
experience with the advanced approaches, they may revisit the AVCs for
wholesale exposures and retail exposures, along with other calibration
issues identified during the parallel run and transitional floor
periods (as described below) and make changes to the rule as necessary.
The agencies would address this issue working with the BCBS and other
supervisory and regulatory authorities, as appropriate.
Another important conceptual element of the IRB approach concerns
the treatment of ECL. The IRB approach assumes that reserves should
cover ECL while capital should cover credit losses exceeding ECL (that
is, unexpected credit losses). Accordingly, the final rule, consistent
with the proposal and the New Accord, removes ECL from the risk-
weighted assets calculation but requires a bank to compare its ECL to
its eligible credit reserves (as defined below). If a bank's ECL
exceeds its eligible credit reserves, the bank must deduct the excess
ECL amount 50 percent from tier 1 capital and 50 percent from tier 2
capital. If a bank's eligible credit reserves exceed its ECL, the bank
may include the excess eligible credit reserves amount in tier 2
capital, up to 0.6 percent of the bank's credit risk-weighted
assets.\10\ This treatment is intended to maintain a capital incentive
to reserve prudently and ensure that ECL over a one-year horizon is
covered either by reserves or capital. This treatment also recognizes
that prudent reserving that considers probable losses over the life of
a loan may result in a bank holding reserves in excess of ECL measured
with a one-year horizon. The BCBS calibrated the 0.6 percent limit on
inclusion of excess reserves in tier 2 capital to be approximately as
restrictive as the existing cap on the inclusion of allowance for loan
and lease losses (ALLL) under the 1988 Accord, based on data obtained
in the BCBS's Third Quantitative Impact Study (QIS-3).\11\
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\10\ In contrast, under the general risk-based capital rules,
the allowance for loan and lease losses (ALLL) may be included in
tier 2 capital up to 1.25 percent of total risk-weighted assets.
\11\ BCBS, ``QIS 3: Third Quantitative Impact Study,'' May 2003.
---------------------------------------------------------------------------
In developing the New Accord, the BCBS sought broadly to maintain
the current overall level of minimum risk-based capital requirements
within the banking system. Using data from QIS-3, the BCBS conducted an
analysis of the risk-based capital requirements that would be generated
under the New Accord. Based on this analysis, the BCBS concluded that a
``scaling factor'' (multiplier) should apply to credit risk-weighted
assets. The BCBS, in the New Accord, indicated that the best estimate
of the scaling factor was 1.06. In May 2006, the BCBS decided to
maintain the 1.06 scaling factor based on the results of a fourth
quantitative impact study (QIS-4) conducted in some jurisdictions,
including the United States, and a fifth quantitative impact study
(QIS-5), not conducted in the United States.\12\ The BCBS noted that
national supervisory authorities will continue to monitor capital
requirements during implementation of the New Accord, and that the
BCBS, in turn, will monitor national experiences with the framework.
---------------------------------------------------------------------------
\12\ BCBS press release, ``Basel Committee maintains calibration
of Base II Framework,'' May 24, 2006.
---------------------------------------------------------------------------
The agencies generally agree with the BCBS regarding calibration of
the New Accord. Therefore, consistent with the New Accord and the
proposed rule, the final rule contains a scaling factor of 1.06 for
credit-risk-weighted assets. As the agencies gain more experience with
the advanced approaches, the agencies will revisit the scaling factor
along with other calibration issues identified during the parallel run
and transitional floor periods (described below) and will make changes
to the rule as necessary, working with the BCBS and other supervisory
and regulatory authorities, as appropriate.
2. The AMA for Operational Risk
The final rule also includes the AMA for determining risk-based
capital requirements for operational risk. Under the final rule
(consistent with the proposed rule), operational risk is defined as the
risk of loss resulting from inadequate or failed internal processes,
people, and systems or from external events. This definition of
operational risk includes legal risk--which is the risk of loss
(including litigation costs,
[[Page 69294]]
settlements, and regulatory fines) resulting from the failure of the
bank to comply with laws, regulations, prudent ethical standards, and
contractual obligations in any aspect of the bank's business--but
excludes strategic and reputational risks.
Under the AMA, a bank must use its internal operational risk
management systems and processes to assess its exposure to operational
risk. Given the complexities involved in measuring operational risk,
the AMA provides banks with substantial flexibility and, therefore,
does not require a bank to use specific methodologies or distributional
assumptions. Nevertheless, a bank using the AMA must demonstrate to the
satisfaction of its primary Federal supervisor that its systems for
managing and measuring operational risk meet established standards,
including producing an estimate of operational risk exposure that meets
a one-year, 99.9th percentile soundness standard. A bank's estimate of
operational risk exposure includes both expected operational loss (EOL)
and unexpected operational loss (UOL) and forms the basis of the bank's
risk-based capital requirement for operational risk.
The AMA allows a bank to base its risk-based capital requirement
for operational risk on UOL alone if the bank can demonstrate to the
satisfaction of its primary Federal supervisor that the bank has
eligible operational risk offsets, such as certain operational risk
reserves, that equal or exceed the bank's EOL. To the extent that
eligible operational risk offsets are less than EOL, the bank's risk-
based capital requirement for operational risk must incorporate the
shortfall.
C. Overview of Final Rule
The final rule maintains the general risk-based capital rules'
minimum tier 1 risk-based capital ratio of 4.0 percent and total risk-
based capital ratio of 8.0 percent. The components of tier 1 and total
capital in the final rule are also the same as in the general risk-
based capital rules, with a few adjustments described in more detail
below. The primary difference between the general risk-based capital
rules and the final rule is the methodologies used for calculating
risk-weighted assets. Banks applying the final rule generally must use
their internal risk measurement systems to calculate the inputs for
determining the risk-weighted asset amounts for (i) general credit risk
(including wholesale and retail exposures); (ii) securitization
exposures; (iii) equity exposures; and (iv) operational risk. In
certain cases, however, banks must use external ratings or supervisory
risk weights to determine risk-weighted asset amounts. Each of these
areas is discussed below.
Banks using the final rule also are subject to supervisory review
of their capital adequacy (Pillar 2) and certain public disclosure
requirements to foster transparency and market discipline (Pillar 3).
In addition, each bank using the advanced approaches remains subject to
the tier 1 leverage ratio requirement,\13\ and each DI (as defined in
section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813)) using
the advanced approaches remains subject to the prompt corrective action
(PCA) thresholds.\14\ Banks using the advanced approaches also remain
subject to the market risk rule, where applicable.
---------------------------------------------------------------------------
\13\ See 12 CFR part 3.6(b) and (c) (national banks); 12 CFR
part 208, appendix B (state member banks); 12 CFR part 225, appendix
D (bank holding companies); 12 CFR 325.3 (state nonmember banks); 12
CFR 567.2(a)(2) and 567.8 (savings associations).
\14\ See 12 CFR part 6 (national banks); 12 CFR part 208,
subpart D (state member banks); 12 CFR 325.103 (state nonmember
banks); 12 CFR part 565 (savings associations). In addition, savings
associations remain subject to the tangible capital requirement at
12 CFR 567.2(a)(3) and 567.9.
---------------------------------------------------------------------------
Under the final rule, a bank must identify whether each of its on-
and off-balance sheet exposures is a wholesale, retail, securitization,
or equity exposure. Assets that are not defined by any exposure
category (and certain immaterial portfolios of exposures) generally are
assigned risk-weighted asset amounts equal to their carrying value (for
on-balance sheet exposures) or notional amount (for off-balance sheet
exposures).
Wholesale exposures under the final rule include most credit
exposures to companies, sovereigns, and other governmental entities.
For each wholesale exposure, a bank must assign four quantitative risk
parameters: PD (which is expressed as a decimal (that is, 0.01
corresponds to 1 percent) and is an estimate of the probability that an
obligor will default over a one-year horizon); LGD (which is expressed
as a decimal and reflects an estimate of the economic loss rate if a
default occurs during economic downturn conditions); EAD (which is
measured in dollars and is an estimate of the amount that would be owed
to the bank at the time of default); and M (which is measured in years
and reflects the effective remaining maturity of the exposure). Banks
may factor into their risk parameter estimates the risk mitigating
impact of collateral, credit derivatives, and guarantees that meet
certain criteria. Banks must input the risk parameters for each
wholesale exposure into an IRB risk-based capital formula to determine
the risk-based capital requirement for the exposure.
Retail exposures under the final rule include most credit exposures
to individuals and small credit exposures to businesses that are
managed as part of a segment of exposures with similar risk
characteristics and not managed on an individual-exposure basis. A bank
must classify each of its retail exposures into one of three retail
subcategories--residential mortgage exposures; QREs, such as credit
cards and overdraft lines; and other retail exposures. Within these
three subcategories, the bank must group exposures into segments with
similar risk characteristics. The bank must then assign the risk
parameters PD, LGD, and EAD to each retail segment. The bank may take
into account the risk mitigating impact of collateral and guarantees in
the segmentation process and in the assignment of risk parameters to
retail segments. Like wholesale exposures, the risk parameters for each
retail segment are used as inputs into an IRB risk-based capital
formula to determine the risk-based capital requirement for the
segment.
For securitization exposures, the bank must apply one of three
general approaches, subject to various conditions and qualifying
criteria: the Ratings-Based Approach (RBA), which uses external ratings
to risk-weight exposures; the Internal Assessment Approach (IAA), which
uses internal ratings to risk-weight exposures to asset-backed
commercial paper programs (ABCP programs); or the Supervisory Formula
Approach (SFA), which uses bank inputs that are entered into a
supervisory formula to risk-weight exposures. Securitization exposures
in the form of gain-on-sale or credit-enhancing interest-only strips
(CEIOs)\15\ and securitization exposures that do not qualify for the
RBA, the IAA, or the SFA must be deducted from regulatory capital.
---------------------------------------------------------------------------
\15\ A CEIO is an on-balance sheet asset that, in form or in
substance, (i) represents the contractual right to receive some or
all of the interest and no more than a minimal amount of principal
due on the underlying exposures of a securitization and (ii) exposes
the holder to credit risk directly or indirectly associated with the
underlying exposures that exceeds its pro rata claim on the
underlying exposures, whether through subordination provisions or
other credit-enhancement techniques.
---------------------------------------------------------------------------
Banks may use an internal models approach (IMA) for determining
risk-based capital requirements for equity exposures, subject to
certain qualifying criteria and floors. If a bank does not have a
qualifying internal model for equity exposures, or chooses not to use
such a model, the bank must apply a simple risk weight approach (SRWA)
in which publicly traded equity exposures
[[Page 69295]]
generally are assigned a 300 percent risk weight and non-publicly
traded equity exposures generally are assigned a 400 percent risk
weight. Under both the IMA and the SRWA, equity exposures to certain
entities or made pursuant to certain statutory authorities (such as
community development laws) are subject to a 0 to 100 percent risk
weight.
Banks must develop qualifying AMA systems to determine risk-based
capital requirements for operational risk. Under the AMA, a bank must
use its own methodology to identify operational loss events, measure
its exposure to operational risk, and assess a risk-based capital
requirement for operational risk.
Under the final rule, a bank must calculate its tier 1 and total
risk-based capital ratios by dividing tier 1 capital by total risk-
weighted assets and by dividing total qualifying capital by total risk-
weighted assets, respectively. To calculate total risk-weighted assets,
a bank must first convert the dollar risk-based capital requirements
for exposures produced by the IRB risk-based capital approaches and the
AMA into risk-weighted asset amounts by multiplying the capital
requirements by 12.5 (the inverse of the overall 8.0 percent risk-based
capital requirement). After determining the risk-weighted asset amounts
for credit risk and operational risk, a bank must sum these amounts and
then subtract any excess eligible credit reserves not included in tier
2 capital to determine total risk-weighted assets.
The final rule contains specific public disclosure requirements to
provide important information to market participants on the capital
structure, risk exposures, risk assessment processes, and, hence, the
capital adequacy of a bank. The public disclosure requirements apply
only to the DI or bank holding company representing the top
consolidated level of the banking group that is subject to the advanced
approaches, unless the entity is a subsidiary of a non-U.S. banking
organization that is subject to comparable disclosure requirements in
its home jurisdiction. All banks subject to the rule, however, must
disclose total and tier 1 risk-based capital ratios and the components
of these ratios. The agencies also proposed a package of regulatory
reporting templates for the agencies' use in assessing and monitoring
the levels and components of bank risk-based capital requirements under
the advanced approaches.\16\ These templates will be finalized shortly.
---------------------------------------------------------------------------
\16\ 71 FR 55981 (September 25, 2006).
---------------------------------------------------------------------------
The agencies are aware that the fair value option in generally
accepted accounting principles as used in the United States (GAAP)
raises potential risk-based capital issues not contemplated in the
development of the New Accord. The agencies will continue to analyze
these issues and may make changes to this rule at a future date as
necessary. The agencies would address these issues working with the
BCBS and other supervisory and regulatory authorities, as appropriate.
D. Structure of Final Rule
The agencies are implementing a regulatory framework for the
advanced approaches in which each agency has an advanced approaches
appendix that incorporates (i) definitions of tier 1 and tier 2 capital
and associated adjustments to the risk-based capital ratio numerators,
(ii) the qualification requirements for using the advanced approaches,
and (iii) the details of the advanced approaches.\17\ The agencies also
are incorporating their respective market risk rules, by cross-
reference.\18\
---------------------------------------------------------------------------
\17\ As applicable, certain agencies are also making conforming
changes to existing regulations as necessary to incorporate the new
appendices.
\18\ 12 CFR part 3, Appendix B (for national banks), 12 CFR part
208, Appendix E (for state member banks), 12 CFR part 225, Appendix
E (for bank holding companies), and 12 CFR part 325, Appendix C (for
state nonmember banks). OTS intends to codify a market risk rule for
savings associations at 12 CFR part 567, Appendix D.
---------------------------------------------------------------------------
In this final rule, as in the proposed rule, the agencies are not
restating the elements of tier 1 and tier 2 capital, which largely
remain the same as under the general risk-based capital rules.
Adjustments to the risk-based capital ratio numerators specific to
banks applying the final rule are in part II of the rule and explained
in greater detail in section IV of this preamble.
The final rule has eight parts. Part I identifies criteria for
determining which banks are subject to the rule, provides key
definitions, and sets forth the minimum risk-based capital ratios. Part
II describes the adjustments to the numerator of the regulatory capital
ratios for banks using the advanced approaches. Part III describes the
qualification process and provides qualification requirements for
obtaining supervisory approval for use of the advanced approaches. This
part incorporates critical elements of supervisory oversight of capital
adequacy (Pillar 2).
Parts IV through VII address the calculation of risk-weighted
assets. Part IV provides the risk-weighted assets calculation
methodologies for wholesale and retail exposures; on-balance sheet
assets that do not meet the regulatory definition of a wholesale,
retail, securitization, or equity exposure; and certain immaterial
portfolios of credit exposures. This part also describes the risk-based
capital treatment for over-the-counter (OTC) derivative contracts,
repo-style transactions, and eligible margin loans. In addition, this
part describes the methodologies for reflecting credit risk mitigation
in risk-weighted assets for wholesale and retail exposures.
Furthermore, this part sets forth the risk-based capital requirements
for failed and unsettled securities, commodities, and foreign exchange
transactions.
Part V identifies operating criteria for recognizing risk
transference in the securitization context and outlines the approaches
for calculating risk-weighted assets for securitization exposures. Part
VI describes the approaches for calculating risk-weighted assets for
equity exposures. Part VII describes the calculation of risk-weighted
assets for operational risk. Finally, Part VIII provides public
disclosure requirements for banks employing the advanced approaches
(Pillar 3).
The structure of the preamble generally follows the structure of
the regulatory text. Definitions, however, are discussed in the
portions of the preamble where they are most relevant.
E. Overall Capital Objectives
The preamble to the proposed rule described the agencies' intention
to avoid a material reduction in overall risk-based capital
requirements under the advanced approaches. The agencies also
identified other objectives, such as ensuring that differences in
capital requirements appropriately reflect differences in risk and
ensuring that the U.S. implementation of the New Accord will not be a
significant source of competitive inequity among internationally active
banks or among domestic banks operating under different risk-based
capital rules. The final rule modifies and clarifies the approach the
agencies will use to achieve these objectives.
The agencies proposed a series of transitional floors to provide a
smooth transition to the advanced approaches and to temporarily limit
the amount by which a bank's risk-based capital requirements could
decline over a period of at least three years. The transitional floors
are described in more detail in section III.A.2. of this preamble. The
floors generally prohibit a bank's risk-based capital requirement under
the advanced approaches from falling below 95 percent, 90 percent, and
85 percent of what it would be under the general risk-based capital
[[Page 69296]]
rules during the bank's first, second, and third transitional floor
periods, respectively. The proposal stated that banks would be required
to receive the approval of their primary Federal supervisor before
entering each transitional floor period.
The preamble to the proposal noted that if there was a material
reduction in aggregate minimum regulatory capital upon implementation
of the advanced approaches, the agencies would propose regulatory
changes or adjustments during the transitional floor periods. The
preamble further noted that in this context, materiality would depend
on a number of factors, including the size, source, and nature of any
reduction; the risk profiles of banks authorized to use the advanced
approaches; and other considerations relevant to the maintenance of a
safe and sound banking system. The agencies also stated that they would
view a 10 percent or greater decline in aggregate minimum required
risk-based capital (without reference to the effects of the
transitional floors), compared to minimum required risk-based capital
as determined under the general risk-based capital rules, as a material
reduction warranting modification to the supervisory risk functions or
other aspects of the framework.
Further, the agencies stated that they were ``identifying a
numerical benchmark for evaluating and responding to capital outcomes
during the parallel run and transitional floor periods that do not
comport with the overall capital objectives.'' The agencies also stated
that ``[a]t the end of the transitional floor periods, the agencies
would reevaluate the consistency of the framework, as (possibly)
revised during the transitional floor periods, with the capital goals
outlined in the ANPR and with the maintenance of broad competitive
parity between banks adopting the framework and other banks, and would
be prepared to make further changes to the framework if warranted.''
The agencies viewed the parallel run and transitional floor periods as
``a trial of the new framework under controlled conditions.'' \19\
---------------------------------------------------------------------------
\19\ 71 FR 55839-40 (September 25, 2006).
---------------------------------------------------------------------------
The agencies sought comment on the appropriateness of using a 10
percent or greater decline in aggregate minimum required risk-based
capital as a numerical benchmark for material reductions when
determining whether capital objectives were achieved. Many commenters
objected to the proposed transitional floors and the 10 percent
benchmark on the grounds that both safeguards deviated materially from
the New Accord and the rules implemented by foreign supervisory
authorities. In particular, commenters expressed concerns that the
aggregate 10 percent limit added a degree of uncertainty to their
capital planning process, since the limit was beyond the control of any
individual bank. They maintained that it might take only a few banks
that decided to reallocate funds toward lower-risk activities during
the transition period to impose a penalty on all U.S. banks using the
advanced approaches. Other commenters stated that the benchmark lacked
transparency and would be operationally difficult to apply.
Commenters also criticized the duration, level, and construct of
the transitional floors in the proposed rule. Commenters believed it
was inappropriate to extend the transitional floors by an additional
year (to three years), and raised concerns that the floors were more
binding than those proposed in the New Accord. Commenters strongly
urged the agencies to adopt the transition periods and floors in the
New Accord to limit any competitive inequities that could arise among
internationally active banks.
To better balance commenters' concerns and the agencies' capital
adequacy objectives, the agencies have decided not to include the 10
percent benchmark language in this preamble. This will alleviate
uncertainty and enable each bank to develop capital plans in accordance
with its individual risk profile and business model. The agencies have
taken a number of steps to address their capital adequacy objectives.
Specifically, the agencies are retaining the existing leverage ratio
and PCA requirements and are adopting the three transitional floor
periods at the proposed numerical levels.
Under the final rule, the agencies will jointly evaluate the
effectiveness of the new capital framework. The agencies will issue a
series of annual reports during the transition period that will provide
timely and relevant information on the implementation of the advanced
approaches. In addition, after the end of the second transition year,
the agencies will publish a study (interagency study) that will
evaluate the advanced approaches to determine if there are any material
deficiencies. For any primary Federal supervisor to authorize any bank
to exit the third transitional floor period, the study must determine
that there are no such material deficiencies that cannot be addressed
by then-existing tools, or, if such deficiencies are found, they must
be first remedied by changes to regulation. Notwithstanding the
preceding sentence, a primary Federal supervisor that disagrees with
the finding of material deficiency may not authorize a bank under its
jurisdiction to exit the third transitional floor period unless the
supervisor first provides a public report explaining its reasoning.
The agencies intend to establish a transparent and collaborative
process for conducting the interagency study, consistent with the
recommendations made by the U.S. Government Accountability Office (GAO)
in its report on implementation of the New Accord in the United
States.\20\ In conducting the interagency study the agencies would
consider, for example, the following:
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\20\ United States Government Accountability Office, ``Risk-
Based Capital: Bank Regulators Need to Improve Transparency and
Overcome Impediments to Finalizing the Proposed Basel II Framework''
(GAO-07-253), February 15, 2007.
---------------------------------------------------------------------------
The level of minimum required regulatory capital under
U.S. advanced approaches compared to the capital required by other
international and domestic regulatory capital standards.
Peer comparisons of minimum regulatory capital
requirements, including but not limited to banks' estimates of risk
parameters for portfolios of similar risk.
The processes banks use to develop and assess risk
parameters and advanced systems, and supervisory assessments of their
accuracy and reliability.
Potential cyclical implications.
Changes in portfolio composition or business mix,
including those that might result in changes in capital requirements
per dollar of credit exposure.
Comparison of regulatory capital requirements to market-
based measures of capital adequacy to assess relative minimum capital
requirements across banks and broad asset categories. Market-based
measures might include credit default swap spreads, subordinated debt
spreads, external rating agency ratings, and other market measures of
risk.
Examination of the quality and robustness of advanced risk
management processes related to assessment of capital adequacy, as in
the comprehensive supervisory assessments performed under Pillar 2.
Additional reviews, including analysis of interest rate
and concentration risks that might suggest the need for higher
regulatory capital requirements.
F. Competitive Considerations
A fundamental objective of the New Accord is to strengthen the
soundness
[[Page 69297]]
and stability of the international banking system while maintaining
sufficient consistency in capital adequacy regulation to ensure that
the New Accord will not be a significant source of competitive inequity
among internationally active banks. The agencies support this objective
and believe that it is important to promote continual advancement of
the risk measurement and management practices of large and
internationally active banks.
While all banks should work to enhance their risk management
practices, the advanced approaches and the systems required to support
their use may not be appropriate for many banks from a cost-benefit
point of view. For a number of banks, the agencies believe that the
general risk-based capital rules continue to provide a reasonable
alternative for regulatory risk-based capital measurement purposes.
However, the agencies recognize that a bifurcated risk-based capital
framework inevitably raises competitive considerations. The agencies
have received comments on risk-based capital proposals issued in the
past several years \21\ stating that for some portfolios, competitive
inequities would be worse under a bifurcated framework. These
commenters expressed concern that banks operating under the general
risk-based capital rules would be at a competitive disadvantage
relative to banks applying the advanced approaches because the IRB
approach would likely result in lower risk-based capital requirements
for certain types of exposures.
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\21\ See 68 FR 45900 (Aug. 4, 2003), 70 FR 61068 (Oct. 20,
2005), 71 FR 55830 (Sept. 25, 2006), and 71 FR 77446 (Dec. 26,
2006).
---------------------------------------------------------------------------
The agencies recognize the potential competitive inequities
associated with a bifurcated risk-based capital framework. As part of
their effort to develop a risk-based capital framework that minimizes
competitive inequities and is not disruptive to the banking sector, the
agencies issued the Basel IA proposal in December 2006. The Basel IA
proposal included modifications to the general risk-based capital rules
to improve risk sensitivity and to reduce potential competitive
disparities between domestic banks subject to the advanced approaches
and domestic banks not subject to the advanced approaches. Recognizing
that some banks might prefer not to incur the additional regulatory
burden of moving to modified capital rules, the Basel IA proposal
retained the existing general risk-based capital rules and permitted
banks to opt in to the modified rules. The agencies extended the
comment period for the advanced approaches proposal to coincide with
the comment period on the Basel IA proposal so that commenters would
have an opportunity to analyze the effects of the two proposals
concurrently.\22\
---------------------------------------------------------------------------
\22\ See 71 FR 77518 (Dec. 26, 2006).
---------------------------------------------------------------------------
Seeking to minimize potential competitive inequities and regulatory
burden, a number of commenters on both the advanced approaches proposal
and the Basel IA proposal urged the agencies to adopt all of the
approaches included in the New Accord--including the foundation IRB and
standardized approaches for credit risk and the standardized and basic
indicator approaches for operational risk. In response to these
comments, the agencies have decided to issue a new standardized
proposal, which would replace the Basel IA proposal for banks that do
not apply the advanced approaches. The standardized proposal would
allow banks that are not core banks to implement a standardized
approach for credit risk and an approach to operational risk consistent
with the New Accord. Like the Basel IA proposal, the standardized
proposal will retain the existing general risk-based capital rules for
those banks that do not wish to move to the new rules. The agencies
expect to issue the standardized proposal in the first quarter of 2008.
A number of commenters expressed concern about competitive
inequities among internationally active banks arising from differences
in implementation and application of the New Accord by supervisory
authorities in different countries. In particular, some commenters
asserted that the proposed U.S. implementation would be different from
other countries in a number of key areas, such as the definition of
default, and that these differences would give rise to substantial
implementation cost and burden. Other commenters continued to raise
concern about the delayed implementation schedule in the United States.
As discussed in more detail throughout this preamble, the agencies
have made a number of changes from the proposal to conform the final
rule more closely to the New Accord. These changes should help minimize
regulatory burden and mitigate potential competitive inequities across
national jurisdictions. In addition, the BCBS has established an Accord
Implementation Group, comprised of supervisors from member countries,
whose primary objectives are to work through implementation issues,
maintain a constructive dialogue about implementation processes, and
harmonize approaches as much as possible within the range of national
discretion embedded in the New Accord. The BCBS also has established a
Capital Interpretation Group to foster consistency in applying the New
Accord on an ongoing basis. The agencies intend to participate fully in
these groups to ensure that issues relating to international
implementation and competitive effects are addressed. While supervisory
judgment will play a critical role in the evaluation of risk
measurement and management practices at individual banks, supervisors
remain committed to and have made significant progress toward
developing protocols and information-sharing arrangements that should
minimize burdens on banks operating in multiple countries and ensure
that supervisory authorities are implementing the New Accord as
consistently as possible.
With regard to implementation timing concerns, the agencies believe
that the transitional arrangements described in preamble section
III.A.2. below provide a prudent and reasonable framework for moving to
the advanced approaches. Where international implementation differences
affect an individual bank, the agencies are working with the bank and
appropriate national supervisory authorities to ensure that
implementation proceeds as efficiently as possible.
II. Scope
The agencies have identified three groups of banks: (i) Large or
internationally active banks that are required to adopt the advanced
approaches (core banks); (ii) banks that voluntarily decide to adopt
the advanced approaches (opt-in banks); and (iii) banks that do not
adopt the advanced approaches (general banks). Each core and opt-in
bank is required to meet certain qualification requirements to the
satisfaction of its primary Federal supervisor, which in turn will
consult with other relevant supervisors, before the bank may use the
advanced approaches for risk-based capital purposes.
Pillar 1 of the New Accord requires all banks subject to the New
Accord to calculate capital requirements for exposure to credit risk
and operational risk. The New Accord sets forth three approaches to
calculating the credit risk capital requirement and three approaches to
calculating the operational risk capital requirement. Outside the
United States, countries that are replacing Basel I with the New
[[Page 69298]]
Accord generally have required all banks to comply with the New Accord,
but have provided banks the option of choosing among the New Accord's
various approaches for calculating credit risk and operational risk
capital requirements.
For banks in the United States, the agencies have taken a different
approach. This final rule focuses on the largest and most
internationally active banks and requires those banks to comply with
the most advanced approaches for calculating credit and operational
risk capital requirements (the IRB and the AMA). The final rule allows
other U.S. banks to ``opt in'' to the advanced approaches. The agencies
have decided at this time to require large, internationally active U.S.
banks to use the most advanced approaches of the New Accord. The less
advanced approaches of the New Accord lack the degree of risk
sensitivity of the advanced approaches. The agencies have the view that
risk-sensitive regulatory capital requirements are integral to ensuring
that large, sophisticated banks and the financial system have an
adequate capital cushion to absorb financial losses. Also, the advanced
approaches provide more substantial incentives for banks to improve
their risk measurement and management practices than do the other
approaches. The agencies do not believe that competitive equity
concerns are sufficiently compelling to warrant permitting large,
internationally active U.S. banks to adopt the standardized approaches
in the New Accord.
A. Core and Opt-In Banks
Under section 1(b) of the proposed rule, a DI would be a core bank
if it met either of two independent threshold criteria: (i)
Consolidated total assets of $250 billion or more, as reported on the
most recent year-end regulatory reports; or (ii) consolidated total on-
balance sheet foreign exposure of $10 billion or more at the most
recent year end. To determine total on-balance sheet foreign exposure,
a bank would sum its adjusted cross-border claims, local country
claims, and cross-border revaluation gains calculated in accordance
with the Federal Financial Institutions Examination Council (FFIEC)
Country Exposure Report (FFIEC 009). Adjusted cross-border claims would
equal total cross-border claims less claims with the head office or
guarantor located in another country, plus redistributed guaranteed
amounts to the country of head office or guarantor. The agencies also
proposed that a DI would be a core bank if it is a subsidiary of
another DI or BHC that uses the advanced approaches.
Under the proposed rule, a U.S.-chartered BHC \23\ would be a core
bank if the BHC had: (i) Consolidated total assets (excluding assets
held by an insurance underwriting subsidiary) of $250 billion or more,
as reported on the most recent year-end regulatory reports; (ii)
consolidated total on-balance sheet foreign exposure of $10 billion or
more at the most recent year-end; or (iii) a subsidiary DI that is a
core bank or opt-in bank.
---------------------------------------------------------------------------
\23\ OTS does not currently impose any explicit capital
requirements on savings and loan holding companies and is not
implementing the advanced approaches for these holding companies.
---------------------------------------------------------------------------
The agencies included a question in the proposal seeking
commenters' views on using consolidated total assets (excluding assets
held by an insurance underwriting subsidiary) as one criterion to
determine whether a BHC would be viewed as a core BHC. Some of the
commenters addressing this issue supported the proposed approach,
noting it was a reasonable proxy for mandatory applicability of a
framework designed to measure capital requirements for consolidated
risk exposures of a BHC. Other commenters, particularly foreign banking
organizations and their trade associations, contended that the BHC
asset size threshold criterion instead should be $250 billion of assets
in U.S. subsidiary DIs. These commenters further suggested that if the
Board kept the proposed $250 billion consolidated total BHC assets
criterion, it should limit the scope of this criterion to BHCs with a
majority of their assets in U.S. DI subsidiaries. The Board has decided
to retain the proposed approach using consolidated total assets
(excluding assets held by an insurance underwriting subsidiary) as one
threshold criterion for BHCs in this final rule. This approach
recognizes that BHCs can hold similar assets within and outside of DIs
and reduces potential incentives to structure BHC assets and activities
to arbitrage capital regulations. The final rule continues to exclude
assets held in an insurance underwriting subsidiary of a BHC from the
asset threshold because the advanced approaches were not designed to
address insurance underwriting exposures.
The final rule also retains the threshold criterion for core bank/
BHC status of consolidated total on-balance sheet foreign exposure of
$10 billion or more at the most recent year-end. The calculation of
this exposure amount is unchanged in the final rule.
In the preamble to the proposed rule, the agencies also included a
question on potential regulatory burden associated with requiring a
bank that applies the advanced approaches to implement the advanced
approaches at each subsidiary DI--even if those subsidiary DIs do not
individually meet a threshold criterion. A number of commenters
addressed this issue. While they expressed a range of views, most
commenters maintained that small DI subsidiaries of core banks should
not be required to implement the advanced approaches. Rather,
commenters asserted that these DIs should be permitted to use simpler
methodologies, such as the New Accord's standardized approach.
Commenters asserted there would be regulatory burden and costs
associated with the proposed push-down approach, particularly if a
stand-alone AMA is required at each DI.
The agencies have considered comments on this issue and have
decided to retain the proposed approach. Thus, under the final rule,
each DI subsidiary of a core or opt-in bank is itself a core bank
required to apply the advanced approaches. The agencies believe that
this approach serves as an important safeguard against regulatory
capital arbitrage among affiliated banks that would otherwise be
subject to substantially different capital rules. Moreover, to
calculate its consolidated IRB risk-based capital requirements, a bank
must estimate risk parameters for all credit exposures within the bank
except for exposures in portfolios that, in the aggregate, are
immaterial to the bank. Because the consolidated bank must already
estimate risk parameters for all material portfolios of wholesale and
retail exposures in all of its consolidated subsidiaries, the agencies
believe that there is limited additional regulatory burden associated
with application of the IRB approach at each subsidiary DI. Likewise,
to calculate its consolidated AMA risk-based capital requirements, a
bank must estimate its operational risk exposure using a unit of
measure (defined below) that does not combine business activities or
operational loss events with demonstrably different risk profiles
within the same loss distribution. Each subsidiary DI could have a
demonstrably different risk profile that would require the generation
of separate loss distributions.
However, the agencies recognize there may be situations where
application of the advanced approaches at an individual DI subsidiary
of an advanced approaches bank may not be appropriate. Therefore, the
final rule includes the proposed provision that
[[Page 69299]]
permits a core or opt-in bank's primary Federal supervisor to determine
in writing that application of the advanced approaches is not
appropriate for the DI in light of the bank's asset size, level of
complexity, risk profile, or scope of operations.
B. U.S. Subsidiaries of Foreign Banks
Under the proposed rule, any U.S.-chartered DI that is a subsidiary
of a foreign banking organization would be subject to the U.S.
regulatory capital requirements for domestically-owned U.S. DIs. Thus,
if the U.S. DI subsidiary of a foreign banking organization met any of
the threshold criteria, it would be a core bank and would be subject to
the advanced approaches. If it did not meet any of the criteria, the
U.S. DI could remain a general bank or could opt in to the advanced
approaches, subject to the same qualification process and requirements
as a domestically-owned U.S. DI.
The proposed rule also provided that a top-tier U.S. BHC, and its
subsidiary DIs, that was owned by a foreign banking organization would
be subject to the same threshold levels for core bank determination as
a top-tier BHC that is not owned by a foreign banking organization.\24\
The preamble noted that a U.S. BHC that met the conditions in Federal
Reserve SR letter 01-01 \25\ and that was a core bank would not be
required to meet the minimum capital ratios in the Board's capital
adequacy guidelines, although it would be required to adopt the
advanced approaches, compute and report its capital ratios in
accordance with the advanced approaches, and make the required public
and regulatory disclosures. A DI subsidiary of such a U.S. BHC also
would be a core bank and would be required to adopt the advanced
approaches and meet the minimum capital ratio requirements.
---------------------------------------------------------------------------
\24\ The Board notes that it generally does not apply regulatory
capital requirements to subsidiary BHCs of top-tier U.S. BHCs,
regardless of whether the top-tier U.S. BHC is itself a subsidiary
of a foreign banking organization.
\25\ SR 01-01, ``Application of the Board's Capital Adequacy
Guidelines to Bank Holding Companies Owned by Foreign Banking
Organizations,'' January 5, 2001.
---------------------------------------------------------------------------
Under the final rule, consistent with SR 01-01, a foreign-owned
U.S. BHC that is a core bank and that also is subject to SR 01-01 will,
as a technical matter, be required to adopt the advanced approaches,
and compute and report its capital ratios and make other required
disclosures. It will not, however, be required to maintain the minimum
capital ratios at the U.S. consolidated holding company level unless
otherwise required to do so by the Board. In response to the potential
burden issues identified by commenters and outlined above, the Board
notes that the final rule allows the Board to exempt any BHC from
mandatory application of the advanced approaches. The Board will make
such a determination in light of the BHC's asset size (including
subsidiary DI asset size relative to total BHC asset size), level of
complexity, risk profile, or scope of operation. Similarly, the final
rule allows a primary Federal supervisor to exempt any DI under its
jurisdiction from mandatory application of the advanced approaches. A
primary Federal supervisor will consider the same factors in making its
determination.
C. Reservation of Authority
The proposed rule restated the authority of a bank's primary
Federal supervisor to require a bank to hold an overall amount of
capital greater than would otherwise be required under the rule if the
agency determined that the bank's risk-based capital requirements were
not commensurate with the bank's credit, market, operational, or other
risks. In addition, the preamble of the proposed rule noted the
agencies' expectation that there may be instances when the rule would
generate a risk-weighted asset amount for specific exposures that is
not commensurate with the risks posed by such exposures. Accordingly,
under the proposed rule, the bank's primary Federal supervisor would
retain the authority to require the bank to use a different risk-
weighted asset amount for the exposures or to use different risk
parameters (for wholesale or retail exposures) or model assumptions
(for modeled equity or securitization exposures) than those required
when calculating the risk-weighted asset amount for those exposures.
Similarly, the proposed rule provided explicit authority for a bank's
primary Federal supervisor to require the bank to assign a different
risk-weighted asset amount for operational risk, to change elements of
its operational risk analytical framework (including distributional and
dependence assumptions), or to make other changes to the bank's
operational risk management processes, data and assessment systems, or
quantification systems if the supervisor found that the risk-weighted
asset amount for operational risk produced by the bank under the rule
was not commensurate with the operational risks of the bank. Any agency
that exercised a reservation of authority was expected to notify each
of the other agencies of its determination.
Several commenters raised concerns with the scope of the
reservation of authority, particularly as it would apply to operational
risk. These commenters asserted, for example, that the agencies should
address identified operational risk-related capital deficiencies
through Pillar 2, rather than through requiring a bank to adjust input
variables or techniques used for the calculation of Pillar 1
operational risk capital requirements. Commenters were concerned that
excessive agency Pillar 1 intervention on operational risk might
inhibit innovation.
While the agencies agree that innovation is important and that
general supervisory oversight likely would be sufficient in many cases
to address risk-related capital deficiencies, the agencies also believe
that it is important to retain as much supervisory flexibility as
possible as they move forward with implementation of the final rule. In
general, the proposed reservation of authority represented a
reaffirmation of the current authority of a bank's primary Federal
supervisor to require the bank to hold an overall amount of regulatory
capital or maintain capital ratios greater than would be required under
the general risk-based capital rules. There may be cases where
requiring a bank to assign a different risk-weighted asset amount for
operational risk may not sufficiently address problems associated with
underlying quantification practices and may cause an ongoing
misalignment between the operational risk of a bank and the risk-
weighted asset amount for operational risk generated by the bank's
operational risk quantification system. In view of this and the
inherent flexibility provided for operational risk measurement under
the AMA, the agencies believe it is appropriate to articulate the
specific measures a primary Federal supervisor may take if it
determines that a bank's risk-weighted asset amount for operational
risk is not commensurate with the operational risks of the bank.
Therefore, the final rule retains the reservation of authority as
proposed. The agencies emphasize that any decision to exercise this
authority would be made judiciously and that a bank bears the primary
responsibility for maintaining the integrity, reliability, and accuracy
of its risk management and measurement systems.
D. Principle of Conservatism
Several commenters asked whether it would be permissible not to
apply an aspect of the rule for cost or regulatory burden reasons, if
the result would be
[[Page 69300]]
a more conservative capital requirement. For example, for purposes of
the RBA for securitization exposures, some commenters asked whether a
bank could choose not to track the seniority of a securitization
exposure and, instead, assume that the exposure is not a senior
securitization exposure. Similarly, some commenters asked if risk-based
capital requirements for certain exposures could be calculated ignoring
the benefits of risk mitigants such as collateral or guarantees.
The agencies believe that in some cases it may be reasonable to
allow a bank to implement a simplified capital calculation if the
result is more conservative than would result from a comprehensive
application of the rule. Under a new section 1(d) of the final rule, a
bank may choose not to apply a provision of the rule to one or more
exposures provided that (i) the bank can demonstrate on an ongoing
basis to the satisfaction of its primary Federal supervisor that not
applying the provision would, in all circumstances, unambiguously
generate a risk-based capital requirement for each exposure greater
than that which would otherwise be required under this final rule, (ii)
the bank appropriately manages the risk of those exposures, (iii) the
bank provides written notification to its primary Federal supervisor
prior to applying this principle to each exposure, and (iv) the
exposures to which the bank applies this principle are not, in the
aggregate, material to the bank.
The agencies emphasize that a conservative capital requirement for
a group of exposures does not reduce the need for appropriate risk
management of those exposures. Moreover, the principle of conservatism
applies to the determination of capital requirements for specific
exposures; it does not apply to the qualification or disclosure
requirements in sections 22 and 71 of the final rule. Sections V.A.1.,
V.A.3., and V.E.2. of this preamble contain examples of the appropriate
use of this principle of conservatism.
III. Qualification
A. The Qualification Process
1. In General
Supervisory qualification to use the advanced approaches is an
iterative and ongoing process that begins when a bank's board of
directors adopts an implementation plan and continues as the bank
operates under the advanced approaches. Under the final rule, as under
the proposal, a bank must develop and adopt a written implementation
plan, establish and maintain a comprehensive and sound planning and
governance process to oversee the implementation efforts described in
the plan, demonstrate to its primary Federal supervisor that it meets
the qualification requirements in section 22 of the final rule, and
complete a satisfactory ``parallel run'' (discussed below) before it
may use the advanced approaches for risk-based capital purposes. A
bank's primary Federal supervisor is responsible, after consultation
with other relevant supervisors, for evaluating the bank's initial and
ongoing compliance with the qualification requirements for the advanced
approaches.
Under the final rule, as under the proposed rule, a bank preparing
to implement the advanced approaches must adopt a written
implementation plan, approved by its board of directors, describing in
detail how the bank complies, or intends to comply, with the
qualification requirements. A core bank must adopt a plan no later than
six months after it meets a threshold criterion in section 1(b)(1) of
the final rule. If a bank meets a threshold criterion on the effective
date of the final rule, the bank would have to adopt a plan within six
months of the effective date. Banks that do not meet a threshold
criterion, but are nearing any criterion by internal growth or merger,
are expected to engage in ongoing dialogue with their primary Federal
supervisor regarding implementation strategies to ensure their
readiness to adopt the advanced approaches when a threshold criterion
is reached. An opt-in bank may adopt an implementation plan at any
time. Under the final rule, each core and opt-in bank must submit its
implementation plan, together with a copy of the minutes of the board
of directors' approval of the plan, to its primary Federal supervisor
at least 60 days before the bank proposes to begin its parallel run,
unless the bank's primary Federal supervisor waives this prior notice
provision. The submission to the primary Federal supervisor should
indicate the date that the bank proposes to begin its parallel run.
In developing an implementation plan, a bank must assess its
current state of readiness relative to the qualification requirements
in this final rule. This assessment must include a gap analysis that
identifies where additional work is needed and a remediation or action
plan that clearly sets forth how the bank intends to fill the gaps it
has identified. The implementation plan must comprehensively address
the qualification requirements for the bank and each of its
consolidated subsidiaries (U.S. and foreign-based) with respect to all
portfolios and exposures of the bank and each of its consolidated
subsidiaries. The implementation plan must justify and support any
proposed temporary or permanent exclusion of a business line,
portfolio, or exposure from the advanced approaches. The business
lines, portfolios, and exposures that the bank proposes to exclude from
the advanced approaches must be, in the aggregate, immaterial to the
bank. The implementation plan must include objective, measurable
milestones (including delivery dates and a date when the bank's
implementation of the advanced approaches will be fully operational).
For core banks, the implementation plan must include an explicit first
transitional floor period start date that is no later than 36 months
after the later of the effective date of the rule or the date the bank
meets at least one of the threshold criteria.\26\ Further, the
implementation plan must describe the resources that the bank has
budgeted and that are available to implement the plan.
---------------------------------------------------------------------------
\26\ The bank's primary Federal supervisor may extend the bank's
first transitional floor period start date.
---------------------------------------------------------------------------
The proposed rule allowed a bank to exclude a portfolio of
exposures from the advanced approaches if the bank could demonstrate to
the satisfaction of its primary Federal supervisor that the portfolio,
when combined with all other portfolios of exposures that the bank
sought to exclude from the advanced approaches, was not material to the
bank. Some commenters asserted that a bank should be permitted to
exclude from the advanced approaches any business line, portfolio, or
exposure that is immaterial on a stand-alone basis (regardless of
whether the excluded exposures in the aggregate are material to the
bank). The agencies believe that it is not appropriate for a bank to
permanently exclude a material portion of its exposures from the
enhanced risk sensitivity and risk measurement and management
requirements of the advanced approaches. Accordingly, the final rule
retains the requirement that the business lines, portfolios, and
exposures that the bank proposes to exclude from the advanced
approaches must be, in the aggregate, immaterial to the bank.
During implementation of the advanced approaches, a bank should
work closely with its primary Federal supervisor to ensure that its
risk measurement and management systems are functional and reliable and
are able to generate risk parameter estimates that can be used to
calculate the risk-based capital ratios correctly under the advanced
approaches. The
[[Page 69301]]
implementation plan, including the gap analysis and action plan, will
provide a basis for ongoing supervisory dialogue and review during the
qualification process. The primary Federal supervisor will assess a
bank's progress relative to its implementation plan. To the extent that
adjustments to target dates are needed, these adjustments should be
made subject to the ongoing supervisory discussion between the bank and
its primary Federal supervisor.
2. Parallel Run and Transitional Floor Periods
Under the proposed and final rules, once a bank has adopted its
implementation plan, it must complete a satisfactory parallel run
before it may use the advanced approaches to calculate its risk-based
capital requirements. The proposed rule defined a satisfactory parallel
run as a period of at least four consecutive calendar quarters during
which a bank complied with all of the qualification requirements to the
satisfaction of its primary Federal supervisor.
Many commenters objected to the proposed requirement that the bank
had to meet all of the qualification requirements before it could begin
the parallel run period. The agencies recognize that certain
qualification requirements, such as outcomes analysis, become more
meaningful as a bank gains experience employing the advanced
approaches. The agencies therefore are modifying the definition of a
satisfactory parallel run in the final rule. Under the final rule, a
satisfactory parallel run is a period of at least four consecutive
calendar quarters during which the bank complies with the qualification
requirements to the satisfaction of its primary Federal supervisor.
This revised definition, which does not contain the word ``all,''
recognizes that the qualification of banks for the advanced approaches
during the parallel run period will be an iterative and ongoing
process. The agencies intend to assess individual advanced approaches
methodologies through numerous discussions, reviews, data collection
and analysis, and examination activities. The agencies also emphasize
the critical importance of ongoing validation of advanced approaches
methodologies both before and after initial qualification decisions. A
bank's primary Federal supervisor will review a bank's validation
process and documentation for the advanced approaches on an ongoing
basis through the supervisory process. The bank should include in its
implementation plan the steps it will take to enhance compliance with
the qualification requirements during the parallel run period.
Commenters also requested the flexibility, permitted under the New
Accord, to apply the advanced approaches to some portfolios and other
approaches (such as the standardized approach in the New Accord) to
other portfolios during the transitional floor periods. The agencies
believe, however, that banks applying the advanced approaches should
move expeditiously to extend the robust risk measurement and management
practices required by the advanced approaches to all material
exposures. To preserve these positive risk measurement and management
incentives for banks and to prevent ``cherry picking'' of portfolios,
the final rule retains the provision in the proposed rule that states
that a bank may enter the first transitional floor period only if it
fully complies with the qualification requirements in section 22 of the
rule. As described above, the final rule allows a simplified approach
for portfolios that are, in the aggregate, immaterial to the bank.
Another concern identified by commenters regarding the parallel run
was the asymmetric treatment of mergers and acquisitions consummated
before and after the date a bank qualified to use the advanced
approaches. Under the proposed rule, a bank qualified to use the
advanced approaches that merged with or acquired a company would have
up to 24 months following the calendar quarter during which the merger
or acquisition was consummated to integrate the merged or acquired
company into the bank's advanced approaches capital calculations. In
contrast, the proposed rule could be read to provide that a bank that
merged with or acquired a company before the bank qualified to use the
advanced approaches had to fully implement the advanced approaches for
the merged or acquired company before the bank could qualify to use the
advanced approaches. The agencies agree that this asymmetric treatment
is not appropriate. Accordingly, the final rule applies the merger and
acquisition transition provisions both before and after a bank
qualifies to use the advanced approaches. The merger and acquisition
transition provisions are described in section III.D. of this preamble.
During the parallel run period, a bank continues to be subject to
the general risk-based capital rules but simultaneously calculates its
risk-based capital ratios under the advanced approaches. During this
period, a bank will report its risk-based capital ratios under the
general risk-based capital rules and the advanced approaches to its
primary Federal supervisor through the supervisory process on a
quarterly basis. The agencies will share this information with each
other.
As described above, a bank must provide its board-approved
implementation plan to its primary Federal supervisor at least 60 days
before the bank proposes to begin its parallel run period. A bank also
must receive approval from its primary Federal supervisor before
beginning its first transitional floor period. In evaluating whether to
grant approval to a bank to begin using the advanced approaches for
risk-based capital purposes, the bank's primary Federal supervisor must
determine that the bank fully complies with all the qualification
requirements, the bank has conducted a satisfactory parallel run, and
the bank has an adequate process to ensure ongoing compliance with the
qualification requirements.
To provide for a smooth transition to the advanced approaches, the
proposed rule imposed temporary limits on the amount by which a bank's
risk-based capital requirements could decline over a period of at least
three years (that is, at least four consecutive calendar quarters in
each of the three transitional floor periods). Based on its assessment
of the bank's ongoing compliance with the qualification requirements, a
bank's primary Federal supervisor would determine when the bank is
ready to move from one transitional floor period to the next period
and, after the full transition has been completed, to exit the last
transitional floor period and move to stand-alone use of the advanced
approaches. Table A sets forth the proposed transitional floor periods
for banks moving to the advanced approaches:
Table A.--Transitional Floors
------------------------------------------------------------------------
Transitional
Transitional floor period floor
percentage
------------------------------------------------------------------------
First floor period..................................... 95
Second floor period.................................... 90
Third floor period..................................... 85
------------------------------------------------------------------------
During the proposed transitional floor periods, a bank would
calculate its risk-weighted assets under the general risk-based capital
rules. Next, the bank would multiply this risk-weighted assets amount
by the appropriate floor percentage in the table above. This product
would be the bank's ``floor-adjusted'' risk-weighted assets. Third, the
bank would calculate its tier 1 and total risk-based capital ratios
using the
[[Page 69302]]
definitions of tier 1 and tier 2 capital (and associated deductions and
adjustments) in the general risk-based capital rules for the numerator
values and floor-adjusted risk-weighted assets for the denominator
values. These ratios would be referred to as the ``floor-adjusted risk-
based capital ratios.''
The bank also would calculate its tier 1 and total risk-based
capital ratios using the advanced approaches definitions and rules.
These ratios would be referred to as the ``advanced approaches risk-
based capital ratios.'' In addition, the bank would calculate a tier 1
leverage ratio using tier 1 capital as defined in the proposed rule for
the numerator of the ratio.
During a bank's transitional floor periods, the bank would report
all five regulatory capital ratios described above--two floor-adjusted
risk-based capital ratios, two advanced approaches risk-based capital
ratios, and one leverage ratio. To determine its applicable capital
category for PCA purposes and for all other regulatory and supervisory
purposes, a bank's risk-based capital ratios during the transitional
floor periods would be set equal to the lower of the respective floor-
adjusted risk-based capital ratio and the advanced approaches risk-
based capital ratio.
During the proposed transitional floor periods, a bank's tier 1
capital and tier 2 capital for all non-risk-based-capital supervisory
and regulatory purposes (for example, lending limits and Regulation W
quantitative limits) would be the bank's tier 1 capital and tier 2
capital as calculated under the advanced approaches.
Thus, for example, to be well capitalized under PCA, a bank would
have to have a floor-adjusted tier 1 risk-based capital ratio and an
advanced approaches tier 1 risk-based capital ratio of 6 percent or
greater, a floor-adjusted total risk-based capital ratio and an
advanced approaches total risk-based capital ratio of 10 percent or
greater, and a tier 1 leverage ratio of 5 percent or greater (with tier
1 capital calculated under the advanced approaches). Although the PCA
rules do not apply to BHCs, a BHC would be required to report all five
of these regulatory capital ratios and would have to meet applicable
supervisory and regulatory requirements using the lower of the
respective floor-adjusted risk-based capital ratio and the advanced
approaches risk-based capital ratio.\27\
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\27\ The Board notes that, under the applicable leverage ratio
rule, a BHC that is rated composite ``1'' or that has adopted the
market risk rule has a minimum leverage ratio requirement of 3
percent. For other BHCs, the minimum leverge ratio requirement is 4
percent.
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Under the proposed rule, after a bank completed its transitional
floor periods and its primary Federal supervisor determined the bank
could begin using the advanced approaches with no further transitional
floor, the bank would use its tier 1 and total risk-based capital
ratios as calculated under the advanced approaches and its tier 1
leverage ratio calculated using the advanced approaches definition of
tier 1 capital for PCA and all other supervisory and regulatory
purposes.
Although one commenter supported the proposed transitional
provisions, many commenters objected to these transitional provisions.
Commenters urged the agencies to conform the transitional provisions to
those in the New Accord. Specifically, they requested that the three
transitional floor periods be reduced to two periods and that the
transitional floor percentages be reduced from 95 percent, 90 percent,
and 85 percent to 90 percent and 80 percent. Commenters also requested
that the transitional floor calculation methodology be conformed to the
generally less restrictive methodology of the New Accord. Moreover,
they expressed concern about the requirement that a bank obtain
supervisory approval to move from one transitional floor period to the
next, which could potentially extend each floor period beyond four
calendar quarters.
The agencies believe that the prudential transitional safeguards
are necessary to address concerns identified in the analysis of the
results of QIS-4.\28\ Specifically, the transitional safeguards will
ensure that implementation of the advanced approaches will not result
in a precipitous drop in risk-based capital requirements, and will
provide a smooth transition process as banks refine their advanced
systems. Banks' computation of risk-based capital requirements under
both the general risk-based capital rules and the advanced approaches
during the parallel run and transitional floor periods will help the
agencies assess the impact of the advanced approaches on overall
capital requirements, including whether the change in capital
requirements relative to the general risk-based capital rules is
consistent with the agencies' overall capital objectives. Therefore,
the agencies are adopting in this final rule the proposed level,
duration, and calculation methodology of the transitional floors, with
the revised process for determining when banks may exit the third
transitional floor period discussed in section I.E., above.
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\28\ Preliminary analysis of the QIS-4 submissions evidenced
material reductions in the aggregate minimum required capital for
the QIS-4 participant population and significant dispersion of
results across institutions and portfolio types. See Interagency
Press Release, Banking ``Agencies To Perform Additional Analysis
Before Issuing Notice of Proposed Rulemaking Related To Basel II,''
April 29, 2005.
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Under the final rule, as under the proposed rule, banks that meet
the threshold criteria in section 1(b)(1) (core banks) as of the
effective date of this final rule, and banks that opt in pursuant to
section 1(b)(2) at the earliest possible date, must use the general
risk-based capital rules both during the parallel run and as a basis
for the transitional floor calculations. Should the agencies finalize a
standardized risk-based capital rule, the agencies expect that a bank
that opts in after the earliest possible date or becomes a core bank
after the effective date of the final rule would use the risk-based
capital regime (the general risk-based capital rules or the
standardized risk-based capital rules) used by the bank immediately
before the bank begins its parallel run both during the parallel run
and as a basis for the transitional floor calculations. Under the final
rule, 2008 is the first possible year for a bank to begin its parallel
run and 2009 is the first possible year for a bank to begin its first
of three transitional floor periods.
B. Qualification Requirements
Because the advanced approaches use banks' estimates of certain key
risk parameters to determine risk-based capital requirements, they
introduce greater complexity to the regulatory capital framework and
require banks to possess a high level of sophistication in risk
measurement and risk management systems. As a result, the final rule
requires each core or opt-in bank to meet the qualification
requirements described in section 22 of the final rule to the
satisfaction of its primary Federal supervisor for a period of at least
four consecutive calendar quarters before using the advanced approaches
to calculate its minimum risk-based capital requirements (subject to
the transitional floor provisions for at least an additional three
years). The qualification requirements are written broadly to
accommodate the many ways a bank may design and implement robust
internal credit and operational risk measurement and management
systems, and to permit industry practice to evolve.
Many of the qualification requirements relate to a bank's advanced
IRB systems. A bank's advanced IRB systems must incorporate
[[Page 69303]]
five interdependent components in a framework for evaluating credit
risk and measuring regulatory capital:
(i) A risk rating and segmentation system that assigns ratings to
individual wholesale obligors and exposures and assigns individual
retail exposures to segments;
(ii) A quantification process that translates the risk
characteristics of wholesale obligors and exposures and segments of
retail exposures into numerical risk parameters that are used as inputs
to the IRB risk-based capital formulas;
(iii) An ongoing process that validates the accuracy of the rating
assignments, segmentations, and risk parameters;
(iv) A data management and maintenance system that supports the
advanced IRB systems; and
(v) Oversight and control mechanisms that ensure the advanced IRB
systems are functioning effectively and producing accurate results.
1. Process and Systems Requirements
One of the objectives of the advanced approaches framework is to
provide appropriate incentives for banks to develop and use better
techniques for measuring and managing their risks and to ensure that
capital is adequate to support those risks. Section 3 of the final rule
requires a bank to hold capital commensurate with the level and nature
of all risks to which the bank is exposed. Section 22 of the final rule
specifically requires a bank to have a rigorous process for assessing
its overall capital adequacy in relation to its risk profile and a
comprehensive strategy for maintaining appropriate capital levels
(known as the internal capital adequacy assessment process or ICAAP).
Another objective of the advanced approaches framework is to ensure
comprehensive supervisory review of capital adequacy.
On February 28, 2007, the agencies issued proposed guidance setting
forth supervisory expectations for a bank's ICAAP and addressing the
process for a comprehensive supervisory assessment of capital
adequacy.\29\ As set forth in that guidance, and consistent with
existing supervisory practice, a bank's primary Federal supervisor will
evaluate how well the bank is assessing its capital needs relative to
its risks. The supervisor will assess the bank's overall capital
adequacy and will take into account a bank's ICAAP, its compliance with
the minimum capital requirements set forth in this rule, and all other
relevant information. The primary Federal supervisor will require a
bank to increase its capital levels or ratios if the supervisor
determines that current levels or ratios are deficient or some element
of the bank's business practices suggests the need for higher capital
levels or ratios. In addition, the primary Federal supervisor may,
under its enforcement authority, require a bank to modify or enhance
risk management and internal control authority, or reduce risk
exposures, or take any other action as deemed necessary to address
identified supervisory concerns.
---------------------------------------------------------------------------
\29\ 72 FR 9189.
---------------------------------------------------------------------------
As outlined in the proposed guidance, the agencies expect banks to
implement and continually update the fundamental elements of a sound
ICAAP--identifying and measuring material risks, setting capital
adequacy goals that relate to risk, and ensuring the integrity of
internal capital adequacy assessments. A bank is expected to ensure
adequate capital is held against all material risks.
In developing its ICAAP, a bank should be particularly mindful of
the limitations of regulatory risk-based capital requirements as a
measure of its full risk profile--including risks not covered or not
adequately quantified in the risk-based capital requirements--as well
as specific assumptions embedded in risk-based regulatory capital
requirements (such as diversification in credit portfolios). A bank
should also be mindful of the capital adequacy effects of
concentrations that may arise within each risk type or across risk
types. In general, a bank's ICAAP should reflect an appropriate level
of conservatism to account for uncertainty in risk identification, risk
mitigation or control, quantitative processes, and any use of modeling.
In most cases, this conservatism will result in higher levels of
capital or higher capital ratios being regarded as adequate.
As noted above, each core and opt-in bank must apply the advanced
approaches for risk-based capital purposes at the consolidated top-tier
U.S. legal entity level (either the top-tier U.S. BHC or top-tier DI
that is a core or opt-in bank) and at each DI that is a subsidiary of
such a top-tier legal entity (unless a primary Federal supervisor
provides an exemption under section 1(b)(3) of the final rule). Each
bank that applies the advanced approaches must have an appropriate
infrastructure with risk measurement and management processes that meet
the final rule's qualification requirements and that are appropriate
given the bank's size and level of complexity. Regardless of whether
the systems and models that generate the risk parameters necessary for
calculating a bank's risk-based capital requirements are located at an
affiliate of the bank, each legal entity that applies the advanced
approaches must ensure that the risk parameters (PD, LGD, EAD, and, for
wholesale exposures, M) and reference data used to determine its risk-
based capital requirements are representative of its own credit and
operational risk exposures.
The final rule also requires that the systems and processes that an
advanced approaches bank uses for risk-based capital purposes must be
consistent with the bank's internal risk management processes and
management information reporting systems. This means, for example, that
data from the latter processes and systems can be used to verify the
reasonableness of the inputs the bank uses for calculating risk-based
capital ratios.
2. Risk Rating and Segmentation Systems for Wholesale and Retail
Exposures
To implement the IRB approach, a bank must have internal risk
rating and segmentation systems that accurately and reliably
differentiate between degrees of credit risk for wholesale and retail
exposures. As described below, wholesale exposures include most credit
exposures to companies, sovereigns, and other governmental entities, as
well as some exposures to individuals. Retail exposures include most
credit exposures to individuals and small credit exposures to
businesses that are managed as part of a segment of exposures with
homogeneous risk characteristics. Together, wholesale and retail
exposures cover most credit exposures of banks.
To differentiate among degrees of credit risk, a bank must be able
to make meaningful and consistent distinctions among credit exposures
along two dimensions--default risk and loss severity in the event of a
default. In addition, a bank must be able to assign wholesale obligors
to rating grades that approximately reflect likelihood of default and
must be able to assign wholesale exposures to loss severity rating
grades (or LGD estimates) that approximately reflect the loss severity
expected in the event of default during economic downturn conditions.
As discussed below, the final rule requires banks to treat wholesale
exposures differently from retail exposures when differentiating among
degrees of credit risk; specifically, risk parameters for retail
exposures are assigned at the segment level.
Wholesale Exposures
Under the proposed rule, a bank would be required to have an
internal risk rating system that indicates the likelihood of default of
each individual
[[Page 69304]]
obligor and would either use an internal risk rating system that
indicates the economic loss rate upon default of each individual
exposure or directly assign an LGD estimate to each individual
exposure. A bank would assign an internal risk rating to each wholesale
obligor that reflected the obligor's likelihood of default.
Several commenters objected to the proposed requirement to assign
an internal risk rating to each wholesale obligor that reflected the
obligor's likelihood of default. Commenters asserted that this
requirement was burdensome and unnecessary where a bank underwrote an
exposure based solely on the financial strength of a guarantor and used
the PD substitution approach (discussed below) to recognize the risk
mitigating effects of an eligible guarantee on the exposure. In such
cases, commenters maintained that banks should be allowed to assign a
PD only to the guarantor and not the underlying obligor.
While the agencies believe that maintaining internal risk ratings
of both a protection provider and underlying obligor provides helpful
information for risk management purposes and facilitates a greater
understanding of so-called double default effects, the agencies
appreciate the commenters' concerns about burden in this context.
Accordingly, the final rule does not require a bank to assign an
internal risk rating to an underlying obligor to whom the bank extends
credit based solely on the financial strength of a guarantor, provided
that all of the bank's exposures to that obligor are fully covered by
eligible guarantees and the bank applies the PD substitution approach
to all of those exposures. A bank in this situation is only required to
assign an internal risk rating to the guarantor. However, a bank must
immediately assign an internal risk rating to the obligor if a
guarantee can no longer be recognized under this final rule.
In determining an obligor rating, a bank should consider key
obligor attributes, including both quantitative and qualitative factors
that could affect the obligor's default risk. From a quantitative
perspective, this could include an assessment of the obligor's historic
and projected financial performance, trends in key financial
performance ratios, financial contingencies, industry risk, and the
obligor's position in the industry. On the qualitative side, this could
include an assessment of the quality of the obligor's financial
reporting, non-financial contingencies (for example, labor problems and
environmental issues), and the quality of the obligor's management
based on an evaluation of management's ability to make realistic
projections, management's track record in meeting projections, and
management's ability to effectively adapt to changes in the economy and
the competitive environment.
Under the proposed rule, a bank would assign each legal entity
wholesale obligor to a single rating grade. Accordingly, if a single
wholesale exposure of the bank to an obligor triggered the proposed
rule's definition of default, all of the bank's wholesale exposures to
that obligor would be in default for risk-based capital purposes. In
addition, under the proposed rule, a bank would not be allowed to
consider the value of collateral pledged to support a particular
wholesale exposure (or any other exposure-specific characteristics)
when assigning a rating to the obligor of the exposure. A bank would,
however, consider all available financial information about the
obligor--including, where applicable, the total operating income or
cash flows from all of the obligor's projects or businesses--when
assigning an obligor rating.
While a few commenters expressly supported the proposal's
requirement for banks to assign each legal entity wholesale obligor to
a single rating grade, a substantial number of commenters expressed
reservations about this requirement. These commenters observed that in
certain circumstances an exposure's transaction-specific
characteristics affect its likelihood of default. Commenters asserted
that the agencies should provide greater flexibility and allow banks to
depart from the one-rating-per-obligor requirement based on the
economic substance of an exposure. In particular, commenters maintained
that income-producing real estate lending should be exempt from the
one-rating-per-obligor requirement. The commenters noted that the
probability that an obligor will default on any one such facility
depends primarily on the cash flows from the individual property
securing the facility, not the overall condition of the obligor.
Similarly, several commenters asserted that exposures involving
transfer risk and non-recourse exposures should be exempted from the
one-rating-per-obligor requirement.
In general, the agencies believe that a two-dimensional rating
system that strictly separates borrower and exposure-level
characteristics is a critical underpinning of the IRB approach.
However, the agencies agree that exposures to the same borrower
denominated in different currencies may have different default
probabilities. For example, a sovereign government may impose
prohibitive exchange restrictions that make it impossible for a
borrower to transfer payments in one particular currency.
In addition, the agencies agree that certain income-producing real
estate exposures for which the bank, in economic substance, does not
have recourse to the borrower beyond the real estate serving as
collateral for the exposure, have default probabilities distinct from
that of the borrower. Such situations would arise, for example, where
real estate collateral is located in a state where a bank, under
applicable state law, effectively does not have recourse to the
borrower if the bank pursues the real estate collateral in the event of
default (for example, in a ``one-action'' state or a state with a
similar law). In one-action states such as Arizona, California, Idaho,
Montana, Nevada, and Utah, or in a state with a similar law, such as
New York, the applicable foreclosure laws materially limit a bank's
ability to collect against both the collateral and the borrower.
A third instance in which exposures to the same borrower may have
significantly different default probabilities is when a borrower enters
bankruptcy and the bank extends additional credit to the borrower under
the auspices of the bankruptcy proceedings. This so-called debtor in
possession (DIP) financing is unique from other exposure types because
it typically has priority over existing debt, equity, and other claims
on the borrower. The agencies believe that because of this unique
priority status, if a bank has an exposure to a borrower that declares
bankruptcy and defaults on that exposure, and the bank subsequently
provides DIP financing to that obligor, it may not be appropriate to
require the bank to treat the DIP financing exposure at inception as an
exposure to a defaulted borrower.
To address these circumstances and clarify the application of the
one-rating-per-obligor requirement, the agencies added a definition of
obligor in the final rule. The final rule defines an obligor as the
legal entity or natural person contractually obligated on a wholesale
exposure except that a bank may treat three types of exposures to the
same legal entity or natural person as having separate obligors. First,
exposures to the same legal entity or natural person denominated in
different currencies. Second, (i) income-producing real estate
exposures for which all or substantially all of the repayment of the
exposure is reliant on cash flows of the real estate serving as
collateral for the exposure;
[[Page 69305]]
the bank, in economic substance, does not have recourse to the borrower
beyond the real estate serving as collateral for the exposure; and no
cross-default or cross-acceleration clauses are in place other than
clauses obtained solely in an abundance of caution; and (ii) other
credit exposures to the same legal entity or natural person. Third, (i)
wholesale exposures authorized under section 364 of the U.S. Bankruptcy
Code (11 U.S.C. 364) to a legal entity or natural person who is a
debtor-in-possession for purposes of Chapter 11 of the Bankruptcy Code;
and (ii) other credit exposures to the same legal entity or natural
person. All exposures to a single legal entity or natural person must
be treated as exposures to a single obligor unless they qualify for one
of these three exceptions in the final rule's definition of obligor.
A bank's obligor rating system must have at least seven discrete
(non-overlapping) obligor grades for non-defaulted obligors and at
least one obligor grade for defaulted obligors. The agencies believe
that because the risk-based capital requirement of a wholesale exposure
is directly linked to its obligor rating grade, a bank must have at
least seven non-overlapping obligor grades to differentiate
sufficiently the creditworthiness of non-defaulted wholesale obligors.
A bank must capture the estimated loss severity upon default for a
wholesale exposure either by directly assigning an LGD estimate to the
exposure or by grouping the exposure with other wholesale exposures
into loss severity rating grades (reflecting the bank's estimate of the
LGD of the exposure). LGD is described in more detail below. Whether a
bank chooses to assign LGD values directly or, alternatively, to assign
exposures to rating grades and then quantify the LGD for the rating
grades, the key requirement is that the bank must identify exposure
characteristics that influence LGD. Each of the loss severity rating
grades must be associated with an empirically supported LGD estimate.
Banks employing loss severity grades must have a sufficiently granular
loss severity grading system to avoid grouping together exposures with
widely ranging LGDs.
Retail Exposures
To implement the advanced approach for retail exposures, a bank
must have an internal system that segments its retail exposures to
differentiate accurately and reliably among degrees of credit risk. The
most significant difference between the treatment of wholesale and
retail exposures is that the risk parameters for wholesale exposures
are assigned at the individual exposure level, whereas risk parameters
for retail exposures are assigned at the segment level. Banks typically
manage retail exposures on a segment basis, where each segment contains
exposures with similar risk characteristics. Therefore, a key
characteristic of the final rule's retail framework is that the risk
parameters for retail exposures are assigned to segments of exposures
rather than to individual exposures. Under the retail framework, a bank
groups its retail exposures into segments with homogeneous risk
characteristics and estimates PD and LGD for each segment.
Some commenters stated that for internal risk management purposes
they assign risk parameters at the individual retail exposure level
rather than at the segment level. These commenters requested
confirmation that this practice would be permissible for risk-based
capital purposes under the final rule. The agencies believe that a bank
may use its advanced systems, including exposure-level risk parameter
estimates, to group exposures into segments with homogeneous risk
characteristics. Such exposure-level estimates must be aggregated in
order to assign segment-level risk parameters to each segment of retail
exposures.
A bank must group its retail exposures into three separate
subcategories: (i) Residential mortgage exposures; (ii) QREs; and (iii)
other retail exposures. The bank must classify the retail exposures in
each subcategory into segments to produce a meaningful differentiation
of risk. The final rule requires banks to segment separately (i)
defaulted retail exposures from non-defaulted retail exposures and (ii)
retail eligible margin loans for which the bank adjusts EAD rather than
LGD to reflect the risk mitigating effects of financial collateral from
other retail eligible margin loans. Otherwise, the agencies do not
require that banks consider any particular risk drivers or employ any
minimum number of segments in any of the three retail subcategories.
In determining how to segment retail exposures within each
subcategory for the purpose of assigning risk parameters, a bank should
use a segmentation approach that is consistent with its approach for
internal risk assessment purposes and that classifies exposures
according to predominant risk characteristics or drivers. Examples of
risk drivers could include loan-to-value ratios, credit scores, loan
terms and structure, origination channel, geographical location of the
borrower, collateral type, and bank internal estimates of likelihood of
default and loss severity given default. Regardless of the risk drivers
used, a bank must be able to demonstrate to its primary Federal
supervisor that its system assigns accurate and reliable PD and LGD
estimates for each retail segment on a consistent basis.
Definition of Default
Wholesale default. In the ANPR, the agencies proposed to define
default for a wholesale exposure as either or both of the following
events: (i) The bank determines that the borrower is unlikely to pay
its obligations to the bank in full, without recourse to actions by the
bank such as the realization of collateral; or (ii) the borrower is
more than 90 days past due on principal or interest on any material
obligation to the bank. The ANPR's definition of default was generally
consistent with the New Accord.
A number of commenters on the ANPR encouraged the agencies to use a
wholesale definition of default that varied from the New Accord but
conformed more closely to that used by bank risk managers. Many of
these commenters recommended that the agencies define default for
wholesale exposures as the entry into non-accrual or charge-off status.
In the proposed rule, the agencies amended the ANPR definition of
default to respond to these concerns. Under the proposed definition of
default, a bank's wholesale obligor would be in default if, for any
wholesale exposure of the bank to the obligor, the bank had (i) placed
the exposure on non-accrual status consistent with the Consolidated
Report of Condition and Income (Call Report) Instructions or the Thrift
Financial Report (TFR) and the TFR Instruction Manual; (ii) taken a
full or partial charge-off or write-down on the exposure due to the
distressed financial condition of the obligor; or (iii) incurred a
credit-related loss of 5 percent or more of the exposure's initial
carrying value in connection with the sale of the exposure or the
transfer of the exposure to the held-for-sale, available-for-sale,
trading account, or other reporting category.
The agencies received extensive comment on the proposed definition
of default for wholesale exposures. Commenters observed that the
proposed definition of default was different from and more prescriptive
than the definition in the New Accord and employed in other major
jurisdictions. They asserted that the proposed definition would impose
unjustifiable systems burden and expense on banks operating across
multiple jurisdictions. Commenters also asserted that many
[[Page 69306]]
banks' data collection systems are based on the New Accord's definition
of default, and therefore historical data relevant to the proposed
definition of default are limited. Moreover, commenters expressed
concern that risk parameters estimated using the proposed definition of
default would differ materially from those estimated using the New
Accord's definition of default, resulting in different capital
requirements for U.S. banks relative to their foreign peers.
The 5 percent credit-related loss trigger in the proposed
definition of default for wholesale obligors was the focus of
significant commenter concern. Commenters asserted that the trigger
inappropriately imported LGD and maturity-related considerations into
the definition of default, could hamper the use of loan sales as a risk
management practice, and could cause obligors that are performing on
their obligations to be considered defaulted. These commenters also
claimed that the 5 percent trigger would add significant implementation
burden by, for example, requiring banks to distinguish between credit-
related and non-credit-related losses on sale.
Many commenters requested that the agencies conform the U.S.
wholesale definition of default to the New Accord. Other commenters
requested that banks be allowed the option to apply either the U.S. or
the New Accord definition of default.
The agencies agree that the proposed definition of default for
wholesale obligors could have unintended consequences for
implementation burden and international consistency. Therefore, the
final rule contains a definition of default for wholesale obligors that
is similar to the definition proposed in the ANPR and consistent with
the New Accord. Specifically, under the final rule, a bank's wholesale
obligor is in default if, for any wholesale exposure of the bank to the
obligor: (i) The bank considers that the obligor is unlikely to pay its
credit obligations to the bank in full, without recourse by the bank to
actions such as realizing collateral (if held); or (ii) the obligor is
past due more than 90 days on any material credit obligation to the
bank. The final rule also clarifies, consistent with the New Accord,
that an overdraft is past due once the obligor has breached an advised
limit or has been advised of a limit smaller than the current
outstanding balance.
Consistent with the New Accord, the following elements may be
indications of unlikeliness to pay under this definition:
(i) The bank places the exposure on non-accrual status consistent
with the Call Report Instructions or the TFR and the TFR Instruction
Manual;
(ii) The bank takes a full or partial charge-off or write-down on
the exposure due to the distressed financial condition of the obligor;
(iii) The bank incurs a material credit-related loss in connection
with the sale of the exposure or the transfer of the exposure to the
held-for-sale, available-for-sale, trading account, or other reporting
category;
(iv) The bank consents to a distressed restructuring of the
exposure that is likely to result in a diminished financial obligation
caused by the material forgiveness or postponement of principal,
interest or (where relevant) fees;
(v) The bank has filed as a creditor of the obligor for purposes of
the obligor's bankruptcy under the U.S. Bankruptcy Code (or a similar
proceeding in a foreign jurisdiction regarding the obligor's credit
obligation to the bank); or
(vi) The obligor has sought or has been placed in bankruptcy or
similar protection that would avoid or delay repayment of the exposure
to the bank.
If a bank carries a wholesale exposure at fair value for accounting
purposes, the bank's practices for determining unlikeliness to pay for
purposes of the definition of default should be consistent with the
bank's practices for determining credit-related declines in the fair
value of the exposure.
Like the proposed definition of default for wholesale obligors, the
final rule states that a wholesale exposure to an obligor remains in
default until the bank has reasonable assurance of repayment and
performance for all contractual principal and interest payments on all
exposures of the bank to the obligor (other than exposures that have
been fully written-down or charged-off). The agencies expect a bank to
employ standards for determining whether it has a reasonable assurance
of repayment and performance that are similar to those for determining
whether to restore a loan from non-accrual to accrual status.
Retail default. In response to comments on the ANPR, the agencies
proposed to define default for retail exposures according to the
timeframes for loss classification that banks generally use for
internal purposes. These timeframes are embodied in the FFIEC's Uniform
Retail Credit Classification and Account Management Policy. \30\
Specifically, revolving retail exposures and residential mortgage
exposures would be in default at 180 days past due; other retail
exposures would be in default at 120 days past due. In addition, a
retail exposure would be in default if the bank had taken a full or
partial charge-off or write-down of principal on the exposure for
credit-related reasons. Such an exposure would remain in default until
the bank had reasonable assurance of repayment and performance for all
contractual principal and interest payments on the exposure.
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\30\ FFIEC, ``Uniform Retail Credit Classification and Account
Management Policy,'' 65 FR 36903, June 12, 2000.
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Although some commenters supported the proposed rule's retail
definition of default, others urged the agencies to adopt a 90-days-
past-due default trigger consistent with the New Accord's definition of
default for retail exposures. Other commenters requested that a non-
accrual trigger be added to the retail definition of default similar to
that in the proposed wholesale definition of default. The commenters
viewed this as a practical way to allow a foreign banking organization
to harmonize the U.S. retail definition of default to a home country
definition of default that has a 90-days-past-due trigger.
The agencies believe that adding a non-accrual trigger to the
retail definition of default is not appropriate. Retail non-accrual
practices vary considerably among banks, and adding a non-accrual
trigger to the retail definition of default would result in greater
inconsistency among banks in the treatment of retail exposures.
Moreover, a bank that considers retail exposures to be defaulted at 90
days past due could have significantly different risk parameter
estimates than one that uses 120- and 180-days-past-due thresholds.
Such a bank would likely have higher PD estimates and lower LGD
estimates due to the established tendency of a nontrivial proportion of
U.S. retail exposures to ``cure'' or return to performing status after
becoming 90 days past due and before becoming 120 or 180 days past due.
The agencies believe that the 120- and 180-days-past-due thresholds,
which are consistent with national discretion provided by the New
Accord, reflect a point at which retail exposures in the United States
are unlikely to return to performing status. Therefore, the agencies
are incorporating the proposed retail definition of default without
substantive change in the final rule. (Parallel to the full or partial
[[Page 69307]]
charge-off or write-down trigger for retail exposures not held at fair
value, the agencies added a material negative fair value adjustment of
principal for credit-related reasons trigger for retail exposures held
at fair value.)
The New Accord provides discretion for national supervisors to set
the retail default trigger at up to 180 days past due for different
products, as appropriate to local conditions. Accordingly, banks
implementing the IRB approach in multiple jurisdictions may be subject
to different retail definitions of default in their home and host
jurisdictions. The agencies recognize that it could be costly and
burdensome for a U.S. bank to track default data and estimate risk
parameters based on both the U.S. definition of default and the
definitions of default in non-U.S. jurisdictions where subsidiaries of
the U.S. bank implement the IRB approach. The agencies are therefore
incorporating flexibility into the retail definition of default.
Specifically, for a retail exposure held by a U.S. bank's non-U.S.
subsidiary subject to an internal ratings-based approach to capital
adequacy consistent with the New Accord in a non-U.S. jurisdiction, the
final rule allows the bank to elect to use the definition of default of
that jurisdiction, subject to prior approval by the bank's primary
Federal supervisor. The primary Federal supervisor will revoke approval
for a bank to use this provision if the supervisor finds that the bank
uses the provision to arbitrage differences in national definitions of
default.
The definition of default for retail exposures differs from the
definition for the wholesale portfolio in that the retail default
definition applies on an exposure-by-exposure basis rather than on an
obligor-by-obligor basis. In other words, default on one retail
exposure does not require a bank to treat all other retail obligations
of the same borrower to the bank as defaulted. This difference reflects
the fact that banks generally manage retail credit risk based on
segments of similar exposures rather than through the assignment of
ratings to particular borrowers. In addition, it is quite common for
retail borrowers that default on some of their obligations to continue
payment on others.
Although the retail definition of default does not explicitly
include credit-related losses in connection with loan sales and the
agencies have replaced the 5 percent credit-related loss threshold for
wholesale exposures with a less prescriptive treatment that is
consistent with the New Accord, the agencies expect banks to ensure
that exposure sales do not bias or otherwise distort the estimated risk
parameters assigned by a bank to its wholesale exposures and retail
segments.
Rating Philosophy
A bank's internal risk rating policy for wholesale exposures must
describe the bank's rating philosophy, which is how the bank's
wholesale obligor rating assignments are affected by the bank's choice
of the range of economic, business, and industry conditions that are
considered in the obligor rating process. The philosophical basis of a
bank's rating system is important because, when combined with the
credit quality of individual obligors, it will determine the frequency
of obligor rating changes in a changing economic environment. Rating
systems that rate obligors based on their ability to perform over a
wide range of economic, business, and industry conditions, sometimes
described as ``through-the-cycle'' systems, tend to have ratings that
migrate more slowly as conditions change. Banks that rate obligors
based on a more narrow range of likely expected conditions (primarily
on recent conditions), sometimes called ``point-in-time'' systems, tend
to have ratings that migrate more frequently. Many banks will rate
obligors using an approach that considers a combination of the current
conditions and a wider range of other likely conditions. In any case,
the bank must specify the rating philosophy used and establish a policy
for the migration of obligors from one rating grade to another in
response to economic cycles. A bank should understand the effects of
ratings migration on its risk-based capital requirements and ensure
that sufficient capital is maintained during all phases of the economic
cycle.
Rating and Segmentation Reviews and Updates
Each wholesale obligor rating and (if applicable) wholesale
exposure loss severity rating must reflect current information. A
bank's internal risk rating system for wholesale exposures must provide
for the review and update (as appropriate) of each obligor rating and
(if applicable) loss severity rating whenever the bank receives new
material information, but no less frequently than annually. Under the
proposed rule, a bank's retail exposure segmentation system would
provide for the review and update (as appropriate) of assignments of
retail exposures to segments whenever the bank received new material
information. The proposed rule specified that the review would be
required no less frequently than quarterly.
One commenter noted that quarterly reviews may not be appropriate
for high-quality retail portfolios, such as retail exposures associated
with a bank's wealth management or private banking businesses. The
commenter suggested that banks should have the flexibility to review
and update segmentation assignments for such portfolios on a less
frequent basis appropriate to the credit quality of the portfolios.
The agencies agree that it may be appropriate for a bank to review
and update segmentation assignments for certain high-quality retail
exposures on a less frequent basis than quarterly, provided a bank is
following sound risk management practices. Therefore, the final rule
generally requires a quarterly review and update, as appropriate, of
retail exposure segmentation assignments, allowing some flexibility to
accommodate sound internal risk management practices.
3. Quantification of Risk Parameters for Wholesale and Retail Exposures
A bank must have a comprehensive risk parameter quantification
process that produces accurate, timely, and reliable estimates of the
risk parameters--PD, LGD, EAD, and (for wholesale exposures) M--for its
wholesale obligors and exposures and retail exposures. Statistical
methods and models used to develop risk parameter estimates, as well as
any adjustments to the estimates or empirical data, should be
transparent, well supported, and documented. The following sections of
the preamble discuss the rule's definitions of the risk parameters for
wholesale exposures and retail segments.
Probability of Default (PD)
As noted above, under the final rule, a bank must assign each of
its wholesale obligors to an internal rating grade and then must
associate a PD with each rating grade. PD for a wholesale exposure to a
non-defaulted obligor is the bank's empirically based best estimate of
the long-run average one-year default rate for the rating grade
assigned by the bank to the obligor, capturing the average default
experience for obligors in the rating grade over a mix of economic
conditions (including economic downturn conditions) sufficient to
provide a reasonable estimate of the average one-year default rate over
the economic cycle for the rating grade.
In addition, under the final rule, a bank must assign a PD to each
segment of retail exposures. Some types of retail exposures typically
display a seasoning pattern--that is, the exposures have
[[Page 69308]]
relatively low default rates in their first year, rising default rates
in the next few years, and declining default rates for the remainder of
their terms. Because of the one-year IRB horizon, the proposed rule
provided two different definitions of PD for a segment of non-defaulted
retail exposures based on the materiality of seasoning effects for the
segment or for the segment's retail exposure subcategory. Under the
proposed rule, PD for a segment of non-defaulted retail exposures for
which seasoning effects were not material, or for a segment of non-
defaulted retail exposures in a retail exposure subcategory for which
seasoning effects were not material, would be the bank's empirically
based best estimate of the long-run average of one-year default rates
for the exposures in the segment, capturing the average default
experience for exposures in the segment over a mix of economic
conditions (including economic downturn conditions) sufficient to
provide a reasonable estimate of the average one-year default rate over
the economic cycle for the segment. PD for a segment of non-defaulted
retail exposures for which seasoning effects were material would be the
bank's empirically based best estimate of the annualized cumulative
default rate over the expected remaining life of exposures in the
segment, capturing the average default experience for exposures in the
segment over a mix of economic conditions (including economic downturn
conditions) to provide a reasonable estimate of the average performance
over the economic cycle for the segment.
Commenters objected to this treatment of retail exposures with
material seasoning effects. They asserted that requiring banks to use
an annualized cumulative default rate to recognize seasoning effects
was too prescriptive and would preclude other reasonable approaches.
The agencies believe that commenters have presented reasonable
alternative approaches to recognizing the effects of seasoning in PD
and are, therefore, providing additional flexibility for recognizing
those effects in the final rule.
Based on comments and additional consideration, the agencies also
are clarifying that a segment of retail exposures has material
seasoning effects if there is a material relationship between the time
since origination of exposures within the segment and the bank's best
estimate of the long-run average one-year default rate for the
exposures in the segment. Moreover, because the agencies believe that
the IRB approach must, at a minimum, require banks to hold appropriate
amounts of risk-based capital to address credit risks over a one-year
horizon, the final rule's incorporation of seasoning effects is
explicitly one-directional. Specifically, a bank must increase PDs
above the best estimate of the long-run average one-year default rate
for segments of unseasoned retail exposures, but may not decrease PD
below the best estimate of the long-run average one-year default rate
for a segment of retail exposures that the bank estimates will have
lower PDs in future years due to seasoning.
The final rule defines PD for a segment of non-defaulted retail
exposures as the bank's empirically based best estimate of the long-run
average one-year default rate for the exposures in the segment,
capturing the average default experience for exposures in the segment
over a mix of economic conditions (including economic downturn
conditions) sufficient to provide a reasonable estimate of the average
one-year default rate over the economic cycle for the segment and
adjusted upward as appropriate for segments for which seasoning effects
are material. If a bank does not adjust PD to reflect seasoning effects
for a segment of exposures, it should be able to demonstrate to its
primary Federal supervisor, using empirical analysis, why seasoning
effects are not material or why adjustment is not relevant for the
segment.
For wholesale exposures to defaulted obligors and for segments of
defaulted retail exposures, PD is 100 percent.
Loss Given Default (LGD)
Under the proposed rule, a bank would directly estimate an ELGD and
LGD risk parameter for each wholesale exposure or would assign each
wholesale exposure to an expected loss severity grade and a downturn
loss severity grade, estimate an ELGD risk parameter for each expected
loss severity grade, and estimate an LGD risk parameter for each
downturn loss severity grade. In addition, a bank would estimate an
ELGD and LGD risk parameter for each segment of retail exposures.
Expected Loss Given Default (ELGD)
The proposed rule defined the ELGD of a wholesale exposure as the
bank's empirically based best estimate of the default-weighted average
economic loss per dollar of EAD the bank expected to incur in the event
that the obligor of the exposure (or a typical obligor in the loss
severity grade assigned by the bank to the exposure) defaulted within a
one-year horizon.\31\ The proposed rule defined ELGD for a segment of
retail exposures as the bank's empirically based best estimate of the
default-weighted average economic loss per dollar of EAD the bank
expected to incur on exposures in the segment that default within a
one-year horizon. ELGD estimates would incorporate a mix of economic
conditions (including economic downturn conditions). ELGD had four
functions in the proposed rule--as a component of the calculation of
ECL in the numerator of the risk-based capital ratios; in the EL
component of the IRB risk-based capital formulas; as a floor on the
value of the LGD risk parameter; and as an input into the supervisory
mapping function.
---------------------------------------------------------------------------
\31\ Under the proposal, ELGD was not the statistical expected
value of LGD.
---------------------------------------------------------------------------
Many commenters objected to the proposed rule's requirement for
banks to estimate ELGD for each wholesale exposure and retail segment,
noting that ELGD estimation is not required under the New Accord.
Commenters asserted that requiring ELGD estimation would create a
competitive disadvantage by creating additional systems, compliance,
calculation, and reporting burden for those banks subject to the U.S.
rule, many of which have already substantially developed their systems
based on the New Accord. They also maintained that it would decrease
the comparability of U.S. banks' capital requirements and public
disclosures relative to those of foreign banking organizations applying
the advanced approaches. Several commenters also contended that
defining ECL in terms of ELGD instead of LGD raised tier 1 risk-based
capital requirements for U.S. banks compared to foreign banks using the
New Accord's LGD-based ECL definition.
The agencies have concluded that the regulatory burden and
potential competitive inequities identified by commenters outweigh the
supervisory benefits of the proposed ELGD risk parameter, and are,
therefore, not including it in the final rule. Instead, consistent with
the New Accord, a bank must use LGD for the calculation of ECL and the
EL component of the IRB risk-based capital formulas. Because the
proposed ELGD risk parameter was equal to or less than LGD, this change
generally will have the effect of decreasing both the numerator and
denominator of the risk-based capital ratios.
Consistent with the New Accord, under the final rule, the LGD of a
wholesale exposure or retail segment must not be less than the bank's
[[Page 69309]]
empirically based best estimate of the long-run default-weighted
average economic loss, per dollar of EAD, the bank would expect to
incur if the obligor (or a typical obligor in the loss severity grade
assigned by the bank to the exposure or segment) were to default within
a one-year horizon over a mix of economic conditions, including
economic downturn conditions. The final rule also specifies that LGD
may not be less than zero. The implications of eliminating the ELGD
risk parameter for the supervisory mapping function are discussed
below.
Economic Loss and Post-Default Extensions of Credit
Commenters requested additional clarity regarding the treatment of
post-default extensions of credit. LGD is an estimate of the economic
loss that would be incurred on an exposure, relative to the exposure's
EAD, if the obligor were to default within a one-year horizon during
economic downturn conditions. The estimated economic loss amount must
capture all material credit-related losses on the exposure (including
accrued but unpaid interest or fees, losses on the sale of repossessed
collateral, direct workout costs, and an appropriate allocation of
indirect workout costs). Where positive or negative cash flows on a
wholesale exposure to a defaulted obligor or on a defaulted retail
exposure (including proceeds from the sale of collateral, workout
costs, and draw-downs of unused credit lines) are expected to occur
after the date of default, the estimated economic loss amount must
reflect the net present value of cash flows as of the default date
using a discount rate appropriate to the risk of the exposure. The
possibility of post-default extensions of credit made to facilitate
collection of an exposure would be treated as negative cash flows and
reflected in LGD.
For example, assume a loan to a retailer goes into default. The
bank determines that the recovery would be enhanced by some additional
expenditure to ensure an orderly workout process. One option would be
for the bank to hire a third-party to facilitate the collection of the
loan. Another option would be for the bank to extend additional credit
directly to the defaulted obligor to allow the obligor to make an
orderly liquidation of inventory. Both options represent negative cash
flows on the original exposure, which must be discounted at a rate that
is appropriate to the risk of the exposure.
Economic Downturn Conditions
The expected loss severities of some exposures may be substantially
higher during economic downturn conditions than during other periods,
while for other types of exposures they may not. Accordingly, the
proposed rule required banks to use an LGD estimate that reflected
economic downturn conditions for purposes of calculating the risk-based
capital requirements for wholesale exposures and retail segments.
Several commenters objected to the requirement that LGD estimates
must reflect economic downturn conditions. Some of these commenters
stated that empirical evidence of correlation between economic downturn
and LGD is inconclusive, except in certain cases. A few noted that
estimates of expected LGD include conservative inputs, such as a
conservative estimate of potential loss in the event of default or a
conservative discount rate or collateral assumptions. One commenter
suggested that if a bank can demonstrate it has been prudent in its LGD
estimation and it has no evidence of the cyclicality of LGDs, it should
not be required to calculate downturn LGDs. Other commenters remarked
that the requirement to incorporate downturn conditions into LGD
estimates should not be used as a surrogate for proper modeling of PD/
LGD correlations. Finally, a number of commenters supported a pillar 2
approach for addressing LGD estimation.
Consistent with the New Accord, the final rule maintains the
requirement for a bank to use an LGD estimate that reflects economic
downturn conditions for purposes of calculating the risk-based capital
requirements for wholesale exposures and retail segments. More
specifically, banks must produce for each wholesale exposure (or loss
severity rating grade) and retail segment an estimate of the economic
loss per dollar of EAD that the bank would expect to incur if default
were to occur within a one-year horizon during economic downturn
conditions.
For the purpose of defining economic downturn conditions, the
proposed rule identified two wholesale exposure subcategories--high-
volatility commercial real estate (HVCRE) wholesale exposures and non-
HVCRE wholesale exposures (that is, all wholesale exposures that are
not HVCRE exposures)--and three retail exposure subcategories--
residential mortgage exposures, QREs, and other retail exposures. The
proposed rule defined economic downturn conditions with respect to an
exposure as those conditions in which the aggregate default rates for
the exposure's entire wholesale or retail subcategory held by the bank
(or subdivision of such subcategory selected by the bank) in the
exposure's national jurisdiction (or subdivision of such jurisdiction
selected by the bank) were significantly higher than average.
The agencies specifically sought comment on whether to require
banks to determine economic downturn conditions at a more granular
level than an entire wholesale or retail exposure subcategory in a
national jurisdiction. Some commenters stated that the proposed
requirement is at a sufficiently granular level. Others asserted that
the requirement should be eliminated or made less granular. Those
commenters favoring less granularity stated that aggregate default
rates for different product subcategories in different countries are
unlikely to peak at the same time and that requiring economic downturn
analysis at the product subcategory and national jurisdiction level
does not recognize potential diversification effects across products
and national jurisdictions and is thus overly conservative. Commenters
also maintained that the proposed granularity requirement adds
complexity and implementation burden relative to the New Accord.
The agencies believe that the proposed definition of economic
downturn conditions incorporates an appropriate level of granularity
and are incorporating it unchanged in the final rule. The agencies
understand that downturns in particular geographical subdivisions of
national jurisdictions or in particular industrial sectors may result
in significantly increased loss rates in material subdivisions of a
bank's exposures. The agencies also recognize that diversification
across those subdivisions may mitigate risk for the overall
organization. However, the agencies believe that the required minimum
level of granularity at the subcategory and national jurisdiction level
provides a suitable balance between allowing for the benefits of
diversification and appropriate conservatism for risk-based capital
requirements.
Under the final rule, a bank must consider economic downturn
conditions that appropriately reflect its actual exposure profile. For
example, a bank with a geographical or industry sector concentration in
a subcategory of exposures may find that information relating to a
downturn in that geographical region or industry sector may be more
relevant for the bank than a general downturn affecting many
[[Page 69310]]
regions or industries. The final rule (like the proposed rule) allows
banks to subdivide exposure subcategories or national jurisdictions as
they deem appropriate given the exposures held by the bank. Moreover,
the agencies note that the exposure subcategory/national jurisdiction
granularity requirement is only a minimum granularity requirement.
Supervisory Mapping Function
The proposed rule provided banks two methods of generating LGD
estimates for wholesale exposures and retail segments. First, a bank
could use its own estimates of LGD for a subcategory of exposures if
the bank had prior written approval from its primary Federal supervisor
to use internal estimates for that subcategory of exposures. In
approving a bank's use of internal estimates of LGD, a bank's primary
Federal supervisor would consider whether the bank's internal estimates
of LGD were reliable and sufficiently reflective of economic downturn
conditions. The supervisor would also consider whether the bank has
rigorous and well-documented policies and procedures for identifying
economic downturn conditions for the exposure subcategory, identifying
material adverse correlations between the relevant drivers of default
rates and loss rates given default, and incorporating identified
correlations into internal LGD estimates. If a bank had supervisory
approval to use its own estimates of LGD for an exposure subcategory,
it would use its own estimates of LGD for all exposures within that
subcategory.
As an alternative to internal estimates of LGD, the proposed rule
provided a supervisory mapping function for converting ELGD into LGD
for risk-based capital purposes. A bank that did not qualify to use its
own estimates of LGD for a subcategory of exposures would instead
compute LGD using the linear supervisory mapping function: LGD = 0.08 +
0.92 x ELGD. A bank would not have to apply the supervisory mapping
function to repo-style transactions, eligible margin loans, and OTC
derivative contracts (defined below in section V.C. of this preamble).
The agencies proposed the supervisory mapping function because of
concerns that banks may find it difficult to produce internal estimates
of LGD that are sufficient for risk-based capital purposes because LGD
data for important portfolios may be sparse, and there is limited
industry experience with incorporating downturn conditions into LGD
estimates. The supervisory mapping function provided a pragmatic
methodology for banks to use while refining their LGD estimation
techniques.
In general, commenters viewed the supervisory mapping function as a
significant deviation from the New Accord that would add unwarranted
prescriptiveness and regulatory burden to the U.S. rule. Commenters
requested more flexibility to address problems with LGD estimation,
including the ability to apply appropriate margins of conservatism as
contemplated in the New Accord. Commenters expressed concern that U.S.
supervisors would employ an unreasonably high standard for allowing own
estimates of LGD, forcing banks to use the supervisory mapping function
for an extended period of time. Commenters also expressed concern that
supervisors would view the output of the supervisory mapping function
as a floor on internal estimates of LGD. Commenters asserted that in
both cases risk-based capital requirements would be increased at U.S.
banks relative to their foreign competitors, particularly for high-
quality assets, putting U.S. banks at a competitive disadvantage to
foreign banks.
In particular, many commenters viewed the supervisory mapping
function as overly punitive for exposure categories with relatively low
loss severities, effectively imposing an 8 percent floor on LGD.
Commenters also objected to the proposed requirement that a bank use
the supervisory mapping function for an entire subcategory of exposures
even if it had difficulty estimating LGD only for a small subset of
those exposures.
The agencies continue to believe that the supervisory mapping
function is a reasonable aid for dealing with problems in LGD
estimation. The agencies recognize, however, that there may be several
valid methodologies for addressing such problems. For example, a
relative scarcity of historical loss data for a particular obligor or
exposure type may be addressed by increased reliance on alternative
data sources and data-enhancing tools for quantification and
alternative techniques for validation. In addition, a bank should
reflect in its estimates of risk parameters a margin of conservatism
that is related to the likely range of uncertainty. These concepts are
discussed below in the quantification principles section of the
preamble.
Therefore, the agencies are not including the supervisory mapping
function in the final rule. However, the agencies continue to believe
that the function (and associated estimation of the long-run default-
weighted average economic loss rate given default within a one-year
horizon) is one way a bank could address difficulties in estimating
LGD. However it chooses to estimate LGD, a bank's estimates of LGD must
be reliable and sufficiently reflective of economic downturn
conditions, and the bank should have rigorous and well-documented
policies and procedures for identifying economic downturn conditions
for each exposure subcategory, identifying changes in material adverse
relationships between the relevant drivers of default rates and loss
rates given default, and incorporating identified relationships into
LGD estimates.
Pre-Default Reductions in Exposure
The proposed rule incorporated comments on the ANPR suggesting a
need to better accommodate certain credit products, most prominently
asset-based lending programs, whose structures typically result in a
bank recovering substantial amounts of the exposure prior to the
default date--for example, through paydowns of outstanding principal.
The agencies believe that actions taken prior to default to mitigate
losses are an important component of a bank's overall credit risk
management, and that such actions should be reflected in LGD when banks
can quantify their effectiveness in a reliable manner. In the proposed
rule, this was achieved by measuring LGD relative to the exposure's EAD
(defined in the next section) as opposed to the amount actually owed at
default.\32\
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\32\ To illustrate, suppose that for a particular asset-based
lending exposure the EAD equaled $100 and that for every $1 owed by
the obligor at the time of default the bank's recovery would be
$0.40. Furthermore, suppose that in the event of default within a
one-year horizon, pre-default paydowns of $20 would reduce the
exposure amount to $80 at the time of default. In this case, the
bank's economic loss rate measured relative to the amount owed at
default (60 percent) would exceed the economic loss rate measured
relative to EAD (48 percent = .60 x ($100 -$20)/$100), because the
former does not reflect fully the impact of the pre-default
paydowns.
---------------------------------------------------------------------------
Commenters agreed that the IRB approach should allow banks to
recognize in their risk parameters the benefits of expected pre-default
recoveries and other expected reductions in exposure prior to default.
Some commenters suggested, however, that it is more appropriate to
reflect pre-default recoveries in EAD rather than LGD. Other commenters
supported the proposed rule's approach or asserted that banks should
have the option of incorporating pre-default recoveries in either LGD
or EAD. Commenters discouraged the agencies from restricting the types
of pre-default
[[Page 69311]]
reductions in exposure that could be recognized, and generally
contended that the reductions should be recognized for all exposures
for which a pattern of pre-default reductions can be estimated reliably
and accurately by the bank.
Consistent with the New Accord, the agencies have decided to
maintain the proposed treatment of pre-default reductions in exposure
in the final rule. The final rule does not limit the exposure types to
which a bank may apply this treatment. However, the agencies have
clarified their requirement for quantification of LGD in section
22(c)(4) of the final rule. This section states that where the bank's
quantification of LGD directly or indirectly incorporates estimates of
the effectiveness of its credit risk management practices in reducing
its exposure to troubled obligors prior to default, the bank must
support such estimates with empirical analysis showing that the
estimates are consistent with its historical experience in dealing with
such exposures during economic downturn conditions.
A bank's methods for reflecting changes in exposure during the
period prior to default must be consistent with other aspects of the
final rule. For example, a bank must use a default horizon no longer
than one year, consistent with the one-year default horizon
incorporated in other aspects of the final rule, such as the
quantification of PD. In addition, a pre-default reduction in the
outstanding amount on one exposure that does not reflect a reduction in
the bank's total exposure to the obligor, such as a refinancing, should
not be reflected as a pre-default recovery for LGD quantification
purposes.
The following simplified example illustrates how a bank could
approach incorporating pre-default reductions in exposure in LGD.
Assume a bank has a portfolio of asset-based loans fully collateralized
by receivables. The bank maintains a database of such loans that have
defaulted, which records the exposure at the time of default and the
losses incurred at and after the date of default. After careful
analysis of its historical data, the bank finds that for every $100 of
exposure on a typical asset-based loan at the time of default, properly
discounted average losses are $80 under economic downturn conditions.
Thus, the bank may assign an LGD estimate of 80 percent that is based
on such evidence.
However, assume that the bank division responsible for collections
reports that the bank's loan workout practices generally result in
exposures on the asset-based loans being significantly reduced between
the time the loan is identified internally as a problem exposure and
the time when the obligor is in default for risk-based capital
purposes. The bank studies the pre-default paydown behavior of obligors
that default within the next one-year horizon and during economic
downturn conditions. In particular, the bank uses its internal
historical data to map exposure amounts for asset-based loans at the
time of default to exposure amounts for the same loans at various
points in time prior to default and confirms that the pattern of pre-
default paydowns corresponds to reductions in the bank's overall
exposures to the obligors, as opposed to refinancings.
Robust empirical analysis further indicates that pre-default
paydowns for asset-based loans to obligors that default within the next
one-year horizon during economic downturn conditions depend on the
length of time the loan has been subject to workout. Specifically, the
bank finds that the prospects for further pre-default paydowns diminish
markedly the longer the bank has managed the loan as a problem credit
exposure. For loans that are not in workout or that the bank has placed
in workout for fewer than 90 days, the bank's analysis indicates that
pre-default paydowns on loans to obligors defaulting within the next
year during economic downturn conditions were, on average, 50 percent
of the current amount owed by the obligor. In contrast, for asset-based
loans that have been in workout for at least 90 days, the bank's
analysis indicates that any further pre-default recoveries tend to be
immaterial. Thus, provided this analysis is suitable for estimating
LGDs according to section 22(c) of the final rule, the bank may
appropriately assign an LGD estimate of 40 percent to asset-based loans
that are not in workout or that have been in workout for fewer than 90
days. For asset-based loans that have been in workout for at least 90
days, the bank should assign an LGD of 80 percent.
Exposure at Default (EAD)
Under the proposed rule, EAD for the on-balance sheet component of
a wholesale or retail exposure generally was (i) the bank's carrying
value for the exposure (including net accrued but unpaid interest and
fees) \33\ less any allocated transfer risk reserve for the exposure,
if the exposure was classified as held-to-maturity or for trading; or
(ii) the bank's carrying value for the exposure (including net accrued
but unpaid interest and fees) less any allocated transfer risk reserve
for the exposure and any unrealized gains on the exposure plus any
unrealized losses on the exposure, if the exposure was classified as
available-for-sale.
---------------------------------------------------------------------------
\33\ ``Net accrued but unpaid interest and fees'' are accrued
but unpaid interest and fees net of any amount expensed by the bank
as uncollectable.
---------------------------------------------------------------------------
One commenter asserted that banks should not be required to include
net accrued but unpaid interest and fees in EAD. Rather, this commenter
requested the flexibility to incorporate such interest and fees in
either EAD or LGD. The agencies believe that net accrued but unpaid
interest and fees represent credit exposure to an obligor, similar to
the unpaid principal of a loan extended to the obligor, and thus are
most appropriately included in EAD. Moreover, requiring all banks to
include such interest and fees in EAD rather than LGD promotes
consistency and comparability across banks for regulatory reporting and
public disclosure purposes.
The agencies are therefore maintaining the substance of the
proposed rule's definition of EAD for on-balance sheet exposures in the
final rule. The final rule clarifies that, for purposes of EAD, all
exposures other than securities classified as available-for sale
receive the treatment specified for exposures classified as held-to-
maturity or for trading under the proposal. Some exposures held at fair
value, such as partially funded loan commitments, may have both on-
balance sheet and off-balance sheet components. In such cases, a bank
must compute EAD for both the positive on- and off-balance sheet
components of the exposure.
For the off-balance sheet component of a wholesale or retail
exposure (other than an OTC derivative contract, repo-style
transaction, or eligible margin loan) in the form of a loan commitment
or line of credit, EAD under the proposed rule was the bank's best
estimate of net additions to the outstanding amount owed the bank,
including estimated future additional draws of principal and accrued
but unpaid interest and fees, that were likely to occur over the
remaining life of the exposure assuming the exposure were to go into
default. This estimate of net additions would reflect what would be
expected during a period of economic downturn conditions. This
treatment is retained in the final rule. Also, consistent with the New
Accord, the final rule extends this ``own estimates'' treatment to
trade-related letters of credit and for transaction-related
contingencies. Trade-related letters of credit are short-term self-
liquidating instruments used to finance the movement of goods and are
[[Page 69312]]
collateralized by the underlying goods. A transaction-related
contingency includes such items as a performance bond or performance-
based standby letter of credit.
For the off-balance sheet component of a wholesale or retail
exposure other than an OTC derivative contract, repo-style transaction,
eligible margin loan, loan commitment, or line of credit issued by a
bank, EAD was the notional amount of the exposure. This treatment is
retained in the final rule.
One commenter asked the agencies to permit banks to employ the New
Accord's flexibility to reflect additional draws on lines of credit in
either LGD or EAD. For the same reasons that the agencies are requiring
banks to include net accrued but unpaid interest and fees in EAD, the
agencies have decided to continue the requirement in the final rule for
banks to reflect estimates of additional draws in EAD, consistent with
the proposed rule.
Another commenter noted that the ``remaining life of the exposure''
concept in the proposed definition of EAD for off-balance sheet
exposures is ambiguous and inconsistent with defining PD over a one-
year horizon. To address this commenter's concern, the agencies have
modified the definition of EAD. The final rule requires a bank to
estimate net additions to the outstanding amount owed the bank in the
event of default over a one-year horizon.
Other commenters noted that banks may reduce their exposure to
certain sectors in periods of economic downturn, and inquired as to the
extent to which such practices may be reflected in EAD estimates. The
agencies believe that such practices may be reflected in EAD estimates
for loan commitments, lines of credit, trade-related letters of credit,
and transaction-related contingencies to the extent that those
practices are reflected in the bank's data on defaulted exposures. They
may be reflected in EAD estimates for on-balance sheet exposures only
at the time the on-balance sheet exposure is actually reduced.
To illustrate the EAD concept, assume a bank has a $100 unsecured,
fully drawn, two-year term loan with $10 of interest payable at the end
of the first year and a balloon payment of $110 at the end of the term.
Suppose it has been six months since the loan's origination, and
accrued interest equals $5. The EAD of this loan would be equal to the
outstanding principal amount plus accrued interest, or $105.
Next, consider the case of an open-end revolving credit line of
$100, on which the borrower had drawn $70 (the unused portion of the
line is $30). Current accrued but unpaid interest and fees are zero.
The bank can document that, on average, during economic downturn
conditions, 20 percent of the remaining undrawn amounts are drawn in
the year preceding a firm's default. Therefore, the bank's estimate of
future draws is $6 (20% x $30). Additionally, the bank's analysis
indicates that, on average, during economic downturn conditions, such a
facility can be expected to have accrued at the time of default unpaid
interest and commitment fees equal to three months of interest against
the drawn amount and 0.5 percent against the undrawn amount, which in
this example is assumed to equal $0.25. Thus, the EAD for estimated
future accrued but unpaid interest and fees equals $0.25. In sum, the
EAD should be the drawn amount plus estimated future accrued but unpaid
fees plus the estimated amount of future draws = $76.25 ($70 + $0.25 +
$6).
Under the proposed rule, EAD for a segment of retail exposures was
the sum of the EADs for each individual exposure in the segment. The
agencies have changed this provision in the final rule, recognizing
that banks typically estimate EAD for a segment of retail exposures
rather than on an individual exposure basis.
Under the final and proposed rules, for wholesale or retail
exposures in which only the drawn balance has been securitized, the
bank must reflect its share of the exposures' undrawn balances in EAD.
The undrawn balances of revolving exposures for which the drawn
balances have been securitized must be allocated between the seller's
and investors' interests on a pro rata basis, based on the proportions
of the seller's and investors' shares of the securitized drawn
balances. For example, if the EAD of a group of securitized exposures'
undrawn balances is $100, and the bank's share (seller's interest) in
the securitized exposures is 25 percent, the bank must reflect $25 in
EAD for the undrawn balances.
The final rule (like the proposed rule) contains a separate
treatment of EAD for OTC derivative contracts, which is in section 32
of the rule and discussed in more detail in section V.C. of the
preamble. The final rule also clarifies that a bank may use the
treatment of EAD in section 32 of the rule for repo-style transactions
and eligible margin loans, or the bank may use the general definition
of EAD described in this section for such exposures.
General Quantification Principles
The final rule, like the proposed rule, requires data used by a
bank to estimate risk parameters to be relevant to the bank's actual
wholesale and retail exposures and of sufficient quality to support the
determination of risk-based capital requirements for the exposures. For
wholesale exposures, estimation of the risk parameters must be based on
a minimum of five years of default data to estimate PD, seven years of
loss severity data to estimate LGD, and seven years of exposure amount
data to estimate EAD. For segments of retail exposures, estimation of
risk parameters must be based on a minimum of five years of default
data to estimate PD, five years of loss severity data to estimate LGD,
and five years of exposure amount data to estimate EAD. Default, loss
severity, and exposure amount data must include periods of economic
downturn conditions or the bank must adjust its estimates of risk
parameters to compensate for the lack of data from such periods. Banks
must base their estimates of PD, LGD, and EAD on the final rule's
definition of default, and must review at least annually and update (as
appropriate) their risk parameters and risk parameter quantification
process.
In all cases, banks are expected to use the best available data for
quantifying the risk parameters. A bank could meet the minimum data
requirement by using internal data, external data, or pooled data
combining internal data with external data. Internal data refers to any
data on exposures held in a bank's existing or historical portfolios,
including data elements or information provided by third parties
regarding such exposures. External data refers to information on
exposures held outside of the bank's portfolio or aggregate information
across an industry. For new lines of business, where a bank lacks
sufficient internal data, a bank likely will need to use external data
to supplement its internal data.
The agencies recognize that the minimum sample period for reference
data provided in the final rule may not provide the best available
results. A longer sample period usually captures varying economic
conditions better than a shorter sample period. In addition, a longer
sample period will include more default observations for LGD and EAD
estimation. Banks should consider using a longer-than-minimum sample
period when possible. However, the potential increase in precision
afforded by a larger sample size should be weighed against the
potential for diminished
[[Page 69313]]
comparability of older data to the existing portfolio.
Portfolios With Limited Data or Limited Defaults
Many commenters requested further clarity about the procedures that
banks should use to estimate risk parameters for portfolios
characterized by a lack of internal data or with very little default
experience. In particular, the GAO report recommended that the agencies
provide additional clarity on this issue. Several commenters indicated
that the agencies should establish criteria for identifying homogeneous
portfolios of low-risk exposures and allow banks to apportion expected
loss between LGD and PD for those portfolios rather than estimating
each risk parameter separately. Other commenters suggested that the
agencies consider whether banks should be permitted to use the New
Accord's standardized approach for credit risk for such portfolios.
The final rule requires banks to meet the qualification
requirements in section 22 for all portfolios of exposures. The
agencies expect that banks demonstrating appropriately rigorous
processes and sufficient degrees of conservatism for portfolios with
limited data or limited defaults will be able to meet the qualification
requirements. Section 22(c)(3) of the final rule specifically states
that a bank's risk parameter quantification process ``must produce
appropriately conservative risk parameter estimates where the bank has
limited relevant data.'' The agencies believe that this section
provides sufficient flexibility and incentives for banks to develop and
document sound practices for applying the IRB approach to portfolios
lacking sufficient data.
The section of the preamble below expands upon potential approaches
to portfolios with limited data. The BCBS publication ``Validation of
low-default portfolios in the Basel II Framework'' \34\ also provides a
resource for banks facing this issue. The agencies will work with banks
through the supervisory and examination processes to address particular
situations.
---------------------------------------------------------------------------
\34\ BCBS, Basel Committee Newsletter No. 6, ``Validation of
low-default portfolios in the Base II Framework,'' September 2005.
---------------------------------------------------------------------------
Portfolios with limited data. The final rule, like the proposal,
permits the use of external data in quantification of risk parameters.
External data should be informative of, and appropriate to, a bank's
existing exposures. In some cases, a bank may be able to acquire and
use external data from a third party to estimate risk parameters until
the bank's internal database meets the requirements of the rule.
Alternatively, a bank may be able to identify a set of data-rich
internal exposures that could be used to inform the estimation of risk
parameters for the portfolio for which it has insufficient data. The
key considerations for a bank in determining whether to use alternative
data sources will be whether such data are sufficiently accurate,
complete, representative and informative of the bank's existing
exposures and whether the bank's quantification of risk parameters is
rigorously conducted and well documented.
For instance, consider a bank that has recently extended its credit
card operations to include a new market segment for credit card loans
and, therefore, has limited internal data on the performance of the
exposures in this new market segment. The bank could acquire external
data from various vendors that would provide a broad, market-wide
picture of default and loss experience in the new market segment. This
external data could then be supplemented by the bank's internal data
and experience with its existing credit card operations. By comparing
the bank's experience with its existing customers to the market data,
the bank can refine the risk parameters estimated from the external
data on the new market segment and make those parameters more accurate
for the bank's new market segment of exposures. Using the combination
of these data sources, the bank may be able to estimate appropriately
conservative estimates of risk parameters for its new market segment of
exposures. If the bank is not able to do so, it must include the new
market segment of exposures in its set of aggregate immaterial
exposures and apply a 100 percent risk weight.
Portfolios with limited defaults. Commenters indicated that they
had experienced very few defaults for some portfolios, most notably
margin loans and exposures to some sovereign issuers, which made it
difficult to separately estimate PD and LGD. The agencies recognize
that some portfolios have experienced very few defaults and have very
low loss experiences. The absence of defaults or losses in historical
data does not, however, preclude the potential for defaults or large
losses to arise in future circumstances. Moreover, as discussed
previously, the ability to separate EL into PD and LGD is a key
component of the IRB approach.
As with the cases described above in which internal data are
limited in all dimensions, external data from some related portfolios
or for similar obligors may be used to estimate risk parameters that
are then mapped to the low default portfolio or obligor. For example,
banks could consider instances of near default or credit deterioration
short of default in these low default portfolios to inform estimates of
what might happen if a default were to occur. Similarly, scenario
analysis that evaluates the hypothetical impact of severe market
disruptions may help inform the bank's parameter estimates for margin
loans. For very low-risk wholesale obligors that have publicly traded
financial instruments, banks may be able to glean information about the
relative values of PD and LGD from different changes in credit spreads
on instruments of different maturity or from different moves in credit
spreads and equity prices. In all cases, risk parameter estimates
should incorporate a degree of conservatism that is appropriate for the
overall rigor of the quantification process.
Other quantification process considerations. Both internal and
external reference data should not differ systematically from a bank's
existing portfolio in ways that seem likely to be related to default
risk, loss severity, or exposure at default. Otherwise, the derived PD,
LGD, or EAD estimates may not be applicable to the bank's existing
portfolio. Accordingly, the bank must conduct a comprehensive review
and analysis of reference data at least annually to determine the
relevance of reference data to the bank's exposures, the quality of
reference data to support PD, LGD, and EAD estimates, and the
consistency of reference data to the definition of default in the final
rule. Furthermore, a bank must have adequate internal or external data
to estimate the risk parameters PD, LGD, and EAD (each of which
incorporates a one-year time horizon) for all wholesale exposure and
retail segments, including those originated for sale or that are in the
securitization pipeline.
As noted above, periods of economic downturn conditions must be
included in the data sample (or adjustments to risk parameters must be
made). If the reference data include data from beyond the minimum
number of years (to capture a period of economic downturn conditions or
for other valid reasons), the reference data need not cover all of the
intervening years. However, a bank should justify the exclusion of
available data and, in particular, any temporal discontinuities in data
used. Including periods of economic downturn conditions increases the
size and potentially the breadth of the reference data set. According
to some empirical studies, the average loss rate is higher during
periods of economic downturn
[[Page 69314]]
conditions, such that exclusion of such periods would bias LGD or EAD
estimates downward and unjustifiably lower risk-based capital
requirements.
Risk parameter estimates should take into account the robustness of
the quantification process. The assumptions and adjustments embedded in
the quantification process should reflect the degree of uncertainty or
potential error inherent in the process. In practice, a reasonable
estimation approach likely would result in a range of defensible risk
parameter estimates. The choices of the particular assumptions and
adjustments that determine the final estimate, within the defensible
range, should reflect the uncertainty in the quantification process.
More uncertainty in the process should be reflected in the assignment
of final risk parameter estimates that result in higher risk-based
capital requirements relative to a quantification process with less
uncertainty. The degree of conservatism applied to adjust for
uncertainty should be related to factors such as the relevance of the
reference data to a bank's existing exposures, the robustness of the
models, the precision of the statistical estimates, and the amount of
judgment used throughout the process. A bank is not required to add a
margin of conservatism at each step if doing so would produce an
excessively conservative result. Instead, the overall margin of
conservatism should adequately account for all uncertainties and
weaknesses in the quantification process. Improvements in the
quantification process (including use of more complete data and better
estimation techniques) may reduce the appropriate degree of
conservatism over time.
Judgment will inevitably play a role in the quantification process
and may materially affect the estimates of risk parameters. Judgmental
adjustments to estimates are often necessary because of limitations on
available reference data or because of inherent differences between the
reference data and the bank's existing exposures. The bank's risk
parameter quantification process must produce appropriately
conservative risk parameter estimates when the bank has limited
relevant data, and any adjustments that are part of the quantification
process must not result in a pattern of bias toward lower risk
parameter estimates. This does not prohibit individual adjustments that
result in lower estimates of risk parameters, as both upward and
downward adjustments are expected. Individual adjustments are less
important than broad patterns; consistent signs of judgmental decisions
that materially lower risk parameter estimates may be evidence of
systematic bias, which is not permitted.
In estimating relevant risk parameters, banks should not rely on
the possibility of U.S. government financial assistance, except for the
financial assistance that the U.S. government has a legally binding
commitment to provide.
4. Optional Approaches That Require Prior Supervisory Approval
A bank that intends to apply the internal models methodology to
counterparty credit risk, the double default treatment for credit risk
mitigation, the IAA for securitization exposures to ABCP programs, or
the IMA to equity exposures must receive prior written approval from
its primary Federal supervisor. The criteria on which approval will be
based are described in the respective sections below.
5. Operational Risk
A bank must have operational risk management processes, data and
assessment systems, and quantification systems that meet the
qualification requirements in section 22(h) of the final rule. A bank
must have an operational risk management function that is independent
of business line management. The operational risk management function
is responsible for the design, implementation, and oversight of the
bank's operational risk data and assessment systems, operational risk
quantification systems, and related processes. The roles and
responsibilities of the operational risk management function may vary
between banks, but should be clearly documented. The operational risk
management function should have an organizational stature commensurate
with the bank's operational risk profile. At a minimum, the bank's
operational risk management function should ensure the development of
policies and procedures for the explicit management of operational risk
as a distinct risk to the bank's safety and soundness.
A bank also must establish and document a process to identify,
measure, monitor, and control operational risk in bank products,
activities, processes, and systems. This process should provide for the
consistent and comprehensive collection of the data needed to estimate
the bank's exposure to operational risk. This process must capture
business environment and internal control factors affecting the bank's
operational risk profile. The process must also ensure reporting of
operational risk exposures, operational loss events, and other relevant
operational risk information to business unit management, senior
management, and to the board of directors (or a designated committee of
the board).
The final rule defines an operational loss event as an event that
results in loss and is associated with any of the seven operational
loss event type categories. Under the final rule, the agencies have
included definitions of the seven operational loss event type
categories, consistent with the descriptions outlined in the New
Accord. The seven operational loss event type categories are: (i)
Internal fraud, which is the operational loss event type category that
comprises operational losses resulting from an act involving at least
one internal party of a type intended to defraud, misappropriate
property or circumvent regulations, the law or company policy,
excluding diversity and discrimination-type events; (ii) external
fraud, which is the operational loss event type category that comprises
operational losses resulting from an act by a third party of a type
intended to defraud, misappropriate property or circumvent the law;
\35\ (iii) employment practices and workplace safety, which is the
operational loss event type category that comprises operational losses
resulting from an act inconsistent with employment, health, or safety
laws or agreements, payment of personal injury claims, or payment
arising from diversity or discrimination events; (iv) clients,
products, and business practices, which is the operational loss event
type category that comprises operational losses resulting from the
nature or design of a product or from an unintentional or negligent
failure to meet a professional obligation to specific clients
(including fiduciary and suitability requirements); (v) damage to
physical assets, which is the operational loss event type category that
comprises operational losses resulting from the loss of or damage to
physical assets from natural disaster or other events; (vi) business
disruption and system failures, which is the operational loss event
type category that comprises operational losses resulting from
disruption of business or system failures; and (vii) execution,
delivery, and process management, which is the operational loss event
type category that comprises operational losses resulting from failed
transaction processing or process management or losses arising from
[[Page 69315]]
relations with trade counterparties and vendors.
---------------------------------------------------------------------------
\35\ Retail credit card losses arising from non-contractual,
third-party initiated fraud (for example, identity theft) are
external fraud operational losses. All other third-party initiated
credit losses are to be treated as credit risk losses.
---------------------------------------------------------------------------
The final rule does not require a bank to capture internal
operational loss event data according to these categories. However,
unlike the proposed rule, the final rule requires that a bank must be
able to map such data into the seven operational loss event type
categories. The agencies believe such mapping will promote reporting
consistency and comparability across banks and is consistent with
expectations in the New Accord.\36\
---------------------------------------------------------------------------
\36\ New Accord, ] 673.
---------------------------------------------------------------------------
A bank's operational risk management processes should reflect the
scope and complexity of its business lines, as well as its corporate
organizational structure. Each bank's operational risk profile is
unique and should have a tailored risk management approach appropriate
for the scale and materiality of the operational risks present in the
bank.
Operational Risk Data and Assessment System
A bank must have an operational risk data and assessment system
that incorporates on an ongoing basis the following four elements:
internal operational loss event data, external operational loss event
data, results of scenario analysis, and assessments of the bank's
business environment and internal controls. These four operational risk
elements should aid the bank in identifying the level and trend of
operational risk, determining the effectiveness of operational risk
management and control efforts, highlighting opportunities to better
mitigate operational risk, and assessing operational risk on a forward-
looking basis. A bank's operational risk data and assessment system
must be structured in a manner consistent with the bank's current
business activities, risk profile, technological processes, and risk
management processes.
The proposed rule defined operational loss as a loss (excluding
insurance or tax effects) resulting from an operational loss event.
Operational losses included all expenses associated with an operational
loss event except for opportunity costs, forgone revenue, and costs
related to risk management and control enhancements implemented to
prevent future operational losses. The definition of operational loss
is an important issue, as it is a critical building block in a bank's
calculation of its operational risk capital requirement under the AMA.
More specifically, the bank's estimate of operational risk exposure--
the basis for determining a bank's risk-weighted asset amount for
operational risk--is an estimate of aggregate operational losses
generated by the bank's AMA process.
Many commenters supported the agencies' proposed definition of
operational loss and viewed it as appropriate and consistent with
general use within the banking industry. Some commenters, however,
opposed the inclusion of a specific definition of operational loss and
asserted that the proposed treatment of operational loss is too
prescriptive. In addition, some commenters maintained that including a
definition of operational loss is inconsistent with the New Accord,
which does not explicitly define operational loss. In response to a
specific question in the proposal, many commenters asserted that the
definition of operational loss should relate to its impact on
regulatory capital rather than economic capital concepts. One
commenter, however, recommended using the replacement cost of any fixed
asset affected by an operational loss event to reflect the actual
financial impact of the event.
Because operational losses are the building blocks in a bank's
calculation of its operational risk capital requirement under the AMA,
the agencies continue to believe that it is necessary to define what is
meant by operational loss to achieve comparability and foster
consistency both across banks and across business lines within a bank.
Additionally, the agencies agree with those commenters who asserted
that the definition of operational loss should relate to its impact on
regulatory capital. Therefore, the agencies have adopted the proposed
definition of operational loss unchanged.
In the preamble to the proposed rule, the agencies recognized that
there was a potential to double-count all or a portion of the risk-
based capital requirement associated with fixed assets. Under the
proposed rule, the credit-risk-weighted asset amount for a bank's
premises would equal the carrying value of the premises on the
financial statements of the bank, determined in accordance with GAAP. A
bank's operational risk exposure estimate addressing bank premises
generally would be different than, and in addition to, the risk-based
capital requirement generated under the proposed rule and could, at
least in part, address the same risk exposure. The majority of
commenters on this issue recommended removing the credit risk capital
requirement for premises and other fixed assets and preserving only the
operational risk capital requirement.
The agencies are maintaining the proposed rule's treatment of fixed
assets in the final rule. The New Accord generally provides a risk
weight of 100 percent for assets for which an IRB treatment is not
specified.\37\ Consistent with the New Accord, the final rule provides
that the risk-weighted asset amount for any on-balance sheet asset that
does not meet the definition of a wholesale, retail, securitization, or
equity exposure is equal to the carrying value of the asset. Also
consistent with the New Accord, the final rule continues to include
damage to physical assets among the operational loss event types
incorporated into a bank's operational risk exposure estimate.\38\ The
agencies believe that requiring a bank to calculate both a credit risk
and operational risk capital requirement for premises and fixed assets
is justified in light of the fact that the credit risk capital
requirement covers a broader set of risks, whereas the operational risk
capital requirement covers potential physical damage to the asset. The
agencies view this treatment of premises and other fixed assets as
consistent with the New Accord and have confirmed that the approach is
consistent with the approaches used by other jurisdictions implementing
the New Accord.
---------------------------------------------------------------------------
\37\ New Accord, ] 214.
\38\ New Accord, Annex 9.
---------------------------------------------------------------------------
A bank must have a systematic process for capturing and using
internal operational loss event data in its operational risk data and
assessment systems. The final rule defines a bank's internal
operational loss event data as its gross operational loss amounts,
dates, recoveries, and relevant causal information for operational loss
events occurring at the bank. Under the proposed rule, a bank's
operational risk data and assessment system would include a minimum
historical observation period of five years of internal operational
losses. With approval of its primary Federal supervisor, however, a
bank could use a shorter historical observation period to address
transitional situations such as integrating a new business line. A bank
also could refrain from collecting internal operational loss event data
for individual operational losses below established dollar threshold
amounts if the bank could demonstrate to the satisfaction of its
primary Federal supervisor that the thresholds were reasonable, did not
exclude important internal operational loss event data, and permitted
the bank to capture substantially all the dollar value of the bank's
operational losses.
[[Page 69316]]
Several commenters expressed concern over the proposal's five-year
minimum historical observation period requirement for internal
operational loss event data. These commenters recommended that the
agencies align this provision with the New Accord, which allows for a
three-year historical observation period upon initial AMA
implementation.
While the proposed rule required a bank to include in its
operational risk data and assessment systems a historical observation
period of at least five years for internal operational loss event data,
it also provided for a shorter observation period subject to agency
approval to address transitional situations, such as integrating a new
business line. The agencies believe that these proposed provisions
provide sufficient flexibility to consider other situations, on a case-
by-case basis, in which a shorter observation period may be
appropriate, such as a bank's initial implementation of an AMA.
Therefore, the final rule retains the five-year historical observation
period requirements and the transitional flexibility for internal
operational loss event data, as proposed.
In relation to the provision that permits a bank to refrain from
collecting internal operational loss event data below established
thresholds, a few commenters sought clarification of the proposed
requirement that the thresholds must permit the bank to capture
``substantially all'' of the dollar value of a bank's operational
losses. In particular, they questioned whether a bank must collect all
or a very high percentage of operational losses or whether smaller
losses could be modeled.
To demonstrate the appropriateness of its threshold for internal
operational loss event data collection, a bank might choose to collect
all internal operational loss event data, at least for a time, to
support a meaningful analysis around the appropriateness of its chosen
data collection threshold. Alternatively, a bank might be able to
obtain data from systems outside of its operational risk data and
assessment system (for example, the bank's general ledger system) to
demonstrate the impact of choosing different thresholds on its
operational risk exposure estimates.
With respect to the commenters' question regarding modeling smaller
losses, the agencies would consider permitting such an approach based
on whether the approach meets the overall qualification requirements
outlined in the final rule. In particular, the agencies would consider
whether the bank satisfies those requirements pertaining to a bank's
operational risk quantification system as well as its control,
oversight, and validation mechanisms. Such modeling considerations,
however, would not eliminate the requirement for a bank to demonstrate
the appropriateness of any established internal operational loss event
data collection thresholds.
A bank also must establish a systematic process to determine its
methodologies for incorporating external operational loss event data
into its operational risk data and assessment systems. The proposed and
final rules define external operational loss event data for a bank as
gross operational loss amounts, dates, recoveries, and relevant causal
information for operational loss events occurring at organizations
other than the bank. External operational loss event data may serve a
number of different purposes in a bank's operational risk data and
assessment systems. For example, external operational loss event data
may be a particularly useful input in determining a bank's level of
exposure to operational risk when internal operational loss event data
are limited. In addition, external operational loss event data provide
a means for the bank to understand industry experience and, in turn,
provide a means for the bank to assess the adequacy of its internal
operational loss event data.
While internal and external operational loss event data provide a
historical perspective on operational risk, it is also important that a
bank incorporate forward-looking elements into its operational risk
data and assessment systems. Accordingly, under the final rule, as
under the proposed rule, a bank must incorporate business environment
and internal control factors into its operational risk data and
assessment systems to assess fully its exposure to operational risk. In
principle, a bank with strong internal controls in a stable business
environment would have less exposure to operational risk than a bank
with internal control weaknesses that is growing rapidly or introducing
new products. In this regard, a bank should identify and assess the
level and trends in operational risk and related control structures at
the bank. These assessments should be current and comprehensive across
the bank, and they should identify the operational risks facing the
bank. The framework established by a bank to maintain these risk
assessments should be sufficiently flexible to accommodate increasing
complexity, new activities, changes in internal control systems, and an
increasing volume of information. A bank must also periodically compare
the results of its prior business environment and internal control
factor assessments against the bank's actual operational losses
incurred in the intervening period.
A few commenters sought clarification on the agencies' expectations
regarding a bank's periodic comparisons of its prior business
environment and internal control factor assessments against its actual
operational losses. One commenter expressed concern over the difficulty
of conducting an empirically robust analysis to fulfill the
requirement.
Under the final rule, a bank has flexibility in the approach it
uses to conduct its business environment and internal control factor
assessments. As such, the methods for conducting comparisons of these
assessments against actual operational loss experience may also vary
and precise modeling calibration may not be practical. The agencies
maintain, however, that it is important for a bank to perform such
comparisons to ensure that its assessments are current, reasonable, and
appropriately factored into the bank's AMA framework. In addition, the
comparisons could highlight the need for potential adjustments to the
bank's operational risk management processes.
A bank also must have a systematic process for determining its
methodologies for incorporating scenario analysis into its operational
risk data and assessment systems. As an input to a bank's operational
risk data and assessment systems, scenario analysis is especially
relevant for business lines or operational loss event types where
internal data, external data, and assessments of the business
environment and internal control factors do not provide a sufficiently
robust estimate of the bank's exposure to operational risk.
Similar to business environment and internal control factor
assessments, the results of scenario analysis provide a means for a
bank to incorporate a forward-looking element into its operational risk
data and assessment systems. Under the proposed rule, scenario analysis
was defined as a systematic process of obtaining expert opinions from
business managers and risk management experts to derive reasoned
assessments of the likelihood and loss impact of plausible high-
severity operational losses. The agencies have clarified this
definition in the final rule to recognize that there are various
methods and inputs a bank may use to conduct its scenario analysis. For
this reason, the modified definition indicates that scenario analysis
may
[[Page 69317]]
include the well-reasoned evaluation and use of external operational
loss event data, adjusted as appropriate to ensure relevance to a
bank's operational risk profile and control structure.
A bank's operational risk data and assessment systems must include
credible, transparent, systematic, and verifiable processes that
incorporate all four operational risk elements (that is, internal
operational loss event data, external operational loss event data,
scenario analysis, and business environment and internal control
factors). The bank should have clear standards for the collection and
modification of all elements. The bank should combine these four
elements in a manner that most effectively enables it to quantify its
exposure to operational risk.
Operational Risk Quantification System
A bank must have an operational risk quantification system that
generates estimates of its operational risk exposure using its
operational risk data and assessment systems. The final rule defines
operational risk exposure as the 99.9th percentile of the distribution
of potential aggregate operational losses, as generated by the bank's
operational risk quantification system over a one-year horizon (and not
incorporating eligible operational risk offsets or qualifying
operational risk mitigants). The mean of such a total loss distribution
is the bank's EOL. The final rule defines EOL as the expected value of
the distribution of potential aggregate operational losses, as
generated by the bank's operational risk quantification system using a
one-year horizon. The bank's UOL is the difference between the bank's
operational risk exposure and the bank's EOL.
A few commenters sought clarification on whether the agencies would
impose specific requirements around the use and weighting of the four
elements of a bank's operational risk data and assessment system, and
whether there were any limitations on how external data or scenario
analysis could be used as modeling inputs. Another commenter expressed
concern that for some U.S.-chartered DIs that were subsidiaries of
foreign banking organizations, it might be difficult to ever have
enough internal operational loss event data to generate statistically
significant operational risk exposure estimates.
The agencies recognize that banks will have different inputs and
methodologies for estimating their operational risk exposure given the
inherent flexibility of the AMA. It follows that the weights assigned
in combining the four required elements of a bank's operational risk
data and assessment system (internal operational loss event data,
external operational loss event data, scenario analysis, and
assessments of the bank's business environment and internal control
factors) will also vary across banks. Factors affecting the weighting
include a bank's operational risk profile, operational loss experience,
internal control environment, and relative quality and content of the
four elements. These factors will influence the emphasis placed on
certain elements relative to others. As such, the agencies are not
prescribing specific requirements around the weighting of each element,
nor are they placing any specific limitations on the use of the
elements. In view of this flexibility, however, under the final rule a
bank's operational risk quantification systems must include a credible,
transparent, systematic, and verifiable approach for weighting the use
of the four elements.
As part of its operational risk exposure estimate, a bank must use
a unit of measure that is appropriate for the bank's range of business
activities and the variety of operational loss events to which it is
exposed. The proposed rule defined a unit of measure as the level (for
example, organizational unit or operational loss event type) at which
the bank's operational risk quantification system generated a separate
distribution of potential operational losses. Under the proposed rule,
a bank could not combine business activities or operational loss events
with different risk profiles within the same loss distribution.
Many commenters expressed concern that the prohibition against
combining business activities or operational loss events with different
risk profiles within the same loss distribution was an impractical
standard because some level of combination was unavoidable.
Additionally, commenters noted that data limitations made it difficult
to quantify risk profiles at a granular level. Commenters also
expressed concern that the proposed rule appeared to preclude the use
of ``top-down'' approaches, given that under a firm-wide approach
business activities or operational loss events with different risk
profiles would necessarily be combined within the same loss
distribution. One commenter suggested that, because of data limitations
and the potential for wide variations in risk profiles within
individual business lines and/or types of operational loss events,
banks be afforded some latitude in moving from a ``top-down'' approach
to a ``bottom-up'' approach.
The agencies have retained the proposed definition of unit of
measure in the final rule. The agencies recognize, however, that there
is a need for flexibility in assessing whether a bank's chosen unit of
measure is appropriate for the bank's range of business activities and
the variety of operational loss events to which it is exposed. In some
instances, data limitations may indeed prevent a bank's operational
risk quantification systems from generating a separate distribution of
potential operational losses for certain business lines or operational
loss event types. Therefore, the agencies have modified the final rule
to provide a bank more flexibility in devising an appropriate unit of
measure. Specifically, a bank must employ a unit of measure that is
appropriate for its range of business activities and the variety of
operational loss events to which it is exposed, and that does not
combine business activities or operational loss events with
demonstrably different risk profiles within the same loss distribution.
The agencies recognize that operational losses across operational
loss event types and business lines may be related. Under the final
rule, as under the proposed rule, a bank may use its internal estimates
of dependence among operational losses within and across business lines
and operational loss event types if the bank can demonstrate to the
satisfaction of its primary Federal supervisor that its process for
estimating dependence is sound, robust to a variety of scenarios,
implemented with integrity, and allows for the uncertainty surrounding
the estimates. The agencies expect that a bank's assumptions regarding
dependence will be conservative given the uncertainties surrounding
dependence modeling for operational risk. If a bank does not satisfy
the requirements surrounding dependence, the bank must sum operational
risk exposure estimates across units of measure to calculate its total
operational risk exposure.
Under the proposed rule, dependence was defined as ``a measure of
the association among operational losses across and within business
lines and operational loss event types.'' One commenter recommended
that the agencies revise the definition of dependence to ``a measure of
the association among operational losses across and within units of
measure.'' The agencies recognize that examples of units of measure
include, but are not limited to, business lines and operational loss
event types, and that a bank's operational risk quantification system
could generate distributions of potential operational losses that are
[[Page 69318]]
separate from its business lines and operational loss event types.
Units of measure can also encompass correlations over time. Therefore,
the agencies have amended the final rule to define dependence as a
measure of the association among operational losses across and within
units of measure.
As noted above, under the proposed rule, a bank that did not
satisfy the requirements surrounding dependence would sum operational
risk exposure estimates across units of measure to calculate its total
operational risk exposure. Several commenters asserted that the New
Accord does not require a bank to sum its operational risk exposure
estimates across units of measure if the bank cannot demonstrate
adequate support of its dependence assumptions. One commenter asked the
agencies to remove this requirement from the final rule. Several
commenters suggested that if a bank cannot provide sufficient support
for its dependence estimates, a conservative assumption of positive
dependence is warranted, but not an assumption of perfect positive
dependence as implied by the summation requirement. Another commenter
suggested that the dependence assumption should be based upon a
conservative statistical analysis of industry data.
The New Accord states that, absent a satisfactory demonstration of
a bank's ``systems for determining correlations'' to its national
supervisor, ``risk measures for different operational risk estimates
must be added for purposes of calculating the regulatory minimum
capital requirement.'' \39\ The agencies continue to believe that this
treatment of operational risk exposure estimates across units of
measure is prudent until the relationships among operational losses are
better understood. Therefore, the final rule retains the proposed
rule's requirement regarding the summation of operational risk exposure
estimates.
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\39\ New Accord, ]669.
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Several commenters believed that a bank should be permitted to
demonstrate the nature of the relationship between the causes of
different operational losses based on any available informative
empirical evidence. These commenters suggested that such evidence could
be statistical or anecdotal, and could be based on information ranging
from established statistical techniques to more general mathematical
approaches to clear logical arguments about the degree to which risks
and losses are related, or the similarity of circumstance between the
bank and a peer group for which acceptable estimates of dependency are
available.
The agencies recognize that there may be different ways to estimate
the relationship among operational losses across and within units of
measure. Therefore, under the final rule, a bank has flexibility to use
different methodologies to demonstrate dependence across units of
measure. However, the bank must demonstrate to the satisfaction of its
primary Federal supervisor that its process for estimating dependence
is sound, robust to a variety of scenarios, implemented with integrity,
and allows for the uncertainty surrounding the estimates.
A bank's chosen unit of measure affects how it should account for
dependence. Explicit assumptions regarding dependence across units of
measure are always necessary to estimate operational risk exposure at
the bank level. However, explicit assumptions regarding dependence
within units of measure are not necessary, and under many circumstances
models assume statistical independence within each unit of measure. The
use of only a few units of measure increases the need to ensure that
dependence within units of measure is suitably reflected in the
operational risk exposure estimate.
In addition, the bank's process for estimating dependence should
provide for ongoing monitoring, recognizing that dependence estimates
can change. The agencies expect that a bank's approach for developing
explicit and objective dependence determinations will improve over
time. As such, the bank should develop a process for assessing
incremental improvements to the approach (for example, through out-of-
sample testing).
Under the final rule, as under the proposed rule, a bank must
review and update (as appropriate) its operational risk quantification
system whenever the bank becomes aware of information that may have a
material effect on the bank's estimate of operational risk exposure,
but no less frequently than annually.
The agencies recognize that, in limited circumstances, there may
not be sufficient data available for a bank to generate a credible
estimate of its own operational risk exposure at the 99.9 percent
confidence level. In these limited circumstances, under the proposed
rule, a bank could use an alternative operational risk quantification
system, subject to prior approval by the bank's primary Federal
supervisor. The alternative approach was not available at the BHC
level.
One commenter asserted that, in line with the New Accord's
continuum of operational risk measurement approaches, all banks,
including BHCs, should be permitted to adopt an alternative operational
risk quantification system, such as the New Accord's standardized
approach or allocation approach. The commenter further noted that a
bank's use of an allocation approach should not be subject to more
stringent terms and conditions than those set forth in the New Accord.
The agencies are maintaining the alternative approach provision in
the final rule. The agencies are not prescribing specific estimation
methodologies under this approach and expect use of an alternative
approach to occur on a very limited basis. A bank proposing to use an
alternative operational risk quantification system must submit a
proposal to its primary Federal supervisor. In evaluating a bank's
proposal, the primary Federal supervisor will review the bank's
justification for requesting use of an alternative approach in light of
the bank's size, complexity, and risk profile. The bank's primary
Federal supervisor will also consider whether the estimate of
operational risk under the alternative approach is appropriate (for
example, whether the estimate results in capital levels that are
commensurate with the bank's operational risk profile and is sensitive
to changes in the bank's risk profile) and can be supported
empirically. Furthermore, the agencies expect a bank using an
alternative operational risk quantification system to adhere to the
rule's qualification requirements, including establishment and use of
operational risk management processes and data and assessment systems.
As under the proposed rule, the alternative approach is not available
at the BHC level.
A bank proposing an alternative approach to operational risk based
on an allocation methodology should be aware of certain limitations
associated with the use of such an approach. Specifically, the agencies
will not permit a DI to accept an allocation of operational risk
capital requirements that includes non-DIs. Unlike the cross-guarantee
provision of the Federal Deposit Insurance Act, which provides that a
DI is liable for any losses incurred by the FDIC in connection with the
failure of a commonly-controlled DI, there are no statutory provisions
requiring cross-guarantees between a DI and its non-DI affiliates. \40\
Furthermore, depositors and creditors of a DI generally have no legal
recourse to
[[Page 69319]]
capital funds that are not held by the DI or its affiliate DIs.
---------------------------------------------------------------------------
\40\ 12 U.S.C. 1815(e).
---------------------------------------------------------------------------
6. Data Management and Maintenance
A bank must have data management and maintenance systems that
adequately support all aspects of the bank's advanced IRB systems,
operational risk management processes, operational risk data and
assessment systems, operational risk quantification systems, and, to
the extent the bank uses the following systems, the internal models
methodology, the double default excessive correlation detection
process, the IMA for equity exposures, and the IAA for securitization
exposures to ABCP programs (collectively, advanced systems).
The bank's data management and maintenance systems must adequately
support the timely and accurate reporting of risk-based capital
requirements. Specifically, a bank must retain sufficient data elements
related to key risk drivers to permit monitoring, validation, and
refinement of the bank's advanced systems. A bank's data management and
maintenance systems should generally support the rule's qualification
requirements relating to quantification, validation, and control and
oversight mechanisms, as well as the bank's broader risk management and
reporting needs. The precise data elements to be collected are dictated
by the features and methodologies of the risk measurement and
management systems employed by the bank. To meet the significant data
management challenges presented by the quantification, validation, and
control and oversight requirements of the advanced approaches, a bank
must retain data in an electronic format that allows timely retrieval
for analysis, reporting, and disclosure purposes. The agencies did not
receive any material comments on these data management requirements.
7. Control and Oversight Mechanisms
The consequences of an inaccurate or unreliable advanced system can
be significant, particularly regarding the calculation of risk-based
capital requirements. Accordingly, bank senior management is
responsible for ensuring that all advanced systems function effectively
and comply with the qualification requirements.
Under the proposed rule, a bank's board of directors (or a
designated committee of the board) would at least annually evaluate the
effectiveness of, and approve, the bank's advanced systems. Multiple
commenters objected to this requirement. Commenters suggested that a
bank's board of directors should have more narrowly defined
responsibilities, and that evaluation of a bank's advanced systems
would be more effectively and appropriately accomplished by senior
management.
The agencies believe that a bank's board of directors has ultimate
accountability for the effectiveness of the bank's advanced systems.
However, the agencies agree that it is not necessarily the
responsibility of a bank's board of directors to conduct an evaluation
of the effectiveness of a bank's advanced systems. Evaluation may
include transaction testing, validation, and audit activities more
appropriately the responsibility of senior management. Accordingly, the
final rule requires a bank's board of directors to review the
effectiveness of, and approve, the bank's advanced systems at least
annually.
To support senior management's and the board of directors''
oversight responsibilities, a bank must have an effective system of
controls and oversight that ensures ongoing compliance with the
qualification requirements; maintains the integrity, reliability, and
accuracy of the bank's advanced systems; and includes adequate
corporate governance and project management processes. Banks have
flexibility to determine how to achieve integrity in their risk
management systems. Banks are, however, expected to follow standard
control principles in their systems such as checks and balances,
separation of duties, appropriateness of incentives, and data integrity
assurance, including that of information purchased from third parties.
Moreover, the oversight process should be sufficiently independent of
the advanced systems'' development, implementation, and operation to
ensure the integrity of the component systems. The objective of risk
management system oversight is to ensure that the various systems used
in determining risk-based capital requirements are operating as
intended. The oversight process should draw conclusions on the
soundness of the components of the risk management system, identify
errors and flaws, and recommend corrective action as appropriate.
Validation
A bank must validate its advanced systems on an ongoing basis.
Validation is the set of activities designed to give the greatest
possible assurances of accuracy of the advanced systems. Validation
includes three broad components: (i) Evaluation of the conceptual
soundness of the advanced systems; (ii) ongoing monitoring that
includes process verification and comparison of the bank's internal
estimates with relevant internal and external data sources or results
from other estimation techniques (benchmarking); and (iii) outcomes
analysis that includes back-testing.
Each of these three components of validation must be applied to the
bank's risk rating and segmentation systems, risk parameter
quantification processes, and internal models that are part of the
bank's advanced systems. A sound validation process should take
business cycles into account, and any adjustments for stages of the
economic cycle should be clearly specified in advance and fully
documented as part of the validation policy. Senior management of the
bank should be notified of the validation results and should take
corrective action where appropriate.
A bank's validation process must be independent of the advanced
systems' development, implementation, and operation, or be subject to
independent assessment of its adequacy and effectiveness. A bank should
ensure that individuals who perform the review are not biased in their
assessment due to their involvement in the development, implementation,
or operation of the processes or products. For example, reviews of the
internal risk rating and segmentation systems should be performed by
individuals who were not part of the development, implementation, or
maintenance of those systems. In addition, individuals performing the
reviews should possess the requisite technical skills and expertise to
fulfill their mandate.
The first component of validation is evaluating conceptual
soundness, which involves assessing the quality of the design and
construction of a risk measurement or management system. This
evaluation of conceptual soundness should include documentation and
empirical evidence supporting the methods used and the variables
selected in the design and quantification of the bank's advanced
systems. The documentation should also evidence an understanding of the
systems' limitations. The development of internal risk rating and
segmentation systems and their quantification processes requires banks
to exercise judgment. Validation should ensure that these judgments are
well informed and considered, and generally include a body of expert
opinion. A bank should review developmental evidence whenever the bank
makes material changes in its advanced systems.
[[Page 69320]]
The second component of the validation process for a bank's
advanced systems is ongoing monitoring to confirm that the systems were
implemented appropriately and continue to perform as intended. Such
monitoring involves process verification and benchmarking. Process
verification includes verifying that internal and external data are
accurate and complete, as well as ensuring that: Internal risk rating
and segmentation systems are being used, monitored, and updated as
designed; ratings are assigned to wholesale obligors and exposures as
intended; and appropriate remediation is undertaken if deficiencies
exist.
Benchmarking means the comparison of a bank's internal estimates
with relevant internal and external data or with estimates based on
other estimation techniques. Banks are required to use alternative data
sources or risk assessment approaches to draw inferences about the
validity of their internal risk ratings, segmentations, risk parameter
estimates, and model outputs on an ongoing basis. For credit risk
ratings, examples of alternative data sources include independent
internal raters (such as loan review), external rating agencies,
wholesale and retail credit risk models developed independently, or
retail credit bureau models. Because it may take considerable time
before outcomes with which to conduct sufficiently robust backtesting
are available, benchmarking will be a very important validation device.
Benchmarking applies to all quantification processes and internal risk
rating and segmentation activities.
Benchmarking allows a bank to compare its estimates with those of
other estimation techniques and data sources. Results of benchmarking
exercises can be a valuable diagnostic tool in identifying potential
weaknesses in a bank's risk quantification system. While benchmarking
activities allow for inferences about the appropriateness of the
quantification processes and internal risk rating and segmentation
systems, they are not the same as backtesting. Differences observed
between the bank's risk estimates and the benchmark do not necessarily
indicate that the internal risk ratings, segmentation decisions, or
risk parameter estimates are in error. The benchmark itself is an
alternative prediction, and the difference may be due to different data
or methods. As part of the benchmarking exercise, the bank should
investigate the source of the differences and whether the extent of the
differences is appropriate.
The third component of the validation process is outcomes analysis,
which is the comparison of the bank's forecasts of risk parameters and
other model outputs with actual outcomes. A bank's outcomes analysis
must include backtesting, which is the comparison of the bank's
forecasts generated by its internal models with actual outcomes during
a sample period not used in model development. In this context,
backtesting is one form of out-of-sample testing. The agencies note
that in other contexts backtesting may refer to in-sample fit, but in-
sample fit analysis is not what the rule requires a bank to do as part
of the advanced approaches validation process.
Actual outcomes should be compared with expected ranges around the
estimated values of the risk parameters and model results. Randomness
and many other variables will make discrepancies between realized
outcomes and the estimated risk parameters inevitable. Therefore the
expected ranges should take into account relevant elements of a bank's
internal risk rating or segmentation processes. For example, depending
on the bank's rating philosophy, year-by-year realized default rates
may be expected to differ significantly from the long-run one-year
average. Also, changes in economic conditions between the historical
data and current period can lead to differences between actual outcomes
and estimates.
One commenter asserted that requiring a bank to perform a
statistically robust form of backtesting would be an impractically high
standard for AMA qualification given the nature of operational risk.
The commenter further claimed that validating an operational risk model
must rely on the robustness of the logical structure of the model and
the appropriateness of the resultant operational risk exposure when
benchmarked against other established reference points.
The agencies recognize that it may take considerable time before
actual outcomes outside of the sample period used in model development
are available that would allow a bank to backtest its operational risk
models by comparing its internal estimates with these outcomes. The
agencies also acknowledge that a bank may be unable to backtest an
operational risk model with the same degree of statistical precision
that it is able to backtest an internal market risk model. When a
bank's backtesting process is not sufficiently robust, a bank may need
to rely more heavily on benchmarking and other alternative validation
devices. The agencies maintain, however, that backtesting provides
important feedback on the accuracy of model outputs and that a bank
should be able to assess how actual losses compare with estimates
previously generated by its model.
Internal Audit
A bank must have an internal audit function independent of
business-line management that at least annually assesses the
effectiveness of the controls supporting the bank's advanced systems.
Internal audit should review the validation process, including
validation procedures, responsibilities, results, timeliness, and
responsiveness to findings. Further, internal audit should evaluate the
depth, scope, and quality of the risk management system review process
and conduct appropriate testing to ensure that the conclusions of these
reviews are well founded. Internal audit must report its findings at
least annually to the bank's board of directors (or a committee
thereof).
Stress Testing
A bank must periodically stress test its advanced systems. Stress
testing analysis is a means of understanding how economic cycles,
especially downturns as described by stress scenarios, affect risk-
based capital requirements, including migration across rating grades or
segments and the credit risk mitigation benefits of double default
treatment. Stress testing analysis consists of identifying stress
scenarios and then assessing the effects of the scenarios on key
performance measures, including risk-based capital requirements. Under
the rule, changes in borrower credit quality will lead to changes in
risk-based capital requirements. Because credit quality changes
typically reflect changing economic conditions, risk-based capital
requirements may also vary with the economic cycle. During an economic
downturn, risk-based capital requirements will increase if wholesale
obligors or retail exposures migrate toward lower credit quality rating
grades or segments.
Supervisors expect banks to manage their regulatory capital
position so that they remain at least adequately capitalized during all
phases of the economic cycle. A bank that credibly estimates regulatory
capital levels during a downturn can be more confident of appropriately
managing regulatory capital.
Banks should use a range of plausible but severe scenarios and
methods when stress testing to manage regulatory capital. Scenarios may
be historical, hypothetical, or model-based. Key variables specified in
a scenario may include, for example, interest rates, transition
matrices (ratings and score-
[[Page 69321]]
band segments), asset values, credit spreads, market liquidity,
economic growth rates, inflation rates, exchange rates, or unemployment
rates. A bank may choose to have scenarios apply to an entire
portfolio, or it may identify scenarios specific to various sub-
portfolios. The severity of the stress scenarios should be consistent
with the periodic economic downturns experienced in the bank's market
areas. Such scenarios may be less severe than those used for other
purposes, such as testing a bank's solvency.
The scope of stress testing analysis should be broad and include
all material portfolios. The time horizon of the analysis should be
consistent with the specifics of the scenario and should be long enough
to measure the material effects of the scenario on key performance
measures. For example, if a scenario such as a historical recession has
material income and segment or ratings migration effects over two
years, the appropriate time horizon is at least two years.
8. Documentation
A bank must adequately document all material aspects of its
advanced systems, including but not limited to the internal risk rating
and segmentation systems, risk parameter quantification processes,
model design, assumptions, and validation results. The guiding
principle governing documentation is that it should support the
requirements for the quantification, validation, and control and
oversight mechanisms as well as the bank's broader risk management and
reporting needs. Documentation is also critical to the supervisory
oversight process.
The bank should document the rationale for all material assumptions
underpinning its chosen analytical frameworks, including the choice of
inputs, distributional assumptions, and weighting of quantitative and
qualitative elements. The bank also should document and justify any
subsequent changes to these assumptions.
C. Ongoing Qualification
A bank using the advanced approaches must meet the qualification
requirements on an ongoing basis. Banks are expected to improve their
advanced systems as they improve data gathering capabilities and as
industry practice evolves. To facilitate the supervisory oversight of
systems changes, a bank must notify its primary Federal supervisor when
it makes a change to its advanced systems that results in a material
change in the bank's risk-weighted asset amount for an exposure type,
or when the bank makes any significant change to its modeling
assumptions.
If an agency determines that a bank that uses the advanced
approaches to calculate its risk-based capital requirements has fallen
out of compliance with one or more of the qualification requirements,
the agency will notify the bank of its failure to comply. After
receiving such notice, a bank must establish and submit a plan
satisfactory to its primary Federal supervisor to return to compliance.
If the bank's primary Federal supervisor determines that the bank's
risk-based capital requirements are not commensurate with the bank's
credit, market, operational, or other risks, it may require the bank to
calculate its risk-based capital requirements using the general risk-
based capital rules or a modified form of the advanced approaches (for
example, with fixed supervisory risk parameters).
Under the proposed rule, a bank that fell out of compliance with
the qualification requirements would also be required to disclose
publicly its noncompliance with the qualification requirements promptly
after receiving notice of noncompliance from its primary Federal
supervisor. Commenters objected to this requirement, noting that it is
not one of the public disclosure requirements of the New Accord. The
agencies have determined that the public disclosure of noncompliance is
not always necessary, because the disclosure may not reflect the degree
of noncompliance. Therefore, the agencies are not including a general
noncompliance disclosure requirement in the final rule. However, the
agencies acknowledge that a bank's significant noncompliance with the
qualification requirements is an important factor in market
participants' assessments of the bank's risk profile and, thus, a
primary Federal supervisor may require public disclosure of
noncompliance with the qualification requirements if such noncompliance
is significant.
D. Merger and Acquisition Transition Provisions
Due to the advanced approaches' rigorous systems requirements, a
bank that merges with or acquires another company might not be able to
quickly integrate the merged or acquired company's exposures into its
risk-based capital calculations. The proposed rule provided transition
provisions that would allow the acquiring bank time to integrate the
merged or acquired company into its advanced approaches, subject to an
implementation plan submitted to the bank's primary Federal supervisor.
As proposed, the transition provisions applied only to banks that had
already qualified to use the advanced approaches. The agencies
recognize, however, that a bank in the process of qualifying to use the
advanced approaches may merge with or acquire a company and need time
to integrate the company into its advanced approaches on an
implementation schedule distinct from its original implementation plan.
In the final rule, the agencies are therefore allowing banks to take
advantage of the proposed rule's transition provisions for mergers and
acquisitions both before and after they qualify to use the advanced
approaches.
Under the proposed rule, a bank could use the transition provisions
for the merged or acquired company's exposures for up to 24 months
following the calendar quarter during which the merger or acquisition
consummates. A bank's primary Federal supervisor could extend the
transition period for up to an additional 12 months. Commenters
generally supported this timeframe and associated supervisory
flexibility. Therefore, the final rule adopts the proposed rule's
merger and acquisition transition timeframe without change.
To take advantage of the merger and acquisition transition
provisions, the acquiring bank must submit to its primary Federal
supervisor an implementation plan for using the advanced approaches for
the merged or acquired company. The proposed rule required a bank to
submit such a plan within 30 days of consummating the merger or
acquisition. Many commenters asserted that the 30-day timeframe for
submission of an implementation plan may be too short, particularly
given the many integration activities that must take place immediately
following the consummation of a merger or acquisition. These commenters
generally suggested that banks instead be given 90 or 180 days to
submit the implementation plan. The agencies agree with these
commenters that the proposed timeframe for submitting an implementation
plan may be too short. Accordingly, the final rule requires a bank to
submit an implementation plan within 90 days of the consummation of a
merger or acquisition.
Under the final rule, if a bank that uses the advanced approaches
to calculate risk-based capital requirements merges with or acquires a
company that does not calculate risk-based capital requirements using
the advanced approaches, the acquiring bank may use the general risk-
based capital rules to compute the risk-weighted assets and associated
capital
[[Page 69322]]
for the merged or acquired company's exposures during the merger and
acquisition transition timeframe. Any ALLL (net of allocated transfer
risk reserves) associated with the acquired company's exposures may be
included in the acquiring bank's tier 2 capital up to 1.25 percent of
the acquired company's risk-weighted assets.\41\ Such ALLL is excluded
from the acquiring bank's eligible credit reserves. The risk-weighted
assets of the acquired company are not included in the acquiring bank's
credit-risk-weighted assets but are included in the acquiring bank's
total risk-weighted assets. If the acquiring bank uses the general
risk-based capital rules for acquired exposures, it must disclose
publicly the amounts of risk-weighted assets and qualifying capital
calculated under the general risk-based capital rules with respect to
the acquired company and under this rule for the acquiring bank. The
primary Federal supervisor of the bank will monitor the merger or
acquisition to determine whether the acquiring bank's application of
the general risk-based capital rules for the acquired company produces
appropriate risk-based capital requirements for the assets of the
acquired company in light of the overall risk profile of the acquiring
bank.
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\41\ Any amount of the acquired company's ALLL that was
eliminated in accounting for the acquisition is not included in the
acquiring bank's regulatory capital.
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Similarly, a core or opt-in bank that merges with or acquires
another core or opt-in bank might not be able to apply its systems for
the advanced approaches immediately to the acquired bank's exposures.
Accordingly, the final rule permits a core or opt-in bank that merges
with or acquires another core or opt-in bank to use the acquired bank's
advanced approaches to determine the risk-weighted asset amounts for,
and deductions from capital associated with, the acquired bank's
exposures during the merger and acquisition transition timeframe.
A third potential merger or acquisition scenario is a bank subject
to the general risk-based capital rules that merges with or acquires a
bank that uses the advanced approaches. If, after the merger or
acquisition, the acquiring bank is not a core bank, it could choose to
opt in to the advanced approaches or to apply the general risk-based
capital rules to the consolidated bank. If the acquiring bank chooses
to remain on the general risk-based capital rules, the bank must
immediately apply the general risk-based capital rules to all its
exposures, including those of the acquired bank.
If the acquiring bank chooses or is required to move to the
advanced approaches, however, it could apply the advanced approaches to
the acquired exposures (provided that it continues to meet all of the
qualification requirements for those exposures) for up to 24 months
(with a potential 12-month extension) while it completes the process of
qualifying to use the advanced approaches for the entire bank. If the
acquiring bank has not begun implementing the advanced approaches at
the time of the merger or acquisition, it may instead use the
transition timeframes described in section III.A. of the preamble and
section 21 of the final rule. In the latter case, the bank must consult
with its primary Federal supervisor regarding the appropriate risk-
based capital treatment of the acquired exposures. In no case may a
bank permanently apply the advanced approaches only to an acquired
bank's exposures and not to the consolidated bank.
Because eligible credit reserves and the ALLL are treated
differently under the general risk-based capital rules and the advanced
approaches, the final rule specifies how the acquiring bank must treat
the general allowances associated with the merged or acquired company's
exposures during the period when the general risk-based capital rules
apply to the acquiring bank. Specifically, ALLL associated with the
exposures of the merged or acquired company may not be directly
included in the acquiring bank's tier 2 capital. Rather, any excess
eligible credit reserves (that is, eligible credit reserves minus total
expected credit losses) associated with the merged or acquired
company's exposures may be included in the acquiring bank's tier 2
capital up to 0.6 percent of the credit-risk-weighted assets associated
with those exposures.
IV. Calculation of Tier 1 Capital and Total Qualifying Capital
The final rule maintains the minimum risk-based capital ratio
requirements of 4.0 percent tier 1 capital to total risk-weighted
assets and 8.0 percent total qualifying capital to total risk-weighted
assets. A bank's total qualifying capital is the sum of its tier 1
(core) capital elements and tier 2 (supplemental) capital elements,
subject to various limits and restrictions, minus certain deductions
(adjustments). The agencies are not restating the elements of tier 1
and tier 2 capital in the final rule. Those capital elements generally
remain as they are currently in the general risk-based capital
rules.\42\ Consistent with the proposed rule, the final rule includes
regulatory text for certain adjustments to the capital elements for
purposes of the advanced approaches.
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\42\ See 12 CFR part 3, Appendix A, Sec. 2 (national banks); 12
CFR part 208, Appendix A, Sec. II (state member banks); 12 CFR part
225, Appendix A, Sec. II (bank holding companies); 12 CFR part 325,
Appendix A, Sec. I (state nonmember banks); and 12 CFR 567.5
(savings associations).
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Under the final rule, consistent with the proposal, after
identifying the elements of tier 1 and tier 2 capital, a bank must make
certain adjustments to determine its tier 1 capital and total
qualifying capital (the numerator of the total risk-based capital
ratio). Some of these adjustments are made only to the tier 1 portion
of the capital base. Other adjustments are made 50 percent from tier 1
capital and 50 percent from tier 2 capital.\43\ A bank must still have
at least 50 percent of its total qualifying capital in the form of tier
1 capital.\44\
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\43\ If the amount deductible from tier 2 capital exceeds the
bank's actual tier 2 capital, however, the bank must deduct the
shortfall amount from tier 1 capital.
\44\ Any assets deducted from capital in computing the numerator
of the risk-based capital ratios are also not included in risk-
weighted assets in the denominator of the ratio.
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Under the final rule, as under the proposal, a bank must deduct
from tier 1 capital goodwill, other intangible assets, and deferred tax
assets to the same extent that those assets are deducted from tier 1
capital under the general risk-based capital rules. Thus, all goodwill
is deducted from tier 1 capital. Certain intangible assets--including
mortgage servicing assets, non-mortgage servicing assets, and purchased
credit card relationships--that meet the conditions and limits in the
general risk-based capital rules do not have to be deducted from tier 1
capital. Likewise, deferred tax assets that are dependent upon future
taxable income and that meet the valuation requirements and limits in
the general risk-based capital rules do not have to be deducted from
tier 1 capital.\45\
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\45\ See 12 CFR part 3, Appendix A, Sec. 2 (national banks); 12
CFR part 208, Appendix A, Sec. II (state member banks); 12 CFR part
225, Appendix A, Sec. II (bank holding companies); 12 CFR part 325,
Appendix A, Sec. I (state nonmember banks). OTS existing rules are
formulated differently, but include similar deductions. Under OTS
rules, for example, goodwill is included within the definition of
``intangible assets'' and is deducted from tier 1 (core) capital
along with other intangible assets. See 12 CFR 567.1 and
567.5(a)(2)(i). Similarly, purchased credit card relationships and
mortgage and non-mortgage servicing assets are included in capital
to the same extent as the other agencies' rules. See 12 CFR
567.5(a)(2)(ii) and 567.12. The deduction of deferred tax assets is
discussed in Thrift Bulletin 56.
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Under the general risk-based capital rules, a bank also must deduct
from its
[[Page 69323]]
tier 1 capital certain percentages of the adjusted carrying value of
its nonfinancial equity investments. An advanced approaches bank is not
required to make these deductions. Instead, the bank's equity exposures
generally are subject to the equity treatment in part VI of the final
rule and described in section V.F. of this preamble.\46\
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\46\ By contrast, OTS rules require the deduction of equity
investments from total capital. 12 CFR 567.5(c)(2)(ii). ``Equity
investments'' are defined to include (i) investments in equity
securities (other than investments in subsidiaries, equity
investments that are permissible for national banks, indirect
ownership interests in certain pools of assets (for example, mutual
funds), Federal Home Loan Bank stock and Federal Reserve Bank
stock); and (ii) investments in certain real property. 12 CFR 567.1.
Savings associations applying the final rule are not required to
deduct investments in equity securities. Instead, such investments
are subject to the equity treatment in part VI of the final rule.
Equity investments in real estate continue to be deducted to the
same extent as under the general risk-based capital rules.
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A number of commenters urged the agencies to revisit the existing
definitions of tier 1 and tier 2 capital, including some of the
deductions. Some offered specific suggestions, such as removing the
requirement to deduct goodwill from tier 1 capital or revising the
limitations on certain capital instruments that may be included in
regulatory capital. Other commenters noted that the definition of
regulatory capital and related deductions should be thoroughly debated
internationally before changes are made in any one national
jurisdiction. The agencies believe that the definition of regulatory
capital should be as consistent as possible across national
jurisdictions. The BCBS has formed a working group that is currently
looking at issues related to the definition of regulatory capital.
Accordingly, the agencies have not modified the existing definition of
regulatory capital and related deductions at this time, other than with
respect to implementation of the advanced approaches.
Under the general risk-based capital rules, a bank is allowed to
include in tier 2 capital its ALLL up to 1.25 percent of risk-weighted
assets (net of certain deductions). Amounts of ALLL in excess of this
limit are deducted from the gross amount of risk-weighted assets.
Under the proposed rule, the ALLL was treated differently. The
proposed rule included a methodology for adjusting risk-based capital
requirements based on a comparison of the bank's eligible credit
reserves to its ECL. The proposed rule defined eligible credit reserves
as all general allowances, including the ALLL, established through a
charge against earnings to absorb credit losses associated with on-or
off-balance sheet wholesale and retail exposures. As proposed, eligible
credit reserves did not include allocated transfer risk reserves
established pursuant to 12 U.S.C. 3904\47\ and other specific reserves
created against recognized losses. The final rule maintains the
proposed definition of eligible credit reserves.
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\47\ 12 U.S.C. 3904 does not apply to savings associations
regulated by the OTS. As a result, the OTS final rule does not refer
to allocated transfer risk reserves.
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The proposed rule defined a bank's total ECL as the sum of ECL for
all wholesale and retail exposures other than exposures to which the
bank applied the double default treatment (described below). The bank's
ECL for a wholesale exposure to a non-defaulted obligor or a non-
defaulted retail segment was equal to the product of PD, ELGD, and EAD
for the exposure or segment. The ECL for non-defaulted exposures thus
reflected expected economic losses, including the cost of carry and
direct and indirect workout expenses. The bank's ECL for a wholesale
exposure to a defaulted obligor or a defaulted retail segment was equal
to the bank's impairment estimate for allowance purposes for the
exposure or segment. The ECL for defaulted exposures thus was based on
accounting measures of credit loss incorporated into a bank's charge-
off and reserving practices.
In the proposal, the agencies solicited comment on a possible
alternative treatment for determining ECL for a defaulted exposure that
would be more consistent with the proposed treatment of ECL for non-
defaulted exposures. That alternative approach calculated ECL as the
bank's current carrying value of the exposure multiplied by the bank's
best estimate of the expected economic loss rate associated with the
exposure (measured relative to the current carrying value). Commenters
on this issue generally supported the proposed treatment and expressed
some concern about the added complexity of the alternative treatment.
The agencies believe that, for defaulted exposures, any difference
between a bank's best estimate of economic losses and its impairment
estimate for ALLL purposes is likely to be small. The agencies also
believe that the proposed ALLL impairment approach is less burdensome
for banks than the ``best estimate of economic loss'' approach. As a
result, the agencies are retaining this aspect of the proposed
definition of ECL for defaulted exposures. The agencies recognize that
this treatment requires a bank to specify how much of its ALLL is
attributable to defaulted exposures, and emphasize that a bank must
capture all material economic losses on defaulted exposures when
building its databases for estimating LGDs for non-defaulted exposures.
The agencies also sought comment on the appropriate measure of ECL
for assets held at fair value with gains and losses flowing through
earnings. Commenters expressed the view that there should be no ECL for
such assets because expected losses on such assets already have been
removed from regulatory capital. The agencies agree with this position
and, therefore, under the final rule, a bank may assign an ECL of zero
to assets held at fair value with gains and losses flowing through
earnings. The agencies are otherwise maintaining the proposed
definition of ECL in the final rule, with the substitution of LGD for
ELGD noted above.
Under the final rule, consistent with the proposal, a bank must
compare the total dollar amount of its ECL to its eligible credit
reserves. If there is a shortfall of eligible credit reserves compared
to total ECL, the bank must deduct 50 percent of the shortfall from
tier 1 capital and 50 percent from tier 2 capital. If eligible credit
reserves exceed total ECL, the excess portion of eligible credit
reserves may be included in tier 2 capital up to 0.6 percent of credit-
risk-weighted assets.
A number of commenters objected to the 0.6 percent limit on
inclusion of excess reserves in tier 2 capital and suggested that there
should be a higher or no limit on the amount of excess reserves that
may be included in regulatory capital. While the 0.6 percent limit is
part of the New Accord, some commenters asserted that this limitation
would put U.S. banks at a competitive disadvantage because U.S.
accounting practices (as compared to accounting practices in many other
countries) lead to higher reserves that are more likely to exceed the
limitation. Another commenter asserted that the proposed limitation on
excess reserves is more restrictive than the current cap on ALLL in the
general risk-based capital rules. Finally, several commenters suggested
that because ALLL is the first buffer against credit losses, it should
be included without limit in tier 1 capital.
The agencies believe that the proposed 0.6 percent limit on
inclusion of excess reserves in tier 2 capital is roughly equivalent to
the 1.25 percent cap in the general risk-based capital rules and serves
to maintain general consistency in the treatment of reserves
[[Page 69324]]
domestically and internationally. Accordingly, the agencies have
included the 0.6 percent cap in the final rule.
Under the proposed rule, a bank would deduct from tier 1 capital
any after-tax gain-on-sale. Gain-on-sale was defined as an increase in
a bank's equity capital that resulted from a securitization, other than
an increase in equity capital that resulted from the bank's receipt of
cash in connection with the securitization. The agencies designed this
deduction to offset accounting treatments that produce an increase in a
bank's equity capital and tier 1 capital at the inception of a
securitization--for example, a gain attributable to a CEIO that results
from Financial Accounting Standard (FAS) 140 accounting treatment for
the sale of underlying exposures to a securitization special purpose
entity (SPE). Over time, as the bank, from an accounting perspective,
realizes the increase in equity capital and tier 1 capital booked at
the inception of the securitization through actual receipt of cash
flows, the amount of the required deduction would shrink accordingly.
Under the general risk-based capital rules,\48\ a bank must deduct
CEIOs, whether purchased or retained, from tier 1 capital to the extent
that the CEIOs exceed 25 percent of the bank's tier 1 capital. Under
the proposed rule, a bank would deduct CEIOs from tier 1 capital to the
extent they represent gain-on-sale, and would deduct any remaining
CEIOs 50 percent from tier 1 capital and 50 percent from tier 2
capital.
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\48\ See 12 CFR part 3, Appendix A, Sec. 2(c)(4) (national
banks); 12 CFR part 208, Appendix A, Sec. I.B.1.c. (state member
banks); 12 CFR part 225, Appendix A, Sec. I.B.1.c. (bank holding
companies); 12 CFR part 325, Appendix A, Sec. I.B.5. (state
nonmember banks); 12 CFR 567.5(a)(2)(iii) and 567.12(d)(2) (savings
associations).
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Under the proposed rule, certain other securitization exposures
also would be deducted from tier 1 and tier 2 capital. These exposures
included, for example, securitization exposures with an applicable
external rating (defined below) that is more than one category below
investment grade (for example, below BB-) and most subordinated unrated
securitization exposures. When a bank deducted a securitization
exposure (other than gain-on-sale) from regulatory capital, the bank
would take the deduction 50 percent from tier 1 capital and 50 percent
from tier 2 capital. Moreover, under the proposal, a bank could
calculate any deductions from tier 1 and tier 2 capital with respect to
a securitization exposure (including after-tax gain-on-sale) net of any
deferred tax liabilities associated with the exposure.
The agencies received a number of comments on the proposed
securitization-linked deductions. In particular, some commenters urged
the agencies to retain the general risk-based capital rule for
deducting only CEIOs that exceed 25 percent of tier 1 capital. Some of
these commenters noted that the ``harsher'' securitization-linked
deductions under the advanced approaches could have a significant tier
1 capital impact and, accordingly, could have an unwarranted effect on
a bank's tier 1 leverage ratio calculation. A few commenters encouraged
the agencies to permit a bank to replace the deduction approach for
certain securitization exposures with a 1,250 percent risk weight
approach, in part to mitigate potential tier 1 leverage ratio effects.
The agencies are retaining the securitization-related deductions as
proposed. The proposed deductions are part of the New Accord's
securitization framework. The agencies believe that they should be
retained to foster consistency among participants in the international
securitization markets.
The proposed rule also required a bank to deduct the bank's
exposure on certain unsettled and failed capital markets transactions
50 percent from tier 1 capital and 50 percent from tier 2 capital. The
agencies are retaining this deduction as proposed.
The agencies are also retaining, as proposed, the deductions in the
general risk-based capital rules for investments in unconsolidated
banking and finance subsidiaries and reciprocal holdings of bank
capital instruments. Further, the agencies are retaining the current
treatment for national and state banks that control or hold an interest
in a financial subsidiary. As required by the Gramm-Leach-Bliley Act,
assets and liabilities of the financial subsidiary are not consolidated
with those of the bank for risk-based capital purposes and the bank
must deduct its equity investment (including retained earnings) in the
financial subsidiary from regulatory capital--50 percent from tier 1
capital and 50 percent from tier 2 capital.\49\ A BHC generally does
not deconsolidate the assets and liabilities of the financial
subsidiaries of the BHC's subsidiary banks and does not deduct from its
regulatory capital the equity investments of its subsidiary banks in
financial subsidiaries. Rather, a BHC generally fully consolidates the
financial subsidiaries of its subsidiary banks. These treatments
continue under the final rule.
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\49\ See Public Law 106-102 (November 12, 1999), codified, among
other places, at 12 U.S.C. 24a. See also 12 CFR 5.39(h)(1) (national
banks); 12 CFR 208.73(a) (state member banks); 12 CFR part 325,
Appendix A, Sec. I.B.2. (state nonmember banks). Again, OTS rules
are formulated differently. For example, OTS rules do not use the
terms ``unconsolidated banking and finance subsidiary'' or
``financial subsidiary.'' Rather, as required by section 5(t)(5) of
the Home Owners' Loan Act (HOLA), equity and debt investments in
non-includable subsidiaries (generally subsidiaries that are engaged
in activities that are not permissible for a national bank) are
deducted from assets and tier 1 (core) capital. 12 CFR
567.5(a)(2)(iv) and (v). As required by HOLA, OTS will continue to
deduct non-includable subsidiaries. Reciprocal holdings of bank
capital instruments are deducted from a savings association's total
capital under 12 CFR 567.5(c)(2).
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For BHCs with consolidated insurance underwriting subsidiaries that
are functionally regulated by a State insurance regulator (or subject
to comparable supervision and regulatory capital requirements in a non-
U.S. jurisdiction), the proposed rule set forth the following
treatment. The assets and liabilities of the subsidiary would be
consolidated for purposes of determining the BHC's risk-weighted
assets. However, the BHC would deduct from tier 1 capital an amount
equal to the insurance underwriting subsidiary's minimum regulatory
capital requirement as determined by its functional (or equivalent)
regulator. For U.S. regulated insurance underwriting subsidiaries, this
amount generally would be 200 percent of the subsidiary's Authorized
Control Level as established by the appropriate state insurance
regulator.
The proposal noted that its approach with respect to functionally
regulated consolidated insurance underwriting subsidiaries was
different from the New Accord, which broadly endorses a deconsolidation
and deduction approach for insurance subsidiaries. The proposal
acknowledged the Board's concern that a full deconsolidation and
deduction approach does not capture the credit risk in insurance
underwriting subsidiaries at the consolidated BHC level.
Several commenters objected to the proposed deduction from tier 1
capital and instead supported a deduction 50 percent from tier 1
capital and 50 percent from tier 2 capital. Others supported the full
deduction and deconsolidation approach endorsed by the New Accord and
maintained that, by contrast, the proposed approach was overly
conservative and resulted in a double-count of capital requirements for
insurance regulation and banking regulation.
The Board continues to believe that a consolidated BHC risk-based
capital measure should incorporate all credit, market, and operational
risks to which the BHC is exposed, regardless of the
[[Page 69325]]
legal entity subsidiary where a risk exposure resides. The Board also
believes that a fully consolidated approach minimizes the potential for
regulatory capital arbitrage; it eliminates incentives to book
individual exposures at a subsidiary that is deducted from the
consolidated entity for capital purposes where a different, potentially
more favorable, capital requirement is applied at the subsidiary.
Moreover, the Board does not agree that the proposed approach results
in a double-count of capital requirements. Rather, the capital
requirements imposed by a functional regulator or other supervisory
authority at the subsidiary level reflect the capital needs at the
particular subsidiary. The consolidated measure of minimum capital
requirements should reflect the consolidated organization.
Thus, the Board is retaining the proposed requirement that assets
and liabilities of insurance underwriting subsidiaries are consolidated
for determining risk-weighted assets. The Board has modified the final
rule for BHCs, however, to allow the associated capital deduction to be
made 50 percent from tier 1 capital and 50 percent from tier 2 capital.
V. Calculation of Risk-Weighted Assets
Under the final rule, a bank's total risk-weighted assets is the
sum of its credit risk-weighted assets and risk-weighted assets for
operational risk, minus the sum of its excess eligible credit reserves
(eligible credit reserves in excess of its total ECL) not included in
tier 2 capital. Unlike under the proposal, allocated transfer risk
reserves are not subtracted from total risk-weighted assets under the
final rule. Because the EAD of wholesale exposures and retail segments
is calculated net of any allocated transfer risk reserves, a second
subtraction of the reserves from risk-weighted assets is not
appropriate.
A. Categorization of Exposures
To calculate credit risk-weighted assets, a bank must determine
risk-weighted asset amounts for exposures that have been grouped into
four general categories: wholesale, retail, securitization, and equity.
It must also identify and determine risk-weighted asset amounts for
assets not included in an exposure category and any non-material
portfolios of exposures to which the bank elects not to apply the IRB
approach. To exclude a portfolio from the IRB approach, a bank must
demonstrate to the satisfaction of its primary Federal supervisor that
the portfolio (when combined with all other portfolios of exposures
that the bank seeks to exclude from the IRB approach) is not material
to the bank. As described above, credit-risk-weighted assets is defined
as 1.06 multiplied by the sum of total wholesale and retail risk-
weighted assets, risk-weighted assets for securitization exposures, and
risk-weighted assets for equity exposures.
1. Wholesale Exposures
Consistent with the proposed rule, the final rule defines a
wholesale exposure as a credit exposure to a company, individual,
sovereign entity, or other governmental entity (other than a
securitization exposure, retail exposure, or equity exposure).\50\ The
term ``company'' is broadly defined to mean a corporation, partnership,
limited liability company, depository institution, business trust, SPE,
association, or similar organization. Examples of a wholesale exposure
include: (i) A non-tranched guarantee issued by a bank on behalf of a
company; \51\ (ii) a repo-style transaction entered into by a bank with
a company and any other transaction in which a bank posts collateral to
a company and faces counterparty credit risk; (iii) an exposure that a
bank treats as a covered position under the market risk rule for which
there is a counterparty credit risk capital requirement; (iv) a sale of
corporate loans by a bank to a third party in which the bank retains
full recourse; (v) an OTC derivative contract entered into by a bank
with a company; (vi) an exposure to an individual that is not managed
by the bank as part of a segment of exposures with homogeneous risk
characteristics; and (vii) a commercial lease.
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\50\ The proposed rule excluded from the definition of a
wholesale exposure certain pre-sold one-to-four family residential
construction loans and certain multifamily residential loans. The
treatment of such loans under the final rule is discussed below in
section V.B.5. of the preamble.
\51\ As described below, tranched guarantees (like most
transactions that involve a tranching of credit risk) generally are
securitization exposures under the final rule. The final rule
defines a guarantee broadly to include almost any transaction (other
than a credit derivative) that involves the transfer of the credit
risk of an exposure from one party to another party. This definition
of guarantee generally includes, for example, a credit spread option
under which a bank has agreed to make payments to its counterparty
in the event of an increase in the credit spread associated with a
particular reference obligation issued by a company.
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The agencies proposed two subcategories of wholesale exposures--
HVCRE exposures and non-HVCRE exposures. Under the proposed rule, HVCRE
exposures would be subject to a separate IRB risk-based capital formula
that would produce a higher risk-based capital requirement for a given
set of risk parameters than the IRB risk-based capital formula for non-
HVCRE wholesale exposures. Further, the agencies proposed that once an
exposure was determined to be an HVCRE exposure, it would remain an
HVCRE exposure until paid in full, sold, or converted to permanent
financing.
The proposed rule defined an HVCRE exposure as a credit facility
that finances or has financed the acquisition, development, or
construction of real property, excluding facilities that finance (i)
one-to four-family residential properties or (ii) commercial real
estate projects that meet the following conditions: (A) The exposure's
loan-to-value (LTV) ratio is less than or equal to the applicable
maximum supervisory LTV ratio in the real estate lending standards of
the agencies; \52\ (B) the borrower has contributed capital to the
project in the form of cash or unencumbered readily marketable assets
(or has paid development expenses out-of-pocket) of at least 15 percent
of the real estate's appraised ``as completed'' value; and (C) the
borrower contributed the amount of capital required before the bank
advances funds under the credit facility, and the capital contributed
by the borrower or internally generated by the project is contractually
required to remain in the project throughout the life of the project.
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\52\ 12 CFR part 34, Subpart D (OCC); 12 CFR part 208, Appendix
C (Board); 12 CFR part 365, Appendix A (FDIC); and 12 CFR 560.100-
560.101 (OTS).
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Several commenters raised issues related to the requirement that
banks must separate HVCRE exposures from other wholesale exposures. One
commenter asserted that a separate risk-weight function for HVCRE
exposures is unnecessary because the higher risk associated with such
exposures would be reflected in higher PDs and LGDs. Other commenters
stated that tracking the exception requirements for acquisition,
development, or construction loans would be burdensome and expressed
concern that all multifamily loans could be subject to the HVCRE
treatment. Yet other commenters requested that the agencies exclude
from the definition of HVCRE all multifamily acquisition, development,
or construction loans; additional commercial real estate exposures; and
other exposures with significant project equity and/or pre-sale
commitments. A few commenters supported the proposed approach to HVCRE
exposures.
The agencies have determined that the proposed definition of HVCRE
exposures strikes an appropriate balance between risk-sensitivity and
simplicity.
[[Page 69326]]
Thus, the final rule retains the definition as proposed. If a bank does
not want to track compliance with the definition for burden-related
reasons, the bank may choose to apply the HVCRE risk-weight function to
all credit facilities that finance the acquisition, construction, or
development of multifamily and commercial real property. The agencies
believe that this treatment would be an appropriate application of the
principle of conservatism discussed in section II.D. of the preamble
and set forth in section 1(d) of the final rule.
The New Accord identifies five sub-classes of specialized lending
for which the primary source of repayment of the obligation is the
income generated by the financed asset(s) rather than the independent
capacity of a broader commercial enterprise. The sub-classes are
project finance, object finance, commodities finance, income-producing
real estate, and HVCRE. The New Accord provides a methodology to
accommodate banks that cannot meet the requirements for the estimation
of PD for these exposure types. The proposed rule did not include a
separate treatment for specialized lending beyond the separate IRB
risk-based capital formula for HVCRE exposures specified in the New
Accord. The agencies noted in the proposal that sophisticated banks
that would be applying the advanced approaches in the United States
should be able to estimate risk parameters for specialized lending. The
agencies continue to believe that banks using the advanced approaches
in the United States should be able to estimate risk parameters for
specialized lending and, therefore, have not adopted a separate
treatment for specialized lending in the final rule.
In contrast to the New Accord, the agencies did not propose a
separate risk-based capital function for exposures to small- and
medium-size enterprises (SMEs). The SME function in the New Accord
generates a lower risk-based capital requirement for an exposure to an
SME than for an exposure to a larger firm that has the same risk
parameter values. The agencies were not aware of compelling evidence
that smaller firms are subject to less systematic risk than is already
reflected in the wholesale exposure risk-based capital formula, which
specifies lower AVCs as PDs increase.
A number of commenters objected to this aspect of the proposal and
urged the agencies to include in the final rule the SME risk-based
capital function from the New Accord. Several commenters expressed
concern about potential competitive disparities in the market for SME
lending between U.S. banks and foreign banks subject to rules that
include the New Accord's treatment of SME exposures. Others asserted
that lower AVCs and risk-based capital requirements were appropriate
for SME exposures because the asset values of exposures to smaller
firms are more idiosyncratic than those of exposures to larger firms.
While commenters raised important issues related to SME exposures,
the agencies have decided not to add a distinct risk-weight function
for such exposures to the final rule. The agencies continue to believe
that a distinct risk-weight function with a lower AVC for SME exposures
is not substantiated by sufficient empirical evidence and may give rise
to a domestic competitive inequity between banks subject to the
advanced approaches and banks subject to the general risk-based capital
rules.
2. Retail Exposures
Under the final rule, as under the proposed rule, retail exposures
generally include exposures (other than securitization exposures or
equity exposures) to an individual and small exposures to businesses
that are managed as part of a segment of similar exposures, not on an
individual-exposure basis. There are three subcategories of retail
exposure: (i) Residential mortgage exposures; (ii) QREs; and (iii)
other retail exposures. The final rule retains the proposed definitions
of the retail exposure subcategories and, thus, defines residential
mortgage exposure as an exposure that is primarily secured by a first
or subsequent lien on one- to four-family residential property.\53\
This includes both term loans and HELOCs. An exposure primarily secured
by a first or subsequent lien on residential property that is not one
to four family also is included as a residential mortgage exposure as
long as the exposure has both an original and current outstanding
amount of no more than $1 million. There is no upper limit on the size
of an exposure that is secured by one-to four-family residential
properties. To be a residential mortgage exposure, the bank must manage
the exposure as part of a segment of exposures with homogeneous risk
characteristics. Residential mortgage loans that are managed on an
individual basis, rather than managed as part of a segment, are
categorized as wholesale exposures.
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\53\ The proposed rule excluded from the definition of a
residential mortgage exposure certain pre-sold one- to-four family
residential construction loans and certain multifamily residential
loans. The treatment of such loans under the final rule is discussed
below in section V.B.5. of the preamble.
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QREs are defined as exposures to individuals that are (i)
revolving, unsecured, and unconditionally cancelable by the bank to the
fullest extent permitted by Federal law; (ii) have a maximum exposure
amount (drawn plus undrawn) of up to $100,000; and (iii) are managed as
part of a segment of exposures with homogeneous risk characteristics.
In practice, QREs typically include exposures where customers'
outstanding borrowings are permitted to fluctuate based on their
decisions to borrow and repay, up to a limit established by the bank.
Most credit card exposures to individuals and overdraft lines on
individual checking accounts are QREs.
The category of other retail exposures includes two types of
exposures. First, all exposures to individuals for non-business
purposes (other than residential mortgage exposures and QREs) that are
managed as part of a segment of similar exposures are other retail
exposures. Such exposures may include personal term loans, margin
loans, auto loans and leases, credit card accounts with credit lines
above $100,000, and student loans. There is no upper limit on the size
of these types of retail exposures to individuals. Second, exposures to
individuals or companies for business purposes (other than residential
mortgage exposures and QREs), up to a single-borrower exposure
threshold of $1 million, that are managed as part of a segment of
similar exposures are other retail exposures. For the purpose of
assessing exposure to a single borrower, the bank must aggregate all
business exposures to a particular legal entity and its affiliates that
are consolidated under GAAP. If that borrower is a natural person, any
consumer loans (for example, personal credit card loans or mortgage
loans) to that borrower would not be part of the aggregate. A bank
could distinguish a consumer loan from a business loan by the loan
department through which the loan is made. Exposures to a borrower for
business purposes primarily secured by residential property count
toward the $1 million single-borrower other retail business exposure
threshold.\54\
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\54\ The proposed rule excluded from the definition of an other
retail exposure certain pre-sold one-to-four family residential
construction loans and certain multifamily residential loans. The
treatment of such loans under the final rule is discussed below in
section V.B.5. of the preamble.
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The residual value portion of a retail lease exposure is excluded
from the definition of an other retail exposure. Consistent with the
New Accord, a bank must assign the residual value portion
[[Page 69327]]
of a retail lease exposure a risk-weighted asset amount equal to its
residual value as described in section 31 of the final rule.
3. Securitization Exposures
The proposed rule defined a securitization exposure as an on-
balance sheet or off-balance sheet credit exposure that arises from a
traditional or synthetic securitization (including credit-enhancing
representations and warranties). A traditional securitization was
defined as a transaction in which (i) all or a portion of the credit
risk of one or more underlying exposures is transferred to one or more
third parties other than through the use of credit derivatives or
guarantees; (ii) the credit risk associated with the underlying
exposures has been separated into at least two tranches reflecting
different levels of seniority; (iii) performance of the securitization
exposures depends on the performance of the underlying exposures; and
(iv) all or substantially all of the underlying exposures are financial
exposures. Examples of financial exposures are loans, commitments,
receivables, asset-backed securities, mortgage-backed securities, other
debt securities, equity securities, or credit derivatives. The proposed
rule also defined mortgage-backed pass-through securities guaranteed by
Fannie Mae or Freddie Mac (whether or not issued out of a structure
that tranches credit risk) as securitization exposures.
A synthetic securitization was defined as a transaction in which
(i) all or a portion of the credit risk of one or more underlying
exposures is transferred to one or more third parties through the use
of one or more credit derivatives or guarantees (other than a guarantee
that transfers only the credit risk of an individual retail exposure);
(ii) the credit risk associated with the underlying exposures has been
separated into at least two tranches reflecting different levels of
seniority; (iii) performance of the securitization exposures depends on
the performance of the underlying exposures; and (iv) all or
substantially all of the underlying exposures are financial exposures.
Accordingly, the proposed definition of a securitization exposure
included tranched cover or guarantee arrangements--that is,
arrangements in which an entity transfers a portion of the credit risk
of an underlying exposure to one or more guarantors or credit
derivative providers but also retains a portion of the credit risk,
where the risk transferred and the risk retained are of different
seniority levels.
The preamble to the proposal noted that, provided there is a
tranching of credit risk, securitization exposures could include, among
other things, asset-backed and mortgage-backed securities; loans, lines
of credit, liquidity facilities, and financial standby letters of
credit; credit derivatives and guarantees; loan servicing assets;
servicer cash advance facilities; reserve accounts; credit-enhancing
representations and warranties; and CEIOs. Securitization exposures
also could include assets sold with retained tranched recourse.
As explained in the proposal, if a bank purchases an asset-backed
security issued by a securitization SPE and purchases a credit
derivative to protect itself from credit losses associated with the
asset-backed security, the purchase of the credit derivative by the
investing bank does not turn the traditional securitization into a
synthetic securitization. Instead, the investing bank would be viewed
as having purchased a traditional securitization exposure and would
reflect the CRM benefits of the credit derivative through the
securitization CRM rules described later in the preamble and in section
46 of the rule. Moreover, if a bank provides a guarantee or a credit
derivative on a securitization exposure, that guarantee or credit
derivative would also be a securitization exposure.
Commenters raised several objections to the proposed definitions of
traditional and synthetic securitizations. First, several commenters
objected to the requirement that all or substantially all of the
underlying exposures must be financial exposures. These commenters
noted that the securitization market rapidly evolves and expands to
cover new asset classes--such as intellectual property rights, project
finance revenues, and entertainment royalties--that may or may not be
financial assets. Commenters expressed particular concern that the
proposed definitions may exclude from the securitization framework
leases that include a material lease residual component.
The agencies believe that requiring all or substantially all of the
underlying exposures for a securitization to be financial exposures
creates an important boundary between the wholesale and retail
frameworks, on the one hand, and the securitization framework, on the
other hand. Accordingly, the agencies are maintaining this requirement
in the final rule. The securitization framework was designed to address
the tranching of the credit risk of financial exposures and was not
designed, for example, to apply to tranched credit exposures to
commercial or industrial companies or nonfinancial assets. Accordingly,
under the final rule, a specialized loan to finance the construction or
acquisition of large-scale projects (for example, airports and power
plants), objects (for example, ships, aircraft, or satellites), or
commodities (for example, reserves, inventories, precious metals, oil,
or natural gas) generally is not a securitization exposure because the
assets backing the loan typically are nonfinancial assets (the
facility, object, or commodity being financed). In addition, although
some structured transactions involving income-producing real estate or
HVCRE can resemble securitizations, these transactions generally would
not be securitizations because the underlying exposure would be real
estate. Consequently, exposures resulting from the tranching of the
risks of nonfinancial assets are not subject to the final rule's
securitization framework, but generally are subject to the rules for
wholesale exposures.
Based on their cash flow characteristics, for purposes of the final
rule, the agencies would consider many of the asset classes identified
by commenters including lease residuals and entertainment royalties--to
be financial assets. Both the designation of exposures as
securitization exposures and the calculation of risk-based capital
requirements for securitization exposures will be guided by the
economic substance of a transaction rather than its legal form.\55\
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\55\ Several commenters asked the agencies to confirm that the
typical syndicated credit facility would not be a securitization
exposure. The agencies confirm that a syndicated credit facility is
not a securitization exposure so long as less than substantially all
of the borrower's assets are financial exposures.
---------------------------------------------------------------------------
Some commenters asserted that the proposal generally to define as
securitization exposures all exposures involving credit risk tranching
of underlying financial assets was too broad. The proposed definition
captured many exposures these commenters did not consider to be
securitization exposures, including tranched exposures to a single
underlying financial exposure and exposures to many hedge funds and
private equity funds. Commenters requested flexibility to apply the
wholesale or equity framework (depending on the exposure) rather than
the securitization framework to these exposures.
The agencies believe that a single, unified approach to dealing
with the tranching of credit risk is important to create a level
playing field across the securitization, credit derivative, and other
financial markets, and therefore have decided to maintain the proposed
treatment of tranched exposures to a
[[Page 69328]]
single underlying financial asset in the final rule. The agencies
believe that basing the applicability of the securitization framework
on the presence of some minimum number of underlying exposures would
complicate the rule and would create a divergence from the New Accord,
without any material improvement in risk sensitivity. The
securitization framework is designed specifically to deal with tranched
exposures to credit risk. Moreover, the principal risk-based capital
approaches of the securitization framework take into account the
effective number of underlying exposures.
The agencies agree with commenters that the proposed definition for
securitization exposures was quite broad and captured some exposures
that would more appropriately be treated under the wholesale or equity
frameworks. To limit the scope of the IRB securitization framework, the
agencies have modified the definition of traditional securitization in
the final rule to make clear that operating companies are not
traditional securitizations (even if all or substantially all of their
assets are financial exposures). For purposes of the final rule's
definition of traditional securitization, operating companies generally
are companies that produce goods or provide services beyond the
business of investing, reinvesting, holding, or trading in financial
assets. Examples of operating companies are depository institutions,
bank holding companies, securities brokers and dealers, insurance
companies, and non-bank mortgage lenders. Accordingly, an equity
investment in an operating company, such as a bank, generally would be
an equity exposure under the final rule; a debt investment in an
operating company, such as a bank, generally would be a wholesale
exposure under the final rule.
Investment firms, which generally do not produce goods or provide
services beyond the business of investing, reinvesting, holding, or
trading in financial assets, are not operating companies for purposes
of the final rule and would not qualify for this general exclusion from
the definition of traditional securitization. Examples of investment
firms would include companies that are exempted from the definition of
an investment company under section 3(a) of the Investment Company Act
of 1940 (15 U.S.C. 80a-3(a)) by either section 3(c)(1) (15 U.S.C. 80a-
3(c)(1)) or section 3(c)(7) (15 U.S.C. 80a-3(c)(7)) of the Act.
The final definition of a traditional securitization also provides
the primary Federal supervisor of a bank with discretion to exclude
from the definition of traditional securitization investment firms that
exercise substantially unfettered control over the size and composition
of their assets, liabilities, and off-balance sheet transactions. The
agencies will consider a number of factors in the exercise of this
discretion, including an assessment of the investment firm's leverage,
risk profile, and economic substance. This supervisory exclusion is
intended to provide discretion to a bank's primary Federal supervisor
to distinguish structured finance transactions, to which the
securitization framework was designed to apply, from more flexible
investment firms such as many hedge funds and private equity funds.
Only investment firms that can easily change the size and composition
of their capital structure, as well as the size and composition of
their assets and off-balance sheet exposures, would be eligible for
this exclusion from the definition of traditional securitization under
this new provision. The agencies do not consider managed collateralized
debt obligation vehicles, structured investment vehicles, and similar
structures, which allow considerable management discretion regarding
asset composition but are subject to substantial restrictions regarding
capital structure, to have substantially unfettered control. Thus, such
transactions meet the final rule's definition of traditional
securitization.
The agencies also have added two additional exclusions to the
definition of traditional securitization for small business investment
companies (SBICs) and community development investment vehicles. As a
result, a bank's equity investments in SBICs and community development
equity investments generally are treated as equity exposures under the
final rule.
The agencies remain concerned that the line between securitization
exposures and non-securitization exposures may be difficult to draw in
some circumstances. In addition to the supervisory exclusion from the
definition of traditional securitization described above, the agencies
have added a new component to the definition of traditional
securitization to specifically permit a primary Federal supervisor to
scope certain transactions into the securitization framework if
justified by the economics of the transaction. Similar to the analysis
for excluding an investment firm from treatment as a traditional
securitization, the agencies will consider the economic substance,
leverage, and risk profile of transactions to ensure that the
appropriate IRB classification is made. The agencies will consider a
number of factors when assessing the economic substance of a
transaction including, for example, the amount of equity in the
structure, overall leverage (whether on-or off-balance sheet), whether
redemption rights attach to the equity investor, and the ability of the
junior tranches to absorb losses without interrupting contractual
payments to more senior tranches.
One commenter asked whether a bank could ignore the credit
protection provided by a tranched guarantee for risk-based capital
purposes and instead calculate the risk-based capital requirement for
the guaranteed exposure as if the guarantee did not exist. The agencies
believe that this treatment would be an appropriate application of the
principle of conservatism discussed in section II.D. of this preamble
and set forth in section 1(d) of the final rule.
As noted above, the proposed rule defined mortgage-backed pass-
through securities guaranteed by Fannie Mae or Freddie Mac (whether or
not issued out of a structure that tranches credit risk) as
securitization exposures. The agencies have reconsidered this proposal
and have concluded that a special treatment for these securities is
inconsistent with the New Accord and would violate the fundamental
credit-tranching-based nature of the definition of securitization
exposures. The final rule therefore does not define all mortgage-backed
pass-through securities guaranteed by Fannie Mae or Freddie Mac to be
securitization exposures. As a result, those mortgage-backed securities
that involve tranching of credit risk will be securitization exposures;
those mortgage-backed securities that do not involve tranching of
credit risk will not be securitization exposures.\56\
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\56\ Several commenters asked the agencies to clarify whether a
special purpose entity that issues multiple classes of securities
that have equal priority in the capital structure of the issuer but
different maturities would be considered a securitization SPE. The
agencies do not believe that maturity differentials alone constitute
credit risk tranching for purposes of the definitions of traditional
securitization and synthetic securitization.
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A few commenters asserted that OTC derivatives with a
securitization SPE as the counterparty should be excluded from the
definition of securitization exposure and treated as wholesale
exposures. The agencies believe that the securitization framework is
the most appropriate way to assess the counterparty credit risk of such
exposures because this risk is a tranched exposure to the credit risk
of the underlying financial assets of the
[[Page 69329]]
securitization SPE. The agencies are addressing specific commenter
concerns about the burden of applying the securitization framework to
these exposures in preamble section V.E. below and section 42(a)(5) of
the final rule.
4. Equity Exposures
The proposed rule defined an equity exposure to mean:
(i) A security or instrument whether voting or non-voting that
represents a direct or indirect ownership interest in, and a residual
claim on, the assets and income of a company, unless: (A) The issuing
company is consolidated with the bank under GAAP; (B) the bank is
required to deduct the ownership interest from tier 1 or tier 2
capital; (C) the ownership interest is redeemable; (D) the ownership
interest incorporates a payment or other similar obligation on the part
of the issuing company (such as an obligation to pay periodic
interest); or (E) the ownership interest is a securitization exposure.
(ii) A security or instrument that is mandatorily convertible into
a security or instrument described in (i).
(iii) An option or warrant that is exercisable for a security or
instrument described in (i).
(iv) Any other security or instrument (other than a securitization
exposure) to the extent the return on the security or instrument is
based on the performance of a security or instrument described in (i).
For example, a short position in an equity security or a total return
equity swap would be characterized as an equity exposure.
The proposal noted that nonconvertible term or perpetual preferred
stock generally would be considered wholesale exposures rather than
equity exposures. Financial instruments that are convertible into an
equity exposure only at the option of the holder or issuer also
generally would be considered wholesale exposures rather than equity
exposures provided that the conversion terms do not expose the bank to
the risk of losses arising from price movements in that equity
exposure. Upon conversion, the instrument would be treated as an equity
exposure. In addition, the agencies note that unfunded equity
commitments, which are commitments to make equity investments at a
future date, meet the definition of an equity exposure.
Many commenters expressed support for the proposed definition of
equity exposure, except for the proposed exclusion of equity
investments in hedge funds and other leveraged investment vehicles, as
discussed above. The agencies are adopting the proposed definition for
equity exposures with one exception. They have eliminated in the final
rule the exclusion of a redeemable ownership interest from the
definition of equity exposure. The agencies believe that redeemable
ownership interests, such as those in mutual funds and private equity
funds, are most appropriately treated as equity exposures.
The agencies anticipate that, as a general matter, each of a bank's
exposures will fit in one and only one exposure category. One exception
to this principle is that equity derivatives generally will meet the
definition of an equity exposure (because of the bank's exposure to the
underlying equity security) and the definition of a wholesale exposure
(because of the bank's credit risk exposure to the counterparty). In
such cases, as discussed in more detail below, the bank's risk-based
capital requirement for the equity derivative generally is the sum of
its risk-based capital requirement for the derivative counterparty
credit risk and for the underlying exposure.
5. Boundary Between Operational Risk and Other Risks
With the introduction of an explicit risk-based capital requirement
for operational risk, issues arise about the proper treatment of
operational losses that also could be attributed to either credit risk
or market risk. The agencies recognize that these boundary issues are
important and have significant implications for how banks must compile
loss data sets and compute risk-based capital requirements under the
final rule. Consistent with the treatment in the New Accord and the
proposed rule, banks must treat operational losses that are related to
market risk as operational losses for purposes of calculating risk-
based capital requirements under this final rule. For example, losses
incurred from a failure of bank personnel to properly execute a stop
loss order, from trading fraud, or from a bank selling a security when
a purchase was intended, must be treated as operational losses.
Under the proposed rule, banks would treat losses that are related
to both operational risk and credit risk as credit losses for purposes
of calculating risk-based capital requirements. For example, where a
loan defaults (credit risk) and the bank discovers that the collateral
for the loan was not properly secured (operational risk), the bank's
resulting loss would be attributed to credit risk (not operational
risk). This general separation between credit and operational risk is
supported by current U.S. accounting standards for the treatment of
credit risk.
To be consistent with prevailing practice in the credit card
industry, the proposed rule included an exception to this standard for
retail credit card fraud losses. Specifically, retail credit card
losses arising from non-contractual, third party-initiated fraud (for
example, identity theft) would be treated as external fraud operational
losses under the proposed rule. All other third party-initiated losses
would be treated as credit losses.
Generally, commenters urged the agencies not to be prescriptive on
risk boundary issues and to give banks discretion to categorize risk as
they deem appropriate, subject to supervisory review. Other commenters
noted that boundary issues are so significant that the agencies should
not contemplate any additional exceptions to treating losses related to
both credit and operational risk as credit losses unless the exceptions
are agreed to by the BCBS. Several commenters objected to specific
aspects of the agencies' proposal and suggested that additional types
of losses related to credit risk and operational risk, including losses
related to check fraud, overdraft fraud, and small business loan fraud,
should be treated as operational losses for purposes of calculating
risk-based capital requirements. One commenter expressly noted its
support for the agencies' proposal, which effectively requires banks to
treat losses on HELOCs related to both credit risk and operational risk
as credit losses for purposes of calculating risk-based capital
requirements.
Because of the substantial potential impact boundary issues have on
risk-based capital requirements under the advanced approaches, there
should be consistency across U.S. banks in how they categorize losses
that relate to both credit risk and operational risk. Moreover, the
agencies believe that international consistency on this issue is an
important objective. Therefore, the final rule maintains the proposed
boundaries for losses that relate to both credit risk and operational
risk and does not incorporate any additional exemptions beyond that in
the proposal.
6. Boundary Between the Final Rule and the Market Risk Rule
For banks subject to the market risk rule, the existing market risk
rule applies to all positions classified as trading positions in
regulatory reports. The New Accord establishes additional criteria for
positions to be eligible for application of the market risk rule. The
[[Page 69330]]
agencies are incorporating these additional criteria into the market
risk rule through a separate rulemaking that is expected to be
finalized soon and published in the Federal Register. Under this final
rule, as under the proposal, core and opt-in banks subject to the
market risk rule must use the market risk rule for exposures that are
covered positions under the market risk rule. Core and opt-in banks not
subject to the market risk rule must use this final rule for all of
their exposures.
B. Risk-Weighted Assets for General Credit Risk (Wholesale Exposures,
Retail Exposures, On-Balance Sheet Assets That Are Not Defined by
Exposure Category, and Immaterial Credit Portfolios)
Under the proposed rule, the wholesale and retail risk-weighted
assets calculation consisted of four phases: (1) Categorization of
exposures; (2) assignment of wholesale exposures to rating grades and
segmentation of retail exposures; (3) assignment of risk parameters to
wholesale obligors and exposures and segments of retail exposures; and
(4) calculation of risk-weighted asset amounts. The agencies did not
receive any negative comments on the four phases for calculating
wholesale and retail risk-weighted assets and, thus, are adopting the
four-phase concept as proposed. Where applicable, the agencies have
clarified particular issues within the four-phase process.
1. Phase 1--Categorization of Exposures
In phase 1, a bank must determine which of its exposures fall into
each of the four principal IRB exposure categories--wholesale
exposures, retail exposures, securitization exposures, and equity
exposures. In addition, a bank must identify within the wholesale
exposure category certain exposures that receive a special treatment
under the wholesale framework. These exposures include HVCRE exposures,
sovereign exposures, eligible purchased wholesale exposures, eligible
margin loans, repo-style transactions, OTC derivative contracts,
unsettled transactions, and eligible guarantees and eligible credit
derivatives that are used as credit risk mitigants.
The treatment of HVCRE exposures and eligible purchased wholesale
receivables is discussed below in this section. The treatment of
eligible margin loans, repo-style transactions, OTC derivative
contracts, and eligible guarantees and eligible credit derivatives that
are credit risk mitigants is discussed in section V.C. of the preamble.
In addition, sovereign exposures and exposures to or directly and
unconditionally guaranteed by the Bank for International Settlements,
the International Monetary Fund, the European Commission, the European
Central Bank, and multilateral development banks are exempt from the
0.03 percent floor on PD discussed in the next section.
The proposed rule recognized as multilateral development banks only
those multilateral lending institutions or regional development banks
in which the U.S. government is a shareholder or contributing member.
The final rule adopts a slightly expanded definition of multilateral
development bank. Specifically, under the final rule, multilateral
development bank is defined to include the International Bank for
Reconstruction and Development, the International Finance Corporation,
the Inter-American Development Bank, the Asian Development Bank, the
African Development Bank, the European Bank for Reconstruction and
Development, the European Investment Bank, the European Investment
Fund, the Nordic Investment Bank, the Caribbean Development Bank, the
Islamic Development Bank, the Council of Europe Development Bank; any
multilateral lending institution or regional development bank in which
the U.S. government is a shareholder or contributing member; and any
multilateral lending institution that a bank's primary Federal
supervisor determines poses comparable credit risk.
In phase 1, a bank also must subcategorize its retail exposures as
residential mortgage exposures, QREs, or other retail exposures. In
addition, a bank must identify any on-balance sheet asset that does not
meet the definition of a wholesale, retail, securitization, or equity
exposure, as well as any non-material portfolio of exposures to which
it chooses, subject to supervisory review, not to apply the IRB risk-
based capital formulas.
2. Phase 2--Assignment of Wholesale Obligors and Exposures to Rating
Grades and Retail Exposures to Segments
In phase 2, a bank must assign each wholesale obligor to a single
rating grade (for purposes of assigning an estimated PD) and may assign
each wholesale exposure to loss severity rating grades (for purposes of
assigning an estimated LGD). A bank that elects not to use a loss
severity rating grade system for a wholesale exposure must directly
assign an estimated LGD to the wholesale exposure in phase 3. As a part
of the process of assigning wholesale obligors to rating grades, a bank
must identify which of its wholesale obligors are in default. In
addition, a bank must group its retail exposures within each retail
subcategory into segments that have homogeneous risk characteristics.
\57\
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\57\ If the bank determines the EAD for eligible margin loans
using the approach in section 32(b) of the rule, it must segment
retail eligible margin loans for which the bank uses this approach
separately from other retail exposures.
---------------------------------------------------------------------------
Segmentation is the grouping of exposures within each subcategory
according to the predominant risk characteristics of the borrower (for
example, credit score, debt-to-income ratio, and delinquency) and the
exposure (for example, product type and LTV ratio). In general, retail
segments should not cross national jurisdictions. A bank has
substantial flexibility to use the retail portfolio segmentation it
believes is most appropriate for its activities, subject to the
following broad principles:
Differentiation of risk--Segmentation should provide
meaningful differentiation of risk. Accordingly, in developing its risk
segmentation system, a bank should consider the chosen risk drivers'
ability to separate risk consistently over time and the overall
robustness of the bank's approach to segmentation.
Reliable risk characteristics--Segmentation should use
borrower-related risk characteristics and exposure-related risk
characteristics that reliably and consistently over time differentiate
a segment's risk from that of other segments.
Consistency--Risk drivers for segmentation should be
consistent with the predominant risk characteristics used by the bank
for internal credit risk measurement and management.
Accuracy--The segmentation system should generate segments
that separate exposures by realized performance and should be designed
so that actual long-run outcomes closely approximate the retail risk
parameters estimated by the bank.
A bank might choose to segment exposures by common risk drivers
that are relevant and material in determining the loss characteristics
of a particular retail product. For example, a bank may segment
mortgage loans by LTV band, age from origination, geography,
origination channel, and credit score. Statistical modeling, expert
judgment, or some combination of the two may determine the most
relevant risk drivers. Alternatively, a bank might segment by grouping
exposures with similar loss characteristics, such as loss rates or
[[Page 69331]]
default rates, as determined by historical performance of segments with
similar risk characteristics.
A bank must segment defaulted retail exposures separately from non-
defaulted retail exposures and should base the segmentation of
defaulted retail exposures on characteristics that are most predictive
of current loss and recovery rates. This segmentation should provide
meaningful differentiation so that individual exposures within each
defaulted segment do not have material differences in their expected
loss severity.
Banks commonly obtain tranched credit protection, for example
first-loss or second-loss guarantees, on certain retail exposures such
as residential mortgages. The proposal recognized that the
securitization framework, which applies to tranched wholesale
exposures, is not appropriate for individual retail exposures.
Therefore, the agencies proposed to exclude tranched guarantees that
apply only to an individual retail exposure from the securitization
framework. The preamble to the proposal noted that an important result
of this exclusion is that, in contrast to the treatment of wholesale
exposures, a bank may recognize recoveries from both a borrower and a
guarantor for purposes of estimating LGD for certain retail exposures.
Most commenters who addressed the agencies' proposed treatment for
tranched retail guarantees supported the proposed approach. One
commenter urged the agencies to extend the treatment of tranched
guarantees of retail exposures to wholesale exposures. Another
commenter asserted that the proposed treatment was inconsistent with
the New Accord.
The agencies have determined that while the securitization
framework is the most appropriate risk-based capital treatment for most
tranched guarantees, the regulatory burden associated with applying it
to tranched guarantees of individual retail exposures exceeds the
supervisory benefit. The agencies are therefore adopting the proposed
treatment in the final rule and excluding tranched guarantees of
individual retail exposures from the securitization framework.
Some banks expressed concern about the treatment of eligible margin
loans under the New Accord. Due to the highly collateralized nature and
low loss frequency of margin loans, banks typically collect little
customer-specific information that they could use to differentiate
margin loans into segments. The agencies believe that a bank could
appropriately segment its margin loan portfolio using only product-
specific risk drivers, such as product type and origination channel. A
bank could then use the definition of default to associate a PD and LGD
with each segment. As described in section 32 of the rule, a bank may
adjust the EAD of eligible margin loans to reflect the risk-mitigating
effect of financial collateral. If a bank elects this option to adjust
the EAD of eligible margin loans, it must associate an LGD with the
segment that does not reflect the presence of collateral.
Under the proposal, if a bank was not able to estimate PD and LGD
for an eligible margin loan, the bank could apply a 300 percent risk
weight to the EAD of the loan. Commenters generally objected to this
approach. As discussed in section III.B.3. of the preamble, several
commenters asserted that the agencies should permit banks to treat
margin loans and other portfolios that exhibit low loss frequency or
for which a bank has limited data on a portfolio basis, by apportioning
EL between PD and LGD for portfolios rather than estimating each risk
parameter separately. Other commenters suggested that banks should be
expected to develop sound practices for applying the IRB approach to
such exposures and adopt an appropriate degree of conservatism to
address the level of uncertainty in the estimation process. Several
commenters added that if a bank simply is unable to estimate PD and LGD
for eligible margin loans, they would support the agencies' proposal to
apply a flat risk weight to the EAD of eligible margin loans. However,
they asserted that the risk weight should not exceed 100 percent given
the low levels of loss associated with these types of exposures.
As discussed in section III.B.3. of the preamble, the final rule
provides flexibility and incentives for banks to develop and document
sound practices for applying the IRB approach to portfolios with
limited data or default history, which may include eligible margin
loans. However, the agencies believe that for banks facing particular
challenges with respect to estimating PD and LGD for eligible margin
loans, the proposed application of a 300 percent risk weight to the EAD
of an eligible margin loan is a reasonable alternative. The option
balances pragmatism with the provision of appropriate incentives for
banks to develop processes to apply the IRB approach to such exposures.
Accordingly, the final rule continues to provide banks with the option
of applying a 300 percent risk weight to the EAD of an eligible margin
loan for which it cannot estimate PD and LGD.
Purchased Wholesale Exposures
A bank may also elect to use a top-down approach, similar to the
treatment of retail exposures, for eligible purchased wholesale
exposures. Under the final rule, as under the proposal, this approach
may be used for exposures purchased directly by the bank. In addition,
the final rule clarifies that this approach also may be used for
exposures purchased by a securitization SPE in which the bank has
invested and for which the bank calculates the capital requirement on
the underlying exposures (KIRB) for purposes of the SFA (as
defined in section V.E.4. of the preamble). Under this approach, in
phase 2, a bank would group its eligible purchased wholesale exposures
into segments that have homogeneous risk characteristics. To be an
eligible purchased wholesale exposure, several criteria must be met:
The purchased wholesale exposure must be purchased from an
unaffiliated seller and must not have been directly or indirectly
originated by the purchasing bank or securitization SPE;
The purchased wholesale exposure must be generated on an
arm's-length basis between the seller and the obligor (intercompany
accounts receivable and receivables subject to contra-accounts between
firms that buy and sell to each other would not satisfy this
criterion);
The purchasing bank must have a claim on all proceeds from
the exposure or a pro rata interest in the proceeds;
The purchased wholesale exposure must have an effective
remaining maturity of less than one year; and
The purchased wholesale exposure must, when consolidated
by obligor, not represent a concentrated exposure relative to the
portfolio of purchased wholesale exposures.
Wholesale Lease Residuals
The agencies proposed a treatment for wholesale lease residuals
that differs from the New Accord. A wholesale lease residual typically
exposes a bank to the risk of a decline in value of the leased asset
and to the credit risk of the lessee. Although the New Accord provides
for a flat 100 percent risk weight for wholesale lease residuals, the
preamble to the proposal noted that the agencies believed this
treatment was excessively punitive for leases to highly creditworthy
lessees. Accordingly, the proposed rule required a bank to treat its
net investment in a wholesale lease as a single exposure to the lessee.
As proposed, there would not be a separate capital calculation for the
wholesale lease residual. Commenters on this issue broadly supported
the agencies'
[[Page 69332]]
proposed approach. The agencies believe the proposed approach
appropriately reflects current bank risk management practice and are
adopting the proposed approach in the final rule.
Commenters also requested this treatment for retail lease
residuals. However, the agencies have determined that the proposal to
apply a flat 100 percent risk weight for retail lease residuals,
consistent with the New Accord, appropriately balances risk sensitivity
and complexity and are maintaining this treatment in the final rule.
3. Phase 3--Assignment of Risk Parameters to Wholesale Obligors and
Exposures and Retail Segments
In phase 3, a bank associates a PD with each wholesale obligor
rating grade; associates an LGD with each wholesale loss severity
rating grade or assigns an LGD to each wholesale exposure; assigns an
EAD and M to each wholesale exposure; and assigns a PD, LGD, and EAD to
each segment of retail exposures. In some cases it may be reasonable to
assign the same PD, LGD, or EAD to multiple segments of retail
exposures. The quantification phase for PD, LGD, and EAD can generally
be divided into four steps--obtaining historical reference data,
estimating the risk parameters for the reference data, mapping the
historical reference data to the bank's current exposures, and
determining the risk parameters for the bank's current exposures. As
discussed in more detail below, quantification of M is accomplished
through direct computation based on the contractual characteristics of
the exposure.
A bank should base its estimation of the values assigned to PD,
LGD, and EAD \58\ on historical reference data that are a reasonable
proxy for the bank's current exposures and that provide meaningful
predictions of the performance of such exposures. A ``reference data
set'' consists of a set of exposures to defaulted wholesale obligors
and defaulted retail exposures (in the case of LGD and EAD estimation)
or to both defaulted and non-defaulted wholesale obligors and retail
exposures (in the case of PD estimation).
---------------------------------------------------------------------------
\58\ EAD for repo-style transactions and eligible margin loans
may be calculated as described in section 32 of the final rule. EAD
for OTC derivatives must be calculated as described in section 32 of
the final rule.
---------------------------------------------------------------------------
The reference data set should be described using a set of observed
characteristics. Relevant characteristics might include debt ratings,
financial measures, geographic regions, the economic environment and
industry/sector trends during the time period of the reference data,
borrower and loan characteristics related to the risk parameters (such
as loan terms, LTV ratio, credit score, income, debt-to-income ratio,
or performance history), or other factors that are related in some way
to the risk parameters. Banks may use more than one reference data set
to improve the robustness or accuracy of the parameter estimates.
A bank should then apply statistical techniques to the reference
data to determine a relationship between risk characteristics and the
estimated risk parameter. The result of this step is a model that ties
descriptive characteristics to the risk parameter estimates. In this
context, the term ``model'' is used in the most general sense; a model
may use simple concepts, such as the calculation of averages, or more
complex ones, such as an approach based on rigorous regression
techniques. This step may include adjustments for differences between
this final rule's definition of default and the default definition in
the reference data set, or adjustments for data limitations. This step
includes adjustments for seasoning effects related to retail exposures,
if material.
A bank may use more than one estimation technique to generate
estimates of the risk parameters, especially if there are multiple sets
of reference data or multiple sample periods. If multiple estimates are
generated, the bank should have a clear and consistent policy on
reconciling and combining the different estimates.
Once a bank estimates PD, LGD, and EAD for its reference data sets,
it should create a link between its portfolio data and the reference
data based on corresponding characteristics. Variables or
characteristics that are available for the existing portfolio should be
mapped or linked to the variables used in the default, loss-severity,
or exposure amount model. In order to effectively map the data,
reference data characteristics need to allow for the construction of
rating and segmentation criteria that are consistent with those used on
the bank's portfolio. An important element of mapping is making
adjustments for differences between reference data sets and the bank's
exposures.
Finally, a bank must apply the risk parameters estimated for the
reference data to the bank's actual portfolio data. As noted above, the
bank must attribute a PD to each wholesale obligor risk grade, an LGD
to each wholesale loss severity grade or wholesale exposure, an EAD and
M to each wholesale exposure, and a PD, LGD, and EAD to each segment of
retail exposures. If multiple data sets or estimation methods are used,
the bank must adopt a means of combining the various estimates at this
stage.
The final rule, as noted above, permits a bank to elect to segment
its eligible purchased wholesale exposures like retail exposures. A
bank that chooses to apply this treatment must directly assign a PD,
LGD, EAD, and M to each such segment. If a bank can estimate ECL (but
not PD or LGD) for a segment of eligible purchased wholesale exposures,
the bank must assume that the LGD of the segment equals 100 percent and
that the PD of the segment equals ECL divided by EAD. The bank must
estimate ECL for the eligible purchased wholesale exposures without
regard to any assumption of recourse or guarantees from the seller or
other parties. The bank must then use the wholesale exposure formula in
section 31(e) of the final rule to determine the risk-based capital
requirement for each segment of eligible purchased wholesale exposures.
A bank may recognize the credit risk mitigation benefits of
collateral that secures a wholesale exposure by adjusting its estimate
of the LGD of the exposure and may recognize the credit risk mitigation
benefits of collateral that secures retail exposures by adjusting its
estimate of the PD and LGD of the segment of retail exposures. In
certain cases, however, a bank may take financial collateral into
account in estimating the EAD of repo-style transactions, eligible
margin loans, and OTC derivative contracts (as provided in section 32
of the final rule).
Consistent with the proposed rule, the final rule also provides
that a bank may use an EAD of zero for (i) derivative contracts that
are publicly traded on an exchange that requires the daily receipt and
payment of cash-variation margin; (ii) derivative contracts and repo-
style transactions that are outstanding with a qualifying central
counterparty (defined below), but not for those transactions that the
qualifying central counterparty has rejected; and (iii) credit risk
exposures to a qualifying central counterparty that arise from
derivative contracts and repo-style transactions in the form of
clearing deposits and posted collateral. The final rule, like the
proposed rule, defines a qualifying central counterparty as a
counterparty (for example, a clearing house) that: (i) Facilitates
trades between counterparties in one or more financial markets by
either guaranteeing trades or novating contracts; (ii) requires all
participants in its arrangements to be fully collateralized on a daily
basis; and (iii) the bank demonstrates to the
[[Page 69333]]
satisfaction of its primary Federal supervisor is in sound financial
condition and is subject to effective oversight by a national
supervisory authority.
Some repo-style transactions and OTC derivative contracts giving
rise to counterparty credit risk may result, from an accounting point
of view, in both on- and off-balance sheet exposures. A bank that uses
an EAD approach to measure the exposure amount of such transactions is
not required to apply separately a risk-based capital requirement to an
on-balance sheet receivable from the counterparty recorded in
connection with that transaction. Because any exposure arising from the
on-balance sheet receivable is captured in the risk-based capital
requirement determined under the EAD approach, a separate capital
requirement would double count the exposure for regulatory capital
purposes.
A bank may take into account the risk reducing effects of eligible
guarantees and eligible credit derivatives in support of a wholesale
exposure by applying the PD substitution approach or the LGD adjustment
approach to the exposure as provided in section 33 of the final rule
or, if applicable, applying the double default treatment to the
exposure as provided in section 34 of the final rule. A bank may decide
separately for each wholesale exposure that qualifies for the double
default treatment whether to apply the PD substitution approach, the
LGD adjustment approach, or the double default treatment. A bank may
take into account the risk-reducing effects of guarantees and credit
derivatives in support of retail exposures in a segment when
quantifying the PD and LGD of the segment.
The proposed rule imposed several supervisory limitations on risk
parameters assigned to wholesale obligors and exposures and segments of
retail exposures. First, the PD for each wholesale obligor or segment
of retail exposures could not be less than 0.03 percent, except for
exposures to or directly and unconditionally guaranteed by a sovereign
entity, the Bank for International Settlements, the International
Monetary Fund, the European Commission, the European Central Bank, or a
multilateral development bank, to which the bank assigns a rating grade
associated with a PD of less than 0.03 percent.
Second, the LGD of a segment of residential mortgage exposures
(other than segments of residential mortgage exposures for which all or
substantially all of the principal of the exposures is directly and
unconditionally guaranteed by the full faith and credit of a sovereign
entity) could not be less than 10 percent. These supervisory floors on
PD and LGD applied regardless of whether the bank recognized an
eligible guarantee or eligible credit derivative as provided in
sections 33 and 34 of the proposed rule.
Commenters did not object to the floor on PD, and the agencies are
including it in the final rule. A number of commenters, however,
objected to the 10 percent floor on LGD for segments of residential
mortgage exposures. These commenters asserted that the floor would
penalize low-risk mortgage lending and would provide a disincentive for
obtaining high-quality collateral. The agencies continue to believe
that the LGD floor is appropriate at least until banks and the agencies
gain more experience with the advanced approaches. Accordingly, the
agencies are maintaining the floor in the final rule. As the agencies
gain more experience with the advanced approaches they will reconsider
the need for the floor together with other calibration issues
identified during the parallel run and transitional floor periods. The
agencies also intend to address this issue and other calibration issues
with the BCBS and other supervisory and regulatory authorities, as
appropriate.
The 10 percent LGD floor for residential mortgage exposures applies
at the segment level. The agencies will not allow a bank to
artificially group exposures into segments to avoid the LGD floor for
mortgage products. A bank should use consistent risk drivers to
determine its retail exposure segmentations and not artificially
segment low LGD loans with higher LGD loans to avoid the floor.
A bank also must calculate M for each wholesale exposure. Under the
proposed rule, for wholesale exposures other than repo-style
transactions, eligible margin loans, and OTC derivative contracts
subject to a qualifying master netting agreement (defined in section
V.C.2. of this preamble), M was defined as the weighted-average
remaining maturity (measured in whole or fractional years) of the
expected contractual cash flows from the exposure, using the
undiscounted amounts of the cash flows as weights. A bank could use its
best estimate of future interest rates to compute expected contractual
interest payments on a floating-rate exposure, but it could not
consider expected but noncontractually required returns of principal,
when estimating M. A bank could, at its option, use the nominal
remaining maturity (measured in whole or fractional years) of the
exposure. The M for repo-style transactions, eligible margin loans, and
OTC derivative contracts subject to a qualifying master netting
agreement was the weighted-average remaining maturity (measured in
whole or fractional years) of the individual transactions subject to
the qualifying master netting agreement, with the weight of each
individual transaction set equal to the notional amount of the
transaction. The M for netting sets for which the bank used the
internal models methodology was calculated as described in section
32(c) of the proposed rule.
Many commenters requested more flexibility in the definition of M,
including the ability to estimate noncontractually required prepayments
and the ability to use either discounted or undiscounted cash flows.
However, the agencies believe that the proposed definition of M, which
is consistent with the New Accord, is appropriately conservative and
provides for a consistent definition of M across internationally active
banks. The final rule therefore maintains the proposed definition of M.
Under the final rule, as under the proposal, for most exposures M
may be no greater than five years and no less than one year. For
exposures that have an original maturity of less than one year and are
not part of a bank's ongoing financing of the obligor, however, a bank
may set M as low as one day, consistent with the New Accord. An
exposure is not part of a bank's ongoing financing of the obligor if
the bank (i) has a legal and practical ability not to renew or roll
over the exposure in the event of credit deterioration of the obligor;
(ii) makes an independent credit decision at the inception of the
exposure and at every renewal or rollover; and (iii) has no substantial
commercial incentive to continue its credit relationship with the
obligor in the event of credit deterioration of the obligor. Examples
of transactions that may qualify for the exemption from the one-year
maturity floor include amounts due from other banks, including deposits
in other banks; bankers'' acceptances; sovereign exposures; short-term
self-liquidating trade finance exposures; repo-style transactions;
eligible margin loans; unsettled trades and other exposures resulting
from payment and settlement processes; and collateralized OTC
derivative contracts subject to daily remargining.
[[Page 69334]]
4. Phase 4--Calculation of Risk-Weighted Assets
After a bank assigns risk parameters to each of its wholesale
obligors and exposures and retail segments, the bank must calculate the
dollar risk-based capital requirement for each wholesale exposure to a
non-defaulted obligor and each segment of non-defaulted retail
exposures (except eligible guarantees and eligible credit derivatives
that hedge another wholesale exposure). Other than for exposures to
which the bank applies the double default treatment in section 34 of
the final rule, a bank makes this calculation by inserting the risk
parameters for the wholesale obligor and exposure or retail segment
into the appropriate IRB risk-based capital formula specified in Table
B, and multiplying the output of the formula (K) by the EAD of the
exposure or segment.\59\ Section 34 contains a separate double default
risk-based capital requirement formula. Eligible guarantees and
eligible credit derivatives that are hedges of a wholesale exposure are
reflected in the risk-weighted assets amount of the hedged exposure (i)
through adjustments made to the risk parameters of the hedged exposure
under the PD substitution or LGD adjustment approach in section 33 of
the final rule or (ii) through a separate double default risk-based
capital requirement formula in section 34 of the final rule.
---------------------------------------------------------------------------
\59\ Alternatively, as noted above, a bank may apply a 300
percent risk weight to the EAD of an eligible margin loan if the
bank is not able to assign a rating grade to the obligor of the
loan.
---------------------------------------------------------------------------
BILLING CODE 4810-33-P; 6210-01-P; 6714-01-P; 6720-01-P
[[Page 69335]]
[GRAPHIC] [TIFF OMITTED] TR07DE07.001
The sum of the dollar risk-based capital requirements for wholesale
exposures to non-defaulted obligors (including exposures subject to the
double default treatment described below) and segments of non-defaulted
retail exposures equals the total dollar risk-based capital requirement
for those exposures and segments. The total dollar risk-based capital
requirement multiplied by 12.5 equals the risk-weighted asset amount.
Under the proposed rule, to compute the risk-weighted asset amount
for a wholesale exposure to a defaulted obligor, a bank would first
have to compare two amounts: (i) The sum of 0.08 multiplied by the EAD
of the wholesale exposure plus the amount of any charge-offs or write-
downs on the exposure; and (ii) K for the wholesale exposure (as
determined in Table B immediately before the obligor became defaulted),
multiplied by the EAD of the exposure immediately before the exposure
became defaulted. If the amount calculated in (i) were equal to or
greater than the amount calculated in (ii), the dollar risk-based
capital requirement for the exposure would be 0.08 multiplied by the
EAD of the exposure. If the amount calculated in (i) were less than the
amount calculated in (ii), the dollar risk-based capital requirement
for the exposure would be K for the exposure (as determined in Table B
immediately before the obligor became defaulted), multiplied by the
[[Page 69336]]
EAD of the exposure. The reason for this comparison was to ensure that
a bank did not receive a regulatory capital benefit as a result of the
exposure moving from non-defaulted to defaulted status.
The proposed rule provided a simpler approach for segments of
defaulted retail exposures. The dollar risk-based capital requirement
for a segment of defaulted retail exposures was 0.08 multiplied by the
EAD of the segment.
Some commenters objected to the proposed risk-based capital
treatment of defaulted wholesale exposures, which differs from the
approach in the New Accord. These commenters contended that it would be
burdensome to track the pre-default risk-based capital requirements for
purposes of the proposed comparison. These commenters also claimed that
the cost and burden of the proposed treatment of defaulted wholesale
exposures would subject banks to a competitive disadvantage relative to
international counterparts subject to an approach similar to that in
the New Accord.
In view of commenters' concerns about cost and regulatory burden,
the final rule treats defaulted wholesale exposures the same as
defaulted retail exposures. The dollar risk-based capital requirement
of a wholesale exposure to a defaulted obligor equals 0.08 multiplied
by the EAD of the exposure. The agencies will review banks' practices
to ensure that banks are not moving exposures from non-defaulted to
defaulted status for the primary purpose of obtaining a reduction in
risk-based capital requirements.
To convert the dollar risk-based capital requirements for defaulted
exposures into a risk-weighted asset amount, the bank must sum the
dollar risk-based capital requirements for all wholesale exposures to
defaulted obligors and segments of defaulted retail exposures and
multiply the sum by 12.5.
A bank may assign a risk-weighted asset amount of zero to cash
owned and held in all offices of the bank or in transit, and for gold
bullion held in the bank's own vaults or held in another bank's vaults
on an allocated basis, to the extent the gold bullion assets are offset
by gold bullion liabilities. The risk-weighted asset amount for an on-
balance sheet asset that does not meet the definition of a wholesale,
retail, securitization, or equity exposure--for example, property,
plant, and equipment and mortgage servicing rights--is its carrying
value. The risk-weighted asset amount for a portfolio of exposures that
the bank has demonstrated to its primary Federal supervisor's
satisfaction is, when combined with all other portfolios of exposures
that the bank seeks to treat as immaterial for risk-based capital
purposes, not material to the bank generally is its carrying value (for
on-balance sheet exposures) or notional amount (for off-balance sheet
exposures). For this purpose, the notional amount of an OTC derivative
contract that is not a credit derivative is the EAD of the derivative
as calculated in section 32 of the final rule. If an OTC derivative
contract is a credit derivative, the notional amount is the notional
amount of the credit derivative.
Total wholesale and retail risk-weighted assets are defined as the
sum of risk-weighted assets for wholesale exposures to non-defaulted
obligors and segments of non-defaulted retail exposures, wholesale
exposures to defaulted obligors and segments of defaulted retail
exposures, assets not included in an exposure category, non-material
portfolios of exposures (as calculated under section 31 of the final
rule), and unsettled transactions (as calculated under section 35 of
the final rule and described in section V.D. of the preamble) minus the
amounts deducted from capital pursuant to the general risk-based
capital rules (excluding those deductions reversed in section 12 of the
final rule).
5. Statutory Provisions on the Regulatory Capital Treatment of Certain
Mortgage Loans
The general risk-based capital rules assign 50 percent and 100
percent risk weights to certain one-to four-family residential pre-sold
construction loans and multifamily residential loans.\60\ The agencies
adopted these provisions as a result of the Resolution Trust
Corporation Refinancing, Restructuring, and Improvement Act of 1991
(RTCRRI Act).\61\ The RTCRRI Act mandates that each agency provide in
its capital regulations (i) A 50 percent risk weight for certain one-to
four-family residential pre-sold construction loans and multifamily
residential loans that meet specific statutory criteria in the RTCRRI
Act and any other underwriting criteria imposed by the agencies; and
(ii) a 100 percent risk weight for one-to four-family residential pre-
sold construction loans for residences for which the purchase contract
is cancelled.\62\
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\60\ See 12 CFR part 3, Appendix A, section 3(a)(3)(iii)
(national banks); 12 CFR part 208, Appendix A, section III.C.3.
(state member banks); 12 CFR part 225, Appendix A, section III.C.3.
(bank holding companies); 12 CFR part 325, Appendix A, section II.C.
(state nonmember banks); 12 CFR 567.6(a)(1)(iii) and (iv) (savings
associations).
\61\ See Sec. Sec. 618(a) and (b) of the RTCRRI Act, Pub. L.
102-233. The first class includes loans for the construction of a
residence consisting of 1-to-4 family dwelling units that have been
pre-sold under firm contracts to purchasers who have obtained firm
commitments for permanent qualifying mortgages and have made
substantial earnest money deposits. The second class includes loans
that are secured by a first lien on a residence consisting of more
than 4 dwelling units if the loan meets certain criteria outlined in
the RTCRRI Act.
\62\ See Sec. Sec. 618(a) and (b) of the RTCRRI Act.
---------------------------------------------------------------------------
When Congress enacted the RTCRRI Act in 1991, the agencies' risk-
based capital rules reflected the Basel I framework. Consequently, the
risk weight treatment for certain categories of mortgage loans in the
RTCRRI Act assumes a risk weight bucketing approach, instead of the
more risk-sensitive IRB approach in the advanced approaches.
In the proposed rule, the agencies identified three types of
residential mortgage loans addressed by the RTCRRI Act that would
continue to receive the risk weights provided in the Act. Consistent
with the general risk-based capital rules, the proposed rule would
apply the following risk weights (instead of the risk weights that
would otherwise be produced under the IRB risk-based capital formulas):
(i) A 50 percent risk weight for one-to four-family residential
construction loans if the residences have been pre-sold under firm
contracts to purchasers who have obtained firm commitments for
permanent qualifying mortgages and have made substantial earnest money
deposits, and the loans meet the other underwriting characteristics
established by the agencies in the general risk-based capital rules;
\63\ (ii) a 50 percent risk weight for multifamily residential loans
that meet certain statutory loan-to-value, debt-to-income,
amortization, and performance requirements, and meet the other
underwriting characteristics established by the agencies in the general
risk-based capital rules; \64\ and (iii) a 100 percent risk weight for
one-to four-family residential pre-sold construction loans for a
residence for which the purchase contract is cancelled.\65\ Under the
proposal, mortgage loans that did not meet the relevant criteria would
not qualify for the statutory risk weights and would be risk-weighted
according to the IRB risk-based capital formulas.
---------------------------------------------------------------------------
\63\ See Sec. 618(a)(1)((B) of the RTCRRI Act.
\64\ See Sec. 618(b)(1)(B) of the RTCRRI Act.
\65\ See Sec. 618(a)(2) of the RTCRRI Act.
---------------------------------------------------------------------------
Commenters generally opposed the proposed assignment of a 50
percent risk weight to multifamily and pre-sold single family
residential construction exposures. Commenters maintained that the
RTCRRI Act capital requirements do not align with risk, are contrary to
the
[[Page 69337]]
intent of the New Accord and to its implementation in other
jurisdictions, and would impose additional compliance burdens on banks
without any associated benefit.
The agencies agree with these concerns and have decided to adopt in
the final rule an alternative described in the preamble to the proposed
rule. The proposed rule's preamble noted the tension between the
statutory risk weights provided by the RTCRRI Act and the more risk-
sensitive IRB approaches to risk-based capital requirements. The
preamble observed that the RTCRRI Act permits the agencies to prescribe
additional underwriting characteristics for identifying loans that are
subject to the 50 percent statutory risk weights, provided these
underwriting characteristics are ``consistent with the purposes of the
minimum acceptable capital requirements to maintain the safety and
soundness of financial institutions.'' The agencies asked whether they
should impose the following additional underwriting criteria as
additional requirements for a core or opt-in bank to qualify for the
statutory 50 percent risk weight for a particular mortgage loan: (i)
That the bank has an IRB risk measurement and management system in
place that assesses the PD and LGD of prospective residential mortgage
exposures; and (ii) that the bank's IRB system generates a 50 percent
risk weight for the loan under the IRB risk-based capital formula. If
the bank's IRB system does not generate a 50 percent risk weight for a
particular loan, the loan would not qualify for the statutory risk
weight and would receive the risk weight generated by the IRB system.
A few commenters opposed this alternative approach and indicated
that the additional underwriting criteria would increase operational
burden. Other commenters, however, observed that compliance with the
additional underwriting criteria would not be burdensome.
After careful consideration of the comments and further analysis of
the text, spirit and legislative history of the RTCRRI Act, the
agencies have concluded that they should impose the additional
underwriting criteria described in the preamble to the proposed rule as
minimum requirements for a core or opt-in bank to use the statutory 50
percent risk weight for particular loans. The agencies believe that the
imposition of these criteria is consistent with the plain language of
the RTCRRI Act, which allows a bank to use the 50 percent risk weight
only if it meets the additional underwriting characteristics
established by the agencies. The agencies have concluded that the
additional underwriting characteristics imposed in the final rule are
``consistent with the purposes of the minimum acceptable capital
requirements to maintain the safety and soundness of financial
institution,'' because the criteria will make the risk-based capital
requirement for these loans a function of each bank's historical loss
experience for the loans and will therefore more accurately reflect the
performance and risk of loss for these loans. The additional
underwriting characteristics are also consistent with the purposes and
legislative history of RTCRRI Act, which was designed to reflect the
true level of risk associated with these types of mortgage loans and to
do so in accordance with the Basel Accord.\66\
---------------------------------------------------------------------------
\66\ See, e.g., Floor debate for the Resolution Trust
Corporation Refinancing, Restructuring, and Improvement Act of 1991,
p. H11853, House of Representatives, Nov. 26, 1991 (Rep. Wylie)
---------------------------------------------------------------------------
A capital-related provision of the Federal Deposit Insurance
Corporation Improvement Act of 1991 (``FDICIA''), enacted by Congress
just four days after its adoption of the RTCRRI Act, also supports the
addition of the new underwriting characteristics. Section 305(b)(1)(B)
of FDICIA \67\ directs each agency to revise its risk-based capital
standards for insured depository institutions to ensure that those
standards ``reflect the actual performance and expected risk of loss of
multifamily mortgages.'' Although this addresses only multifamily
mortgage loans (and not one-to four-family residential pre-sold
construction loans), it provides the agencies with a Congressional
mandate--equal in force and power to section 618 of the RTCRRI Act--to
enhance the risk sensitivity of the regulatory capital treatment of
multifamily mortgage loans. Crucially, the IRB approach required of
core and opt-in banks will produce capital requirements that more
accurately reflect both performance and risk of loss for multifamily
mortgage loans than either the Basel I risk weight or the RTCRRI Act
risk weight.
---------------------------------------------------------------------------
\67\ 12 U.S.C. 1828.
---------------------------------------------------------------------------
As noted above, section 618(a)(2) of the RTCRRI Act mandates that
each agency amend its capital regulations to provide a 100 percent risk
weight to any single-family residential construction loan for which the
purchase contract is cancelled. Because the statute does not authorize
the agencies to establish additional underwriting characteristics for
this small category of loans, the final rule, like the proposed rule,
provides a 100 percent risk weight for single-family residential
construction loans for which the purchase contract is cancelled.
C. Credit Risk Mitigation (CRM) Techniques
Banks use a number of techniques to mitigate credit risk. This
section of the preamble describes how the final rule recognizes the
risk-mitigating effects of both financial collateral (defined below)
and nonfinancial collateral, as well as guarantees and credit
derivatives, for risk-based capital purposes. To recognize credit risk
mitigants for risk-based capital purposes, a bank should have in place
operational procedures and risk management processes that ensure that
all documentation used in collateralizing or guaranteeing a transaction
is legal, valid, binding, and enforceable under applicable law in the
relevant jurisdictions. The bank should have conducted sufficient legal
review to reach a well-founded conclusion that the documentation meets
this standard and should reconduct such a review as necessary to ensure
continuing enforceability.
Although the use of CRM techniques may reduce or transfer credit
risk, it simultaneously may increase other risks, including
operational, liquidity, and market risks. Accordingly, it is imperative
that banks employ robust procedures and processes to control risks,
including roll-off risk and concentration of risks, arising from the
bank's use of CRM techniques and to monitor the implications of using
CRM techniques for the bank's overall credit risk profile.
1. Collateral
Under the final rule, a bank generally recognizes collateral that
secures a wholesale exposure as part of the LGD estimation process and
generally recognizes collateral that secures a retail exposure as part
of the PD and LGD estimation process, as described above in section
V.B.3. of the preamble. However, in certain limited circumstances
described in the next section, a bank may adjust EAD to reflect the
risk mitigating effect of financial collateral.
Although the final rule does not contain specific regulatory
requirements about how a bank incorporates collateral into PD or LGD
estimates, a bank should, when reflecting the credit risk mitigation
benefits of collateral in its estimation of the risk parameters of a
wholesale or retail exposure:
(i) Conduct sufficient legal review to ensure, at inception and on
an ongoing basis, that all documentation used in the collateralized
transaction is binding on
[[Page 69338]]
all parties and legally enforceable in all relevant jurisdictions;
(ii) Consider the correlation between obligor risk and collateral
risk in the transaction;
(iii) Consider any currency and/or maturity mismatch between the
hedged exposure and the collateral;
(iv) Ground its risk parameter estimates for the transaction in
historical data, using historical recovery rates where available; and
(v) Fully take into account the time and cost needed to realize the
liquidation proceeds and the potential for a decline in collateral
value over this time period.
The bank also should ensure that:
(i) The legal mechanism under which the collateral is pledged or
transferred ensures that the bank has the right to liquidate or take
legal possession of the collateral in a timely manner in the event of
the default, insolvency, or bankruptcy (or other defined credit event)
of the obligor and, where applicable, the custodian holding the
collateral;
(ii) The bank has taken all steps necessary to fulfill legal
requirements to secure its interest in the collateral so that it has
and maintains an enforceable security interest;
(iii) The bank has clear and robust procedures to ensure
observation of any legal conditions required for declaring the default
of the borrower and prompt liquidation of the collateral in the event
of default;
(iv) The bank has established procedures and practices for (A)
conservatively estimating, on a regular ongoing basis, the market value
of the collateral, taking into account factors that could affect that
value (for example, the liquidity of the market for the collateral and
obsolescence or deterioration of the collateral), and (B) where
applicable, periodically verifying the collateral (for example, through
physical inspection of collateral such as inventory and equipment); and
(v) The bank has in place systems for promptly requesting and
receiving additional collateral for transactions whose terms require
maintenance of collateral values at specified thresholds.
2. Counterparty Credit Risk of Repo-Style Transactions, Eligible Margin
Loans, and OTC Derivative Contracts
This section describes two EAD-based methodologies--a collateral
haircut approach and an internal models methodology--that a bank may
use instead of an LGD estimation methodology to recognize the benefits
of financial collateral in mitigating the counterparty credit risk
associated with repo-style transactions, eligible margin loans,
collateralized OTC derivative contracts, and single product groups of
such transactions with a single counterparty subject to a qualifying
master netting agreement (netting sets).\68\ A third methodology, the
simple VaR methodology, is also available to recognize financial
collateral mitigating the counterparty credit risk of single product
netting sets of repo-style transactions and eligible margin loans.
These methodologies are substantially the same as those in the
proposal, except for a few differences identified below.
---------------------------------------------------------------------------
\68\ For purposes of the internal models methodology in section
32(d) of the rule, discussed below in section V.C.4. of this
preamble, netting set also means a group of transactions with a
single counterparty that are subject to a qualifying cross-product
master netting agreement.
---------------------------------------------------------------------------
One difference from the proposal is that, consistent with the New
Accord, under the final rule these three methodologies may also be used
to recognize the benefits of any collateral (not only financial
collateral) mitigating the counterparty credit risk of repo-style
transactions that are included in a bank's VaR-based measure under the
market risk rule. In response to comments requesting broader
application of the EAD-based methodologies for recognizing the risk-
mitigating effect of collateral, the agencies added this flexibility to
the final rule to enhance international consistency and reduce
regulatory burden.
A bank may use any combination of the three methodologies for
collateral recognition; however, it must use the same methodology for
similar exposures. This means that, as a general matter, the agencies
expect a bank to use one of the three methodologies for all its repo-
style transactions, one of the three methodologies for all its eligible
margin loans, and one of the three methodologies for all its OTC
derivative contracts. A bank may, however, apply a different
methodology to subsets of repo-style transactions, eligible margin
loans, or OTC derivatives by product type or geographical location if
its application of different methodologies is designed to separate
transactions that do not have similar risk profiles and is not designed
to arbitrage the rule. For example, a bank may choose to use one
methodology for agency securities lending transactions--that is, repo-
style transactions in which the bank, acting as agent for a customer,
lends the customer's securities and indemnifies the customer against
loss--and another methodology for all other repo-style transactions.
This section also describes the methodology for calculating EAD for
an OTC derivative contract or set of OTC derivative contracts subject
to a qualifying master netting agreement. Table C illustrates which EAD
estimation methodologies may be applied to particular types of
exposure.
Table C
----------------------------------------------------------------------------------------------------------------
Models approach
Current Collateral ---------------------------------
exposure haircut Simple VaR \69\ Internal models
methodology approach methodology methodology
----------------------------------------------------------------------------------------------------------------
OTC derivative.............................. X ............... ............... X
Recognition of collateral for OTC ............... \70\ X ............... X
derivatives................................
Repo-style transaction...................... ............... X X X
Eligible margin loan........................ ............... X X X
Cross-product netting set................... ............... ............... ............... X
----------------------------------------------------------------------------------------------------------------
[[Page 69339]]
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\69\ Only repo-style transactions and eligible margin loans
subject to a single-product qualifying master netting agreement are
eligible for the simple VaR methodology.
\70\ In conjunction with the current exposure methodology.
---------------------------------------------------------------------------
Qualifying Master Netting Agreement
Under the final rule, consistent with the proposal, a qualifying
master netting agreement is defined to mean any written, legally
enforceable bilateral agreement, provided that:
(i) The agreement creates a single legal obligation for all
individual transactions covered by the agreement upon an event of
default, including bankruptcy, insolvency, or similar proceeding, of
the counterparty;
(ii) The agreement provides the bank the right to accelerate,
terminate, and close-out on a net basis all transactions under the
agreement and to liquidate or set off collateral promptly upon an event
of default, including upon an event of bankruptcy, insolvency, or
similar proceeding, of the counterparty, provided that, in any such
case, any exercise of rights under the agreement will not be stayed or
avoided under applicable law in the relevant jurisdictions;
(iii) The bank has conducted sufficient legal review to conclude
with a well-founded basis (and has maintained sufficient written
documentation of that legal review) that the agreement meets the
requirements of paragraph (ii) of this definition and that in the event
of a legal challenge (including one resulting from default or from
bankruptcy, insolvency, or similar proceeding) the relevant court and
administrative authorities would find the agreement to be legal, valid,
binding, and enforceable under the law of the relevant jurisdictions;
(iv) The bank establishes and maintains procedures to monitor
possible changes in relevant law and to ensure that the agreement
continues to satisfy the requirements of this definition; and
(v) The agreement does not contain a walkaway clause (that is, a
provision that permits a non-defaulting counterparty to make lower
payments than it would make otherwise under the agreement, or no
payment at all, to a defaulter or the estate of a defaulter, even if
the defaulter or the estate of the defaulter is a net creditor under
the agreement).
The agencies consider the following jurisdictions to be relevant
for a qualifying master netting agreement: the jurisdiction in which
each counterparty is chartered or the equivalent location in the case
of non-corporate entities, and if a branch of a counterparty is
involved, then also the jurisdiction in which the branch is located;
the jurisdiction that governs the individual transactions covered by
the agreement; and the jurisdiction that governs the agreement.
EAD for Repo-Style Transactions and Eligible Margin Loans
Under the final rule, a bank may recognize the risk-mitigating
effect of financial collateral that secures a repo-style transaction,
eligible margin loan, or single-product netting set of such
transactions and the risk-mitigating effect of any collateral that
secures a repo-style transaction that is included in a bank's VaR-based
measure under the market risk rule through an adjustment to EAD rather
than LGD. The bank may use a collateral haircut approach or one of two
models approaches: a simple VaR methodology (for single-product netting
sets of repo-style transactions or eligible margin loans) or an
internal models methodology. Figure 2 illustrates the methodologies
available for calculating EAD and LGD for eligible margin loans and
repo-style transactions.
[[Page 69340]]
[GRAPHIC] [TIFF OMITTED] TR07DE07.002
The proposed rule defined a repo-style transaction as a repurchase
or reverse repurchase transaction, or a securities borrowing or
securities lending transaction (including a transaction in which the
bank acts as agent for a customer and indemnifies the customer against
loss), provided that:
(i) The transaction is based solely on liquid and readily
marketable securities or cash;
(ii) The transaction is marked to market daily and subject to daily
margin maintenance requirements;
(iii) The transaction is executed under an agreement that provides
the bank the right to accelerate, terminate, and close-out the
transaction on a net basis and to liquidate or set off collateral
promptly upon an event of default (including upon an event of
bankruptcy, insolvency, or similar proceeding) of the counterparty,
provided that, in any such case, any exercise of rights under the
agreement will not be stayed or avoided under applicable law in the
relevant jurisdictions;\71\ and
---------------------------------------------------------------------------
\71\ This requirement is met where all transactions under the
agreement (i) are executed under U.S. law and (ii) constitute
``securities contracts'' or ``repurchase agreements'' under section
555 or 559, respectively, of the Bankruptcy Code (11 U.S.C. 555 or
559), qualified financial contracts under section 11(e)(8) of the
Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or netting
contracts between or among financial institutions under sections
401-407 of the Federal Deposit Insurance Corporation Improvement Act
of 1991 (12 U.S.C. 4401-4407) or the Federal Reserve Board's
Regulation EE (12 CFR part 231).
---------------------------------------------------------------------------
(iv) The bank has conducted and documented sufficient legal review
to conclude with a well-founded basis that the agreement meets the
requirements of paragraph (iii) of this definition and is legal, valid,
binding, and enforceable under applicable law in the relevant
jurisdictions.
In the proposal, the agencies recognized that criterion (iii) above
may pose challenges for certain transactions that would not be eligible
for certain exemptions from bankruptcy or receivership laws because the
counterparty--for example, a sovereign entity or a pension fund--is not
subject to such laws. The agencies sought comment on ways this
criterion could be crafted to accommodate such transactions when
justified on prudential grounds, while ensuring that the requirements
in criterion (iii) are met for transactions that are eligible for those
exemptions.
Several commenters responded to this question by urging the
agencies to modify the third component of the repo-style transaction
definition in accordance with the 2006 interagency securities borrowing
rule.\72\ Under the securities borrowing rule, the agencies accorded
preferential risk-based capital treatment for cash-collateralized
securities borrowing transactions that either met a bankruptcy standard
such as the standard in criterion (iii) above or were overnight or
unconditionally cancelable at any time by the bank. Commenters
maintained that banks are able to terminate promptly a repo-style
transaction with a counterparty whose financial condition is
deteriorating so long as the transaction is done on an overnight basis
or is unconditionally cancelable by the bank. As a result, these
commenters contended that events of default and losses on such
transactions are very rare.
---------------------------------------------------------------------------
\72\ 71 FR 8932, February 22, 2006.
---------------------------------------------------------------------------
The agencies have decided to modify the definition of repo-style
transaction consistent with this suggestion by commenters and
consistent with the 2006 securities borrowing rule. The agencies
believe that this modification will resolve, in a manner that preserves
safety and soundness, technical difficulties that banks would have had
in meeting the proposed rule's
[[Page 69341]]
definition for a material proportion of their repo-style transactions.
Consistent with the 2006 securities borrowing rule, a reasonably short
notice period, typically no more than the standard settlement period
associated with the securities underlying the repo-style transaction,
would not detract from the unconditionality of the bank's termination
rights. With regard to overnight transactions, the counterparty
generally should have no expectation, either explicit or implicit, that
the bank will automatically roll over the transaction. The agencies are
maintaining in substance all the other components of the proposed
definition of repo-style transaction.
The proposed rule defined an eligible margin loan as an extension
of credit where:
(i) The credit extension is collateralized exclusively by debt or
equity securities that are liquid and readily marketable;
(ii) The collateral is marked to market daily and the transaction
is subject to daily margin maintenance requirements;
(iii) The extension of credit is conducted under an agreement that
provides the bank the right to accelerate and terminate the extension
of credit and to liquidate or set off collateral promptly upon an event
of default (including upon an event of bankruptcy, insolvency, or
similar proceeding) of the counterparty, provided that, in any such
case, any exercise of rights under the agreement will not be stayed or
avoided under applicable law in the relevant jurisdictions; \73\ and
(iv) The bank has conducted and documented sufficient legal review
to conclude with a well-founded basis that the agreement meets the
requirements of paragraph (iii) of this definition and is legal, valid,
binding, and enforceable under applicable law in the relevant
jurisdictions.
---------------------------------------------------------------------------
\73\ This requirement is met under the circumstances described
in footnote 73. Under the U.S. Bankruptcy Code, ``margin loans'' are
a type of securities contract, but the term ``margin loan'' does not
encompass all loans that happen to be secured by securities
collateral. Rather, Congress intended the term ``margin loan'' to
include only those loans commonly known in the industry as margin
loans, such as credit permitted in an account under the Board's
Regulation T or where a financial intermediary extends credit for
the purchase, sale, carrying, or trading of securities. See H.R.
Rep. No. 109-131, at 119, 130 (2005).
---------------------------------------------------------------------------
Commenters generally supported this definition, but some objected
to the prescriptiveness of criterion (iii). Criterion (iii) is
necessary to ensure that a bank is quickly able to realize the value of
its collateral in the event of obligor default. Collateral stayed by
bankruptcy and not liquidated until a date far in the future is more
appropriately reflected as a discounted positive cash flow in LGD
estimation. Criterion (iii) is satisfied when the bank has conducted
sufficient legal review to conclude with a well-founded basis (and has
maintained sufficient written documentation of that legal review) that
a margin loan would be exempt from the bankruptcy auto-stay. The
agencies are therefore maintaining substantially the same definition of
eligible margin loan in the final rule.
With the exception of repo-style transactions that are included in
a bank's VaR-based measure under the market risk rule (as discussed
above), for purposes of determining EAD for repo-style transactions,
eligible margin loans, and OTC derivatives, and recognizing collateral
mitigating the counterparty credit risk of such exposures, the final
rule (consistent with the proposed rule) allows banks to take into
account only financial collateral. The proposed rule defined financial
collateral as collateral in the form of any of the following
instruments in which the bank has a perfected, first priority security
interest or the legal equivalent thereof: (i) Cash on deposit with the
bank (including cash held for the bank by a third-party custodian or
trustee); (ii) gold bullion; (iii) long-term debt securities that have
an applicable external rating of one category below investment grade or
higher (for example, at least BB-); (iv) short-term debt instruments
that have an applicable external rating of at least investment grade
(for example, at least A-3); (v) equity securities that are publicly
traded; (vi) convertible bonds that are publicly traded; and (vii)
mutual fund shares and money market mutual fund shares if a price for
the shares is publicly quoted daily.
In connection with this definition, the agencies asked for comment
on the appropriateness of requiring that a bank have a perfected, first
priority security interest, or the legal equivalent thereof, in the
definition of financial collateral. A couple of commenters supported
this requirement, but several other commenters objected. The objecting
commenters acknowledged that the requirement would generally be
consistent with current U.S. collateral practices for repo-style
transactions, eligible margin loans, and OTC derivatives, but they
criticized the requirement on the grounds that: (i) Obtaining a
perfected, first priority security interest may not be the current
market practice outside the United States; (ii) U.S. practices may
evolve in such a fashion as to not meet this requirement; and (iii) the
requirement is not explicit in the New Accord. Other commenters asked
the agencies to clarify that the requirement would be met for all or
certain forms of collateral if the bank had possession and control of
the collateral and a reasonable basis to believe it could promptly
liquidate the collateral.
The agencies believe that in order to use the EAD adjustment
approaches for exposures within the United States, a bank must have a
perfected, first priority security interest in collateral, with the
exception of cash on deposit with the bank and certain custodial
arrangements. The agencies have modified the proposed requirement to
address a concern raised by several commenters that a bank could fail
to satisfy the first priority security interest requirement because of
the senior security interest of a third-party custodian involved as an
intermediary in the transaction. Under the final rule, a bank meets the
security interest requirement so long as the bank has a perfected,
first priority security interest in the collateral notwithstanding the
prior security interest of any custodial agent. Outside of the United
States, the definition of financial collateral can be satisfied as long
as the bank has the legal equivalent of a perfected, first priority
security interest. For example, cash on deposit with the bank is an
example of the legal equivalent of a perfected, first priority security
interest. The agencies intend to apply this ``legal equivalent''
standard flexibly to deal with non-U.S. collateral access regimes.
The agencies also invited comment on the extent to which assets
that do not meet the definition of financial collateral are the basis
of repo-style transactions engaged in by banks or are taken by banks as
collateral for eligible margin loans or OTC derivatives. The agencies
also inquired as to whether the definition of financial collateral
should be expanded to reflect any other asset types.
A substantial number of commenters asked the agencies to add asset
types to the list of financial collateral. The principal recommended
additions included: (i) Non-investment-grade externally rated bonds;
(ii) bonds that are not externally rated; (iii) all financial
instruments; (iv) letters of credit; (v) mortgages loans; and (vi)
certificates of deposit. Some commenters that advocated inclusion of a
wider range of bonds admitted that it may be reasonable to impose some
sort of liquidity requirement on the additional bonds and to impose a
25-50 percent standard supervisory haircut for such additional bonds.
Some of the commenters that advocated inclusion of
[[Page 69342]]
a broader range of bonds and mortgages asserted that such inclusion
would be warranted by the exemption from bankruptcy auto-stay accorded
to repo-style transactions involving such assets by the U.S. Bankruptcy
Code.\74\
---------------------------------------------------------------------------
\74\ 11 U.S.C. 559.
---------------------------------------------------------------------------
As described above, to enhance international consistency and
conform the final rule more closely to the New Accord, the agencies
have decided to permit a bank to use the EAD approach for all repo-
style transactions that are included in a bank's VaR-based measure
under the market risk rule, regardless of the underlying collateral
type. The agencies are satisfied that such repo-style transactions
would be based on collateral that is sufficiently liquid to justify
applying the EAD approach.
The agencies have included conforming residential mortgages in the
definition of financial collateral and as acceptable underlying
instruments in the definitions of repo-style transaction and eligible
margin loan based on the liquidity of such mortgages and their
widespread use as collateral in repo-style transactions. However,
because this inclusion goes beyond the New Accord's recognition of
financial collateral, the agencies decided to take a conservative
approach and require banks to use the standard supervisory haircut
approach, with a 25 percent haircut and minimum ten-business-day
holding period, in order to recognize conforming residential mortgage
collateral in EAD (other than for repo-style transactions that are
included in a bank's VaR-based measure under the market risk rule). Use
of the standard supervisory haircut approach for repo-style
transactions, eligible margin loans, and OTC derivatives collateralized
by conforming mortgages does not preclude a bank's use of the other EAD
adjustment approaches for exposures collateralized by other types of
financial collateral. Due to concerns about both competitive equity and
the liquidity and price availability of other types of collateral, the
agencies are not otherwise expanding the proposed definition of
financial collateral in the final rule.
Collateral Haircut Approach
Under the collateral haircut approach of the final rule, similar to
the proposed rule, a bank must set EAD equal to the sum of three
quantities: (i) The value of the exposure less the value of the
collateral; (ii) the absolute value of the net position in a given
instrument or in gold (where the net position in a given instrument or
in gold equals the sum of the current market values of the instrument
or gold the bank has lent, sold subject to repurchase, or posted as
collateral to the counterparty minus the sum of the current market
values of that same instrument or gold the bank has borrowed, purchased
subject to resale, or taken as collateral from the counterparty)
multiplied by the market price volatility haircut appropriate to the
instrument or gold; and (iii) the sum of the absolute values of the net
position of any cash or instruments in each currency that is different
from the settlement currency multiplied by the haircut appropriate to
each currency mismatch. To determine the appropriate haircuts, a bank
may choose to use standard supervisory haircuts or, with prior written
approval from its primary Federal supervisor, its own estimates of
haircuts.
In the preamble to the proposed rule, for purposes of the
collateral haircut approach, the agencies clarified that a given
security would include, for example, all securities with a single
Committee on Uniform Securities Identification Procedures (CUSIP)
number and would not include securities with different CUSIP numbers,
even if issued by the same issuer with the same maturity date. The
agencies sought comment on alternative approaches for determining a
given security for purposes of the collateral haircut approach. A few
commenters expressed support for the proposed CUSIP approach to
defining a given security, but one commenter asked the agencies to
permit each bank the flexibility to define given security. The
collateral haircut approach in the final rule is based on a bank's net
position in a ``given instrument or gold'' rather than in a ``given
security'' to more precisely capture the positions to which a bank must
apply the haircuts. To enhance safety and soundness and comparability
across banks, the agencies believe that it is important to preserve the
relatively clear CUSIP approach to defining a given instrument for
purposes of the collateral haircut approach. Accordingly, the agencies
are maintaining the CUSIP approach as appropriate for determining a
given instrument for instruments that are securities.
Standard supervisory haircuts. Under the final rule, as under the
proposed rule, if a bank chooses to use standard supervisory haircuts,
it must use an 8 percent haircut for each currency mismatch and the
haircut appropriate to each security in Table D below. These haircuts
are based on the ten-business-day holding period for eligible margin
loans and must be multiplied by the square root of \1/2\ to convert the
standard supervisory haircuts to the five-business-day minimum holding
period for repo-style transactions. A bank must adjust the standard
supervisory haircuts upward on the basis of a holding period longer
than ten business days for eligible margin loans or five business days
for repo-style transactions where and as appropriate to take into
account the illiquidity of an instrument.
[[Page 69343]]
[GRAPHIC] [TIFF OMITTED] TR07DE07.003
As an example, assume a bank that uses standard supervisory
haircuts has extended an eligible margin loan of $100 that is
collateralized by five-year U.S. Treasury notes with a market value of
$100. The value of the exposure less the value of the collateral would
be zero, and the net position in the security ($100) times the
supervisory haircut (.02) would be $2. There is no currency mismatch.
Therefore, the EAD of the exposure would be $0 + $2 = $2.
---------------------------------------------------------------------------
\75\ The proposed and final rules define a ``main index'' as the
S&P 500 Index, the FTSE All-World Index, and any other index for
which the bank demonstrates to the satisfaction of its primary
Federal supervisor that the equities represented in the index have
comparable liquidity, depth of market, and size of bid-ask spreads
as equities in the S&P 500 Index and the FTSE All-World Index.
---------------------------------------------------------------------------
Own estimates of haircuts. Under the final rule, as under the
proposal, with the prior written approval of the bank's primary Federal
supervisor, a bank may calculate security type and currency mismatch
haircuts using its own internal estimates of market price volatility
and foreign exchange volatility. The bank's primary Federal supervisor
would base approval to use internally estimated haircuts on the
satisfaction of certain minimum qualitative and quantitative standards.
These standards include: (i) The bank must use a 99th percentile one-
tailed confidence interval and a minimum five-business-day holding
period for repo-style transactions and a minimum ten-business-day
holding period for all other transactions; (ii) the bank must adjust
holding periods upward where and as appropriate to take into account
the illiquidity of an instrument; (iii) the bank must select a
historical observation period for calculating haircuts of at least one
year; and (iv) the bank must update its data sets and recompute
haircuts no less frequently than quarterly and reassess data sets and
haircuts whenever market prices change materially. A bank must estimate
individually the volatilities of the exposure, the collateral, and
foreign exchange rates, and may not take into account the correlations
between them.
Under the final rule, as under the proposal, a bank that uses
internally estimated haircuts must adhere to the following rules. The
bank may calculate internally estimated haircuts for categories of debt
securities that have an applicable external rating of at least
investment grade. The haircut for a category of securities must be
representative of the internal volatility estimates for securities in
that category that the bank has lent, sold subject to repurchase,
posted as collateral, borrowed, purchased subject to resale, or taken
as collateral. In determining
[[Page 69344]]
relevant categories, the bank must at a minimum take into account (i)
the type of issuer of the security; (ii) the applicable external rating
of the security; (iii) the maturity of the security; and (iv) the
interest rate sensitivity of the security. A bank must calculate a
separate internally estimated haircut for each individual debt security
that has an applicable external rating below investment grade and for
each individual equity security. In addition, a bank must internally
estimate a separate currency mismatch haircut for each individual
mismatch between each net position in a currency that is different from
the settlement currency.
One commenter recommended that the agencies permit banks to use
category-based internal estimate haircuts for non-investment-grade
bonds and equity securities. The agencies have decided to adopt the
proposed rule's provisions on category-based haircuts because they are
consistent with the New Accord and because the volatilities of non-
investment-grade bonds and of equity securities are more dependent on
idiosyncratic, issuer-specific events than the volatility of
investment-grade bonds.
Under the final rule, as under the proposal, when a bank calculates
an internally estimated haircut on a TN-day holding period,
which is different from the minimum holding period for the transaction
type, the bank must calculate the applicable haircut (HM)
using the following square root of time formula:
[GRAPHIC] [TIFF OMITTED] TR07DE07.006
Where:
(i) TM = five for repo-style transactions and ten for
eligible margin loans;
(ii) TN = holding period used by the bank to derive
HN; and
(iii) HN = haircut based on the holding period
TN.
Simple VaR Methodology
As noted above, under the final rule, as under the proposal, a bank
may use one of two internal models approaches to recognize the risk
mitigating effects of financial collateral that secures a repo-style
transaction or eligible margin loan. This section of the preamble
describes the simple VaR methodology; a later section of the preamble
describes the internal models methodology (which also may be used to
determine the EAD for OTC derivative contracts). The agencies received
no material comments on the simple VaR methodology and are adopting the
methodology without change from the proposal.
With the prior written approval of its primary Federal supervisor,
a bank may estimate EAD for repo-style transactions and eligible margin
loans subject to a single product qualifying master netting agreement
using a VaR model. Under the simple VaR methodology, a bank's EAD for
the transactions subject to such a netting agreement is equal to the
value of the exposures minus the value of the collateral plus a VaR-
based estimate of potential future exposure (PFE). The value of the
exposures is the sum of the current market values of all securities and
cash the bank has lent, sold subject to repurchase, or posted as
collateral to a counterparty under the netting set. The value of the
collateral is the sum of the current market values of all securities
and cash the bank has borrowed, purchased subject to resale, or taken
as collateral from a counterparty under the netting set. The VaR-based
estimate of PFE is an estimate of the bank's maximum exposure on the
netting set over a fixed time horizon with a high level of confidence.
Specifically, the VaR model must estimate the bank's 99th
percentile, one-tailed confidence interval for an increase in the value
of the exposures minus the value of the collateral ([Sigma]E-[Sigma]C)
over a five-business-day holding period for repo-style transactions or
over a ten-business-day holding period for eligible margin loans using
a minimum one-year historical observation period of price data
representing the instruments that the bank has lent, sold subject to
repurchase, posted as collateral, borrowed, purchased subject to
resale, or taken as collateral.
The qualification requirements for the use of a VaR model are less
stringent than the qualification requirements for the internal models
methodology described below. The main ongoing qualification requirement
for using a VaR model is that the bank must validate its VaR model by
establishing and maintaining a rigorous and regular backtesting regime.
3. EAD for OTC Derivative Contracts
Under the final rule, as under the proposed rule, a bank may use
either the current exposure methodology or the internal models
methodology to determine the EAD for OTC derivative contracts. An OTC
derivative contract is defined as a derivative contract that is not
traded on an exchange that requires the daily receipt and payment of
cash-variation margin. A derivative contract is defined to include
interest rate derivative contracts, exchange rate derivative contracts,
equity derivative contracts, commodity derivative contracts, credit
derivatives, and any other instrument that poses similar counterparty
credit risks. The rule also defines derivative contracts to include
unsettled securities, commodities, and foreign exchange trades with a
contractual settlement or delivery lag that is longer than the normal
settlement period (which the rule defines as the lesser of the market
standard for the particular instrument or five business days). This
includes, for example, agency mortgage-backed securities transactions
conducted in the To-Be-Announced market.
Figure 3 illustrates the treatment of OTC derivative contracts.
[[Page 69345]]
[GRAPHIC] [TIFF OMITTED] TR07DE07.004
Current Exposure Methodology
The final rule's current exposure methodology for determining EAD
for single OTC derivative contracts is similar to the methodology in
the general risk-based capital rules and is the same as the current
exposure methodology in the proposal. Under the current exposure
methodology, the EAD for an OTC derivative contract is equal to the sum
of the bank's current credit exposure and PFE on the derivative
contract. The current credit exposure for a single OTC derivative
contract is the greater of the mark-to-market value of the derivative
contract or zero.
The final rule's current exposure methodology for OTC derivative
contracts subject to qualifying master netting agreements is also
similar to the treatment in the agencies' general risk-based capital
rules and, with one exception discussed below, is the same as the
treatment in the proposal. Under the general risk-based capital rules
and under the proposed rule, a bank could not recognize netting
agreements for OTC derivative contracts for risk-based capital purposes
unless it obtained a written and reasoned legal opinion representing
that, in the event of a legal challenge, the bank's exposure would be
found to be the net amount in the relevant jurisdictions.\76\ The
agencies asked for comment on methods banks would use to ensure
enforceability of single product OTC derivative netting agreements in
the absence of an explicit written legal opinion requirement.
---------------------------------------------------------------------------
\76\ This requirement was found in footnote 8 of the proposed
rule text (in section 32(b)(2)).
---------------------------------------------------------------------------
Although one commenter supported the proposed rule's written legal
opinion requirement, many other commenters asked the agencies to remove
this requirement. These commenters maintained that, provided a
transaction is conducted in a jurisdiction and with a counterparty type
that is covered by a commissioned legal opinion, use of industry-
developed standardized contracts for certain OTC derivative products
and reliance on commissioned legal opinions as to the enforceability of
these contracts should be a sufficient guarantor of enforceability.
These commenters added that reliance on such commissioned legal
opinions is standard market practice.
The agencies continue to believe that the legal enforceability of
netting agreements is a necessary condition for a bank to recognize
netting effects in its capital calculation. However, the agencies have
conducted additional analysis and agree that a unique, written legal
opinion is not necessary in all cases to ensure the enforceability of
an OTC derivative netting agreement. Accordingly, the agencies have
removed the requirement that a bank obtain a written and well reasoned
legal opinion for each of its qualifying master netting agreements that
cover OTC derivatives. As a result, under the final rule, to obtain
netting treatment for multiple OTC derivative contracts subject to a
qualifying master netting agreement, a
[[Page 69346]]
bank must conduct sufficient legal review to conclude with a well-
founded basis (and maintain sufficient written documentation of that
legal review) that the agreement would provide termination netting
benefits and is legal, valid, binding, and enforceable. In some cases,
this requirement could be met by reasoned reliance on a commissioned
legal opinion or an in-house counsel analysis. In other cases,
however--for example, involving certain new derivative transactions or
derivative counterparties in unusual jurisdictions--the bank would need
to obtain an explicit written legal opinion from external or internal
legal counsel addressing the particular situation.
The proposed rule's conversion factor (CF) matrix used to compute
PFE was based on the matrices in the general risk-based capital rules,
with two exceptions. First, under the proposed rule, the CF for credit
derivatives that are not used to hedge the credit risk of exposures
subject to an IRB credit risk capital requirement was specified to be
5.0 percent for contracts with investment-grade reference obligors and
10.0 percent for contracts with non-investment-grade reference
obligors.\77\ The CF for a credit derivative contract did not depend on
the remaining maturity of the contract. The second change was that
floating/floating basis swaps were no longer exempted from the CF for
interest rate derivative contracts. The exemption was put into place
when such swaps were very simple, and the agencies believed it was no
longer appropriate given the evolution of the product. The computation
of the PFE of multiple OTC derivative contracts subject to a qualifying
master netting agreement did not change from the general risk-based
capital rules. The agencies received no material comment on these
provisions of the proposed rule and have adopted them as proposed.
---------------------------------------------------------------------------
\77\ The counterparty credit risk of a credit derivative that is
used to hedge the credit risk of an exposure subject to an IRB
credit risk capital requirement is captured in the IRB treatment of
the hedged exposure, as detailed in sections 33 and 34 of the
proposed rule.
---------------------------------------------------------------------------
Under the final rule, as under the proposed rule, if an OTC
derivative contract is collateralized by financial collateral and a
bank uses the current exposure methodology to determine EAD for the
exposure, the bank must first determine an unsecured EAD as described
above and in section 32(c) of the rule. To take into account the risk-
reducing effects of the financial collateral, the bank may either
adjust the LGD of the contract or, if the transaction is subject to
daily marking-to-market and remargining, adjust the EAD of the contract
using the collateral haircut approach for repo-style transactions and
eligible margin loans described above and in section 32(b) of the rule.
Under part VI of the final rule, and of the proposed rule, a bank
must treat an equity derivative contract as an equity exposure and
compute a risk-weighted asset amount for that exposure. If the bank is
using the internal models approach for its equity exposures, it also
must compute a risk-weighted asset amount for its counterparty credit
risk exposure on the equity derivative contract. However, if the bank
is using the simple risk weight approach for its equity exposures, it
may choose not to hold risk-based capital against the counterparty
credit risk of the equity derivative contract. Likewise, a bank that
purchases a credit derivative that is recognized under section 33 or 34
of the rule as a credit risk mitigant for an exposure that is not a
covered position under the market risk rule does not have to compute a
separate counterparty credit risk capital requirement for the credit
derivative.\78\ If a bank chooses not to hold risk-based capital
against the counterparty credit risk of such equity or credit
derivative contracts, it must do so consistently for all such equity
derivative contracts or for all such credit derivative contracts.
Further, where the contracts are subject to a qualifying master netting
agreement, the bank must either include them all or exclude them all
from any measure used to determine counterparty credit risk exposure to
all relevant counterparties for risk-based capital purposes.
---------------------------------------------------------------------------
\78\ The agencies recognize that there are reasons why a bank's
credit portfolio might contain purchased credit protection on a
reference name in a notional principal amount that exceeds the
bank's currently measured EAD to that obligor. If the protection
amount of the credit derivative is materially greater than the EAD
of the exposure being hedged, however, the bank generally must treat
the credit derivative as two separate exposures and calculate a
counterparty credit risk capital requirement for the exposure that
is not providing credit protection to the hedged exposure.
---------------------------------------------------------------------------
In addition, where a bank provides protection through a credit
derivative that is not treated as a covered position under the market
risk rule, it must treat the credit derivative as a wholesale exposure
to the reference obligor and compute a risk-weighted asset amount for
the credit derivative under section 31 of the rule. The bank need not
compute a counterparty credit risk capital requirement for the credit
derivative, so long as it does so consistently for all such credit
derivatives and either includes all or excludes all such credit
derivatives that are subject to a qualifying master netting agreement
from any measure used to determine counterparty credit risk exposure to
all relevant counterparties for risk-based capital purposes. Where the
bank provides protection through a credit derivative treated as a
covered position under the market risk rule, it must compute a
counterparty credit risk capital requirement for the credit derivative
under section 31 of the rule.
4. Internal Models Methodology
The final rule, like the proposed rule, includes an internal models
methodology for the calculation of EAD for the counterparty credit
exposure of OTC derivatives, eligible margin loans, and repo-style
transactions. The internal models methodology requires a risk model
that estimates EAD at the level of a netting set. A transaction not
subject to a qualifying master netting agreement is considered to be
its own netting set and a bank must calculate EAD for each such
transaction individually.
A bank may use the internal models methodology for OTC derivatives
(collateralized or uncollateralized) and single-product netting sets
thereof, for eligible margin loans and single-product netting sets
thereof, or for repo-style transactions and single-product netting sets
thereof. A bank that uses the internal models methodology for a
particular transaction type (that is, OTC derivative contracts,
eligible margin loans, or repo-style transactions) must use the
internal models methodology for all transactions of that transaction
type. However, a bank may choose whether or not to use the internal
models methodology for each transaction type.
A bank also may use the internal models methodology for OTC
derivatives, eligible margin loans, and repo-style transactions subject
to a qualifying cross-product master netting agreement if (i) the bank
effectively integrates the risk mitigating effects of cross-product
netting into its risk management and other information technology
systems; and (ii) the bank obtains the prior written approval of its
primary Federal supervisor.
The final rule tracks the proposed rule by defining a qualifying
cross-product master netting agreement as a qualifying master netting
agreement that provides for termination and close-out netting across
multiple types of financial transactions or qualifying master netting
agreements in the event of a counterparty's default, provided that:
(i) The underlying financial transactions are OTC derivative
contracts, eligible margin loans, or repo-style transactions; and
[[Page 69347]]
(ii) The bank obtains a written legal opinion verifying the
validity and enforceability of the netting agreement under applicable
law of the relevant jurisdictions if the counterparty fails to perform
upon an event of default, including upon an event of bankruptcy,
insolvency, or similar proceeding.
As discussed in the proposal, banks use several measures to manage
their exposure to the counterparty credit risk of repo-style
transactions, eligible margin loans, and OTC derivatives, including
PFE, expected exposure (EE), and expected positive exposure (EPE). PFE
is the maximum exposure estimated to occur over a future horizon at a
high level of statistical confidence. Banks often use PFE when
measuring counterparty credit risk exposure against counterparty credit
limits. EE is the expected value of the probability distribution of
non-negative credit risk exposures to a counterparty at any specified
future date, whereas EPE is the time-weighted average of individual
expected exposures estimated for a given forecasting horizon (one year
in the proposed rule). The final rule clarifies that, when estimating
EE, a bank must set any negative market values in the probability
distribution of market values to a counterparty at a specified future
date to zero to convert the probability distribution of market values
to the probability distribution of credit risk exposures. Banks
typically compute EPE, EE, and PFE using a common stochastic model.
A paper published by the BCBS in July 2005 titled ``The Application
of Basel II to Trading Activities and the Treatment of Double Default
Effects'' notes that EPE is an appropriate EAD measure for determining
risk-based capital requirements for counterparty credit risk because
transactions with counterparty credit risk ``are given the same
standing as loans with the goal of reducing the capital treatment's
influence on a firm's decision to extend an on-balance sheet loan
rather than engage in an economically equivalent transaction that
involves exposure to counterparty credit risk.'' \79\ An adjustment to
EPE, called ``effective EPE'' and described below, is used in the
calculation of EAD under the internal models methodology. EAD is
calculated as a multiple of effective EPE.
---------------------------------------------------------------------------
\79\ BCBS, ``The Application of Basel II to Trading Activities
and the Treatment of Double Default Effects,'' July 2005, ] 15.
---------------------------------------------------------------------------
To address the concern that EE and EPE may not capture risk arising
from the replacement of existing short-term positions over the one-year
horizon used for capital requirements (rollover risk) or may
underestimate the exposures of eligible margin loans, repo-style
transactions, and OTC derivatives with short maturities, the final
rule, like the proposed rule, uses a netting set's effective EPE as the
basis for calculating EAD for counterparty credit risk. Consistent with
the use of a one-year PD horizon, effective EPE is the time-weighted
average of effective EE over one year where the weights are the
proportion that an individual effective EE represents in a one-year
time interval. If all contracts in a netting set mature before one
year, effective EPE is the average of effective EE until all contracts
in the netting set mature. For example, if the longest maturity
contract in the netting set matures in six months, effective EPE would
be the average of effective EE over six months.
Effective EE is defined as:
Effective EEtk = max(Effective EEtk-1, EEtk)
where exposure is measured at future dates t1, t2, t3, * * * and
effective EEt0 equals current exposure. Alternatively, a bank may
use a measure that is more conservative than effective EPE for every
counterparty (that is, a measure based on peak exposure) with prior
approval of its primary Federal supervisor.
The final rule clarifies that if a bank hedges some or all of the
counterparty credit risk associated with a netting set using an
eligible credit derivative, the bank may take the reduction in exposure
to the counterparty into account when estimating EE. If the bank
recognizes this reduction in exposure to the counterparty in its
estimate of EE, it must also use its internal model to estimate a
separate EAD for the bank's exposure to the protection provider of the
credit derivative.
The EAD for instruments with counterparty credit risk must be
determined assuming economic downturn conditions. To accomplish this
determination in a prudent manner, the internal models methodology sets
EAD equal to EPE multiplied by a scaling factor termed ``alpha.'' Alpha
is set at 1.4; a bank's primary Federal supervisor has the flexibility
to raise this value based on the bank's specific characteristics of
counterparty credit risk. In addition, with supervisory approval, a
bank may use its own estimate of alpha, subject to a floor of 1.2.
In the proposal, the agencies requested comment on all aspects of
the effective EPE approach to counterparty credit risk and, in
particular, on the appropriateness of the monotonically increasing
effective EE function, the alpha constant of 1.4, and the floor on
internal estimates of alpha of 1.2. Commenters expressed a number of
objections to the proposed rule's internal models methodology.
Several commenters contended that banks that use the internal
models methodology should be permitted to calculate effective EPE at
the counterparty level and should not be required to calculate
effective EPE at the netting set level. These commenters indicated that
while the New Accord mandates calculation at the netting set level,
those banks that currently use an EPE-style approach to measuring
counterparty credit risk for internal risk management purposes
typically use a counterparty-by-counterparty EPE approach. They
asserted that forcing banks to use a netting-set-by-netting-set
approach would be burdensome for banks and would provide the agencies
no material regulatory benefits, as netting effects are taken into
account in the calculation of EE.
The agencies have retained the netting set focus of the calculation
of effective EPE to preserve international consistency. The agencies
will continue to review the implications, particularly with respect to
the appropriate recognition of netting benefits, of allowing banks to
calculate effective EPE at the counterparty level.
One commenter objected to the proposed rule's requirement that a
bank use effective EE (as opposed to EE). This commenter contended that
effective EE is an excessively conservative and imprecise mechanism to
address rollover risk in a portfolio of short-term transactions. The
commenter represented that rollover risk should be addressed under
Pillar 2 rather than Pillar 1. The agencies continue to believe that
rollover risk is a core credit risk that should be covered by explicit
risk-based capital requirements. The agencies also remain concerned
that EE and EPE (as opposed to effective EE and effective EPE) would
not adequately incorporate rollover risk and do not believe that bank
internal estimates of rollover risk are sufficiently reliable at this
time to use for risk-based capital purposes. To ensure consistency with
the New Accord and in light of the lack of alternative prudent
mechanisms to incorporate rollover risk, the agencies continue to
include effective EE and effective EPE in the final rule.
Several commenters criticized the default alpha of 1.4 and the 1.2
floor on internal estimates of alpha. These commenters contended that
these supervisory alphas were too conservative for many dealer banks
with large, diverse, and granular portfolios of repo-style
transactions, eligible margin
[[Page 69348]]
loans, and OTC derivatives. Although the agencies acknowledge the
possibility that certain banks with certain types of portfolios at
certain times could warrant an alpha of less than 1.2, the agencies
believe it is important to have a supervisory floor on alpha. This
floor will ensure consistency with the New Accord, comparability among
the various banks that use the internal models methodology, and
sufficient capital through the economic cycle for securities financing
transactions and OTC derivatives. Therefore, the agencies are retaining
the alpha floor as proposed.
Similar to the proposal, under the final rule a bank's primary
Federal supervisor must determine that the bank meets certain
qualifying criteria before the bank may use the internal models
methodology. These criteria consist of the following operational
requirements, modeling standards, and model validation requirements.
First, the bank must have the systems capability to estimate EE on
a daily basis. While this requirement does not require the bank to
report EE daily, or even estimate EE daily, the bank must demonstrate
that it is capable of performing the estimation daily.
Second, the bank must estimate EE at enough future time points to
accurately reflect all future cash flows of contracts in the netting
set. To accurately reflect the exposure arising from a transaction, the
model should incorporate those contractual provisions, such as reset
dates, that can materially affect the timing, probability, or amount of
any payment. The requirement reflects the need for an accurate estimate
of EPE. However, in order to balance the ability to calculate exposures
with the need for information on timely basis, the number of time
points is not specified.
Third, the bank must have been using an internal model that broadly
meets the minimum standards to calculate the distributions of exposures
upon which the EAD calculation is based for a period of at least one
year prior to approval. This requirement is to ensure that the bank has
integrated the modeling into its counterparty credit risk management
process.
Fourth, the bank's model must account for the non-normality of
exposure distribution where appropriate. Non-normality of exposure
distribution means high loss events occur more frequently than would be
expected on the basis of a normal distribution, the statistical term
for which is leptokurtosis. In many instances, there may not be a need
to account for this. Expected exposures are much less likely to be
affected by leptokurtosis than peak exposures or high percentile
losses. However, the bank must demonstrate that its EAD measure is not
affected by leptokurtosis or must account for it within the model.
Fifth, the bank must measure, monitor, and control the exposure to
a counterparty over the whole life of all contracts in the netting set,
in addition to accurately measuring and actively monitoring the current
exposure to counterparties. The bank should exercise active management
of both existing exposure and exposure that could change in the future
due to market moves.
Sixth, the bank must be able to measure and manage current
exposures gross and net of collateral held, where appropriate. The bank
must estimate expected exposures for OTC derivative contracts both with
and without the effect of collateral agreements. By contrast, under the
proposed rule, a bank would have to measure and manage current exposure
gross and net of collateral held. Some commenters criticized this
requirement as inconsistent with the New Accord and bank internal risk
management practices. The agencies agree and have revised the rule to
only require a bank to ``be able to'' measure and manage current
exposures gross and net of collateral.
Seventh, the bank must have procedures to identify, monitor, and
control specific wrong-way risk throughout the life of an exposure. In
this context, wrong-way risk is the risk that future exposure to a
counterparty will be high when the counterparty's probability of
default is also high. Wrong-way risk generally arises from events
specific to the counterparty, rather than broad market downturns.
Eighth, the data used by the bank should be adequate for the
measurement and modeling of the exposures. In particular, the model
must use current market data to compute current exposures. When a bank
uses historical data to estimate model parameters, the bank must use at
least three years of data that cover a wide range of economic
conditions. This requirement reflects the longer horizon for
counterparty credit risk exposures compared to market risk exposures.
The data must be updated at least quarterly or more frequently if
market conditions warrant. Banks should consider using model parameters
based on forward looking measures, where appropriate.
Ninth, the bank must subject its models used in the calculation of
EAD to an initial validation and annual model review process. The model
review should consider whether the inputs and risk factors, as well as
the model outputs, are appropriate. The review of outputs should
include a rigorous program of backtesting model outputs against
realized exposures.
Maturity Under the Internal Models Methodology
Like corporate loan exposures, counterparty exposure on netting
sets is susceptible to changes in economic value that stem from
deterioration in the counterparty's creditworthiness short of default.
The effective maturity parameter (M) reflects the impact of these
changes on capital. The formula used to compute M for netting sets with
maturities greater than one year must be different than that generally
applied to wholesale exposures in order to reflect how counterparty
credit exposures change over time. The final rule's definition of M
under the internal models methodology is identical to that of the
proposed rule and is based on a weighted average of expected exposures
over the life of the transactions relative to their one year exposures.
Consistent with the New Accord, the final rule expands upon the
proposal by providing that a bank that uses an internal model to
calculate a one-sided credit valuation adjustment may use the effective
credit duration estimated by the model as M(EPE) in place of the
formula in the paragraph below.
If the remaining maturity of the exposure or the longest-dated
contract contained in a netting set is greater than one year, the bank
must set M for the exposure or netting set equal to the lower of 5
years or M(EPE), where:
[[Page 69349]]
[GRAPHIC] [TIFF OMITTED] TR07DE07.007
and (ii) dfk is the risk-free discount factor for future
time period tk. The cap of five years on M is consistent
with the treatment of wholesale exposures under section 31 of the rule.
If the remaining maturity of the exposure or the longest-dated
contract in the netting set is one year or less, the bank must set M
for the exposure or netting set equal to one year except as provided in
section 31(d)(7) of the rule. In this case, repo-style transactions,
eligible margin loans, and collateralized OTC derivative transactions
subject to daily remargining agreements may use the effective maturity
of the longest maturity transaction in the netting set as M.
Collateral Agreements Under the Internal Models Methodology
The provisions of the final rule on collateral agreements under the
internal models methodology are the same as those of the proposed rule.
Under the final rule, if a bank has prior written approval from its
primary Federal supervisor, it may capture within its internal model
the effect on EAD of a collateral agreement that requires receipt of
collateral when exposure to the counterparty increases. In no
circumstances, however, may a bank take into account in EAD collateral
agreements triggered by deterioration of counterparty credit quality.
Several commenters asked the agencies to permit banks to incorporate in
EAD collateral agreements that are dependent on a decline in the
external rating of the counterparty. The agencies do not believe that
banks are able to model the necessary correlations with sufficient
reliability to accept these types of collateral agreements under the
internal models methodology at this time.
In the context of the internal models methodology, the rule defines
a collateral agreement as a legal contract that: (i) Specifies the time
when, and circumstances under which, the counterparty is required to
exchange collateral with the bank for a single financial contract or
for all financial contracts covered under a qualifying master netting
agreement; and (ii) confers upon the bank a perfected, first priority
security interest (notwithstanding the prior security interest of any
custodial agent), or the legal equivalent thereof, in the collateral
posted by the counterparty under the agreement. This security interest
must provide the bank with a right to close out the financial positions
and the collateral upon an event of default of or failure to perform by
the counterparty under the collateral agreement. A contract would not
satisfy this requirement if the bank's exercise of rights under the
agreement may be stayed or avoided under applicable law in the relevant
jurisdictions.
If a bank's internal model does not capture the effects of
collateral agreements, the final rule provides a ``shortcut'' method to
provide the bank with some benefit, in the form of a smaller EAD, for
collateralized counterparties. Under the shortcut method, effective EPE
is the lesser of a threshold amount (linked to the exposure amount at
which a counterparty must post collateral) plus an add-on and effective
EPE without a collateral agreement. Although any bank may use this
``shortcut'' method under the internal models methodology, the agencies
expect banks that make extensive use of collateral agreements to
develop the modeling capacity to measure the impact of such agreements
on EAD. The shortcut method provided in the final rule is identical to
the shortcut method provided in the proposed rule.
Alternative Methods
Under the final rule, consistent with the proposed rule, a bank
using the internal models methodology may use an alternative method to
determine EAD for certain transactions, provided that the bank can
demonstrate to its primary Federal supervisor that the method's output
is more conservative than an alpha of 1.4 (or higher) times effective
EPE.
Use of an alternative method may be appropriate where a new product
or business line is being developed, where a recent acquisition has
occurred, or where the bank believes that other more conservative
methods to measure counterparty credit risk for a category of
transactions are prudent. The alternative method should be applied to
all similar transactions. When an alternative method is used, the bank
should either treat the particular transactions concerned as a separate
netting set with the counterparty or apply the alternative model to the
entire original netting set.
The agencies recognize that for new OTC derivative products a bank
may need a transition period during which to incorporate a new product
into its internal models methodology or to demonstrate that an
alternative method is more conservative than an alpha of 1.4 (or
higher) times effective EPE. The final rule therefore provides that for
material portfolios of new OTC derivative products, a bank may assume
that the current exposure methodology in section 32(c) of the rule
meets the conservatism requirement for a period not longer than 180
days. As a general matter, the agencies expect that the current
exposure methodology in section 32(c) of the rule would be an
acceptable, more conservative method for immaterial portfolios of OTC
derivatives.
5. Guarantees and Credit Derivatives That Cover Wholesale Exposures
The New Accord specifies that a bank may adjust either the PD or
the LGD of a wholesale exposure to reflect the risk mitigating effects
of a guarantee or credit derivative. Similarly, under the final rule,
as under the proposed rule, a bank may choose either a PD substitution
or an LGD adjustment approach to recognize the risk mitigating effects
of an eligible guarantee or eligible credit derivative on a wholesale
exposure (or in certain circumstances may choose to use a double
default treatment, as discussed below). In all cases a bank must use
the same risk parameters for calculating ECL for a wholesale exposure
as it uses for calculating the risk-based capital requirement for the
exposure. Moreover, in all cases, a bank's ultimate PD and LGD for the
hedged wholesale exposure may not be lower than the PD and LGD floors
discussed above and described in section 31(d) of the rule.
Eligible Guarantees and Eligible Credit Derivatives
Under the proposed rule, guarantees and credit derivatives had to
meet specific eligibility requirements to be recognized as CRM for a
wholesale exposure. The proposed rule defined an eligible guarantee as
a guarantee that:
[[Page 69350]]
(i) Is written and unconditional;
(ii) Covers all or a pro rata portion of all contractual payments
of the obligor on the reference exposure;
(iii) Gives the beneficiary a direct claim against the protection
provider;
(iv) Is non-cancelable by the protection provider for reasons other
than the breach of the contract by the beneficiary;
(v) Is legally enforceable against the protection provider in a
jurisdiction where the protection provider has sufficient assets
against which a judgment may be attached and enforced; and
(vi) Requires the protection provider to make payment to the
beneficiary on the occurrence of a default (as defined in the
guarantee) of the obligor on the reference exposure without first
requiring the beneficiary to demand payment from the obligor.
Commenters suggested a number of improvements to the proposed
definition of eligible guarantee. One commenter asked the agencies to
clarify that the unconditionality requirement in criterion (i) of the
definition would be interpreted consistently with the New Accord's
requirement that ``there should be no clause in the protection contract
outside the direct control of the bank that could prevent the
protection provider from being obliged to pay out in a timely manner in
the event that the original counterparty fails to make the payment(s)
due.'' \80\ The agencies are not providing the requested clarification.
The agencies have acquired considerable experience in the intricate
issue of the conditionality of guarantees under the general risk-based
capital rules and intend to address the meaning of ``unconditional'' in
the context of eligible guarantees under this final rule on a case-by-
case basis going forward.
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\80\ New Accord, ]189.
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This same commenter also asked the agencies to revise the second
criterion of the definition from coverage of ``all or a pro rata
portion of all contractual payments of the obligor on the reference
exposure'' to coverage of ``all or a pro rata portion of all principal
or due and payable amounts on the reference exposure.'' The agencies
have decided to preserve the second criterion of the eligible guarantee
definition without change to ensure that a bank only obtains CRM
benefits from credit risk mitigants that cover all sources of credit
exposure to the obligor. Although it is appropriate to provide partial
CRM benefits under the wholesale framework for partial but pro rata
guarantees of all contractual payments, the agencies are less
comfortable with providing partial CRM benefits under the wholesale
framework where the extent of the loss coverage of the credit exposure
is not so easily quantifiable. Accordingly, for example, if a bank
obtains a principal-only or interest-only guarantee of a corporate
bond, the guarantee will not qualify as an eligible guarantee and the
bank will not be able to obtain any CRM benefits from the guarantee.
Some commenters asked the agencies to modify the fourth criterion
of the eligible guarantee definition to clarify, consistent with the
New Accord, that a guarantee that is terminable by the bank and the
protection provider by mutual consent may qualify as an eligible
guarantee. This is an appropriate clarification of the definition and,
therefore, the agencies have amended the fourth criterion of the
definition to require that the guarantee be non-cancelable by the
protection provider unilaterally.
One commenter asked the agencies to modify the fifth criterion of
the eligible guarantee definition, which requires the guarantee to be
legally enforceable in a jurisdiction where the protection provider has
sufficient assets, by deleting the word ``sufficient.'' The agencies
have preserved the fifth criterion of the proposed definition intact.
The agencies do not think that it would be consistent with safety and
soundness to permit a bank to obtain CRM benefits under the rule if the
guarantee were not legally enforceable against the protection provider
in a jurisdiction where the protection provider has sufficient
available assets.
Finally, some commenters objected to the sixth and final criterion
of the eligible guarantee definition, which requires the protection
provider to make payments to the beneficiary upon default of the
obligor without first requiring the beneficiary to demand payment from
the obligor. The agencies have decided to modify this criterion to make
it more consistent with the New Accord and actual market practice. The
final rule's sixth criterion requires only that the guarantee permit
the bank to obtain payment from the protection provider in the event of
an obligor default in a timely manner and without first having to take
legal actions to pursue the obligor for payment.
The agencies also have performed additional analysis and review of
the definition of eligible guarantee and have decided to add two
additional criteria to the definition. The first additional criterion
prevents guarantees from certain affiliated companies from being
eligible guarantees. Under the final rule, a guarantee will not be an
eligible guarantee if the protection provider is an affiliate of the
bank (other than an affiliated depository institution, bank, securities
broker or dealer, or insurance company that does not control the bank
and that is subject to consolidated supervision and regulation
comparable to that imposed on U.S. depository institutions, securities
broker-dealers, or insurance companies). For purposes of the
definition, an affiliate of a bank is defined as a company that
controls, is controlled by, or is under common control with, the bank.
Control of a company is defined as (i) ownership, control, or holding
with power to vote 25 percent or more of a class of voting securities
of the company; or (ii) consolidation of the company for financial
reporting purposes.
The strong correlations among the financial conditions of
affiliated parties would typically render guarantees from affiliates of
the bank of little value precisely when the bank would need them most--
when the bank itself is in financial distress.\81\ For example, a
guarantee that a bank might receive from its parent shell bank holding
company would provide little credit risk mitigation to the bank as the
bank approached insolvency because the financial condition of the
holding company would depend critically on the financial health of the
subsidiary bank. Moreover, the holding company typically would
experience no increase in its regulatory capital requirement for
issuing the guarantee because the guarantee would be on behalf of a
consolidated subsidiary and would be eliminated in the consolidation of
the holding company's financial statements.\82\
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\81\ This concern of the agencies is the same concern that led
the agencies to exclude from the definition of tier 1 capital any
instrument that has credit-sensitive features--such as an interest
rate or dividend rate that increases as the credit quality of the
bank issuer declines or an investor put right that is triggered by a
decline in issuer credit quality. See, e.g., 12 CFR part 208,
appendix A, section II.A.1.b.
\82\ Although the Board's Regulation W places strict
quantitative and qualitative limits on guarantees issued by a bank
on behalf of an affiliate, it does not restrict all guarantees
issued by an affiliate on behalf of a bank. See, e.g., 12 CFR
223.3(e).
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The agencies have decided, however, that a bank should be able to
recognize CRM benefits by obtaining a guarantee from an affiliated
insured depository institution, bank, securities broker or dealer, or
insurance company that does not control the bank and that is subject to
consolidated supervision and regulation comparable to that imposed on
U.S. depository institutions, securities broker-dealers, or insurance
companies (as the case may be). A
[[Page 69351]]
depository institution for this purpose includes all subsidiaries of
the depository institution except financial subsidiaries. The final
rule recognizes guarantees from these types of affiliates because they
are financial institutions subject to prudential regulation by national
or state supervisory authorities. The agencies expect that the
prudential regulation of the affiliate would help prevent the affiliate
from exposing itself excessively to the credit exposures of the bank.
Similarly, these affiliates would be subject to regulatory capital
requirements of their own and should experience an increase in their
regulatory capital requirements for issuing the guarantee.
The second additional criterion precludes a guarantee from eligible
guarantee status if the guarantee increases the beneficiary's cost of
credit protection in response to deterioration in the credit quality of
the reference exposure. This additional criterion is consistent with
the New Accord's treatment of guarantees and with the proposed rule's
operational requirements for synthetic securitizations.
The proposed rule defined an eligible credit derivative as a credit
derivative in the form of a credit default swap, nth-to-
default swap, or total return swap provided that:
(i) The contract meets the requirements of an eligible guarantee
and has been confirmed by the protection purchaser and the protection
provider;
(ii) Any assignment of the contract has been confirmed by all
relevant parties;
(iii) If the credit derivative is a credit default swap or
nth-to-default swap, the contract includes the following
credit events:
(A) Failure to pay any amount due under the terms of the reference
exposure (with a grace period that is closely in line with the grace
period of the reference exposure); and
(B) Bankruptcy, insolvency, or inability of the obligor on the
reference exposure to pay its debts, or its failure or admission in
writing of its inability generally to pay its debts as they become due,
and similar events;
(iv) The terms and conditions dictating the manner in which the
contract is to be settled are incorporated into the contract;
(v) If the contract allows for cash settlement, the contract
incorporates a robust valuation process to estimate loss reliably and
specifies a reasonable period for obtaining post-credit event
valuations of the reference exposure;
(vi) If the contract requires the protection purchaser to transfer
an exposure to the protection provider at settlement, the terms of the
exposure provide that any required consent to transfer may not be
unreasonably withheld;
(vii) If the credit derivative is a credit default swap or
nth-to-default swap, the contract clearly identifies the
parties responsible for determining whether a credit event has
occurred, specifies that this determination is not the sole
responsibility of the protection provider, and gives the protection
purchaser the right to notify the protection provider of the occurrence
of a credit event; and
(viii) If the credit derivative is a total return swap and the bank
records net payments received on the swap as net income, the bank
records offsetting deterioration in the value of the hedged exposure
(either through reductions in fair value or by an addition to
reserves).
Commenters generally supported the proposed rule's definition of
eligible credit derivative, but two commenters asked for a series of
changes. These commenters asked that the final rule specifically
reference contingent credit default swaps (CCDSs) in the list of
eligible forms of credit derivatives. CCDS are a relatively new type of
credit derivative, and the agencies are still considering their
appropriate role within the risk-based capital rules. However, to
enable the rule to adapt to future market innovations, the agencies
have revised the definition of eligible credit derivative to add to the
list of eligible credit derivative forms ``any other form of credit
derivative approved by'' the bank's primary Federal supervisor.\83\
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\83\ One commenter also asked the agencies to clarify that a
bank should translate the phrase ``beneficiary'' in the definition
of eligible guarantee to ``protection purchaser'' when confirming
that a credit derivative meets all the requirements of the
definition of eligible guarantee. The agencies have not amended the
rule to address this point, but do confirm that such translation is
appropriate.
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One commenter asked that the agencies amend the third criterion of
the eligible credit derivative definition, which applies to credit
default swaps and nth-to-default swaps. The commenter
indicated that standard practice in the credit derivatives market is
for a credit default swap to contain provisions that exempt the
protection provider from making default payments to the protection
purchaser if the reference obligor's failure to pay is in an amount
below a de minimis threshold. The agencies do not believe that safety
and soundness would be materially impaired by conforming this criterion
of the eligible credit derivative definition to the current standard
market practice. Under the final rule, therefore, a credit derivative
will satisfy the definition of an eligible credit derivative if the
protection provider's obligation to make default payments to the
protection purchaser is triggered only if the reference obligor's
failure to pay exceeds any applicable minimal payment threshold that is
consistent with standard market practice.
Finally, a commenter asked for clarification of the meaning of the
sixth criterion of the definition of eligible credit derivative, which
states that if the contract requires the protection purchaser to
transfer an exposure to the protection provider at settlement, the
terms of the exposure provide that any required consent to transfer may
not be unreasonably withheld. To address any potential ambiguity about
which exposure's transferability must be analyzed, the agencies have
amended the sixth component to read: ``If the contract requires the
protection purchaser to transfer an exposure to the protection provider
at settlement, the terms of at least one of the exposures that is
permitted to be transferred under the contract must provide that any
required consent to transfer may not be unreasonably withheld.''
The proposed rule also provided that a bank may recognize an
eligible credit derivative that hedges an exposure that is different
from the credit derivative's reference exposure used for determining
the derivative's cash settlement value, deliverable obligation, or
occurrence of a credit event only if:
(i) The reference exposure ranks pari passu (that is, equal) or
junior to the hedged exposure; and
(ii) The reference exposure and the hedged exposure are exposures
to the same legal entity, and legally enforceable cross-default or
cross-acceleration clauses are in place.
One commenter acknowledged that the proposal's pari passu ceiling
is consistent with the New Accord but asked for clarification that the
provision only requires reference exposure equality or subordination
with respect to priority of payments. Although the agencies have
concluded that it is not necessary to amend the rule to provide this
clarification, the agencies agree that the pari passu ceiling relates
to priority of payments only.
Two commenters also asked the agencies to provide an exception to
the cross-default/cross-acceleration requirement where the hedged
exposure is an OTC derivative contract or a qualifying master netting
agreement that covers OTC derivative contracts.
[[Page 69352]]
Although some parts of the debt markets have incorporated obligations
from OTC derivative contracts in cross-default/cross-acceleration
clauses, the commenter asserted that the practice is not prevalent in
many parts of the market. In addition, the commenter maintained that,
unlike a failure to pay on a loan or a bond, failure to pay on an OTC
derivative contract generally would not trigger a credit event with
respect to the reference exposure of the credit default swap. The
agencies have not made this change. The proposed cross-default/cross-
acceleration requirement is consistent with the New Accord. In
addition, the agencies are reluctant to permit a bank to obtain CRM
benefits for an exposure hedged by a credit derivative whose reference
exposure is different than the hedged exposure unless the hedged and
reference exposures would default simultaneously. If the hedged
exposure could default prior to the default of the reference exposure,
the bank may suffer losses on the hedged exposure and not be able to
collect default payments on the credit derivative. The final rule
clarifies that, in order to recognize the credit risk mitigation
benefits of an eligible credit derivative, cross-default/cross-
acceleration provisions must assure payments under the credit
derivative are triggered if the obligor fails to pay under the terms of
the hedged exposure.
PD Substitution Approach
Under the PD substitution approach of the final rule, as under the
proposal, if the protection amount (as defined below) of the eligible
guarantee or eligible credit derivative is greater than or equal to the
EAD of the hedged exposure, a bank may substitute for the PD of the
hedged exposure the PD associated with the rating grade of the
protection provider. If the bank determines that full substitution
leads to an inappropriate degree of risk mitigation, the bank may
substitute a higher PD for that of the protection provider.
If the guarantee or credit derivative provides the bank with the
option to receive immediate payout on triggering the protection, then
the bank must use the lower of the LGD of the hedged exposure (not
adjusted to reflect the guarantee or credit derivative) and the LGD of
the guarantee or credit derivative. If the guarantee or credit
derivative does not provide the bank with the option to receive
immediate payout on triggering the protection (and instead provides for
the guarantor to assume the payment obligations of the obligor over the
remaining life of the hedged exposure), the bank must use the LGD of
the guarantee or credit derivative.
If the protection amount of the eligible guarantee or eligible
credit derivative is less than the EAD of the hedged exposure, however,
the bank must treat the hedged exposure as two separate exposures
(protected and unprotected) to recognize the credit risk mitigation
benefit of the guarantee or credit derivative. The bank must calculate
its risk-based capital requirement for the protected exposure under
section 31 of the rule (using a PD equal to the protection provider's
PD, an LGD determined as described above, and an EAD equal to the
protection amount of the guarantee or credit derivative). If the bank
determines that full substitution leads to an inappropriate degree of
risk mitigation, the bank may use a higher PD than that of the
protection provider. The bank must calculate its risk-based capital
requirement for the unprotected exposure under section 31 of the rule
(using a PD equal to the obligor's PD, an LGD equal to the hedged
exposure's LGD not adjusted to reflect the guarantee or credit
derivative, and an EAD equal to the EAD of the original hedged exposure
minus the protection amount of the guarantee or credit derivative).
The protection amount of an eligible guarantee or eligible credit
derivative is defined as the effective notional amount of the guarantee
or credit derivative reduced by any applicable haircuts for maturity
mismatch, lack of restructuring, and currency mismatch (each described
below). The effective notional amount of a guarantee or credit
derivative is the lesser of the contractual notional amount of the
credit risk mitigant and the EAD of the hedged exposure, multiplied by
the percentage coverage of the credit risk mitigant. For example, the
effective notional amount of a guarantee that covers, on a pro rata
basis, 40 percent of any losses on a $100 bond would be $40.
The agencies received no material comments on the above-described
structure of the PD substitution approach, and the final rule's PD
substitution approach is substantially the same as that of the proposed
rule.
LGD Adjustment Approach
Under the LGD adjustment approach of the final rule, as under the
proposal, if the protection amount of the eligible guarantee or
eligible credit derivative is greater than or equal to the EAD of the
hedged exposure, the bank's risk-based capital requirement for the
hedged exposure is the greater of (i) the risk-based capital
requirement for the exposure as calculated under section 31 of the rule
(with the LGD of the exposure adjusted to reflect the guarantee or
credit derivative); or (ii) the risk-based capital requirement for a
direct exposure to the protection provider as calculated under section
31 of the rule (using the bank's PD for the protection provider, the
bank's LGD for the guarantee or credit derivative, and an EAD equal to
the EAD of the hedged exposure).
If the protection amount of the eligible guarantee or eligible
credit derivative is less than the EAD of the hedged exposure, however,
the bank must treat the hedged exposure as two separate exposures
(protected and unprotected) in order to recognize the credit risk
mitigation benefit of the guarantee or credit derivative. The bank's
risk-based capital requirement for the protected exposure would be the
greater of (i) the risk-based capital requirement for the protected
exposure as calculated under section 31 of the rule (with the LGD of
the exposure adjusted to reflect the guarantee or credit derivative and
EAD set equal to the protection amount of the guarantee or credit
derivative); or (ii) the risk-based capital requirement for a direct
exposure to the protection provider as calculated under section 31 of
the rule (using the bank's PD for the protection provider, the bank's
LGD for the guarantee or credit derivative, and an EAD set equal to the
protection amount of the guarantee or credit derivative). The bank must
calculate its risk-based capital requirement for the unprotected
exposure under section 31 of the rule using a PD set equal to the
obligor's PD, an LGD set equal to the hedged exposure's LGD (not
adjusted to reflect the guarantee or credit derivative), and an EAD set
equal to the EAD of the original hedged exposure minus the protection
amount of the guarantee or credit derivative.
The agencies received no material comments on the above-described
structure of the LGD adjustment approach, and the final rule's LGD
adjustment approach is substantially the same as that of the proposed
rule.
The PD substitution approach allows a bank to effectively assess
risk-based capital against a hedged exposure as if it were a direct
exposure to the protection provider, and the LGD adjustment approach
produces a risk-based capital requirement for a hedged exposure that is
never lower than that of a direct exposure to the protection provider.
Accordingly, these approaches do not fully reflect the risk mitigation
benefits certain types of guarantees and
[[Page 69353]]
credit derivatives may provide because the resulting risk-based capital
requirement does not consider the joint probability of default of the
obligor of the hedged exposure and the protection provider, sometimes
referred to as the ``double default'' benefit. The agencies have
decided, consistent with the New Accord and the proposed rule, to
recognize double default benefits in the wholesale framework only for
certain hedged exposures covered by certain guarantees and credit
derivatives. A later section of the preamble describes which hedged
exposures are eligible for the double default treatment and describes
the double default treatment that is available to those exposures.
Maturity Mismatch Haircut
Under the final rule, a bank that seeks to reduce the risk-based
capital requirement on a wholesale exposure by recognizing an eligible
guarantee or eligible credit derivative must adjust the effective
notional amount of the credit risk mitigant downward to reflect any
maturity mismatch between the hedged exposure and the credit risk
mitigant. A maturity mismatch occurs when the residual maturity of a
credit risk mitigant is less than that of the hedged exposure(s).
The proposed rule provided, consistent with the New Accord, that
when the hedged exposures have different residual maturities, the
longest residual maturity of any of the hedged exposures would be used
as the residual maturity of all hedged exposures. One commenter
criticized this provision as excessively conservative. The agencies
agree and have decided to restrict the application of this provision to
securitization CRM.\84\ Accordingly, under the final rule, to calculate
the risk-based capital requirement for a group of hedged wholesale
exposures that are covered by a single eligible guarantee under which
the protection provider has agreed to backstop all contractual payments
associated with each hedged exposure, a bank should treat each hedged
exposure as if it were fully covered by a separate eligible guarantee.
To determine whether any of the hedged wholesale exposures has a
maturity mismatch with the eligible guarantee, the bank must assess
whether the residual maturity of the eligible guarantee is less than
that of the hedged exposure.
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\84\ Under the final rule, if an eligible guarantee provides
tranched credit protection to a group of hedged exposures--for
example, the guarantee covers the first 2 percent of aggregate
losses for the group--the bank must determine the risk-based capital
requirements for the hedged exposures under the securitization
framework.
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The residual maturity of a hedged exposure is the longest possible
remaining time before the obligor is scheduled to fulfil its obligation
on the exposure. When determining the residual maturity of the
guarantee or credit derivative, embedded options that may reduce the
term of the credit risk mitigant must be taken into account so that the
shortest possible residual maturity for the credit risk mitigant is
used to determine the potential maturity mismatch. Where a call is at
the discretion of the protection provider, the residual maturity of the
guarantee or credit derivative is the first call date. If the call is
at the discretion of the bank purchasing the protection, but the terms
of the arrangement at inception of the guarantee or credit derivative
contain a positive incentive for the bank to call the transaction
before contractual maturity, the remaining time to the first call date
is the residual maturity of the credit risk mitigant. For example,
where there is a step-up in the cost of credit protection in
conjunction with a call feature or where the effective cost of
protection increases over time even if credit quality remains the same
or improves, the residual maturity of the credit risk mitigant is the
remaining time to the first call.
Eligible guarantees and eligible credit derivatives with maturity
mismatches may only be recognized if their original maturities are
equal to or greater than one year. As a result, a guarantee or credit
derivative is not recognized for a hedged exposure with an original
maturity of less than one year unless the credit risk mitigant has an
original maturity of equal to or greater than one year or an effective
residual maturity equal to or greater than that of the hedged exposure.
In all cases, credit risk mitigants with maturity mismatches may not be
recognized when they have an effective residual maturity of three
months or less.
When a maturity mismatch exists, a bank must apply the following
maturity mismatch adjustment to determine the effective notional amount
of the guarantee or credit derivative adjusted for maturity mismatch:
Pm = E x (t-0.25)/(T-0.25), where:
(i) Pm = effective notional amount of the credit risk mitigant
adjusted for maturity mismatch;
(ii) E = effective notional amount of the credit risk mitigant;
(iii) t = lesser of T or effective residual maturity of the
credit risk mitigant, expressed in years; and
(iv) T = lesser of 5 or effective residual maturity of the
hedged exposure, expressed in years.
Other than as discussed above with respect to pools of hedged
exposures with different residual maturities, the final rule's
provisions on maturity mismatch do not differ from those of the
proposed rule.
Restructuring Haircut
Under the final rule, as under the proposed rule, a bank that seeks
to recognize an eligible credit derivative that does not include a
distressed restructuring as a credit event that triggers payment under
the derivative must reduce the recognition of the credit derivative by
40 percent. A distressed restructuring is a restructuring of the hedged
exposure involving forgiveness or postponement of principal, interest,
or fees that results in a charge-off, specific provision, or other
similar debit to the profit and loss account.
In other words, the effective notional amount of the credit
derivative adjusted for lack of restructuring credit event (and
maturity mismatch, if applicable) is: Pr = Pm x 0.60, where:
(i) Pr = effective notional amount of the credit risk mitigant,
adjusted for lack of restructuring credit event (and maturity
mismatch, if applicable); and
(ii) Pm = effective notional amount of the credit risk mitigant
adjusted for maturity mismatch (if applicable).
Two commenters opposed the 40 percent restructuring haircut. One
commenter contended that the 40 percent haircut is too punitive. The
other commenter contended that the 40 percent haircut should not apply
when the hedged exposure is an OTC derivative contract or a qualifying
master netting agreement that covers OTC derivative contracts. The 40
percent haircut is a rough estimate of the reduced CRM benefits that
accrue to a bank that purchases a credit derivative without
restructuring coverage. Nonetheless, the agencies recognize that
restructuring events could result in substantial economic losses to a
bank. Moreover, the 40 percent haircut is consistent with the New
Accord and is a reasonably prudent mechanism for ensuring that banks do
not receive excessive CRM benefits for purchasing credit protection
that does not cover all material sources of economic loss to the bank
on the hedged exposure.
The final rule's provisions on lack of restructuring as a credit
event do not differ from those of the proposed rule.
[[Page 69354]]
Currency Mismatch Haircut
Under the final rule, as under the proposed rule, where the
eligible guarantee or eligible credit derivative is denominated in a
currency different from that in which any hedged exposure is
denominated, the effective notional amount of the guarantee or credit
derivative must be adjusted for currency mismatch (and maturity
mismatch and lack of restructuring credit event, if applicable). The
adjusted effective notional amount is calculated as: Pc = Pr x (1-Hfx),
where:
(i) Pc = effective notional amount of the credit risk mitigant,
adjusted for currency mismatch (and maturity mismatch and lack of
restructuring credit event, if applicable);
(ii) Pr = effective notional amount of the credit risk mitigant
(adjusted for maturity mismatch and lack of restructuring credit
event, if applicable); and
(iii) Hfx = haircut appropriate for the currency mismatch
between the credit risk mitigant and the hedged exposure.
A bank may use a standard supervisory haircut of 8 percent for Hfx
(based on a ten-business-day holding period and daily marking-to-market
and remargining). Alternatively, a bank may use internally estimated
haircuts for Hfx based on a ten-business-day holding period and daily
marking-to-market and remargining if the bank qualifies to use the own-
estimates haircuts in paragraph (b)(2)(iii) of section 32, the simple
VaR methodology in paragraph (b)(3) of section 32, or the internal
models methodology in paragraph (d) of section 32 of the rule. The bank
must scale these haircuts up using a square root of time formula if the
bank revalues the guarantee or credit derivative less frequently than
once every ten business days.
The agencies received no comments on the currency mismatch
provisions discussed above, and the final rule's provisions on currency
mismatch do not differ from those of the proposed rule.
Example
Assume that a bank holds a five-year $100 corporate exposure,
purchases a $100 credit derivative to mitigate its credit risk on
the exposure, and chooses to use the PD substitution approach. The
unsecured LGD of the corporate exposure is 30 percent; the LGD of
the credit derivative is 80 percent. The credit derivative is an
eligible credit derivative, has the bank's exposure as its reference
exposure, has a three-year maturity, no restructuring provision, no
currency mismatch with the bank's hedged exposure, and the
protection provider assumes the payment obligations of the obligor
upon default. The effective notional amount and initial protection
amount of the credit derivative would be $100. The maturity mismatch
would reduce the protection amount to $100 x (3-.25)/(5-.25) or
$57.89. The haircut for lack of restructuring would reduce the
protection amount to $57.89 x 0.6 or $34.74. So the bank would treat
the $100 corporate exposure as two exposures: (i) An exposure of
$34.74 with the PD of the protection provider, an LGD of 80 percent,
and an M of five; and (ii) an exposure of $65.26 with the PD of the
obligor, an LGD of 30 percent, and an M of five.
Multiple Credit Risk Mitigants
The New Accord provides that if multiple credit risk mitigants (for
example, two eligible guarantees) cover a single exposure, a bank must
disaggregate the exposure into portions covered by each credit risk
mitigant (for example, the portion covered by each guarantee) and must
calculate separately the risk-based capital requirement of each
portion.\85\ The New Accord also indicates that when credit risk
mitigants provided by a single protection provider have differing
maturities, they should be subdivided into separate layers of
protection.\86\ In the proposal, the agencies invited comment on
whether and how the agencies should address these and other similar
situations in which multiple credit risk mitigants cover a single
exposure.
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\85\ New Accord, ]206.
\86\ Id.
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Commenters generally agreed that the agencies should provide
additional guidance about how to address situations where multiple
credit risk mitigants cover a single exposure. Although one commenter
recommended that the agencies permit banks effectively to recognize
triple default benefits in situations where two credit risk mitigants
cover a single exposure, commenters did not provide material specific
suggestions as to their preferred approach to addressing these
situations. Thus, the agencies have decided to adopt the New Accord's
principles for dealing with multiple credit risk mitigant situations.
The agencies have added several additional provisions to section 33(a)
of the final rule to provide clarity in this area.
Double Default Treatment
As noted above, the final rule, like the proposed rule, contains a
separate risk-based capital methodology for hedged exposures eligible
for double default treatment. The final rule's double default
provisions are identical to those of the proposed rule, with the
exception of some limited changes to the definition of an eligible
double default guarantor discussed below.
To be eligible for double default treatment, a hedged exposure must
be fully covered or covered on a pro rata basis (that is, there must be
no tranching of credit risk) by an uncollateralized single-reference-
obligor credit derivative or guarantee (or certain n\th\-to-default
credit derivatives) provided by an eligible double default guarantor
(as defined below). Moreover, the hedged exposure must be a wholesale
exposure other than a sovereign exposure.\87\ In addition, the obligor
of the hedged exposure must not be an eligible double default
guarantor, an affiliate of an eligible double default guarantor, or an
affiliate of the guarantor.
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\87\ The New Accord permits certain retail small business
exposures to be eligible for double default treatment. Under the
final rule, however, a bank must effectively desegment a retail
small business exposure (thus rendering it a wholesale exposure) to
make it eligible for double default treatment.
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The proposed rule defined eligible double default guarantor to
include a depository institution (as defined in section 3 of the
Federal Deposit Insurance Act (12 U.S.C. 1813)); a bank holding company
(as defined in section 2 of the Bank Holding Company Act (12 U.S.C.
1841)); a savings and loan holding company (as defined in 12 U.S.C.
1467a) provided all or substantially all of the holding company's
activities are permissible for a financial holding company under 12
U.S.C. 1843(k)); a securities broker or dealer registered (under the
Securities Exchange Act of 1934) with the Securities and Exchange
Commission (SEC); an insurance company in the business of providing
credit protection (such as a monoline bond insurer or re-insurer) that
is subject to supervision by a state insurance regulator; a foreign
bank (as defined in section 211.2 of the Federal Reserve Board's
Regulation K (12 CFR 211.2)); a non-U.S. securities firm; or a non-U.S.
based insurance company in the business of providing credit protection.
The proposal required an eligible double default guarantor to (i) have
a bank-assigned PD that, at the time the guarantor issued the guarantee
or credit derivative, was equal to or lower than the PD associated with
a long-term external rating of at least the third highest investment-
grade rating category; and (ii) have a current bank-assigned PD that is
equal to or lower than the PD associated with a long-term external
rating of at least investment grade. In addition, the proposal
permitted a non-U.S. based bank, securities firm, or insurance company
to qualify as an eligible double default guarantor only if the firm
were subject to consolidated supervision and regulation comparable to
that imposed on U.S. depository institutions, securities firms, or
insurance companies (as the case may be) or had issued an
[[Page 69355]]
outstanding and unsecured long-term debt security without credit
enhancement that had a long-term applicable external rating in one of
the three highest investment-grade rating categories.
Commenters expressed two principal criticisms of the proposed
definition of an eligible double default guarantor. First, commenters
asked the agencies to conform the definition to the New Accord by
permitting a foreign financial firm to qualify so long as it had an
outstanding long-term debt security with an external rating of
investment grade or higher (for example, BBB- or higher) instead of in
one of the three highest investment-grade rating categories (for
example, A- or higher). In light of the other eligibility criteria, the
agencies have concluded that it would be appropriate to conform this
provision of the definition to the New Accord.
Commenters also requested that the agencies conform the definition
of eligible double default guarantor to the New Accord by permitting a
financial firm to qualify so long as it had a bank-assigned PD, at the
time the guarantor issued the guarantee or credit derivative or at any
time thereafter, that was equal to or lower than the PD associated with
a long-term external rating of at least the third highest investment-
grade rating category. In light of the other eligibility criteria, the
agencies have concluded that it would be appropriate to conform this
provision of the definition to the New Accord.
Effectively, under the final rule, the scope of an eligible double
default guarantor is limited to financial firms whose normal business
includes the provision of credit protection, as well as the management
of a diversified portfolio of credit risk. This restriction arises from
the agencies' concern to limit double default recognition to financial
institutions that have a high level of credit risk management expertise
and that provide sufficient market disclosure. The restriction is also
designed to limit the risk of excessive correlation between the
creditworthiness of the guarantor and the obligor of the hedged
exposure due to their performance depending on common economic factors
beyond the systematic risk factor. As a result, hedged exposures to
potential credit protection providers or affiliates of credit
protection providers are not eligible for the double default treatment.
In addition, the agencies have excluded hedged exposures to sovereign
entities from eligibility for double default treatment because of the
potential high correlation between the creditworthiness of a sovereign
and that of a guarantor.
One commenter urged the agencies to delete the requirement that the
obligor of a hedged exposure that qualifies for double default
treatment not be an eligible double default guarantor or an affiliate
of such an entity. This commenter represented that this requirement
significantly constrained the scope of application of double default
treatment and assumed inappropriately that there is an excessive amount
of correlation among all financial firms. The agencies acknowledge that
this requirement is a crude mechanism to prevent excessive wrong-way
risk, but the agencies have decided to retain the requirement in light
of its consistency with the New Accord and the limited ability of banks
to measure accurately correlations among obligors.
In addition to limiting the types of guarantees, credit
derivatives, guarantors, and hedged exposures eligible for double
default treatment, the rule limits wrong-way risk further by requiring
a bank to implement a process to detect excessive correlation between
the creditworthiness of the obligor of the hedged exposure and the
protection provider. The bank must receive prior written approval from
its primary Federal supervisor for this process in order to recognize
double default benefits for risk-based capital purposes. To apply
double default treatment to a particular hedged exposure, the bank must
determine that there is not excessive correlation between the
creditworthiness of the obligor of the hedged exposure and the
protection provider. For example, the creditworthiness of an obligor
and a protection provider would be excessively correlated if the
obligor derives a high proportion of its income or revenue from
transactions with the protection provider. If excessive correlation is
present, the bank may not use the double default treatment for the
hedged exposure.
The risk-based capital requirement for a hedged exposure subject to
double default treatment is calculated by multiplying a risk-based
capital requirement for the hedged exposure (as if it were unhedged) by
an adjustment factor that considers the PD of the protection provider
(see section 34 of the rule). Thus, the PDs of both the obligor of the
hedged exposure and the protection provider are factored into the
hedged exposure's risk-based capital requirement. In addition, as under
the PD substitution treatment in section 33 of the rule, the bank is
allowed to set LGD equal to the lower of the LGD of the hedged exposure
(not adjusted to reflect the guarantee or credit derivative) or the LGD
of the guarantee or credit derivative if the guarantee or credit
derivative provides the bank with the option to receive immediate
payout on the occurrence of a credit event. Otherwise, the bank must
set LGD equal to the LGD of the guarantee or credit derivative.
Accordingly, in order to apply the double default treatment, the bank
must estimate a PD for the protection provider and an LGD for the
guarantee or credit derivative. Finally, a bank using the double
default treatment must make applicable adjustments to the protection
amount of the guarantee or credit derivative to reflect maturity
mismatches, currency mismatches, and lack of restructuring coverage (as
under the PD substitution and LGD adjustment approaches in section 33
of the rule).
One commenter objected that the calibration of the double default
formula under the proposed rule was too conservative because it assumed
an excessive amount of correlation between the obligor of the hedged
exposure and the protection provider. The agencies have decided to
leave the calibration unaltered in light of its consistency with the
New Accord. The agencies will evaluate this decision over time and will
raise this issue with the BCBS if appropriate.
6. Guarantees and Credit Derivatives That Cover Retail Exposures
Like the proposal, the final rule provides a different treatment
for guarantees and credit derivatives that cover retail exposures than
for those that cover wholesale exposures. The approach set forth above
for guarantees and credit derivatives that cover wholesale exposures is
an exposure-by-exposure approach consistent with the overall exposure-
by-exposure approach the rule takes to wholesale exposures. The
agencies believe that a different treatment for guarantees that cover
retail exposures is necessary and appropriate because of the rule's
segmentation approach to retail exposures. The approaches to retail
guarantees described in this section generally apply only to guarantees
of individual retail exposures. Guarantees of multiple retail exposures
(such as pool private mortgage insurance (PMI)) are typically tranched
(that is, they cover less than the full amount of the hedged exposures)
and, therefore, are securitization exposures under the final rule.
The rule does not specify the ways in which guarantees and credit
derivatives may be taken into account in the segmentation of retail
exposures.
[[Page 69356]]
Likewise, the rule does not explicitly limit the extent to which a bank
may take into account the credit risk mitigation benefits of guarantees
and credit derivatives in its estimation of the PD and LGD of retail
segments, except by the application of overall floors on certain PD and
LGD assignments. This approach has the principal advantage of being
relatively easy for banks to implement--the approach generally would
not disrupt the existing retail segmentation practices of banks and
would not interfere with banks' quantification of PD and LGD for retail
segments.
In the proposal, the agencies expressed some concern, however, that
this approach would provide banks with substantial discretion to
incorporate double default and double recovery effects. To address
these concerns, the preamble to the proposed rule described two
possible alternative treatments for guarantees of retail exposures. The
first alternative distinguished between eligible retail guarantees and
all other (non-eligible) guarantees of retail exposures. Under this
alternative, an eligible retail guarantee would be an eligible
guarantee that applies to a single retail exposure and is (i) PMI
issued by a highly creditworthy insurance company; or (ii) issued by a
sovereign entity or a political subdivision of a sovereign entity.
Under this alternative, a bank would be able to recognize the
credit risk mitigation benefits of eligible retail guarantees that
cover retail exposures in a segment by adjusting its estimates of LGD
for the segment to reflect recoveries from the guarantor. However, the
bank would have to estimate the PD of a segment without reflecting the
benefit of guarantees. Specifically, a segment's PD would be an
estimate of the stand-alone probability of default for the retail
exposures in the segment, before taking account of any guarantees.
Accordingly, for this limited set of traditional guarantees of retail
exposures by high credit quality guarantors, a bank would be allowed to
recognize the benefit of the guarantee when estimating LGD but not when
estimating PD.
This alternative approach would provide a different treatment for
non-eligible retail guarantees. In short, within the retail framework,
a bank would not be able to recognize non-eligible retail guarantees
when estimating PD and LGD for any segment of retail exposures. A bank
would be required to estimate PD and LGD for segments containing retail
exposures with non-eligible guarantees as if the exposures were not
guaranteed. However, a bank would be permitted to recognize non-
eligible retail guarantees provided by a wholesale guarantor by
treating the hedged retail exposure as a direct exposure to the
guarantor and applying the appropriate wholesale IRB risk-based capital
formula. In other words, for retail exposures covered by non-eligible
retail guarantees, a bank would be permitted to reflect the guarantee
by ``desegmenting'' the retail exposures (which effectively would
convert the retail exposures into wholesale exposures) and then
applying the rules set forth above for guarantees that cover wholesale
exposures. Thus, under this approach, a bank would not be allowed to
recognize either double default or double recovery effects for non-
eligible retail guarantees.
A second alternative that the agencies described in the preamble to
the proposed rule would permit a bank to recognize the credit risk
mitigation benefits of all eligible guarantees (whether eligible retail
guarantees or not) that cover retail exposures by adjusting its
estimates of LGD for the relevant segments, but would subject a bank's
risk-based capital requirement for a segment of retail exposures that
are covered by one or more non-eligible retail guarantees to a floor.
Under this second alternative, the agencies could impose a floor on
risk-based capital requirements of between 2 percent and 6 percent on
such a segment of retail exposures.
A substantial number of commenters supported the flexible approach
in the text of the proposed rule. A few commenters also supported the
first alternative approach in the preamble of the proposed rule.
Commenters uniformly urged the agencies not to adopt the second
alternative approach. The agencies have decided to adopt the approach
to retail guarantees in the text of the proposed rule and not to adopt
either alternative approach described in the proposed rule preamble.
Although the first alternative approach addresses prudential concerns,
the agencies have concluded that it is excessively conservative and
prescriptive and would not harmonize with banks' internal risk
measurement and management practices. The agencies also have determined
that the second alternative approach is insufficiently risk sensitive
and is not consistent with the New Accord. In light of the final rule's
flexible approach to retail guarantees, the agencies expect banks to
limit their use of guarantees in the retail segmentation process and
retail risk parameter estimation process to situations where the bank
has particularly reliable data about the CRM benefits of such
guarantees.
D. Unsettled Securities, Foreign Exchange, and Commodity Transactions
Section 35 of the final rule describes the risk-based capital
requirements for unsettled and failed securities, foreign exchange, and
commodities transactions. The agencies did not receive any material
comments on this aspect of the proposed rule and are adopting it as
proposed.
Under the final rule, certain transaction types are excluded from
the scope of section 35, including:
(i) Transactions accepted by a qualifying central counterparty that
are subject to daily marking-to-market and daily receipt and payment of
variation margin (which do not have a risk-based capital requirement);
\88\
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\88\ The agencies consider a qualifying central counterparty to
be the functional equivalent of an exchange, and have long exempted
exchange-traded contracts from risk-based capital requirements.
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(ii) Repo-style transactions (the risk-based capital requirements
of which are determined under sections 31 and 32 of the final rule);
(iii) One-way cash payments on OTC derivative contracts (the risk-
based capital requirements of which are determined under sections 31
and 32 of the final rule); and
(iv) Transactions with a contractual settlement period that is
longer than the normal settlement period (defined below), which
transactions are treated as OTC derivative contracts and assessed a
risk-based capital requirement under sections 31 and 32 of the final
rule. The final rule also provides that, in the case of a system-wide
failure of a settlement or clearing system, the bank's primary Federal
supervisor may waive risk-based capital requirements for unsettled and
failed transactions until the situation is rectified.
The final rule contains separate treatments for delivery-versus-
payment (DvP) and payment-versus-payment (PvP) transactions with a
normal settlement period, on the one hand, and non-DvP/non-PvP
transactions with a normal settlement period, on the other hand. The
final rule provides the following definitions of a DvP transaction, a
PvP transaction, and a normal settlement period. A DvP transaction is a
securities or commodities transaction in which the buyer is obligated
to make payment only if the seller has made delivery of the securities
or commodities and the seller is obligated to deliver the securities or
commodities only if the buyer has made payment. A PvP transaction is a
foreign exchange transaction in which each counterparty is obligated to
make a final
[[Page 69357]]
transfer of one or more currencies only if the other counterparty has
made a final transfer of one or more currencies. A transaction has a
normal settlement period if the contractual settlement period for the
transaction is equal to or less than the market standard for the
instrument underlying the transaction and equal to or less than five
business days.
A bank must hold risk-based capital against a DvP or PvP
transaction with a normal settlement period if the bank's counterparty
has not made delivery or payment within five business days after the
settlement date. The bank must determine its risk-weighted asset amount
for such a transaction by multiplying the positive current exposure of
the transaction for the bank by the appropriate risk weight in Table E.
The positive current exposure of a transaction of a bank is the
difference between the transaction value at the agreed settlement price
and the current market price of the transaction, if the difference
results in a credit exposure of the bank to the counterparty.
Table E.--Risk Weights for Unsettled DvP and PvP Transactions
------------------------------------------------------------------------
Risk weight to be
Number of business days after contractual applied to positive
settlement date current exposure
(percent)
------------------------------------------------------------------------
From 5 to 15....................................... 100
From 16 to 30...................................... 625
From 31 to 45...................................... 937.5
46 or more......................................... 1,250
------------------------------------------------------------------------
A bank must hold risk-based capital against any non-DvP/non-PvP
transaction with a normal settlement period if the bank has delivered
cash, securities, commodities, or currencies to its counterparty but
has not received its corresponding deliverables by the end of the same
business day. The bank must continue to hold risk-based capital against
the transaction until the bank has received its corresponding
deliverables. From the business day after the bank has made its
delivery until five business days after the counterparty delivery is
due, the bank must calculate its risk-based capital requirement for the
transaction by treating the current market value of the deliverables
owed to the bank as a wholesale exposure.
For purposes of computing a bank's risk-based capital requirement
for unsettled non-DvP/non-PvP transactions, a bank may assign an
internal obligor rating to a counterparty for which it is not otherwise
required under the final rule to assign an obligor rating on the basis
of the applicable external rating of any outstanding unsecured long-
term debt security without credit enhancement issued by the
counterparty. A bank may estimate a loss severity rating or LGD for the
exposure, or may use a 45 percent LGD for the exposure provided the
bank uses the 45 percent LGD for all such exposures (that is, for all
non-DvP/non-PvP transactions subject to a risk-based capital
requirement other than deduction under section 35 of the final rule).
Alternatively, a bank may use a 100 percent risk weight for all non-
DvP/non-PvP transactions subject to a risk-based capital requirement
other than deduction under section 35 of the final rule.
If, in a non-DvP/non-PvP transaction with a normal settlement
period, the bank has not received its deliverables by the fifth
business day after counterparty delivery was due, the bank must deduct
the current market value of the deliverables owed to the bank 50
percent from tier 1 capital and 50 percent from tier 2 capital.
The total risk-weighted asset amount for unsettled transactions
equals the sum of the risk-weighted asset amount for each DvP and PvP
transaction with a normal settlement period and the risk-weighted asset
amount for each non-DvP/non-PvP transaction with a normal settlement
period.
E. Securitization Exposures
This section describes the framework for calculating risk-based
capital requirements for securitization exposures (the securitization
framework). In contrast to the framework for wholesale and retail
exposures, the securitization framework does not permit a bank to rely
on its internal assessments of the risk parameters of a securitization
exposure.\89\ For securitization exposures, which typically are
tranched exposures to a pool of underlying exposures, such assessments
would require implicit or explicit estimates of correlations among the
losses on the underlying exposures and estimates of the credit risk-
transfering consequences of tranching. Such correlation and tranching
effects are difficult to estimate and validate in an objective manner
and on a going-forward basis. Instead, the securitization framework
relies principally on two sources of information, where available, to
determine risk-based capital requirements: (i) An assessment of the
securitization exposure's credit risk made by a nationally recognized
statistical rating organization (NRSRO); or (ii) the risk-based capital
requirement for the underlying exposures as if the exposures had not
been securitized (along with certain other objective information about
the securitization exposure, such as the size and relative seniority of
the exposure).
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\89\ Although the IAA described below does allow a bank to use
an internal-ratings-based approach to determine its risk-based
capital requirement for an exposure to an ABCP program, banks are
required to follow NRSRO rating criteria and therefore are required
implicitly to use the NRSRO's determination of the correlation of
the underlying exposures in the ABCP program.
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1. Hierarchy of Approaches
The securitization framework contains three general approaches for
determining the risk-based capital requirement for a securitization
exposure: a ratings-based approach (RBA), an internal assessment
approach (IAA), and a supervisory formula approach (SFA). Consistent
with the New Accord and the proposal, under the final rule a bank
generally must apply the following hierarchy of approaches to determine
the risk-based capital requirement for a securitization exposure.
Gains-on-Sale and CEIOs
Under the proposed rule, a bank would deduct from tier 1 capital
any after-tax gain-on-sale resulting from a securitization and would
deduct from total capital any portion of a CEIO that does not
constitute a gain-on-sale, as described in section 42(a)(1) and (c) of
the proposed rule. Thus, if the after-tax gain-on-sale associated with
a securitization equaled $100 while the amount of CEIOs associated with
that same securitization equaled $120, the bank would deduct $100 from
tier 1 capital and $20 from total capital ($10 from tier 1 capital and
$10 from tier 2 capital).
Several commenters asserted that the proposed deductions of gains-
on-sale and CEIOs were excessively conservative, because such
deductions are not reflected in an originating bank's maximum risk-
based capital requirement associated with a single securitization
transaction (described below). Commenters noted that while
securitization does not increase an originating bank's overall risk
exposure to the securitized assets, in some circumstances the proposal
would result in a securitization transaction increasing an originating
bank's risk-based capital requirement. To address this concern, some
commenters suggested deducting CEIOs from total capital only when the
CEIOs constitute a gain-on-sale. Others urged adopting the treatment of
CEIOs in the general risk-based capital rules. Under this treatment,
the entire amount
[[Page 69358]]
of CEIOs beyond a concentration threshold is deducted from total
capital and there is no separate gain-on-sale deduction.
The final rule retains the proposed deduction of gains-on-sale and
CEIOs. These deductions are consistent with the New Accord, and the
agencies believe they are warranted given historical supervisory
concerns with the subjectivity involved in valuations of gains-on-sale
and CEIOs. Furthermore, although the treatments of gains-on-sale and
CEIOs can increase an originating bank's risk-based capital requirement
following a securitization, the agencies believe that such anomalies
will be rare where a securitization transfers significant credit risk
from the originating bank to third parties.
Ratings-Based Approach (RBA)
If a securitization exposure is not a gain-on-sale or CEIO, a bank
must apply the RBA to a securitization exposure if the exposure
qualifies for the RBA. As a general matter, an exposure qualifies for
the RBA if the exposure has an external rating from an NRSRO or has an
inferred rating (that is, the exposure is senior to another
securitization exposure in the transaction that has an external rating
from an NRSRO).\90\ For example, a bank generally must use the RBA
approach to determine the risk-based capital requirement for an asset-
backed security that has an applicable external rating of AA+ from an
NRSRO and for another tranche of the same securitization that is
unrated but senior in all respects to the asset-backed security that
was rated. In this example, the senior unrated tranche would be treated
as if it were rated AA+.
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\90\ A securitization exposure held by an originating bank must
have two or more external ratings or inferred ratings to qualify for
the RBA.
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Internal Assessment Approach (IAA)
If a securitization exposure does not qualify for the RBA but the
exposure is to an ABCP program--such as a credit enhancement or
liquidity facility--the bank may apply the IAA (if the bank, the
exposure, and the ABCP program qualify for the IAA) or the SFA (if the
bank and the exposure qualify for the SFA) to the exposure. As a
general matter, a bank will qualify to use the IAA if the bank
establishes and maintains an internal risk rating system for exposures
to ABCP programs that has been approved by the bank's primary Federal
supervisor. Alternatively, a bank may use the SFA if the bank is able
to calculate a set of risk factors relating to the securitization,
including the risk-based capital requirement for the underlying
exposures as if they were held directly by the bank. A bank that
qualifies for and chooses to use the IAA must use the IAA for all
exposures that qualify for the IAA.
A number of commenters asserted that a bank should be permitted to
use the IAA for a securitization exposure to an ABCP conduit even when
the exposure has an inferred rating, provided all other IAA eligibility
criteria were met. The commenters maintained that the RBA would produce
an excessive risk-based capital requirement for an unrated
securitization exposure, such as a liquidity facility, when the
inferred rating is based on a rated security that is very junior to the
unrated exposure. Commenters suggested that allowing a bank to use the
IAA instead of the RBA in such circumstances would lead to a risk-based
capital requirement that was better aligned with the unrated exposure's
actual risk.
Like the New Accord, the final rule does not allow a bank to use
the IAA for securitization exposures that qualify for the RBA based on
an inferred rating. While in some cases the IAA might produce a more
risk-sensitive capital treatment relative to an inferred rating under
the RBA, the agencies--as well as the majority of commenters--believe
that it is important to retain as much consistency as possible with the
New Accord to provide a level international playing field for financial
services providers in a competitive line of business. The commenters'
concerns relating to inferred ratings apply only to a small proportion
of outstanding ABCP liquidity facilities. In many cases, a bank may
mitigate such concerns by having the ABCP program issue an additional,
intermediate layer of externally rated securities, which would provide
a more accurate reference for inferring a rating on the unrated
liquidity facility. The agencies intend to monitor developments in this
area and, as appropriate, will coordinate any reassessment of the
hierarchy of securitization approaches with the BCBS and other
supervisory and regulatory authorities.
Supervisory Formula Approach (SFA)
If a securitization exposure is not a gain-on-sale or a CEIO, does
not qualify for the RBA, and is not an exposure to an ABCP program for
which the bank is applying the IAA, the bank may apply the SFA to the
exposure if the bank is able to calculate the SFA risk parameters for
the securitization. In many cases, an originating bank would use the
SFA to determine its risk-based capital requirements for retained
securitization exposures.
Deduction
If a securitization exposure is not a gain-on-sale or a CEIO and
does not qualify for the RBA, the IAA, or the SFA, the bank must deduct
the exposure from total capital.
Numerous commenters requested an alternative to deducting the
securitization exposure from capital. Some of these commenters noted
that if a bank does not service the underlying assets, the bank may not
be able to produce highly accurate estimates of a key SFA risk
parameter, KIRB, which is the risk-based capital requirement
as if the underlying assets were held directly by the bank. Commenters
expressed concern that, under the proposal, a bank would be required to
deduct from capital some structured lending products that have long
histories of low credit losses. Commenters maintained that a bank
should be allowed to calculate the securitization exposure's risk-based
capital requirement using the rules for wholesale exposures or using an
IAA-like approach under which the bank's internal risk rating for the
exposure would be mapped into an NRSRO's rating category.
Like the proposal, the final rule contains only those
securitization approaches in the New Accord. As already noted, the
agencies--and most commenters--believe that it is important to minimize
substantive differences between the final rule and the New Accord to
foster international consistency. Furthermore, the agencies believe
that the hierarchy of securitization approaches is sufficiently
comprehensive to accommodate demonstrably low-risk structured lending
arrangements in a risk-sensitive manner. As described in greater detail
below, for securitization exposures that are not eligible for the RBA
or the IAA, a bank has flexibility under the SFA to tailor its
procedures for estimating KIRB to the data that are
available. The agencies recognize that, in light of data shortcomings,
a bank may have to use approaches to estimating KIRB that
are less sophisticated than what the bank might use for similar assets
that it originates, services, and holds directly. Supervisors generally
will review the reasonableness of KIRB estimates in the
context of available data, and will expect estimates of KIRB
to incorporate appropriate conservatism to address any data
shortcomings.
Total risk-weighted assets for securitization exposures equals the
sum of risk-weighted assets calculated under the RBA, IAA, and SFA,
plus any risk-
[[Page 69359]]
weighted asset amounts calculated under the early amortization
provisions in section 47 of the final rule.
Exceptions to the General Hierarchy of Approaches
Consistent with the New Accord and the proposed rule, the final
rule includes a mechanism that generally prevents a bank's effective
risk-based capital requirement from increasing as a result of the bank
securitizing its assets. Specifically, the rule limits a bank's
effective risk-based capital requirement for all of its securitization
exposures to a single securitization to the applicable risk-based
capital requirement if the underlying exposures were held directly by
the bank. Under the rule, unless one or more of the underlying
exposures does not meet the definition of a wholesale, retail,
securitization, or equity exposure, the total risk-based capital
requirement for all securitization exposures held by a single bank
associated with a single securitization (including any regulatory
capital requirement that relates to an early amortization provision,
but excluding any capital requirements that relate to the bank's gain-
on-sale or CEIOs associated with the securitization) cannot exceed the
sum of (i) the bank's total risk-based capital requirement for the
underlying exposures as if the bank directly held the underlying
exposures; and (ii) the bank's total ECL for the underlying exposures.
One commenter urged the agencies to delete the reference to ECL in
the capital calculation. However, the agencies believe it is
appropriate to include the ECL of the underlying exposures in this
calculation because ECL is included in the New Accord's limit, and
because the bank would have had to estimate the ECL of the exposures
and hold reserves or capital against the ECL if the bank held the
underlying exposures on its balance sheet.
This maximum risk-based capital requirement is different from the
general risk-based capital rules. Under the general risk-based capital
rules, banks generally are required to hold a dollar in capital for
every dollar in residual interest, regardless of the effective risk-
based capital requirement on the underlying exposures. The agencies
adopted this dollar-for-dollar capital treatment for a residual
interest to recognize that in many instances the relative size of the
residual interest retained by the originating bank reveals market
information about the quality of the underlying exposures and
transaction structure that may not have been captured under the general
risk-based capital rules. Given the significantly heightened risk
sensitivity of the IRB approach, the agencies believe that the maximum
risk-based capital requirement in the final rule is appropriate.
The securitization framework also includes provisions to limit the
double counting of risks in situations involving overlapping
securitization exposures. While the proposal addressed only those
overlapping exposures arising in the context of exposures to ABCP
programs and mortgage loan swaps with recourse, the final rule
addresses overlapping exposures for securitizations more generally. If
a bank has multiple securitization exposures that provide duplicative
coverage of the underlying exposures of a securitization (such as when
a bank provides a program-wide credit enhancement and multiple pool-
specific liquidity facilities to an ABCP program), the bank is not
required to hold duplicative risk-based capital against the overlapping
position. Instead, the bank would apply to the overlapping position the
applicable risk-based capital treatment under the securitization
framework that results in the highest capital requirement. If different
banks have overlapping exposures to a securitization, however, each
bank must hold capital against the entire maximum amount of its
exposure. Although duplication of capital requirements will not occur
for individual banks, some systemic duplication may occur where
multiple banks have overlapping exposures to the same securitization.
The proposed rule also addressed the risk-based capital treatment
of a securitization of non-IRB assets. Claims to future music concert
and film receivables are examples of financial assets that are not
wholesale, retail, securitization, or equity exposures. In these cases,
the SFA cannot be used because of the absence of a risk-sensitive
measure of the credit risk of the underlying exposures. Specifically,
under the proposed rule, if a bank had a securitization exposure and
any underlying exposure of the securitization was not a wholesale,
retail, securitization or equity exposure, the bank would (i) apply the
RBA if the securitization exposure qualifies for the RBA and is not
gain-on-sale or a CEIO; or (ii) otherwise, deduct the exposure from
total capital.
Numerous commenters asserted that a bank should be allowed to use
the IAA in these situations since, unlike the SFA, the IAA is tied to
NRSRO rating methodologies rather than to the risk-based capital
requirement for the underlying exposures. The agencies believe that
this is a reasonable approach for exposures to ABCP conduits. The final
rule permits a bank to use the IAA for a securitization exposure for
which any underlying exposure of the securitization is not a wholesale,
retail, securitization or equity exposure, provided the securitization
exposure is not gain-on-sale, not a CEIO, and not eligible for the RBA,
and all of the IAA qualification criteria are met.
As described in section V.A.3. of this preamble, a few commenters
asserted that OTC derivatives with a securitization SPE as the
counterparty should be excluded from the definition of securitization
exposure. These commenters objected to the burden of using the
securitization framework to calculate a capital requirement for
counterparty credit risk for OTC derivatives with a securitization SPE.
The agencies continue to believe that the securitization framework is
the most appropriate way to assess the counterparty credit risk of such
exposures, and that in many cases the relatively simple RBA will apply
to such exposures. In response to commenter concerns about burden, the
agencies have decided to add an optional simple risk weight approach
for certain OTC derivatives. Under the final rule, if a securitization
exposure is an OTC derivative contract (other than a credit derivative)
that has a first priority claim on the cash flows from the underlying
exposures (notwithstanding amounts due under interest rate or currency
derivative contracts, fees due, or other similar payments), a bank may
choose to apply an effective 100 percent risk weight to the exposure
rather than the general securitization hierarchy of approaches. This
treatment is subject to supervisory approval.
Like the proposed rule, the final rule contains three additional
exceptions to the general hierarchy. Each exception parallels the
general risk-based capital rules. First, an interest-only mortgage-
backed security must be assigned a risk weight that is no less than 100
percent. Although a number of commenters objected to this risk weight
floor on the grounds that it was not risk sensitive, the agencies
believe that a minimum risk weight of 100 percent is prudent in light
of the uncertainty implied by the substantial price volatility of these
securities. Second, a sponsoring bank that qualifies as a primary
beneficiary and must consolidate an ABCP program as a variable interest
entity under GAAP generally may exclude the consolidated ABCP program
assets from risk-
[[Page 69360]]
weighted assets.\91\ In such cases, the bank must hold risk-based
capital against any securitization exposures of the bank to the ABCP
program. Third, as required by Federal statute, a special set of rules
applies to transfers of small business loans and leases with recourse
by well-capitalized depository institutions.\92\
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\91\ See Financial Accounting Standards Board, Interpretation
No. 46: Consolidation of Variable Interest Entities (January 2003).
\92\ See 12 U.S.C. 1835, which places a cap on the risk-based
capital requirement applicable to a well-capitalized DI that
transfers small business loans with recourse. The final rule does
not expressly state that the agencies may permit adequately
capitalized banks to use the small business recourse rule on a case-
by-case basis because the agencies may do this under the general
reservation of authority contained in section 1 of the rule.
---------------------------------------------------------------------------
Servicer Cash Advances
A traditional securitization typically employs a servicing bank
that--on a day-to-day basis--collects principal, interest, and other
payments from the underlying exposures of the securitization and
forwards such payments to the securitization SPE or to investors in the
securitization. Such servicing banks often provide to the
securitization a credit facility under which the servicing bank may
advance cash to ensure an uninterrupted flow of payments to investors
in the securitization (including advances made to cover foreclosure
costs or other expenses to facilitate the timely collection of the
underlying exposures). These servicer cash advance facilities are
securitization exposures.
Under the final rule, as under the proposed rule, a servicing bank
must determine its risk-based capital requirement for any advances
under such a facility using the hierarchy of securitization approaches
described above. The treatment of the undrawn portion of the facility
depends on whether the facility is an ``eligible'' servicer cash
advance facility. An eligible servicer cash advance facility is a
servicer cash advance facility in which (i) the servicer is entitled to
full reimbursement of advances (except that a servicer may be obligated
to make non-reimburseable advances for a particular underlying exposure
if any such advance is limited to an insignificant amount of the
outstanding principal balance of that exposure); (ii) the servicer's
right to reimbursement is senior in right of payment to all other
claims on the cash flows from the underlying exposures of the
securitization; and (iii) the servicer has no legal obligation to, and
does not, make advances to the securitization if the servicer concludes
the advances are unlikely to be repaid. Consistent with the general
risk-based capital rules with respect to residential mortgage servicer
cash advances, a servicing bank is not required to hold risk-based
capital against the undrawn portion of an eligible servicer cash
advance facility. A bank that provides a non-eligible servicer cash
advance facility must determine its risk-based capital requirement for
the undrawn portion of the facility in the same manner as the bank
would determine its risk-based capital requirement for any other
undrawn securitization exposure.
Amount of a Securitization Exposure
Under the proposed rule, the amount of an on-balance sheet
securitization exposure was the bank's carrying value, if the exposure
was held-to-maturity or for trading, or the bank's carrying value minus
any unrealized gains and plus any unrealized losses on the exposure, if
the exposure was available-for-sale. In general, the amount of an off-
balance sheet securitization exposure was the notional amount of the
exposure. For an OTC derivative contract that was not a credit
derivative, the notional amount was the EAD of the derivative contract
(as calculated in section 32).
In the final rule the agencies are maintaining the substance of the
proposed provision on the amount of a securitization exposure with one
exception. The final rule provides that the amount of a securitization
exposure that is a repo-style transaction, eligible margin loan, or OTC
derivative (other than a credit derivative) is the EAD of the exposure
as calculated in section 32 of the final rule. The agencies believe
this change is consistent with the way banks manage these exposures,
more appropriately reflects the collateral that directly supports these
exposures, and recognizes the credit risk mitigation benefits of
netting where these exposures are part of a cross-product netting set.
Because the collateral associated with a repo-style transaction or
eligible margin loan is reflected in the determination of exposure
amount under section 32 of the rule, these transactions are not
eligible for the general securitization collateral approach in section
46(b) of the final rule. Similarly, if a bank chooses to reflect
collateral associated with an OTC derivative contract in its
determination of exposure amount under section 32 of the rule, it may
not also apply the general securitization collateral approach in
section 46(b) of the final rule. Similar to the definition of EAD for
on-balance sheet exposures, the agencies are clarifying that the amount
of an on-balance sheet securitization exposure is based on whether or
not the exposure is classified as an available for sale security.
Under the proposal, when a securitization exposure to an ABCP
program takes the form of a commitment, such as a liquidity facility,
the notional amount could be reduced to the maximum potential amount
that the bank currently would be required to fund under the
arrangement's documentation (the maximum potential amount that could be
drawn given the assets currently held by the program). Within some ABCP
programs, however, certain commitments, such as liquidity facilities,
may be dynamic in that the maximum amount that can be drawn at any
moment depends on the current credit quality of the program's
underlying assets. That is, if the underlying assets were to remain
fixed, but their credit quality deteriorated, the maximum amount that
could be drawn against the liquidity facility could increase.
The final rule clarifies that in such circumstances the notional
amount of an off-balance sheet securitization exposure to an ABCP
program may be reduced to the maximum potential amount that the bank
could be required to fund given the program's current assets
(calculated without regard to the current credit quality of these
assets). Thus, if $100 is the maximum amount that could be drawn given
the current volume and current credit quality of the program's assets,
but the maximum potential draw against these same assets could increase
to as much as $200 if their credit quality were to deteriorate, then
the exposure amount is $200.
Some commenters recommended capping the securitization amount for
an ABCP liquidity facility at the amount of the outstanding commercial
paper covered by that facility. The agencies believe, however, that
this would be inappropriate if the liquidity provider could be required
to advance a larger amount. The agencies note that when calculating the
exposure amount of a liquidity facility, a bank may take into account
any limits on advances--including limits based on the amount of
commercial paper outstanding--that are contained in the program's
documentation.
Implicit Support
Like the proposed rule, the final rule sets forth the regulatory
capital consequences if a bank provides support to a securitization in
excess of the bank's predetermined contractual obligation to provide
credit support to the securitization. First, consistent with
[[Page 69361]]
the general risk-based capital rules,\93\ a bank that provides such
implicit support must hold regulatory capital against all of the
underlying exposures associated with the securitization as if the
exposures had not been securitized, and must deduct from tier 1 capital
any after-tax gain-on-sale resulting from the securitization. Second,
the bank must disclose publicly (i) that it has provided implicit
support to the securitization, and (ii) the regulatory capital impact
to the bank of providing the implicit support. The bank's primary
Federal supervisor also may require the bank to hold regulatory capital
against all the underlying exposures associated with some or all the
bank's other securitizations as if the exposures had not been
securitized, and to deduct from tier 1 capital any after-tax gain-on-
sale resulting from such securitizations.
---------------------------------------------------------------------------
\93\ Interagency Guidance on Implicit Recourse in Asset
Securitizations, May 23, 2002.
---------------------------------------------------------------------------
Operational Requirements for Traditional Securitizations
In a traditional securitization, an originating bank typically
transfers a portion of the credit risk of exposures to third parties by
selling them to a securitization SPE. Under the final rule, consistent
with the proposed rule, banks engaging in a traditional securitization
may exclude the underlying exposures from the calculation of risk-
weighted assets only if each of the following conditions is met: (i)
The transfer is a sale under GAAP; (ii) the originating bank transfers
to third parties credit risk associated with the underlying exposures;
and (iii) any clean-up calls relating to the securitization are
eligible clean-up calls (as discussed below). Originating banks that
meet these conditions must hold regulatory capital against any
securitization exposures they retain in connection with the
securitization. Originating banks that fail to meet these conditions
must hold regulatory capital against the transferred exposures as if
they had not been securitized and must deduct from tier 1 capital any
gain-on-sale resulting from the transaction. The operational
requirements for synthetic securitization are described in preamble
section V.E.7., below.
Consistent with the general risk-based capital rules, the above
operational requirements refer specifically to GAAP for the purpose of
determining whether a securitization transaction should be treated as
an asset sale or a financing. In contrast, the New Accord stipulates
guiding principles for use in determining whether sale treatment is
warranted. One commenter requested that the agencies conform the
proposed operational requirements for traditional securitizations to
those in the New Accord. The agencies believe that the current
conditions to qualify for sale treatment under GAAP are broadly
consistent with the guiding principles enumerated in the New Accord.
However, if GAAP in this area were to change materially in the future,
the agencies would reassess, and possibly revise, the operational
standards.
Clean-Up Calls
To satisfy the operational requirements for securitizations and
enable an originating bank to exclude the underlying exposures from the
calculation of its risk-based capital requirements, any clean-up call
associated with a securitization must be an eligible clean-up call. The
proposal defined a clean-up call as a contractual provision that
permits a servicer to call securitization exposures (for example,
asset-backed securities) before the stated (or contractual) maturity or
call date. The preamble to the proposed rule explained that, in the
case of a traditional securitization, a clean-up call is generally
accomplished by repurchasing the remaining securitization exposures
once the amount of underlying exposures or outstanding securitization
exposures falls below a specified level. In the case of a synthetic
securitization, the clean-up call may take the form of a clause that
extinguishes the credit protection once the amount of underlying
exposures has fallen below a specified level.
Under the proposed rule, an eligible clean-up call would be a
clean-up call that:
(i) Is exercisable solely at the discretion of the servicer;
(ii) Is not structured to avoid allocating losses to securitization
exposures held by investors or otherwise structured to provide credit
enhancement to the securitization (for example, to purchase non-
performing underlying exposures); and
(iii) (A) For a traditional securitization, is only exercisable
when 10 percent or less of the principal amount of the underlying
exposures or securitization exposures (determined as of the inception
of the securitization) is outstanding.
(B) For a synthetic securitization, is only exercisable when 10
percent or less of the principal amount of the reference portfolio of
underlying exposures (determined as of the inception of the
securitization) is outstanding.
A number of comments addressed the proposed definitions of clean-up
call and eligible clean-up call. One commenter observed that prudential
concerns would also be satisfied if the call were at the discretion of
the originator of the underlying exposures. The agencies concur with
this view and have modified the final rule to state that a clean-up
call may permit the servicer or originating bank to call the
securitization exposures before the stated maturity or call date, and
that an eligible clean-up call must be exercisable solely at the
discretion of the servicer or the originating bank. Commenters also
requested clarification whether, for a securitization that involves a
master trust, the 10 percent requirement described above in criteria
(iii)(A) and (iii)(B) would be interpreted as applying to each series
or tranche of securities issued from the master trust. The agencies
believe this is a reasonable interpretation. Thus, where a
securitization SPE is structured as a master trust, a clean-up call
with respect to a particular series or tranche issued by the master
trust would meet criteria (iii)(A) and (iii)(B) so long as the
outstanding principal amount in that series was 10 percent or less of
its original amount at the inception of the series.
Additional Supervisory Guidance
Over the last several years, the agencies have published a
significant amount of supervisory guidance to assist banks with
assessing the extent to which they have transferred credit risk and,
consequently, may recognize any reduction in required regulatory
capital as a result of a securitization or other form of credit risk
transfer. \94\ In general, the agencies expect banks to continue to use
this guidance, most of which remains applicable to the advanced
approaches securitization framework. Banks are encouraged to consult
with their primary Federal supervisor about transactions that require
additional guidance.
---------------------------------------------------------------------------
\94\ See, e.g., OCC Bulletin 99-46 (Dec. 13, 1999) (OCC); FDIC
Financial Institution Letter 109-99 (Dec. 13, 1999) (FDIC); SR
Letter 99-37 (Dec. 13, 1999) (Board); CEO Ltr. 99-119 (Dec. 14,
1999) (OTS).
---------------------------------------------------------------------------
2. Ratings-Based Approach (RBA)
Under the final rule, as under the proposal, a bank must determine
the risk-weighted asset amount for a securitization exposure that is
eligible for the RBA by multiplying the amount of the exposure by the
appropriate risk-weight provided in the tables in section 43 of the
rule. Under the proposal, whether a securitization exposure was
eligible for the RBA would depend on whether the bank holding the
[[Page 69362]]
securitization exposure is an originating bank or an investing bank. An
originating bank would be eligible to use the RBA for a securitization
exposure if (i) the exposure had two or more external ratings, or (ii)
the exposure had two or more inferred ratings. In contrast, an
investing bank would be eligible to use the RBA for a securitization
exposure if the exposure has one or more external or inferred ratings.
A bank would be an originating bank if it (i) directly or indirectly
originated or securitized the underlying exposures included in the
securitization, or (ii) serves as an ABCP program sponsor to the
securitization.
The proposed rule defined an external rating as a credit rating
assigned by a NRSRO to an exposure, provided (i) the credit rating
fully reflects the entire amount of credit risk with regard to all
payments owed to the holder of the exposure, and (ii) the external
rating is published in an accessible form and is included in the
transition matrices made publicly available by the NRSRO that summarize
the historical performance of positions it has rated. For example, if a
holder is owed principal and interest on an exposure, the credit rating
must fully reflect the credit risk associated with timely repayment of
principal and interest. Under the proposed rule, an exposure's
applicable external rating was the lowest external rating assigned to
the exposure by any NRSRO.
The proposed two-rating requirement for originating banks was the
only material difference between the treatment of originating banks and
investing banks under the proposed securitization framework. Although
the two-rating requirement is not included in the New Accord, it is
generally consistent with the treatment of originating and investing
banks in the general risk-based capital rules. The agencies sought
comment on whether this treatment was appropriate, and on possible
alternative mechanisms that could be employed to ensure the reliability
of external and inferred ratings on securitization exposures retained
by originating banks.
Commenters generally objected to the two-rating requirement for
originating banks. Many asserted that since the credit risk of a given
securitization exposure was the same regardless of the holder, the
risk-based capital treatments also should be the same. Because external
ratings would be publicly available, some commenters contended that
NRSROs will have strong reputational reasons to give unbiased ratings--
even to non-traded securitization exposures retained by originating
banks. The agencies continue to believe that external ratings for
securitization exposures retained by an originating bank, which
typically are not traded, are subject to less market discipline than
ratings for exposures sold to third parties. This disparity in market
discipline warrants more stringent conditions on use of the former for
risk-based capital purposes. Accordingly, the final rule retains the
two-rating requirement for originating banks.
Consistent with the New Accord, the final rule states that an
unrated securitization exposure has an inferred rating if another
securitization exposure issued by the same issuer and secured by the
same underlying exposures has an external rating and this rated
reference exposure (i) is subordinate in all respects to the unrated
securitization exposure; (ii) does not benefit from any credit
enhancement that is not available to the unrated securitization
exposure; and (iii) has an effective remaining maturity that is equal
to or longer than the unrated securitization exposure. Under the RBA,
securitization exposures with an inferred rating are treated the same
as securitization exposures with an identical external rating. This
definition does not permit a bank to assign an inferred rating based on
the ratings of the underlying exposures in a securitization, even when
the unrated securitization exposure is secured by a single, externally
rated security. In particular, such a look-through approach would fail
to meet the requirements that the rated reference exposure must be
issued by the same issuer, secured by the same underlying assets, and
subordinated in all respects to the unrated securitization exposure.
The agencies sought comment on whether they should consider other
bases for inferring a rating for an unrated securitization position,
such as using an applicable credit rating on outstanding long-term debt
of the issuer or guarantor of the securitization exposure. In
situations where an unrated securitization exposure benefited from a
guarantee that covered all contractual payments associated with the
securitization exposure, several commenters advocated allowing an
inferred rating to be assigned based on the long-term rating of the
guarantor. In addition, some commenters recommended that if a senior,
unrated securitization exposure is secured by a single externally rated
underlying security, a bank should be permitted to assign an inferred
rating for the unrated exposure using a look-through approach.
The agencies do not believe there is a compelling need at this time
to supplement the New Accord's methods for determining an inferred
rating. However, if a need develops in the future, the agencies will
seek to revise the New Accord in coordination with the BCBS and other
supervisory and regulatory authorities. In the situations cited above,
the framework already provides simplified methods for calculating a
securitization exposure's risk-based capital requirement. For example,
when a securitization exposure benefits from a full guarantee, such as
from an externally rated monoline insurance company, the exposure's
external rating often will reflect that guarantee. When the guaranteed
securitization exposure is not externally rated, subject to the rules
for recognition of guarantees of securitization exposures in section
46, the unrated securitization exposure may be treated as a direct
(wholesale) exposure to the guarantor. In addition, when a
securitization exposure to an ABCP program is secured by a single,
externally rated asset, a look-through approach may be possible under
the IAA provided that such a look-through is no less conservative than
the applicable NRSRO rating methodologies.
Under the proposal, if a securitization exposure had multiple
external ratings or multiple inferred ratings, a bank would be required
to use the lowest rating (the rating that would produce the highest
risk-based capital requirement). Commenters objected that this
treatment was significantly more conservative than required by the New
Accord, which permits use of the second most favorable rating, and
would unfairly penalize banks in situations where the lowest rating was
unsolicited or an outlier. The agencies recognize commenters' concerns
regarding unsolicited ratings, and note that the New Accord states
banks should use solicited ratings. To maintain consistency with the
general risk-based capital rules, the final rule defines the applicable
external rating of a securitization exposure to be its lowest solicited
external rating and the applicable inferred rating of a securitization
exposure to be the inferred rating based on its lowest solicited
external rating.
For securitization exposures eligible for the RBA, the risk-based
capital requirement per dollar of securitization exposure depends on
four factors: (i) The applicable rating of the exposure; (ii) whether
the rating reflects a long-term or short-term assessment of the
exposure's credit risk; (iii) whether the
[[Page 69363]]
exposure is a ``senior'' exposure; and (iv) a measure of the effective
number (``N'') of underlying exposures. In response to a specific
question posed by the agencies, commenters generally supported linking
risk weights under the RBA to these factors.
In the proposed rule, a ``senior securitization exposure'' was
defined as a securitization exposure that has a first priority claim on
the cash flows from the underlying exposures, disregarding the claims
of a service provider (such as a swap counterparty or trustee,
custodian, or paying agent for the securitization) to fees from the
securitization. Generally, only the most senior tranche of a
securitization would be a senior securitization exposure. For example,
if multiple tranches of a securitization share the transaction's
highest rating, only the tranche with the shortest remaining maturity
would be treated as senior, since other tranches with the same rating
would not have a first claim to cash flows throughout their lifetimes.
A liquidity facility that supports an ABCP program would be a senior
securitization exposure if the liquidity facility provider's right to
reimbursement of the drawn amounts was senior to all claims on the cash
flows from the underlying exposures except claims of a service provider
to fees.
In the final rule, the agencies modified this definition to clarify
two points. First, in the context of an ABCP program, the final rule
specifically states that both the most senior commercial paper issued
by the program and a liquidity facility supporting the program may be
``senior'' exposures if the liquidity facility provider's right to
reimbursement of any drawn amounts is senior to all claims on the cash
flow from the underlying exposures. Second, the final rule clarifies
that when determining whether a securitization exposure is senior, a
bank is not required to consider any amounts due under interest rate or
currency derivative contracts, fees due, or other similar payments.
Consistent with the New Accord, a bank must use Table F below when
a securitization exposure qualifies for the RBA based on a long-term
external rating or an inferred rating based on a long-term external
rating. A bank may apply the risk weights in column 1 of Table F to the
securitization exposure only if the N is six or more and the
securitization exposure is a senior securitization exposure. If N is
six or more but the securitization exposure is not a senior
securitization exposure, the bank must apply the risk weights in column
2 of Table F. Applying the principle of conservatism, however, if N is
six or more a bank may use the risk weights in column 2 of Table F
without determining whether the exposure is senior. A bank must apply
the risk weights in column 3 of Table F to the securitization exposure
if N is less than six.
In certain situations the rule provides a simplified approach for
determining N. If the notional number of underlying exposures of a
securitization is 25 or more or if all the underlying exposures are
retail exposures, a bank may assume that N is six or more (unless the
bank knows or has reason to know that N is less than six). However, if
the notional number of underlying exposures of a securitization is less
than 25 and one or more of the underlying exposures is a non-retail
exposure, the bank must compute N as described in the SFA section
below.
A few commenters wanted to determine N only at the inception of a
securitization transaction, due to the burden of tracking N over time.
The agencies believe that a bank must track N over time to ensure an
appropriate risk-based capital requirement. The number of underlying
exposures in a securitization typically changes over time as some
underlying exposures are repaid or default. As the number of underlying
exposures changes, the risk profile of the associated securitization
exposures changes, and a bank must reflect this change in risk profile
in its risk-based capital requirement.
Table F.--Long-Term Credit Rating Risk Weights Under RBA and IAA
----------------------------------------------------------------------------------------------------------------
Column 1 Column 2 Column 3
--------------------------------------------------------------
Risk weights for Risk weights for
Applicable external or inferred rating senior non-senior Risk weights for
(illustrative rating example) securitization ex- securitization ex- securitization ex-
posures backed by posures backed by posures backed by
granular pools granular pools non-granular pools
(percent) (percent) (percent)
----------------------------------------------------------------------------------------------------------------
Highest investment grade (for example, AAA)...... 7 12 20
----------------------------------------------------------------------------------------------------------------
Second highest investment grade (for example, AA) 8 15 25
----------------------------------------------------------------------------------------------------------------
Third-highest investment grade--positive 10 18 35
designation (for example, A+)...................
--------------------------------------------------------------------------------------------
Third-highest investment grade (for example, A).. 12 20
--------------------------------------------------------------------------------------------
Third-highest investment grade--negative 20 35
designation (for example, A-)...................
----------------------------------------------------------------------------------------------------------------
Lowest investment grade--positive designation 35 50
(for example, BBB+).............................
----------------------------------------------------------------------------------------------------------------
Lowest investment grade (for example, BBB)....... 60 75
----------------------------------------------------------------------------------------------------------------
Lowest investment grade--negative designation
(for example, BBB-)............................. 100
----------------------------------------------------------------------------------------------------------------
One category below investment grade--positive
designation (for example, BB+).................. 250
----------------------------------------------------------------------------------------------------------------
One category below investment grade (for example,
BB)............................................. 425
----------------------------------------------------------------------------------------------------------------
One category below investment grade--negative
designation (for example, BB-).................. 650
----------------------------------------------------------------------------------------------------------------
[[Page 69364]]
More than one category below investment grade.... Deduction from tier 1 and tier 2 capital.
----------------------------------------------------------------------------------------------------------------
A bank must apply the risk weights in Table G when the
securitization exposure qualifies for the RBA based on a short-term
external rating or an inferred rating based on a short-term external
rating. A bank must apply the decision rules outlined in the previous
paragraph to determine which column of Table G applies.
Table G.--Short-Term Credit Rating Risk Weights Under RBA and IAA
----------------------------------------------------------------------------------------------------------------
Column 1 Column 2 Column 3
--------------------------------------------------------------
Risk weights for Risk weights for
Applicable external or inferred rating senior non-senior Risk weights for
(illustrative rating example) securitization ex- securitization ex- securitization ex-
posures backed by posures backed by posures backed by
granular pools granular pools non-granular pools
(percent) (percent) (percent)
----------------------------------------------------------------------------------------------------------------
Highest investment grade (for example, A1)....... 7 12 20
----------------------------------------------------------------------------------------------------------------
Second highest investment grade (for example, A2) 12 20 35
----------------------------------------------------------------------------------------------------------------
Third highest investment grade (for example, A3). 60 75 75
----------------------------------------------------------------------------------------------------------------
All other ratings................................ Deduction from tier 1 and tier 2 capital.
----------------------------------------------------------------------------------------------------------------
Within Tables G and H, risk weights increase as rating grades
decline. Under column 2 of Table F, for example, the risk weights range
from 12 percent for exposures with the highest investment-grade rating
to 650 percent for exposures rated one category below investment grade
with a negative designation. This pattern of risk weights is broadly
consistent with analyses employing standard credit risk models and a
range of assumptions regarding correlation effects and the types of
exposures being securitized.\95\ These analyses imply that, compared
with a corporate bond having a given level of stand-alone credit risk
(for example, as measured by its expected loss rate), a securitization
tranche having the same level of stand-alone credit risk--but backed by
a reasonably granular and diversified pool--will tend to exhibit more
systematic risk.\96\ This effect is most pronounced for below-
investment-grade tranches and is the primary reason why the RBA risk-
weights increase rapidly as ratings deteriorate over this range--much
more rapidly than for similarly rated corporate bonds.
---------------------------------------------------------------------------
\95\ See Vladislav Peretyatkin and William Perraudin, ``Capital
for Asset-Backed Securities,'' Bank of England, February 2003.
\96\ See, e.g., Michael Pykhtin and Ashish Dev, ``Credit Risk in
Asset Securitizations: An Analytical Model,'' Risk (May 2002) S16-
S20.
---------------------------------------------------------------------------
Under the RBA, a securitization exposure that has an investment-
grade rating and has fewer than six effective underlying exposures
generally receives a higher risk weight than a similarly rated
securitization exposure with six or more effective underlying
exposures. This treatment is intended to discourage a bank from
engaging in regulatory capital arbitrage by securitizing very high-
quality wholesale exposures (wholesale exposures with a low PD and
LGD), obtaining external ratings on the securitization exposures issued
by the securitization, and retaining essentially all the credit risk of
the pool of underlying exposures.
A bank must deduct from regulatory capital any securitization
exposure with an external or inferred rating lower than one category
below investment grade for long-term ratings or below investment grade
for short-term ratings. Although this treatment is more conservative
than suggested by credit risk modeling analyses, the agencies believe
that deducting such exposures from regulatory capital is appropriate in
light of significant modeling uncertainties for such low-rated
securitization tranches. Moreover, external ratings of these tranches
are subject to less market discipline because these positions generally
are retained by the bank and are not traded.
The most senior tranches of granular securitizations with long-term
investment-grade external ratings receive a more favorable risk weight
as compared to more subordinated tranches of the same securitizations.
To be considered granular, a securitization must have an N of at least
six. Consistent with the New Accord, the lowest possible risk-weight, 7
percent, applies only to senior securitization exposures receiving the
highest external rating (for example, AAA) and backed by a granular
asset pool.
The agencies sought comment on how well the risk weights in Tables
G and H capture the most important risk factors for securitization
exposures of varying degrees of seniority and granularity. A number of
commenters contended that, in the interest of competitive equity, the
risk weight for senior securitization exposures having the highest
rating and backed by a granular asset pool should be 6 percent, the
level specified in the European Union's Capital Requirements Directive
(CRD). The agencies decided against making this change. There is no
compelling empirical evidence to support a 6 percent risk weight for
all exposures satisfying these conditions
[[Page 69365]]
and, further, a 6 percent risk weight is inconsistent with the New
Accord. Moreover, estimates of the credit risk associated with such
positions tend to be highly sensitive to subjective modeling
assumptions and to the specific types of underlying assets and
structure of the transaction, which supports the use of the more
conservative approach in the New Accord.
3. Internal Assessment Approach (IAA)
Under the final rule, as under the proposal, a bank is permitted to
compute its risk-based capital requirement for a securitization
exposure to an ABCP program (such as a liquidity facility or credit
enhancement) using the bank's internal assessment of the credit quality
of the securitization exposure. The ABCP program may be sponsored by
the bank itself or by a third party. To apply the IAA, the bank's
internal assessment process and the ABCP program must meet certain
qualification requirements in section 44 of the final rule, and the
securitization exposure must initially be internally rated at least
equivalent to investment grade. A bank that elects to use the IAA for
any securitization exposure to an ABCP program must use the IAA to
compute risk-based capital requirements for all securitization
exposures that qualify for the IAA. Under the IAA, a bank maps its
internal credit assessment of a securitization exposure to an
equivalent external credit rating from an NRSRO. The bank must
determine the risk-weighted asset amount for a securitization exposure
by multiplying the amount of the exposure (using the methodology set
forth above in the RBA section) by the appropriate risk weight provided
in Table F or G above.
Under the proposal, a bank required prior written approval from its
primary Federal supervisor before it could use the IAA. Several
commenters objected to this requirement maintaining that approval is
not required under the New Accord and would likely delay a bank being
authorized to use the IAA for new ABCP programs. Instead, commenters
requested a submission and non-objection approach, under which a bank
would be allowed to use the IAA in the absence of any objection from
its supervisor based on examination findings. The final rule retains
the requirement for prior written approval before a bank can use the
IAA. Like other optional approaches in the final rule (for example, the
double default treatment and the internal models methodology), it is
important that the primary Federal supervisor have an opportunity to
review a bank's practices relative to the final rule before allowing a
bank to use the optional approach. If a bank chooses to implement the
IAA at the same time that it implements the advanced approaches, the
IAA review and approval process will be part of the overall
qualification process. If a bank chooses to implement the IAA after it
has qualified for the advanced approaches, prior written approval is a
necessary safeguard for ensuring appropriate application of the IAA.
Furthermore, the agencies believe this requirement can be implemented
without impeding future innovations in ABCP programs.
Similar to the proposed rule, under the final rule a bank must
demonstrate that its internal credit assessment process satisfies all
the following criteria in order to receive approval to use the IAA.
The bank's internal credit assessments of securitization exposures
to ABCP programs must be based on publicly available rating criteria
used by an NRSRO for evaluating the credit risk of the underlying
exposures. The requirement that an NRSRO's rating criteria be publicly
available does not mean that these criteria must be published formally
by the NRSRO. While the agencies expect banks to rely on published
rating criteria when these criteria are available, an NRSRO often
delays publication of rating criteria for securitizations involving new
asset types until the NRSRO builds sufficient experience with such
assets. Similarly, as securitization structures evolve over time,
published criteria may be revised with some lag. Especially for
securitizations involving new structures or asset types, the
requirement that rating criteria be publicly available should be
interpreted broadly to encompass not only published criteria, but also
criteria that are obtained through written correspondence or other
communications with an NRSRO. In such cases, these communications
should be documented and available for review by the bank's primary
Federal supervisor. The agencies believe this flexibility is
appropriate only for unique situations when published rating criteria
are not generally applicable.
A commenter asked whether the applicable NRSRO rating criteria must
cover all contractual payments owed to the bank holding the exposure,
or only contractual principal and interest. For example, liquidity
facilities typically obligate the seller to make certain future fee and
indemnity payments directly to the liquidity bank. These ancillary
obligations, however, are not an exposure to the ABCP program and would
not normally be covered by NRSRO rating criteria, which focus on the
risks of the underlying assets and the exposure's vulnerability to
those risks. The agencies agree that such ancillary obligations of the
seller need not be covered by the applicable NRSRO rating criteria for
an exposure to be eligible for the IAA.
To be eligible for the IAA, a bank must also demonstrate that its
internal credit assessments of securitization exposures used for
regulatory capital purposes are consistent with those used in its
internal risk management process, capital adequacy assessment process,
and management information reporting systems. The bank must also
demonstrate that its internal credit assessment process has sufficient
granularity to identify gradations of risk. Each of the bank's internal
credit assessment categories must correspond to an external credit
rating of an NRSRO. In addition, the bank's internal credit assessment
process, particularly the stress test factors for determining credit
enhancement requirements, must be at least as conservative as the most
conservative of the publicly available rating criteria of the NRSROs
that have provided external credit ratings to the commercial paper
issued by the ABCP program. In light of recent events in the
securitization market, the agencies emphasize that if an NRSRO that
provides an external rating to an ABCP program's commercial paper
changes its methodology, the bank must evaluate whether to revise its
internal assessment process.
Moreover, the bank must have an effective system of controls and
oversight that ensures compliance with these operational requirements
and maintains the integrity and accuracy of the internal credit
assessments. The bank must also have an internal audit function
independent from the ABCP program business line and internal credit
assessment process that assesses at least annually whether the controls
over the internal credit assessment process function as intended. The
bank must review and update each internal credit assessment whenever
new material information is available, but no less frequently than
annually. The bank must also validate its internal credit assessment
process on an ongoing basis, but not less frequently than annually.
Under the proposed rule, in order for a bank to use the IAA on a
specific exposure to an ABCP program, the program had to satisfy the
following requirements:
(i) All commercial paper issued by the ABCP program must have an
external rating.
[[Page 69366]]
(ii) The ABCP program must have robust credit and investment
guidelines (underwriting standards).
(iii) The ABCP program must perform a detailed credit analysis of
the asset sellers' risk profiles.
(iv) The ABCP program's underwriting policy must establish minimum
asset eligibility criteria that include a prohibition of the purchase
of assets that are significantly past due or defaulted, as well as
limitations on concentrations to an individual obligor or geographic
area and the tenor of the assets to be purchased.
(v) The aggregate estimate of loss on an asset pool that the ABCP
program is considering purchasing must consider all sources of
potential risk, such as credit and dilution risk.
(vi) The ABCP program must incorporate structural features into
each purchase of assets to mitigate potential credit deterioration of
the underlying exposures. Such features may include wind-down triggers
specific to a pool of underlying exposures.
Commenters suggested that the program-level eligibility criteria
should apply only to those elements of the ABCP program that are
relevant to the securitization exposure held by the bank in order to
prevent an ABCP program's purchase of a single asset pool that does not
meet the above criteria from disallowing the IAA for securitization
exposures to that program that are unrelated to the non-qualifying
asset pool. The agencies agree that this is a reasonable approach.
Accordingly, the final rule applies criteria (ii) through (vi) to the
exposures underlying a securitization exposure, rather than to the
entire ABCP program. For a program-wide credit enhancement facility,
all of the separate seller-specific arrangements benefiting from that
facility must meet the above requirements for the facility to be
eligible for the IAA.
Several commenters objected to the requirement that the ABCP
program prohibit purchases of significantly past-due or defaulted
assets. Commenters contended that such purchases should be allowed so
long as the applicable NRSRO rating criteria permit and deal
appropriately with such assets. Like the New Accord, the final rule
prohibits the ABCP program from purchasing significantly past-due or
defaulted assets in order to ensure that the IAA is applied only to
securitization exposures that are relatively low-risk at inception.
This criterion would be met if the ABCP program does not fund
underlying assets that are significantly past due or defaulted when
placed into the program (that is, the program's advance rate against
such assets is 0 percent) and the securitization exposure is not
subject to potential losses associated with these assets. The agencies
observe that the rule does not set a specific number-of-days-past due
criterion. In addition, the term `defaulted assets' in criterion (iv)
does not refer to the wholesale and retail definitions of default in
the final rule, but rather may be interpreted as referring to assets
that have been charged off or written down by the seller prior to being
placed into the ABCP program or to assets that would be charged off or
written down under the program's governing contracts.
In addition, commenters asked the agencies to clarify that a bank
may ignore one or more of the eligibility requirements where the
requirement is not relevant to a particular exposure. For example, in
the case of a liquidity facility supporting a static pool of term
loans, it may not be possible to incorporate features into the
transaction that mitigate against a potential deterioration in these
assets, and there may be no use for detailed credit analyses of the
seller following the securitization if the seller has no further
involvement with the transaction. The agencies have modified the final
criterion for determining whether an exposure qualifies for the IAA, to
specify that where relevant, the ABCP program must incorporate
structural features into each purchase of exposures underlying the
securitization exposure to mitigate potential credit deterioration of
the underlying exposures.
4. Supervisory Formula Approach (SFA)
General Requirements
Under the proposed rule, a bank using the SFA would determine the
risk-weighted asset amount for a securitization exposure by multiplying
the SFA risk-based capital requirement for the exposure (as determined
by the supervisory formula set forth below) by 12.5. If the SFA risk
weight for a securitization exposure was 1,250 percent or greater,
however, the bank would deduct the exposure from total capital rather
than risk weight the exposure. The agencies noted that deduction is
consistent with the treatment of other high-risk securitization
exposures, such as CEIOs.
The SFA capital requirement for a securitization exposure depends
on the following seven inputs:
(i) The amount of the underlying exposures (UE);
(ii) The securitization exposure's proportion of the tranche that
contains the securitization exposure (TP);
(iii) The sum of the risk-based capital requirement and ECL for the
underlying exposures (as determined under the final rule as if the
underlying exposures were held directly on the bank's balance sheet)
divided by the amount of the underlying exposures (KIRB);
(iv) The tranche's credit enhancement level (L);
(v) The tranche's thickness (T);
(vi) The securitization's effective number of underlying exposures
(N); and
(vii) The securitization's exposure-weighted average loss given
default (EWALGD).
A bank may only use the SFA to determine its risk-based capital
requirement for a securitization exposure if the bank can calculate
each of these seven inputs on an ongoing basis. In particular, if a
bank cannot compute KIRB because the bank cannot compute the
risk-based capital requirement for all underlying exposures, the bank
may not use the SFA to compute its risk-based capital requirement for
the securitization exposure. In those cases, the bank must deduct the
exposure from regulatory capital.
The SFA capital requirement for a securitization exposure is UE
multiplied by TP multiplied by the greater of (i) 0.0056 * T; or (ii)
S[L+T] - S[L], where:
[[Page 69367]]
[GRAPHIC] [TIFF OMITTED] TR07DE07.008
In these expressions, [beta][Y; a, b] refers to the cumulative beta
distribution with parameters a and b evaluated at Y. In the case where
N = 1 and EWALGD = 100 percent, S[Y] in formula (1) must be calculated
with K[Y] set equal to the product of KIRB and Y, and d set
equal to 1-KIRB. The major inputs to the SFA formula (UE,
TP, KIRB, L, T, EWALGD, and N) are defined below and in
section 45 of the final rule.
The agencies are modifying the SFA treatment of certain high risk
securitization exposures in the final rule. Under the proposed
treatment described above, a bank would have to deduct from total
capital any securitization exposure with a SFA risk weight equal to
1,250 percent. Under certain circumstances, however, a slight increase
in the thickness of the tranche that contains the securitization
exposure (T), holding other SFA risk parameters fixed, could cause the
exposure's SFA risk-weight to fall below 1,250 percent. As a result,
the bank would not deduct any part of the exposure from capital and
would, instead, reflect the entire amount of the SFA risk-based capital
requirement in its risk-weighted assets. Consistent with the New
Accord,\97\ the agencies have removed this anomaly from the final rule.
Under the final rule a bank must deduct from total capital any part of
a securitization exposure that incurs a 1,250 percent risk weight under
the SFA (that is, any part of a securitization exposure covering loss
rates on the underlying assets between zero and KIRB). Any
part of a securitization exposure that incurs less than a 1,250 percent
risk weight must be risk weighted rather than deducted.
---------------------------------------------------------------------------
\97\ New Accord, Annex 7.
---------------------------------------------------------------------------
To illustrate, suppose that an exposure's SFA capital requirement
equaled $15, and UE, TP, KIRB, and L equaled $1000, 1.0,
0.10, and 0.095, respectively. The bank must deduct from total capital
$5 (UE x TP x (KIRB -L)), and the exposure's risk-weighted
asset amount would be $125 (($15-$5) x 12.5).
The specific securitization exposures that are subject to this
deduction treatment under the SFA may change over time in response to
variations in the credit quality of the underlying exposures. For
example, if the pool's IRB capital requirement were to increase after
the inception of a securitization, additional portions of unrated
securitization exposures may fall below KIRB and thus become
subject to deduction under the SFA. Therefore, if at the inception of a
securitization a bank owns an unrated securitization exposure well in
excess of KIRB, the capital requirement on the exposure
could climb rapidly in the event of marked deterioration in the credit
quality of the underlying exposures and
[[Page 69368]]
the bank may be required to deduct the exposure.
The SFA formula effectively imposes a 56 basis point minimum risk-
based capital requirement (8 percent of the 7 percent risk weight) per
dollar of securitization exposure. Although such a floor may impose a
capital requirement that is too high for some securitization exposures,
the agencies continue to believe that some minimum prudential capital
requirement is appropriate in the securitization context. This 7
percent risk-weight floor is also consistent with the lowest capital
requirement available under the RBA and, thus, should reduce incentives
for regulatory capital arbitrage.
The SFA formula is a blend of credit risk modeling results and
supervisory judgment. The function S[Y] incorporates two distinct
features. The first is a pure model-based estimate of the pool's
aggregate systematic or non-diversifiable credit risk that is
attributable to a first loss position covering losses up to and
including Y. Because the tranche of interest covers losses over a
specified range (defined in terms of L and T), the tranche's systematic
risk can be represented as S[L+T] - S[L]. The second feature involves a
supervisory add-on primarily intended to avoid behavioral distortions
associated with what would otherwise be a discontinuity in capital
requirements for relatively thin mezzanine tranches lying just below
and just above the KIRB boundary. Without this add-on, all
tranches at or below KIRB would be deducted from capital,
whereas a very thin tranche just above KIRB would incur a
pure model-based percentage capital requirement that could vary between
zero and one, depending on the number of effective underlying exposures
(N). The supervisory add-on applies primarily to positions just above
KIRB, and its quantitative effect diminishes rapidly as the
distance from KIRB widens.
Apart from the risk-weight floor and other supervisory adjustments
described above, the supervisory formula attempts to be as consistent
as possible with the parameters and assumptions of the IRB approach
that would apply to the underlying exposures if held directly by a
bank.\98\ The specification of S[Y] assumes that KIRB is an
accurate measure of the total systematic credit risk of the pool of
underlying exposures and that a securitization merely redistributes
this systematic risk among its various tranches. In this way, S[Y]
embodies precisely the same asset correlations as are assumed elsewhere
within the IRB approach. In addition, this specification embodies the
result that a pool's systematic risk (KIRB) tends to be
redistributed toward more senior tranches as N declines.\99\ The
importance of pool granularity depends on the pool's average loss
severity rate, EWALGD. For small values of N, the framework implies
that, as EWALGD increases, systematic risk is shifted toward senior
tranches. For highly granular pools, such as securitizations of retail
exposures, EWALGD would have no influence on the SFA capital
requirement.
---------------------------------------------------------------------------
\98\ The conceptual basis for specification of K[x] is developed
in Michael B. Gordy and David Jones, ``Random Tranches,'' Risk
(March 2003), 16(3), 78-83.
\99\ See Michael Pykhtin and Ashish Dev, ``Coarse-grained
CDOs,'' Risk (January 2003), 16(1), 113-116.
---------------------------------------------------------------------------
Inputs to the SFA Formula
Consistent with the proposal, the final rule defines the seven
inputs into the SFA formula as follows:
(i) Amount of the underlying exposures (UE). This input (measured
in dollars) is the EAD of any underlying wholesale and retail exposures
plus the amount of any underlying exposures that are securitization
exposures (as defined in section 42(e) of the proposed rule) plus the
adjusted carrying value of any underlying equity exposures (as defined
in section 51(b) of the proposed rule). UE also includes any funded
spread accounts, cash collateral accounts, and other similar funded
credit enhancements.
(ii) Tranche percentage (TP). TP is the ratio of (i) the amount of
the bank's securitization exposure to (ii) the amount of the
securitization tranche that contains the bank's securitization
exposure.
(iii) KIRB. KIRB is the ratio of (i) the risk-based
capital requirement for the underlying exposures plus the ECL of the
underlying exposures (all as determined as if the underlying exposures
were directly held by the bank) to (ii) UE. The definition of
KIRB includes the ECL of the underlying exposures in the
numerator because if the bank held the underlying exposures on its
balance sheet, the bank also would hold reserves against the exposures.
The calculation of KIRB must reflect the effects of any
credit risk mitigant applied to the underlying exposures (either to an
individual underlying exposure, a group of underlying exposures, or to
the entire pool of underlying exposures). In addition, all assets
related to the securitization must be treated as underlying exposures
for purposes of the SFA, including assets in a reserve account (such as
a cash collateral account).
In practice, a bank's ability to calculate KIRB will
often determine whether it can use the SFA or whether it must instead
deduct an unrated securitization exposure from total capital. As noted
above, there is a need for flexibility when the estimation of
KIRB is constrained by data shortcomings, such as when the
bank holding the securitization exposure is not the servicer of the
underlying assets. The final rule clarifies that the simplified
approach for eligible purchased wholesale exposures (Section 31) may be
used for calculating KIRB.
To reduce the operational burden of estimating KIRB,
several commenters urged the agencies to develop a simple look-through
approach such that when all of the assets held by the SPE are
externally rated, KIRB could be determined directly from the
external ratings of theses assets. The agencies believe that a look-
through approach for estimating KIRB would be inconsistent
with the New Accord and would increase the potential for capital
arbitrage. The agencies note that several simplified methods for
estimating risk-weighted assets for the underlying exposures for the
purposes of computing KIRB are provided in other parts of
the framework. For example, the simplified approach for eligible
purchased wholesale exposures in section 31 may be available when a
bank can estimate risk parameters for segments of underlying wholesale
exposures but not for each of the individual exposures. If the assets
held by the SPE are securitization exposures with external ratings, the
RBA would be used to determine risk-weighted assets for the underlying
exposures based on these ratings. If the assets held by the SPE
represent shares in an investment company (that is, unleveraged, pro
rata ownership interests in a pool of financial assets), the bank may
be eligible to determine risk-weighted assets for the underlying
exposures using the Alternative Modified Look-Through Approach of
Section 54 (d) based on investment limits specified in the program's
prospectus or similar documentation.
(iv) Credit enhancement level (L). L is the ratio of (i) the amount
of all securitization exposures subordinated to the securitization
tranche that contains the bank's securitization exposure to (ii) UE.
Banks must determine L before considering the effects of any tranche-
specific credit enhancements (such as third-party guarantees that
benefit only a single tranche). Any after-tax gain-on-
[[Page 69369]]
sale or CEIOs associated with the securitization may not be included in
L.
Any reserve account funded by accumulated cash flows from the
underlying exposures that is subordinated to the tranche that contains
the bank's securitization exposure may be included in the numerator and
denominator of L to the extent cash has accumulated in the account.
Unfunded reserve accounts (reserve accounts that are to be funded from
future cash flows from the underlying exposures) may not be included in
the calculation of L.
In some cases, the purchase price of receivables will reflect a
discount that provides credit enhancement (for example, first loss
protection) for all or certain tranches. When this arises, L should be
calculated inclusive of this discount if the discount provides credit
enhancement for the securitization exposure.
(v) Thickness of tranche (T). T is the ratio of (i) the size of the
tranche that contains the bank's securitization exposure to (ii) UE.
(vi) Effective number of exposures (N). As a general matter, the
effective number of exposures is calculated as follows:
[GRAPHIC] [TIFF OMITTED] TR07DE07.009
where EADi represents the EAD associated with the
ith instrument in the pool of underlying exposures. For
purposes of computing N, multiple exposures to one obligor must be
treated as a single underlying exposure. In the case of a re-
securitization (a securitization in which some or all of the underlying
exposures are themselves securitization exposures), a bank must treat
each underlying securitization exposure as a single exposure and must
not look through to the exposures that secure the underlying
securitization exposures.
N represents the granularity of a pool of underlying exposures
using an ``effective'' number of exposures concept rather than a
``gross'' number of exposures concept to appropriately assess the
diversification of pools that have individual underlying exposures of
different sizes. An approach that simply counts the gross number of
underlying exposures in a pool treats all exposures in the pool
equally. This simplifying assumption could radically overestimate the
granularity of a pool with numerous small exposures and one very large
exposure. The effective exposure approach captures the notion that the
risk profile of such an unbalanced pool is more like a pool of several
medium-sized exposures than like a pool of a large number of equally
sized small exposures.
For example, suppose Pool A contains four loans with EADs of $100
each. Under the formula set forth above, N for Pool A would be four,
precisely equal to the actual number of exposures. Suppose Pool B also
contains four loans: One loan with an EAD of $100 and three loans with
an EAD of $1. Although both pools contain four loans, Pool B is much
less diverse and granular than Pool A because Pool B is dominated by
the presence of a single $100 loan. Intuitively, therefore, N for Pool
B should be closer to one than to four. Under the formula in the rule,
N for Pool B is calculated as follows:
[GRAPHIC] [TIFF OMITTED] TR07DE07.010
As noted above, when calculating N for a re-securitization, a bank
must treat each underlying securitization exposure as an exposure to a
single obligor. This conservative treatment addresses the concern that
AVCs among securitization exposures can be much greater than the AVCs
among the underlying individual assets securing these securitization
exposures. Because the framework's simple approach to re-
securitizations may result in the differential treatment of
economically similar securitization exposures, the agencies sought
comment on alternative approaches for determining the N of a re-
securitization. While a number of commenters urged that a bank be
permitted to calculate N for re-securitizations of asset-backed
securities by looking through to the underlying pools of assets
securing these securities, none provided theoretical or empirical
evidence to support this recommendation. Absent such evidence, the
final rule remains consistent with New Accord's measurement of N for
re-securitizations.
(vii) Exposure-weighted average loss given default (EWALGD). The
EWALGD is calculated as:
[GRAPHIC] [TIFF OMITTED] TR07DE07.011
where LGDi represents the average LGD associated with all
exposures to the i\th\ obligor. In the case of a re-securitization, an
LGD of 100 percent must be assumed for any underlying exposure that is
a securitization exposure.
Although this treatment of EWALGD is consistent with the New
Accord, several commenters asserted that assigning an LGD of 100
percent to all securitization exposures in the underlying pool was
excessively conservative, particularly for underlying exposures that
are senior, highly rated asset-backed securities. The agencies
acknowledge that in many situations an LGD significantly lower than 100
percent may be appropriate. However, determination of the appropriate
LGD depends on many complex factors, including the characteristics of
the underlying assets and structural features of the securitization,
such as the securitization exposure's thickness. Moreover, for thin
securitization exposures or certain mezzanine positions backed by low-
quality assets, the LGD may in fact be close to 100 percent. In this
light, the agencies believe that any simple alternative to the New
Accord's measurement of EWALGD would increase the potential for capital
arbitrage, and any more risk-sensitive alternative would take
considerable time to develop. Thus, the agencies have retained the
proposed treatment, consistent with the New Accord.
Under certain conditions, a bank may employ the following
simplifications to the SFA. First, for securitizations all of whose
underlying exposures are retail exposures, a bank may set h=0 and v=0.
In addition, if the share of a securitization corresponding to the
largest underlying exposure (C1) is no more than 0.03 (or 3
percent of the underlying exposures), then for purposes of the SFA the
bank may set N equal to the following amount:
[GRAPHIC] [TIFF OMITTED] TR07DE07.012
[[Page 69370]]
where Cm is the ratio of (i) the sum of the amounts of the
largest ``m'' underlying exposures of the securitization; to (ii) UE. A
bank may select the level of ``m'' using its discretion. For example,
if the three largest underlying exposures of a securitization represent
15 percent of the pool of underlying exposures, C3 for the
securitization is 0.15. As an alternative simplification option, if
only C1 is available, and C1 is no more than
0.03, then the bank may set N=1/C1. Under both
simplification options a bank may set EWALGD=0.50 unless one or more of
the underlying exposures is a securitization exposure. If one or more
of the underlying exposures is a securitization exposure, a bank using
a simplification option must set EWALGD=1.
5. Eligible Market Disruption Liquidity Facilities
Under the proposed SFA, there was no special treatment provided for
ABCP liquidity facilities that could be drawn upon only during periods
of general market disruption. In contrast, the New Accord provides a
more favorable capital treatment within the SFA for eligible market
disruption liquidity facilities than for other liquidity facilities.
Under the New Accord, an eligible market disruption liquidity facility
is a liquidity facility that supports an ABCP program and that (i) is
subject to an asset quality test that precludes funding of underlying
exposures that are in default; (ii) can be used to fund only those
exposures that have an investment-grade external rating at the time of
funding, if the underlying exposures that the facility must fund
against are externally rated exposures at the time that the exposures
are sold to the program; and (iii) may only be drawn in the event of a
general market disruption.
The agencies sought comment on the prevalence of eligible market
disruption liquidity facilities that might be subject to the SFA and,
by implication, whether the final rule should incorporate the treatment
provided in the New Accord. Commenters responded that eligible market
disruption liquidity facilities currently are not a material product
line for U.S. banks, but urged international consistency in this area.
To limit additional complexity in the final rule, and because U.S.
banks have limited exposure to eligible market disruption liquidity
facilities, the agencies are not including a separate treatment of
eligible market disruption liquidity facilities in the final rule. The
agencies believe that the final rule provides adequate flexibility to
determine an appropriate capital requirement for market disruption
liquidity facilities.
6. CRM for Securitization Exposures
The treatment of CRM for securitization exposures differs from that
applicable to wholesale and retail exposures, and is largely unchanged
from the proposal. An originating bank that has obtained a credit risk
mitigant to hedge its securitization exposure to a synthetic or
traditional securitization that satisfies the operational criteria in
section 41 of the final rule may recognize the credit risk mitigant,
but only as provided in section 46 of the final rule. An investing bank
that has obtained a credit risk mitigant to hedge a securitization
exposure also may recognize the credit risk mitigant, but only as
provided in section 46. A bank that has used the RBA or IAA to
calculate its risk-based capital requirement for a securitization
exposure whose external or inferred rating (or equivalent internal
rating under the IAA) reflects the benefits of a particular credit risk
mitigant provided to the associated securitization or that supports
some or all of the underlying exposures, however, may not use the
securitization credit risk mitigation rules to further reduce its risk-
based capital requirement for the exposure based on that credit risk
mitigant. For example, a bank that owns a AAA-rated asset-backed
security that benefits from an insurance wrap that is part of the
securitization transaction must calculate its risk-based capital
requirement for the security strictly under the RBA. No additional
credit is given for the presence of the insurance wrap. On the other
hand, if a bank owns a BBB-rated asset-backed security and obtains a
credit default swap from a AAA-rated counterparty to protect the bank
from losses on the security, the bank would be able to apply the
securitization CRM rules to recognize the risk mitigating effects of
the credit default swap and determine the risk-based capital
requirement for the position.
As under the proposal, the final rule contains a treatment of CRM
for securitization exposures separate from the treatment for wholesale
and retail exposures because the wholesale and retail exposure CRM
approaches rely on substitutions of, or adjustments to, the risk
parameters of the hedged exposure. Because the securitization framework
does not rely on risk parameters to determine risk-based capital
requirements for securitization exposures, a different treatment of CRM
for securitization exposures is necessary.
The securitization CRM rules, like the wholesale and retail CRM
rules, address collateral separately from guarantees and credit
derivatives. A bank is not permitted to recognize collateral other than
financial collateral as a credit risk mitigant for securitization
exposures. A bank may recognize financial collateral in determining the
bank's risk-based capital requirement for a securitization exposure
that is not a repo-style transaction, an eligible margin loan, or an
OTC derivative for which the bank has reflected collateral in its
determination of exposure amount under section 32 of the rule by using
a collateral haircut approach. The bank's risk-based capital
requirement for a collateralized securitization exposure is equal to
the risk-based capital requirement for the securitization exposure as
calculated under the RBA or the SFA multiplied by the ratio of adjusted
exposure amount (SE*) to original exposure amount (SE),
Where:
(i) SE* = max {0, [SE-C x (1-Hs-Hfx)]{time} ;
(ii) SE = the amount of the securitization exposure (as calculated
under section 42(e) of the rule);
(iii) C = the current market value of the collateral;
(iv) Hs = the haircut appropriate to the collateral type; and
(v) Hfx = the haircut appropriate for any currency mismatch between
the collateral and the exposure.
Where the collateral is a basket of different asset types or a basket
of assets denominated in different currencies, the haircut on the
basket is
[GRAPHIC] [TIFF OMITTED] TR07DE07.022
,where ai is the current market value of the asset in the
basket divided by the current market value of all assets in the basket
and Hi is the haircut applicable to that asset.
With the prior written approval of its primary Federal supervisor,
a bank may calculate haircuts using its own internal estimates of
market price volatility and foreign exchange volatility, subject to the
requirements for use of own-estimates haircuts contained in section 32
of the rule. Banks that use own-estimates haircuts for collateralized
securitization exposures must assume a minimum holding period
(TM) for securitization exposures of 65 business days.
A bank that does not qualify for and use own-estimates haircuts
must use the collateral type haircuts (Hs) in Table 3 of the final rule
and must use a currency mismatch haircut (Hfx) of 8 percent if the
exposure and the collateral are denominated in different currencies. To
[[Page 69371]]
reflect the longer-term nature of securitization exposures as compared
to securities financing transactions, however, these standard
supervisory haircuts (which are based on a ten-business-day holding
period and daily marking-to-market and remargining) must be adjusted to
a 65-business-day holding period (the approximate number of business
days in a calendar quarter) by multiplying them by the square root of
6.5 (2.549510). A bank also must adjust the standard supervisory
haircuts upward on the basis of a holding period longer than 65
business days where and as appropriate to take into account the
illiquidity of the collateral.
A bank may only recognize an eligible guarantee or eligible credit
derivative provided by an eligible securitization guarantor in
determining the bank's risk-based capital requirement for a
securitization exposure. The definitions of eligible guarantee and
eligible credit derivative apply to both the wholesale and retail
frameworks and the securitization framework. An eligible securitization
guarantor is defined to mean (i) a sovereign entity, the Bank for
International Settlements, the International Monetary Fund, the
European Central Bank, the European Commission, a Federal Home Loan
Bank, the Federal Agricultural Mortgage Corporation (Farmer Mac), a
multilateral development bank, a depository institution (as defined in
section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813)), a
bank holding company (as defined in section 2 of the Bank Holding
Company Act (12 U.S.C. 1841)), a savings and loan holding company (as
defined in 12 U.S.C. 1467a) provided all or substantially all of the
holding company's activities are permissible for a financial holding
company under 12 U.S.C. 1843(k)), a foreign bank (as defined in section
211.2 of the Federal Reserve Board's Regulation K (12 CFR 211.2)), or a
securities firm; (ii) any other entity (other than a securitization
SPE) that has issued and outstanding an unsecured long-term debt
security without credit enhancement that has a long-term applicable
external rating in one of the three highest investment-grade rating
categories; or (iii) any other entity (other than a securitization SPE)
that has a PD assigned by the bank that is lower than or equivalent to
the PD associated with a long-term external rating in the third-highest
investment-grade rating category.
A bank must use the following procedures if the bank chooses to
recognize an eligible guarantee or eligible credit derivative provided
by an eligible securitization guarantor in determining the bank's risk-
based capital requirement for a securitization exposure. If the
protection amount of the eligible guarantee or eligible credit
derivative equals or exceeds the amount of the securitization exposure,
the bank must set the risk-weighted asset amount for the securitization
exposure equal to the risk-weighted asset amount for a direct exposure
to the eligible securitization guarantor (as determined in the
wholesale risk weight function described in section 31 of the final
rule), using the bank's PD for the guarantor, the bank's LGD for the
guarantee or credit derivative, and an EAD equal to the amount of the
securitization exposure (as determined in section 42(e) of the final
rule).
If the protection amount of the eligible guarantee or eligible
credit derivative is less than the amount of the securitization
exposure, the bank must divide the securitization exposure into two
exposures in order to recognize the guarantee or credit derivative. The
risk-weighted asset amount for the securitization exposure is equal to
the sum of the risk-weighted asset amount for the covered portion and
the risk-weighted asset amount for the uncovered portion. The risk-
weighted asset amount for the covered portion is equal to the risk-
weighted asset amount for a direct exposure to the eligible
securitization guarantor (as determined in the wholesale risk weight
function described in section 31 of the rule), using the bank's PD for
the guarantor, the bank's LGD for the guarantee or credit derivative,
and an EAD equal to the protection amount of the credit risk mitigant.
The risk-weighted asset amount for the uncovered portion is equal to
the product of (i) 1.0 minus the ratio of the protection amount of the
eligible guarantee or eligible credit derivative divided by the amount
of the securitization exposure; and (ii) the risk-weighted asset amount
for the securitization exposure without the credit risk mitigant (as
determined in sections 42-45 of the final rule).
For any hedged securitization exposure, the bank must make
applicable adjustments to the protection amount as required by the
maturity mismatch, currency mismatch, and lack of restructuring
provisions in paragraphs (d), (e), and (f) of section 33 of the final
rule. The agencies have clarified in the final rule that the mismatch
provisions apply to any hedged securitization exposure and any more
senior securitization exposure that benefits from the hedge. In the
context of a synthetic securitization, when an eligible guarantee or
eligible credit derivative covers multiple hedged exposures that have
different residual maturities, the bank must use the longest residual
maturity of any of the hedged exposures as the residual maturity of all
the hedged exposures. If the risk-weighted asset amount for a
guaranteed securitization exposure is greater than the risk-weighted
asset amount for the securitization exposure without the guarantee or
credit derivative, a bank may elect not to recognize the guarantee or
credit derivative.
When a bank recognizes an eligible guarantee or eligible credit
derivative provided by an eligible securitization guarantor in
determining the bank's risk-based capital requirement for a
securitization exposure, the bank also must (i) calculate ECL for the
protected portion of the exposure using the same risk parameters that
it uses for calculating the risk-weighted asset amount of the exposure
(that is, the PD associated with the guarantor's rating grade, the LGD
of the guarantee, and an EAD equal to the protection amount of the
credit risk mitigant); and (ii) add this ECL to the bank's total ECL.
7. Synthetic Securitizations
Background
In a synthetic securitization, an originating bank uses credit
derivatives or guarantees to transfer the credit risk, in whole or in
part, of one or more underlying exposures to third-party protection
providers. The credit derivative or guarantee may be either
collateralized or uncollateralized. In the typical synthetic
securitization, the underlying exposures remain on the balance sheet of
the originating bank, but a portion of the originating bank's credit
exposure is transferred to the protection provider or covered by
collateral pledged by the protection provider.
In general, the final rule's treatment of synthetic securitizations
is identical to that of traditional securitizations and to that
described in the proposal. The operational requirements for synthetic
securitizations are more detailed than those for traditional
securitizations and are intended to ensure that the originating bank
has truly transferred credit risk of the underlying exposures to one or
more third-party protection providers.
Although synthetic securitizations typically employ credit
derivatives, which might suggest that such transactions would be
subject to the CRM rules in section 33 of the final rule, banks must
apply the securitization framework when calculating risk-based capital
requirements for a synthetic
[[Page 69372]]
securitization exposure. Banks may ultimately be redirected to the
securitization CRM rules to adjust the securitization framework capital
requirement for an exposure to reflect the CRM technique used in the
transaction.
Operational Requirements for Synthetic Securitizations
For synthetic securitizations, an originating bank may recognize
for risk-based capital purposes the use of CRM to hedge, or transfer
credit risk associated with, underlying exposures only if each of the
following conditions is satisfied:
(i) The credit risk mitigant is financial collateral, an eligible
credit derivative from an eligible securitization guarantor (defined
above), or an eligible guarantee from an eligible securitization
guarantor.
(ii) The bank transfers credit risk associated with the underlying
exposures to third-party investors, and the terms and conditions in the
credit risk mitigants employed do not include provisions that:
(A) Allow for the termination of the credit protection due to
deterioration in the credit quality of the underlying exposures;
(B) Require the bank to alter or replace the underlying exposures
to improve the credit quality of the underlying exposures;
(C) Increase the bank's cost of credit protection in response to
deterioration in the credit quality of the underlying exposures;
(D) Increase the yield payable to parties other than the bank in
response to a deterioration in the credit quality of the underlying
exposures; or
(E) Provide for increases in a retained first loss position or
credit enhancement provided by the bank after the inception of the
securitization.
(iii) The bank obtains a well-reasoned opinion from legal counsel
that confirms the enforceability of the credit risk mitigant in all
relevant jurisdictions.
(iv) Any clean-up calls relating to the securitization are eligible
clean-up calls (as discussed above).
Failure to meet the above operational requirements for a synthetic
securitization prevents the originating bank from using the
securitization framework and requires the originating bank to hold
risk-based capital against the underlying exposures as if they had not
been synthetically securitized. A bank that provides credit protection
to a synthetic securitization must use the securitization framework to
compute risk-based capital requirements for its exposures to the
synthetic securitization even if the originating bank failed to meet
one or more of the operational requirements for a synthetic
securitization.
Consistent with the treatment of traditional securitization
exposures, a bank must use the RBA for synthetic securitization
exposures that have an appropriate number of external or inferred
ratings. For an originating bank, the RBA will typically be used only
for the most senior tranche of the securitization, which often has an
inferred rating. If a bank has a synthetic securitization exposure that
does not have an external or inferred rating, the bank must apply the
SFA to the exposure (if the bank and the exposure qualify for use of
the SFA) without considering any CRM obtained as part of the synthetic
securitization. Then, if the bank has obtained a credit risk mitigant
on the exposure as part of the synthetic securitization, the bank may
apply the securitization CRM rules to reduce its risk-based capital
requirement for the exposure. For example, if the credit risk mitigant
is financial collateral, the bank may use the standard supervisory or
own-estimates haircuts to reduce its risk-based capital requirement. If
the bank is a protection provider to a synthetic securitization and has
obtained a credit risk mitigant on its exposure, the bank may also
apply the securitization CRM rules in section 46 of the final rule to
reduce its risk-based capital requirement on the exposure. If neither
the RBA nor the SFA is available, a bank must deduct the exposure from
regulatory capital.
First-Loss Tranches
If a bank has a first-loss position in a pool of underlying
exposures in connection with a synthetic securitization, the bank must
deduct the position from regulatory capital unless (i) the position
qualifies for use of the RBA or (ii) the bank and the position qualify
for use of the SFA and KIRB is greater than L.
Mezzanine Tranches
In a typical synthetic securitization, an originating bank obtains
credit protection on a mezzanine, or second-loss, tranche of a
synthetic securitization by either (i) obtaining a credit default swap
or financial guarantee from a third-party financial institution; or
(ii) obtaining a credit default swap or financial guarantee from an SPE
whose obligations are secured by financial collateral.
For a bank that creates a synthetic mezzanine tranche by obtaining
an eligible credit derivative or guarantee from an eligible
securitization guarantor, the bank generally will treat the notional
amount of the credit derivative or guarantee (as adjusted to reflect
any maturity mismatch, lack of restructuring coverage, or currency
mismatch) as a wholesale exposure to the protection provider and use
the IRB approach for wholesale exposures to determine the bank's risk-
based capital requirement for the exposure. A bank that creates the
synthetic mezzanine tranche by obtaining from a non-eligible
securitization guarantor a guarantee or credit derivative that is
collateralized by financial collateral generally will (i) first use the
SFA to calculate the risk-based capital requirement on the exposure
(ignoring the guarantee or credit derivative and the associated
collateral); and (ii) then use the securitization CRM rules to
calculate any reductions to the risk-based capital requirement
resulting from the associated collateral. The bank may look only to the
protection provider from which it obtains the guarantee or credit
derivative when determining its risk-based capital requirement for the
exposure (that is, if the protection provider hedges the guarantee or
credit derivative with a guarantee or credit derivative from a third
party, the bank may not look through the protection provider to that
third party when calculating its risk-based capital requirement for the
exposure).
For a bank providing credit protection on a mezzanine tranche of a
synthetic securitization, the bank must use the RBA to determine the
risk-based capital requirement for the exposure if the exposure has an
external or inferred rating. If the exposure does not have an external
or inferred rating and the exposure qualifies for use of the SFA, the
bank may use the SFA to calculate the risk-based capital requirement
for the exposure. If neither the RBA nor the SFA are available, the
bank must deduct the exposure from regulatory capital. If a bank
providing credit protection on the mezzanine tranche of a synthetic
securitization obtains a credit risk mitigant to hedge its exposure,
the bank may apply the securitization CRM rules to reflect the risk
reduction achieved by the credit risk mitigant.
Super-Senior Tranches
A bank that has the most senior position in a pool of underlying
exposures in connection with a synthetic securitization must use the
RBA to calculate its risk-based capital requirement for the exposure if
the exposure has at least one external or inferred rating (in the case
of an investing bank) or at least two external or inferred ratings (in
the case of an
[[Page 69373]]
originating bank). If the super-senior tranche does not have an
external or inferred rating and the bank and the exposure qualify for
use of the SFA, the bank may use the SFA to calculate the risk-based
capital requirement for the exposure. If neither the RBA nor the SFA
are available, the bank must deduct the exposure from regulatory
capital. If an investing bank in the super-senior tranche of a
synthetic securitization obtains a credit risk mitigant to hedge its
exposure, however, the investing bank may apply the securitization CRM
rules to reflect the risk reduction achieved by the credit risk
mitigant.
8. N\th\-to-Default Credit Derivatives
Credit derivatives that provide credit protection only for the
n\th\ defaulting reference exposure in a group of reference exposures
(n\th\-to-default credit derivatives) are similar to synthetic
securitizations that provide credit protection only after the first-
loss tranche has defaulted or become a loss. A simplified treatment is
available to banks that purchase and provide such credit protection. A
bank that obtains credit protection on a group of underlying exposures
through a first-to-default credit derivative must determine its risk-
based capital requirement for the underlying exposures as if the bank
had synthetically securitized only the underlying exposure with the
lowest capital requirement and had obtained no credit risk mitigant on
the other (higher capital requirement) underlying exposures. If the
bank purchases credit protection on a group of underlying exposures
through an n\th\-to-default credit derivative (other than a first-to-
default credit derivative), it may only recognize the credit protection
for risk-based capital purposes either if it has obtained credit
protection on the same underlying exposures in the form of first-
through-(n-1)-to-default credit derivatives, or if n-1 of the
underlying exposures have already defaulted. In such a case, the bank
must again determine its risk-based capital requirement for the
underlying exposures as if the bank had only synthetically securitized
the n-1 underlying exposures with the lowest capital requirement and
had obtained no credit risk mitigant on the other underlying exposures.
A bank that provides credit protection on a group of underlying
exposures through a first-to-default credit derivative must determine
its risk-weighted asset amount for the derivative by applying the RBA
(if the derivative qualifies for the RBA) or, if the derivative does
not qualify for the RBA, by setting its risk-weighted asset amount for
the derivative equal to the product of (i) the protection amount of the
derivative; (ii) 12.5; and (iii) the sum of the risk-based capital
requirements of the individual underlying exposures, up to a maximum of
100 percent. If a bank provides credit protection on a group of
underlying exposures through an n\th\-to-default credit derivative
(other than a first-to-default credit derivative), the bank must
determine its risk-weighted asset amount for the derivative by applying
the RBA (if the derivative qualifies for the RBA) or, if the derivative
does not qualify for the RBA, by setting the risk-weighted asset amount
for the derivative equal to the product of (i) the protection amount of
the derivative; (ii) 12.5; and (iii) the sum of the risk-based capital
requirements of the individual underlying exposures (excluding the n-1
underlying exposures with the lowest risk-based capital requirements),
up to a maximum of 100 percent.
For example, a bank provides credit protection in the form of a
second-to-default credit derivative on a basket of five reference
exposures. The derivative is unrated and the protection amount of the
derivative is $100. The risk-based capital requirements of the
underlying exposures are 2.5 percent, 5.0 percent, 10.0 percent, 15.0
percent, and 20 percent. The risk-weighted asset amount of the
derivative would be $100 x 12.5 x (.05 + .10 + .15 + .20) or $625. If
the derivative were externally rated in the lowest investment-grade
rating category with a positive designation, the risk-weighted asset
amount would be $100 x 0.50 or $50.
9. Early Amortization Provisions
Background
Many securitizations of revolving credit facilities (for example,
credit card receivables) contain provisions that require the
securitization to be wound down and investors to be repaid if the
excess spread falls below a certain threshold.\100\ This decrease in
excess spread may, in some cases, be caused by deterioration in the
credit quality of the underlying exposures. An early amortization event
can increase a bank's capital needs if new draws on the revolving
credit facilities need to be financed by the bank using on-balance
sheet sources of funding. The payment allocations used to distribute
principal and finance charge collections during the amortization phase
of these transactions also can expose a bank to greater risk of loss
than in other securitization transactions. The final rule, consistent
with the proposed rule, assesses a risk-based capital requirement that,
in general, is linked to the likelihood of an early amortization event
to address the risks that early amortization of a securitization poses
to originating banks.
---------------------------------------------------------------------------
\100\ The final rule defines excess spread for a period as gross
finance charge collections and other income received by the
securitization SPE (including market interchange fees) over the
period minus interest paid to holders of securitization exposures,
servicing fees, charge-offs, and other senior trust similar expenses
of the securitization SPE over the period, divided by the principal
balance of the underlying exposures at the end of the period.
---------------------------------------------------------------------------
Consistent with the proposed rule, the final rule defines an early
amortization provision as a provision in a securitization's governing
documentation that, when triggered, causes investors in the
securitization exposures to be repaid before the original stated
maturity of the securitization exposure, unless the provision is solely
triggered by events not related to the performance of the underlying
exposures or the originating bank (such as material changes in tax laws
or regulations).
Under the proposed rule, a bank would not be required to hold
regulatory capital against the investors' interest if early
amortization is solely triggered by events not related to the
performance of the underlying exposures or the originating bank, such
as material changes in tax laws or regulation. Under the New Accord, a
bank is also not required to hold regulatory capital against the
investors' interest if (i) the securitization has a replenishment
structure in which the individual underlying exposures do not revolve
and the early amortization ends the ability of the originating bank to
add new underlying exposures to the securitization; (ii) the
securitization involves revolving assets and contains early
amortization features that mimic term structures; or (iii) investors in
the securitization remain fully exposed to future draws by borrowers on
the underlying exposures even after the occurrence of early
amortization. The agencies sought comment on the appropriateness of
these additional exemptions in the U.S. markets for revolving
securitizations. Most commenters asserted that the exemptions provided
in the New Accord are prudent and should be adopted by the agencies in
order to avoid placing U.S. banking organizations at a competitive
disadvantage relative to foreign competitors. The agencies generally
agree with this view of exemption (iii), above, and the definition of
early amortization provision in the final rule incorporates this
exemption. The
[[Page 69374]]
agencies have not included exemption (i) or (ii). The agencies do not
believe that the exemption for non-revolving exposures is meaningful
because the early amortization provisions apply only to securitizations
with revolving underlying exposures. The agencies also do not believe
that the exemption for early amortization features that mimic term
structures is meaningful in the U.S. market.
Under the final rule, as under the proposed rule, an originating
bank must generally hold risk-based capital against the sum of the
originating bank's interest and the investors' interest arising from a
securitization that contains an early amortization provision. An
originating bank must compute its capital requirement for its interest
using the hierarchy of approaches for securitization exposures as
described above. The originating bank's risk-weighted asset amount for
the investors' interest in the securitization is equal to the product
of the following five quantities: (i) The EAD associated with the
investors' interest; (ii) the appropriate CF as determined below; (iii)
KIRB; (iv) 12.5; and (v) the proportion of the underlying
exposures in which the borrower is permitted to vary the drawn amount
within an agreed limit under a line of credit. The agencies added (v)
to the final rule because, for securitizations containing both
revolving and non-revolving underlying exposures, only the revolving
underlying exposures give rise to the risk of early amortization.
Under the final rule, consistent with the proposal, the investors'
interest with respect to a revolving securitization captures both the
drawn balances and undrawn lines of the underlying exposures that are
allocated to the investors in the securitization. The EAD associated
with the investors' interest is equal to the EAD of the underlying
exposures multiplied by the ratio of:
(i) The total amount of securitization exposures issued by the
securitization SPE to investors; divided by
(ii) The outstanding principal amount of underlying exposures.
In general, the applicable CF depends on whether the early
amortization provision repays investors through a controlled or non-
controlled mechanism and whether the underlying exposures are revolving
retail credit facilities that are uncommitted (unconditionally
cancelable by the bank to the fullest extent of Federal law, such as
credit card receivables) or are other revolving credit facilities (for
example, revolving corporate credit facilities). Consistent with the
New Accord, under the proposed rule a controlled early amortization
provision would meet each of the following conditions:
(i) The originating bank has appropriate policies and procedures to
ensure that it has sufficient capital and liquidity available in the
event of an early amortization;
(ii) Throughout the duration of the securitization (including the
early amortization period) there is the same pro rata sharing of
interest, principal, expenses, losses, fees, recoveries, and other cash
flows from the underlying exposures, based on the originating bank's
and the investors' relative shares of the underlying exposures
outstanding measured on a consistent monthly basis;
(iii) The amortization period is sufficient for at least 90 percent
of the total underlying exposures outstanding at the beginning of the
early amortization period to have been repaid or recognized as in
default; and
(iv) The schedule for repayment of investor principal is not more
rapid than would be allowed by straight-line amortization over an 18-
month period.
An early amortization provision that does not meet any of the above
criteria is a non-controlled early amortization provision.
The agencies solicited comment on the distinction between
controlled and non-controlled early amortization provisions and on the
extent to which banks use controlled early amortization provisions. The
agencies also invited comment on the proposed definition of a
controlled early amortization provision, including in particular the
18-month period set forth above. Commenters generally believed that
very few, if any, revolving securitizations would meet the criteria
needed to qualify for treatment as a controlled early amortization
structure. One commenter maintained that a fixed 18-month straight-line
amortization period was too long for certain exposures, such as prime
credit cards.
The final rule is unchanged from the proposal with respect to
controlled and non-controlled early amortization provisions. The
agencies believe that the proposed eligibility criteria for a
controlled early amortization are important indicators of the risks to
which an originating bank would be exposed in the event of any early
amortization. While a fixed 18-month straight-line amortization period
is unlikely to be the most appropriate period in all cases, it is a
reasonable period for the vast majority of cases. The lower operational
burden of using a single, fixed amortization period warrants the
potential diminution in risk-sensitivity.
Controlled Early Amortization
Under the proposed rule, to calculate the appropriate CF for a
securitization of uncommitted revolving retail exposures that contains
a controlled early amortization provision, a bank would compare the
three-month average annualized excess spread for the securitization to
the point at which the bank is required to trap excess spread under the
securitization transaction. In securitizations that do not require
excess spread to be trapped, or that specify a trapping point based
primarily on performance measures other than the three-month average
annualized excess spread, the excess spread trapping point was 4.5
percent. The bank would divide the three-month average annualized
excess spread level by the excess spread trapping point and apply the
appropriate CF from Table H.
Table H.--Controlled Early Amortization Provisions
------------------------------------------------------------------------
Uncommitted Committed
------------------------------------------------------------------------
Retail Credit Lines............ Three-month average 90% CF
annualized excess
spread, Conversion
Factor (CF).
133.33% of trapping
point or more, 0% CF.
less than 133.33% to
100% of trapping
point, 1% CF.
less than 100% to 75%
of trapping point, 2%
CF.
less than 75% to 50%
of trapping point,
10% CF.
less than 50% to 25%
of trapping point,
20% CF less than 25%
of trapping point,
40% CF.
Non-retail Credit Lines........ 90% CF................ 90% CF
------------------------------------------------------------------------
[[Page 69375]]
A bank would apply a 90 percent CF for all other revolving
underlying exposures (committed exposures and nonretail exposures) in
securitizations containing a controlled early amortization provision.
The proposed CFs for uncommitted revolving retail credit lines were
much lower than for committed retail credit lines or for non-retail
credit lines because of the demonstrated ability of banks to monitor
and, when appropriate, to curtail promptly uncommitted retail credit
lines for customers of deteriorating credit quality. Such account
management tools are unavailable for committed lines, and banks may be
less proactive about using such tools in the case of uncommitted non-
retail credit lines owing to lender liability concerns and the
prominence of broad-based, longer-term customer relationships.
Non-controlled Early Amortization
Under the proposed rule, to calculate the appropriate CF for
securitizations of uncommitted revolving retail exposures that contain
a non-controlled early amortization provision, a bank would perform the
excess spread calculations described in the controlled early
amortization section above and then apply the CFs in Table I.
Table I.--Non-Controlled Early Amortization Provisions
------------------------------------------------------------------------
Uncommitted Committed
------------------------------------------------------------------------
Retail Credit Lines............ Three-month average 100% CF
annualized excess
spread, Conversion
Factor (CF).
133.33% of trapping
point or more, 0% CF.
less than 133.33% to
100% of trapping
point, 5% CF.
less than 100% to 75%
of trapping point,
15% CF.
less than 75% to 50%
of trapping point,
50% CF.
less than 50% of
trapping point, 100%
CF.
Non-retail Credit Lines........ 100% CF............... 100% CF
------------------------------------------------------------------------
A bank would use a 100 percent CF for all other revolving
underlying exposures (committed exposures and nonretail exposures) in
securitizations containing a non-controlled early amortization
provision. In other words, no risk transference would be recognized for
these transactions; an originating bank's IRB capital requirement would
be the same as if the underlying exposures had not been securitized.
A few commenters asserted that the proposed CFs were too high. The
agencies believe, however, that the proposed CFs appropriately capture
the risk to the bank of a potential early amortization event. The
agencies also believe that the proposed CFs, which are consistent with
the New Accord, foster consistency across national jurisdictions.
Therefore, the agencies are maintaining the proposed CFs in the final
rule with one exception, discussed below.
In circumstances where a securitization contains a mix of retail
and nonretail exposures or a mix of committed and uncommitted
exposures, a bank may take a pro rata approach to determining the CF
for the securitization's early amortization provision. If a pro rata
approach is not feasible, a bank must treat the securitization as a
securitization of nonretail exposures if a single underlying exposure
is a nonretail exposure and must treat the securitization as a
securitization of committed exposures if a single underlying exposure
is a committed exposure.
Securitizations of Revolving Residential Mortgage Exposures
The agencies sought comment on the appropriateness of the proposed
4.5 percent excess spread trapping point and on whether there were
other types and levels of early amortization triggers used in
securitizations of revolving retail exposures that should be addressed
by the agencies. Although some commenters believed the 4.5 percent
trapping point assumption was reasonable, others believed that it was
inappropriate for securitizations of HELOCs. Unlike credit card
securitizations, U.S. HELOC securitizations typically do not generate
material excess spread and typically are structured with credit
enhancements and early amortization triggers based on other factors,
such as portfolio loss rates. Under the proposed treatment, banks would
be required to hold capital against the potential early amortization of
most U.S. HELOC securitizations at their inception, rather than only if
the credit quality of the underlying exposures deteriorated. Although
the New Accord does not provide an alternative methodology, the
agencies concluded that the features of the U.S. HELOC securitization
market warrant an alternative approach. Accordingly, the final rule
allows a bank the option of applying either (i) the CFs in Tables I and
J, as appropriate, or (ii) a fixed CF equal to 10 percent to its
securitizations for which all or substantially all of the underlying
exposures are revolving residential mortgage exposures. If a bank
chooses the fixed CF of 10 percent, it must use that CF for all
securitizations for which all or substantially all of the underlying
exposures are revolving residential mortgage exposures. The agencies
will monitor the implementation of this alternative approach to ensure
that it is consistent with safety and soundness.
F. Equity Exposures
1. Introduction and Exposure Measurement
This section describes the final rule's risk-based capital
treatment for equity exposures. Consistent with the proposal, under the
final rule, a bank has the option to use either a simple risk-weight
approach (SRWA) or an internal models approach (IMA) for equity
exposures that are not exposures to an investment fund. A bank must use
a look-through approach for equity exposures to an investment fund.
Although the New Accord provides national supervisors the option to
provide a grandfathering period for equity exposures--whereby for a
maximum of ten years, supervisors could permit banks to exempt from the
IRB treatment equity investments held at the time of the publication of
the New Accord--the proposed rule did not include such a grandfathering
provision. A number of commenters asserted that the proposal was
inconsistent with the New Accord and would subject banks using the
agencies' advanced approaches to significant competitive inequity.
The agencies continue to believe that it is not appropriate or
necessary to incorporate the New Accord's optional ten-year
grandfathering period for equity exposures. The grandfathering concept
would reduce the risk
[[Page 69376]]
sensitivity of the SRWA and IMA. Moreover, the IRB approach does not
provide grandfathering for other types of exposures, and the agencies
see no compelling reason to do so for equity exposures. Further, the
agencies believe that the overall final rule approach to equity
exposures sufficiently mitigates potential competitive issues.
Accordingly, the final rule does not provide a grandfathering period
for equity exposures.
Under the proposed SRWA, a bank generally would assign a 300
percent risk weight to publicly traded equity exposures and a 400
percent risk weight to non-publicly traded equity exposures. Certain
equity exposures to sovereigns, multilateral institutions, and public
sector enterprises would have a risk weight of 0 percent, 20 percent,
or 100 percent; and certain community development equity exposures,
hedged equity exposures, and, up to certain limits, non-significant
equity exposures would receive a 100 percent risk weight.
Alternatively, under the proposed rule, a bank that met certain
minimum quantitative and qualitative requirements on an ongoing basis
and obtained the prior written approval of its primary Federal
supervisor could use the IMA to determine its risk-based capital
requirement for all modeled equity exposures. A bank that qualified to
use the IMA could apply the IMA to its publicly traded and non-publicly
traded equity exposures, or could apply the IMA only to its publicly
traded equity exposures. However, if the bank applied the IMA to its
publicly traded equity exposures, it would be required to apply the IMA
to all such exposures. Similarly, if a bank applied the IMA to both
publicly traded and non-publicly traded equity exposures, it would be
required to apply the IMA to all such exposures. If a bank did not
qualify to use the IMA, or elected not to use the IMA, to compute its
risk-based capital requirements for equity exposures, the bank would
apply the SRWA to assign risk weights to its equity exposures.
Several commenters objected to the proposed restrictions on the use
of the IMA. Commenters asserted that banks should be able to apply the
SRWA and the IMA for different portfolios or subsets of equity
exposures, provided that banks' choices are consistent with internal
risk management practices.
The agencies have not relaxed the proposed restrictions regarding
use of the SRWA and IMA. The agencies remain concerned that if banks
are permitted to employ either the SRWA or IMA to different equity
portfolios, banks could choose one approach over the other to
manipulate their risk-based capital requirements and not for risk
management purposes. In addition, because of concerns about lack of
transparency, it is not prudent to allow a bank to apply the IMA only
to its non-publicly traded equity exposures and not its publicly traded
equity exposures.
The proposed rule defined publicly traded to mean traded on (i) any
exchange registered with the SEC as a national securities exchange
under section 6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f)
or (ii) any non-U.S.-based securities exchange that is registered with,
or approved by, a national securities regulatory authority and that
provides a liquid, two-way market for the exposure (that is, there are
enough independent bona fide offers to buy and sell so that a sales
price reasonably related to the last sales price or current bona fide
competitive bid and offer quotations can be determined promptly and a
trade can be settled at such a price within five business days).
Several commenters explicitly supported the proposed definition of
publicly traded, noting that it is reasonable and consistent with
industry practice. Other commenters requested that the agencies revise
the proposed definition by eliminating the requirement that a non-U.S.-
based securities exchange provide a liquid, two-way market for the
exposure. Commenters asserted that this requirement goes beyond the
definition in the New Accord, which defines a publicly traded equity
exposure as any equity security traded on a recognized security
exchange. They asserted that registration with or approval by the
national securities regulatory authority should suffice, as
registration or approval generally would be predicated on the existence
of a two-way market.
The agencies have retained the definition of publicly traded as
proposed. The agencies believe that the liquid, two-way market
requirement is not in addition to the requirements of the New Accord.
Rather, this requirement clarifies the intent of ``traded'' in the New
Accord and helps to ensure that a sales price reasonably related to the
last sales price or competitive bid and offer quotations can be
determined promptly and settled within five business days.
A bank using either the IMA or the SRWA must determine the adjusted
carrying value for each equity exposure. The proposed rule defined the
adjusted carrying value of an equity exposure as:
(i) For the on-balance sheet component of an equity exposure, the
bank's carrying value of the exposure reduced by any unrealized gains
on the exposure that are reflected in such carrying value but excluded
from the bank's tier 1 and tier 2 capital; \101\ and
---------------------------------------------------------------------------
\101\ The potential downward adjustment to the carrying value of
an equity exposure reflects the fact that 100 percent of the
unrealized gains on available-for-sale equity exposures are included
in carrying value but only up to 45 percent of any such unrealized
gains are included in regulatory capital.
---------------------------------------------------------------------------
(ii) For the off-balance sheet component of an equity exposure, the
effective notional principal amount of the exposure, the size of which
is equivalent to a hypothetical on-balance sheet position in the
underlying equity instrument that would evidence the same change in
fair value (measured in dollars) for a given small change in the price
of the underlying equity instrument, minus the adjusted carrying value
of the on-balance sheet component of the exposure as calculated in (i).
Commenters generally supported the proposed definition of adjusted
carrying value and the agencies are adopting the definition as proposed
with one minor clarification regarding unfunded equity commitments
(discussed below).
The agencies created the definition of the effective notional
principal amount of the off-balance sheet portion of an equity exposure
to provide a uniform method for banks to measure the on-balance sheet
equivalent of an off-balance sheet exposure. For example, if the value
of a derivative contract referencing the common stock of company X
changes the same amount as the value of 150 shares of common stock of
company X, for a small (for example, 1 percent) change in the value of
the common stock of company X, the effective notional principal amount
of the derivative contract is the current value of 150 shares of common
stock of company X regardless of the number of shares the derivative
contract references. The adjusted carrying value of the off-balance
sheet component of the derivative is the current value of 150 shares of
common stock of company X minus the adjusted carrying value of any on-
balance sheet amount associated with the derivative.
The final rule clarifies the determination of the effective
notional principal amount of unfunded equity commitments. Under the
final rule, for an unfunded equity commitment that is unconditional, a
bank must use the notional amount of the commitment. If the unfunded
equity commitment is conditional, the bank must use its best estimate
of the amount that would be funded during economic downturn conditions.
[[Page 69377]]
Hedge Transactions
The agencies proposed specific rules for recognizing hedged equity
exposures; they received no substantive comment on these rules and are
adopting these rules as proposed. For purposes of determining risk-
weighted assets under both the SRWA and the IMA, a bank may identify
hedge pairs, which the final rule defines as two equity exposures that
form an effective hedge provided each equity exposure is publicly
traded or has a return that is primarily based on a publicly traded
equity exposure. A bank may risk weight only the effective and
ineffective portions of a hedge pair rather than the entire adjusted
carrying value of each exposure that makes up the pair. Two equity
exposures form an effective hedge if the exposures either have the same
remaining maturity or each has a remaining maturity of at least three
months; the hedge relationship is documented formally before the bank
acquires at least one of the equity exposures; the documentation
specifies the measure of effectiveness (E) (defined below) the bank
will use for the hedge relationship throughout the life of the
transaction; and the hedge relationship has an E greater than or equal
to 0.8. A bank must measure E at least quarterly and must use one of
three alternative measures of E--the dollar-offset method, the
variability-reduction method, or the regression method.
It is possible that only part of a bank's exposure to a particular
equity instrument is part of a hedge pair. For example, assume a bank
has an equity exposure A with a $300 adjusted carrying value and
chooses to hedge a portion of that exposure with an equity exposure B
with an adjusted carrying value of $100. Also assume that the
combination of equity exposure B and $100 of the adjusted carrying
value of equity exposure A form an effective hedge with an E of 0.8. In
this situation the bank would treat $100 of equity exposure A and $100
of equity exposure B as a hedge pair, and the remaining $200 of its
equity exposure A as a separate, stand-alone equity position.
The effective portion of a hedge pair is E multiplied by the
greater of the adjusted carrying values of the equity exposures forming
the hedge pair, and the ineffective portion is (1-E) multiplied by the
greater of the adjusted carrying values of the equity exposures forming
the hedge pair. In the above example, the effective portion of the
hedge pair would be 0.8 x $100 = $80 and the ineffective portion of the
hedge pair would be (1-0.8) x $100 = $20.
Measures of Hedge Effectiveness
Under the dollar-offset method of measuring effectiveness, the bank
must determine the ratio of the cumulative sum of the periodic changes
in the value of one equity exposure to the cumulative sum of the
periodic changes in the value of the other equity exposure, termed the
ratio of value change (RVC). If the changes in the values of the two
exposures perfectly offset each other, the RVC will be -1. If RVC is
positive, implying that the values of the two equity exposures move in
the same direction, the hedge is not effective and E = 0. If RVC is
negative and greater than or equal to -1 (that is, between zero and -
1), then E equals the absolute value of RVC. If RVC is negative and
less than -1, then E equals 2 plus RVC.
The variability-reduction method of measuring effectiveness
compares changes in the value of the combined position of the two
equity exposures in the hedge pair (labeled X) to changes in the value
of one exposure as though that one exposure were not hedged (labeled
A). This measure of E expresses the time-series variability in X as a
proportion of the variability of A. As the variability described by the
numerator becomes small relative to the variability described by the
denominator, the measure of effectiveness improves, but is bounded from
above by a value of one. E is computed as:
[GRAPHIC] [TIFF OMITTED] TR07DE07.013
Xt = At - Bt
At = the value at time t of the one exposure in a
hedge pair, and
Bt = the value at time t of the other exposure in the
hedge pair.
The value of t will range from zero to T, where T is the length of
the observation period for the values of A and B, and is comprised of
shorter values each labeled t.
The regression method of measuring effectiveness is based on a
regression in which the change in value of one exposure in a hedge pair
is the dependent variable and the change in value of the other exposure
in the hedge pair is the independent variable. E equals the coefficient
of determination of this regression, which is the proportion of the
variation in the dependent variable explained by variation in the
independent variable. However, if the estimated regression coefficient
is positive, then the value of E is zero. The closer the relationship
between the values of the two exposures, the higher E will be.
2. Simple Risk-Weight Approach (SRWA)
Under the SRWA in section 52 of the proposed rule, a bank would
determine the risk-weighted asset amount for each equity exposure,
other than an equity exposure to an investment fund, by multiplying the
adjusted carrying value of the equity exposure, or the effective
portion and ineffective portion of a hedge pair as described above, by
the lowest applicable risk weight in Table J. A bank would determine
the risk-weighted asset amount for an equity exposure to an investment
fund under section 54 of the proposed rule.
If a bank exclusively uses the SRWA for its equity exposures, the
bank's aggregate risk-weighted asset amount for its equity exposures
(other than equity exposures to investment funds) would be equal to the
sum of the risk-weighted asset amounts for each of the bank's
individual equity exposures.
Table J
------------------------------------------------------------------------
Risk weight Equity exposure
------------------------------------------------------------------------
0 Percent............... An equity exposure to an entity whose credit
exposures are exempt from the 0.03 percent
PD floor.
[[Page 69378]]
20 Percent............... An equity exposure to a Federal Home Loan
Bank or Farmer Mac if the equity exposure is
not publicly traded and is held as a
condition of membership in that entity.
100 Percent.............. Community development equity
exposures.
An equity exposure to a Federal Home
Loan Bank or Farmer Mac not subject to a 20
percent risk weight.
The effective portion of a hedge
pair.
Non-significant equity exposures to
the extent less than 10 percent of tier 1
plus tier 2 capital.
300 Percent.............. A publicly traded equity exposure (including
the ineffective portion of a hedge pair).
400 Percent.............. An equity exposure that is not publicly
traded.
------------------------------------------------------------------------
Several commenters addressed the proposed risk weights under the
SRWA. A few commenters asserted that the 100 percent risk weight for
the effective portion of a hedge pair is too high. These commenters
suggested that the risk weight for such exposures should be zero or no
more than 7 percent because the effectively hedged portion of a hedge
pair involves negligible credit risk. One commenter remarked that it
does not believe there is an economic basis for the different risk
weight for an equity exposure to a Federal Home Loan Bank depending on
whether the equity exposure is held as a condition of membership.
The agencies do not agree with commenters' assertion that the
effective portion of a hedge pair entails negligible credit risk. The
agencies believe the 100 percent risk weight under the proposal is an
appropriate and prudential safeguard; thus, it is maintained in the
final rule. Banks that seek to more accurately account for equity
hedging in their risk-based capital requirements should use the IMA.
The agencies agree that different risk weights for an equity
exposure to a Federal Home Loan Bank or Farmer Mac depending on whether
the equity exposure is held as a condition of membership do not have an
economic justification, given the similar risk profile of the
exposures. Accordingly, under the final rule SRWA, all equity exposures
to a Federal Home Loan Bank or to Farmer Mac receive a 20 percent risk
weight.
Non-significant Equity Exposures
Under the SRWA, a bank may apply a 100 percent risk weight to non-
significant equity exposures. The proposed rule defined non-significant
equity exposures as equity exposures to the extent that the aggregate
adjusted carrying value of the exposures did not exceed 10 percent of
the bank's tier 1 capital plus tier 2 capital.
Several commenters objected to the 10 percent materiality threshold
for determining significance. They asserted that this standard is more
conservative than the 15 percent threshold under the OCC, FDIC, and
Board general risk-based capital rules for nonfinancial equity
investments.
The agencies note that the applicable general risk-based capital
rules address only nonfinancial equity investments; that the 15 percent
threshold is a percentage only of tier 1 capital; and that the 15
percent threshold was designed for that particular rule. The proposed
materiality threshold of 10 percent of tier 1 plus tier 2 capital is
consistent with the New Accord and is intended to identify non-
significant holdings of equity exposures under a different type of
capital framework. Thus, the two threshold limits are not directly
comparable. The agencies believe that the proposed 10 percent threshold
for determining non-significant equity exposures is appropriate for the
advanced approaches and, thus, are adopting it as proposed.
As discussed above in preamble section V.A.3., the agencies have
discretion under the final rule to exclude from the definition of a
traditional securitization those investment firms that exercise
substantially unfettered control over the size and composition of their
assets, liabilities, and off-balance sheet exposures. Equity exposures
to investment firms that would otherwise be a traditional
securitization were it not for the specific agency exclusion are
leveraged exposures to the underlying financial assets of the
investment firm. The agencies believe that equity exposure to such
firms with greater than immaterial leverage warrant a 600 percent risk
weight under the SRWA, due to their particularly high risk. Moreover,
the agencies believe that the 100 percent risk weight assigned to non-
significant equity exposures is inappropriate for equity exposures to
investment firms with greater than immaterial leverage.
Under the final rule, to compute the aggregate adjusted carrying
value of a bank's equity exposures for determining non-significance,
the bank may exclude (i) equity exposures that receive less than a 300
percent risk weight under the SRWA (other than equity exposures
determined to be non-significant); (ii) the equity exposure in a hedge
pair with the smaller adjusted carrying value; and (iii) a proportion
of each equity exposure to an investment fund equal to the proportion
of the assets of the investment fund that are not equity exposures or
that qualify as community development equity exposures. If a bank does
not know the actual holdings of the investment fund, the bank may
calculate the proportion of the assets of the fund that are not equity
exposures based on the terms of the prospectus, partnership agreement,
or similar contract that defines the fund's permissible investments. If
the sum of the investment limits for all exposure classes within the
fund exceeds 100 percent, the bank must assume that the investment fund
invests to the maximum extent possible in equity exposures.
When determining which of a bank's equity exposures qualify for a
100 percent risk weight based on non-significance, a bank first must
include equity exposures to unconsolidated small business investment
companies or held through consolidated small business investment
companies described in section 302 of the Small Business Investment Act
of 1958 (15 U.S.C. 682), then must include publicly traded equity
exposures (including those held indirectly through investment funds),
and then must include non-publicly traded equity exposures (including
those held indirectly through investment funds).
The SRWA is summarized in Table K:
[[Page 69379]]
Table K
------------------------------------------------------------------------
Risk weight Equity exposure
------------------------------------------------------------------------
0 Percent............... An equity exposure to an entity whose credit
exposures are exempt from the 0.03 percent
PD floor.
20 Percent............... An equity exposure to a Federal Home Loan
Bank or Farmer Mac.
100 Percent.............. Community development equity
exposures.\102\
The effective portion of a hedge
pair.
Non-significant equity exposures to
the extent less than 10 percent of tier 1
plus tier 2 capital.
300 Percent.............. A publicly traded equity exposure (other than
an equity exposure that receives a 600
percent risk weight and including the
ineffective portion of a hedge pair).
400 Percent.............. An equity exposure that is not publicly
traded (other than an equity exposure that
receives a 600 percent risk weight).
600 percent.............. An equity exposure to an investment firm that
(1) would meet the definition of a
traditional securitization were it not for
the primary Federal supervisor's application
of paragraph (8) of that definition and (2)
has greater than immaterial leverage.
------------------------------------------------------------------------
\102\ The final rule generally defines these exposures as exposures that
would qualify as community development investments under 12 U.S.C.
24(Eleventh), excluding equity exposures to an unconsolidated small
business investment company and equity exposures held through a
consolidated small business investment company described in section
302 of the Small Business Investment Act of 1958 (15 U.S.C. 682). For
savings associations, community development investments would be
defined to mean equity investments that are designed primarily to
promote community welfare, including the welfare of low- and moderate-
income communities or families, such as by providing services or jobs,
and excluding equity exposures to an unconsolidated small business
investment company and equity exposures held through a consolidated
small business investment company described in section 302 of the
Small Business Investment Act of 1958 (15 U.S.C. 682).
3. Internal Models Approach (IMA)
The IMA is designed to provide banks with a more sophisticated and
risk-sensitive mechanism for calculating risk-based capital
requirements for equity exposures. To qualify to use the IMA, a bank
must receive prior written approval from its primary Federal
supervisor. To receive such approval, the bank must demonstrate to its
primary Federal supervisor's satisfaction that the bank meets the
quantitative and qualitative criteria discussed below. As noted
earlier, a bank may model both publicly traded and non-publicly traded
equity exposures or model only publicly traded equity exposures.
In the final rule, the agencies clarify that under the IMA, a bank
may use more than one model, as appropriate for its equity exposures,
provided that it has received supervisory approval for use of the IMA,
and each model meets the qualitative and quantitative criteria
specified below and in section 53 of the rule.
IMA Qualification
The bank must have one or more models that (i) assess the potential
decline in value of its modeled equity exposures; (ii) are commensurate
with the size, complexity, and composition of the bank's modeled equity
exposures; and (iii) adequately capture both general market risk and
idiosyncratic risks. The bank's models must produce an estimate of
potential losses for its modeled equity exposures that is no less than
the estimate of potential losses produced by a VaR methodology
employing a 99.0 percent one-tailed confidence interval of the
distribution of quarterly returns for a benchmark portfolio of equity
exposures comparable to the bank's modeled equity exposures using a
long-term sample period. Banks with equity portfolios containing equity
exposures with values that are highly nonlinear in nature (for example,
equity derivatives or convertibles) must employ an internal model
designed to appropriately capture the risks associated with these
instruments.
In addition, the number of risk factors and exposures in the sample
and the data period used for quantification in the bank's models and
benchmarking exercise must be sufficient to provide confidence in the
accuracy and robustness of the bank's estimates. The bank's model and
benchmarking exercise also must incorporate data that are relevant in
representing the risk profile of the bank's modeled equity exposures,
and must include data from at least one equity market cycle containing
adverse market movements relevant to the risk profile of the bank's
modeled equity exposures. In addition, for the reasons described below,
the final rule adds that the bank's benchmarking exercise must be based
on daily market prices for the benchmark portfolio. If the bank's model
uses a scenario methodology, the bank must demonstrate that the model
produces a conservative estimate of potential losses on the bank's
modeled equity exposures over a relevant long-term market cycle. If the
bank employs risk factor models, the bank must demonstrate through
empirical analysis the appropriateness of the risk factors used.
Under the proposed rule, the agencies also required that daily
market prices be available for all modeled equity exposures. The
proposed requirement applied to either direct holdings or proxies.
Several commenters objected to the requirement of daily market prices.
A few asserted that proxies for private equity investments are more
relevant than public market proxies and should be permitted even if
they are only available on a monthly basis. The agencies agree with
commenters on this issue. Accordingly, under the final rule, banks are
not required to have daily market prices for all modeled equity
exposures, either direct holdings or proxies. However, to ensure
sufficient rigor in the modeling process, the final rule requires that
a bank's benchmarking exercise be based on daily market prices for the
benchmark portfolio, as noted above.
Finally, the bank must be able to demonstrate, using theoretical
arguments and empirical evidence, that any proxies used in the modeling
process are comparable to the bank's modeled equity exposures, and that
the bank has made appropriate adjustments for differences. The bank
must derive any proxies for its modeled equity exposures or benchmark
portfolio using historical market data that are relevant to the bank's
modeled equity exposures or benchmark portfolio (or, where not, must
use appropriately adjusted data), and such proxies must be robust
estimates of the risk of the bank's modeled equity exposures.
In evaluating whether a bank has met the criteria described above,
the bank's primary Federal supervisor may consider, among other
factors, (i) the nature of the bank's equity exposures, including the
number and types of equity exposures (for example, publicly traded,
non-publicly traded, long, short); (ii) the risk characteristics and
makeup of the bank's equity exposures, including the extent to which
publicly available price information is obtainable on the exposures;
and (iii) the level and degree of concentration of, and
[[Page 69380]]
correlations among, the bank's equity exposures.
The agencies do not intend to dictate the form or operational
details of a bank's internal model for equity exposures. Accordingly,
the agencies are not prescribing any particular type of model for
determining risk-based capital requirements. Although the final rule
requires a bank that uses the IMA to ensure that its internal model
produces an estimate of potential losses for its modeled equity
exposures that is no less than the estimate of potential losses
produced by a VaR methodology employing a 99.0 percent one-tailed
confidence interval of the distribution of quarterly returns for a
benchmark portfolio of equity exposures, the rule does not require a
bank to use a VaR-based model. The agencies recognize that the type and
sophistication of internal models will vary across banks due to
differences in the nature, scope, and complexity of business lines in
general and equity exposures in particular. The agencies also recognize
that some banks employ models for internal risk management and capital
allocation purposes that can be more relevant to the bank's equity
exposures than some VaR models. For example, some banks employ rigorous
historical scenario analysis and other techniques for assessing the
risk of their equity portfolios.
Banks that choose to use a VaR-based internal model under the IMA
should use a historical observation period that includes a sufficient
amount of data points to ensure statistically reliable and robust loss
estimates relevant to the long-term risk profile of the bank's specific
holdings. The data used to represent return distributions should
reflect the longest sample period for which data are available and
should meaningfully represent the risk profile of the bank's specific
equity holdings. The data sample should be long-term in nature and, at
a minimum, should encompass at least one complete equity market cycle
containing adverse market movements relevant to the risk profile of the
bank's modeled exposures. The data used should be sufficient to provide
conservative, statistically reliable, and robust loss estimates that
are not based purely on subjective or judgmental considerations.
The parameters and assumptions used in a VaR model should be
subject to a rigorous and comprehensive regime of stress-testing. Banks
utilizing VaR models should subject their internal model and estimation
procedures, including volatility computations, to either hypothetical
or historical scenarios that reflect worst-case losses given underlying
positions in both publicly traded and non-publicly traded equities. At
a minimum, banks that use a VaR model should employ stress tests to
provide information about the effect of tail events beyond the level of
confidence assumed in the IMA.
Banks using non-VaR internal models that are based on stress tests
or scenario analyses should estimate losses under worst-case modeled
scenarios. These scenarios should reflect the composition of the bank's
equity portfolio and should produce risk-based capital requirements at
least as large as those that would be required to be held against a
representative market index or other relevant benchmark portfolio under
a VaR approach. For example, for a portfolio consisting primarily of
publicly held equity securities that are actively traded, risk-based
capital requirements produced using historical scenario analyses should
be greater than or equal to risk-based capital requirements produced by
a baseline VaR approach for a major index or sub-index that is
representative of the bank's holdings.
The loss estimate derived from the bank's internal model
constitutes the risk-based capital requirement for the modeled equity
exposures (subject to the supervisory floors described below). The
equity capital requirement is incorporated into a bank's risk-based
capital ratio through the calculation of risk-weighted equivalent
assets. To convert the equity capital requirement into risk-weighted
equivalent assets, a bank must multiply the capital requirement by
12.5.
Risk-Weighted Assets Under the IMA
Under the proposed and final rules, as noted above, a bank may
apply the IMA only to its publicly traded equity exposures or may apply
the IMA to its publicly traded and non-publicly traded equity
exposures. In either case, a bank is not allowed to apply the IMA to
equity exposures that receive a 0 or 20 percent risk weight under the
SRWA, community development equity exposures, and equity exposures to
investment funds (collectively, excluded equity exposures). Unlike the
SRWA, the IMA does not provide for a 10 percent materiality threshold
for non-significant equity exposures.
Several commenters objected to the fact that the IMA does not
provide a 100 percent risk weight for non-significant equity exposures
up to a 10 percent materiality threshold. These commenters maintained
that the lack of a materiality threshold under the IMA will discourage
use of this methodology relative to the SRWA. Commenters suggested that
the agencies incorporate a materiality threshold into the IMA.
The agencies do not believe that it is necessary or appropriate to
incorporate such a threshold under the IMA. The agencies are concerned
that a bank could manipulate significantly its risk-based capital
requirements based on the exposures it chooses to model and those which
it would deem immaterial (and to which it would apply a 100 percent
risk weight). The agencies also believe that a flat 100 percent risk
weight is inconsistent with the risk sensitivity of the IMA.
Under the proposal, if a bank applied the IMA to both publicly
traded and non-publicly traded equity exposures, the bank's aggregate
risk-weighted asset amount for its equity exposures would be equal to
the sum of the risk-weighted asset amount of excluded equity exposures
(calculated outside of the IMA) and the risk-weighted asset amount of
the non-excluded equity exposures (calculated under the IMA). The risk-
weighted asset amount of the non-excluded equity exposures generally
would be set equal to the estimate of potential losses on the bank's
non-excluded equity exposures generated by the bank's internal model
multiplied by 12.5. To ensure that a bank holds a minimum amount of
risk-based capital against its modeled equity exposures, however, the
proposed rule contained a supervisory floor on the risk-weighted asset
amount of the non-excluded equity exposures. As a result of this floor,
the risk-weighted asset amount of the non-excluded equity exposures
could not fall below the sum of (i) 200 percent multiplied by the
aggregate adjusted carrying value or ineffective portion of hedge
pairs, as appropriate, of the bank's non-excluded publicly traded
equity exposures; and (ii) 300 percent multiplied by the aggregate
adjusted carrying value of the bank's non-excluded non-publicly traded
equity exposures.
Also under the proposal, if a bank applied the IMA only to its
publicly traded equity exposures, the bank's aggregate risk-weighted
asset amount for its equity exposures would be equal to the sum of (i)
the risk-weighted asset amount of excluded equity exposures (calculated
outside of the IMA); (ii) 400 percent multiplied by the aggregate
adjusted carrying value of the bank's non-excluded non-publicly traded
equity exposures; and (iii) the aggregate risk-weighted asset amount of
its non-excluded publicly traded equity exposures. The risk-weighted
asset amount of the non-excluded publicly traded equity exposures would
be equal to the estimate of potential losses on the
[[Page 69381]]
bank's non-excluded publicly traded equity exposures generated by the
bank's internal model multiplied by 12.5. Under the proposed rule, the
risk-weighted asset amount for the non-excluded publicly traded equity
exposures would be subject to a floor of 200 percent multiplied by the
aggregate adjusted carrying value or ineffective portion of hedge
pairs, as appropriate, of the bank's non-excluded publicly traded
equity exposures.
Several commenters did not support the concept of floors in a risk-
sensitive approach that requires a comparison to estimates of potential
losses produced by a VaR methodology. If floors are required in the
final rule, however, these commenters noted that the calculation at the
aggregate level would not pose significant operational issues. A few
commenters, in contrast, objected to the proposed aggregate floors,
asserting that it would be operationally difficult to determine
compliance with such floors.
The agencies believe that it is prudent to retain the floor
requirements in the IMA and, thus, are adopting the floor requirements
as described above. The agencies note that the New Accord also imposes
a 200 percent and 300 percent floor for publicly traded and non-
publicly traded equity exposures, respectively. Regarding the proposal
to calculate the floors on an aggregate basis, the agencies believe it
is appropriate to maintain this approach, given that for most banks it
does not seem to pose significant operational issues.
4. Equity Exposures to Investment Funds
The proposed rule included a separate treatment for equity
exposures to investment funds. As proposed, a bank would determine the
risk-weighted asset amount for equity exposures to investment funds
using one of three approaches: the full look-through approach, the
simple modified look-through approach, or the alternative modified
look-through approach, unless the equity exposure to an investment fund
is a community development equity exposure. Such equity exposures would
be subject to a 100 percent risk weight. If an equity exposure to an
investment fund is part of a hedge pair, a bank could use the
ineffective portion of the hedge pair as the adjusted carrying value
for the equity exposure to the investment fund. The risk-weighted asset
amount of the effective portion of the hedge pair is equal to its
adjusted carrying value. A bank could choose to apply a different
approach among the three alternatives to different equity exposures to
investment funds.
The agencies proposed a separate treatment for equity exposures to
an investment fund to prevent banks from arbitraging the proposed
rule's risk-based capital requirements for certain high-risk exposures
and to ensure that banks do not receive a punitive risk-based capital
requirement for equity exposures to investment funds that hold only
low-risk assets. Under the proposal, the agencies defined an investment
fund as a company (i) all or substantially all of the assets of which
are financial assets and (ii) that has no material liabilities.
Generally, commenters supported the separate treatment for equity
exposures to investment funds. However, several commenters objected to
the exclusion of investment funds with material liabilities from this
separate treatment, observing that it would exclude equity exposures to
hedge funds. Several commenters suggested that investment funds with
material liabilities should be eligible for the look-through
approaches. One commenter suggested that the agencies should adopt the
following definition of investment fund: ``A company in which all or
substantially all of the assets are pooled financial assets that are
collectively managed in order to generate a financial return, including
investment companies or funds with material liabilities.'' A few
commenters suggested that equity exposures to investment funds with
material liabilities should be treated under the SRWA or IMA as non-
publicly traded equity exposures rather than the separate treatment
developed for equity exposures to investment funds.
The agencies do not agree with commenters that the look-through
approaches for investment funds should apply to investment vehicles
with material liabilities. The look-through treatment is designed to
capture the risks of an indirect holding of the underlying assets of
the investment fund. Investment vehicles with material liabilities
provide a leveraged exposure to the underlying financial assets and
have a risk profile that may not be appropriately captured by a look-
through approach.
Under the proposal, each of the approaches to equity exposures to
investment funds imposed a 7 percent minimum risk weight on such
exposures. This proposed minimum risk weight was similar to the minimum
7 percent risk weight under the RBA for securitization exposures and
the effective 56 basis point minimum risk-based capital requirement per
dollar of securitization exposure under the SFA.
Several commenters objected to the proposed 7 percent risk weight
floor. A few commenters suggested that the floor should be decreased or
eliminated, particularly for low-risk investment funds that receive the
highest rating from an NRSRO. Others recommended that the 7 percent
risk weight floor should be applied on an aggregate basis rather than
on a fund-by-fund basis.
The agencies proposed the 7 percent risk weight floor as a minimum
risk-based capital requirement for exposures not directly held by a
bank. However, the agencies believe the comments on this issue have
merit and recognize that the floor would provide banks with an
incentive to invest in higher-risk investment funds. Consistent with
the New Accord, the final rule does not impose a 7 percent risk weight
floor on equity exposures to investment funds, on either an individual
or aggregate basis.
Full Look-Through Approach
A bank may use the full look-through approach only if the bank is
able to compute a risk-weighted asset amount for each of the exposures
held by the investment fund. Under the proposed rule, a bank would be
required to calculate the risk-weighted asset amount for each of the
exposures held by the investment fund as if the exposures were held
directly by the bank. Depending on whether the exposures were
wholesale, retail, securitization, or equity exposures, a bank would
apply the appropriate IRB risk-based capital treatment.
Several commenters suggested that the agencies should allow a bank
with supervisory approval to use the IMA to model the underlying assets
of an investment fund by including the bank's pro rata share of the
investment fund's assets in its equities model. The commenters believed
there is no basis for preventing a bank from using the IMA, a
sophisticated and risk-sensitive approach, when a bank has full
position data for an investment fund.
The agencies agree with commenters' views in this regard. If a bank
has full position data for an investment fund and has been approved by
its primary Federal supervisor for use of the IMA, it may include the
underlying equity exposures held by an investment fund, after
adjustment for proportional ownership, in its equities model under the
IMA. Therefore, in the final rule, under the full look-through
approach, a bank must either (i) set the risk-weighted asset amount of
the bank's equity exposure to the investment fund
[[Page 69382]]
equal to product of (A) the aggregate risk-weighted asset amounts of
the exposures held by the fund as if they were held directly by the
bank and (B) the bank's proportional ownership share of the fund; or
(ii) include the bank's proportional ownership share of each exposure
held by the fund in the bank's IMA. If the bank chooses (ii), the risk-
weighted asset amount for the equity exposure to the investment fund is
determined together with the risk-weighted asset amount for the bank's
other non-excluded equity exposures and is subject to the aggregate
floors under this approach.
Simple Modified Look-Through Approach
Under the proposed simple modified look-through approach, a bank
would set the risk-weighted asset amount for its equity exposure to an
investment fund equal to the adjusted carrying value of the equity
exposure multiplied by the highest risk weight in Table L that applies
to any exposure the fund is permitted to hold under its prospectus,
partnership agreement, or similar contract that defines the fund's
permissible investments. The bank could exclude derivative contracts
that are used for hedging, not speculative purposes, and do not
constitute a material portion of the fund's exposures.
Commenters generally supported the simple modified look-through
approach as a low-burden yet moderately risk-sensitive way of treating
equity exposures to an investment fund. However, several commenters
objected to the large jump in risk weights (from a 400 percent to a
1,250 percent risk weight) between investment funds permitted to hold
non-publicly traded equity exposures and investment funds permitted to
hold OTC derivative contracts and/or exposures that must be deducted
from regulatory capital or receive a risk weight greater than 400
percent under the IRB approach. In addition, one commenter objected to
the proposed 20 percent risk weight for the most highly rated money
market mutual funds that are subject to SEC rule 2a-7 governing
portfolio maturity, quality, diversification and liquidity. This
commenter asserted that a 7 percent risk weight for such exposures
would be appropriate.
The agencies agree that the proposed risk-weighting for highly-
rated money market mutual funds subject to SEC rule 2a-7 is
conservative, given the generally low risk of such funds. Accordingly,
the agencies added a new investment fund approach--the Money Market
Fund Approach--which applies a 7 percent risk weight to a bank's equity
exposure to a money market fund that is subject to SEC rule 2a-7 and
that has an applicable external rating in the highest investment-grade
rating category.
The agencies have made no changes to address commenters' concerns
about a lack of intermediate risk weights between 400 percent and 1,250
percent. The agencies believe the range of risk weights is sufficiently
granular to accommodate most equity exposures to investment funds.
Table L.--Modified Look-Through Approaches for Equity Exposures to
Investment Funds
------------------------------------------------------------------------
Risk weight Exposure class or investment fund type
------------------------------------------------------------------------
0 Percent................... Sovereign exposures with a long-term
external rating in the highest investment-
grade rating category and sovereign
exposures of the United States.
20 Percent.................. Exposures with a long-term external rating
in the highest or second-highest
investment-grade rating category;
exposures with a short-term external
rating in the highest investment-grade
rating category; and exposures to, or
guaranteed by, depository institutions,
foreign banks (as defined in 12 CFR
211.2), or securities firms subject to
consolidated supervision or regulation
comparable to that imposed on U.S.
securities broker-dealers that are repo-
style transactions or bankers'
acceptances.
50 Percent.................. Exposures with a long-term external rating
in the third-highest investment-grade
rating category or a short-term external
rating in the second-highest investment-
grade rating category.
100 Percent................. Exposures with a long-term or short-term
external rating in the lowest investment-
grade rating category.
200 Percent................. Exposures with a long-term external rating
one rating category below investment
grade.
300 Percent................. Publicly traded equity exposures.
400 Percent................. Non-publicly traded equity exposures;
exposures with a long-term external
rating two or more rating categories
below investment grade; and unrated
exposures (excluding publicly traded
equity exposures).
1,250 Percent............... OTC derivative contracts and exposures
that must be deducted from regulatory
capital or receive a risk weight greater
than 400 percent under this appendix.
------------------------------------------------------------------------
Alternative Modified Look-Through Approach
Under this approach, a bank may assign the adjusted carrying value
of an equity exposure to an investment fund on a pro rata basis to
different risk-weight categories in Table L based on the investment
limits in the fund's prospectus, partnership agreement, or similar
contract that defines the fund's permissible investments. If the sum of
the investment limits for all exposure classes within the fund exceeds
100 percent, the bank must assume that the fund invests to the maximum
extent permitted under its investment limits in the exposure class with
the highest risk weight under Table L, and continues to make
investments in the order of the exposure class with the next highest
risk-weight under Table L until the maximum total investment level is
reached. If more than one exposure class applies to an exposure, the
bank must use the highest applicable risk weight. A bank may exclude
derivative contracts held by the fund that are used for hedging, not
speculative, purposes and do not constitute a material portion of the
fund's exposures. Other than comments addressing the risk weight table
and the 7 percent floor (addressed above), the agencies did not receive
significant comment on this approach and have adopted it without
significant change.
VI. Operational Risk
This section describes features of the AMA framework for
determining the risk-based capital requirement for operational risk. A
bank meeting the AMA qualifying criteria uses its internal operational
risk quantification system to calculate its risk-based capital
requirement for operational risk.
Currently, the agencies' general risk-based capital rules do not
include an explicit capital charge for operational risk. Rather, the
existing risk-based capital rules were designed to broadly cover all
risks, and therefore implicitly cover operational risk. With the
adoption of the more risk-sensitive treatment under the IRB approach
for credit risk in this final rule, there no
[[Page 69383]]
longer is an implicit capital buffer for other risks.
The agencies recognize that operational risk is a key risk in
banks, and evidence indicates that a number of factors are driving
increases in operational risk. These factors include greater use of
automated technology, proliferation of new and highly complex products,
growth of e-banking transactions and related business applications,
large-scale acquisitions, mergers, and consolidations, and greater use
of outsourcing arrangements. Furthermore, the experience of a number of
high-profile, high-severity operational losses across the banking
industry, including those resulting from legal settlements, highlight
operational risk as a major source of unexpected losses. Because the
implicit regulatory capital buffer for operational risk is removed
under the final rule, the agencies are requiring banks using the IRB
approach for credit risk to use the AMA to address operational risk
when computing their risk-based capital requirement.
As discussed previously, operational risk exposure is the 99.9th
percentile of the distribution of potential aggregate operational
losses as generated by the bank's operational risk quantification
system over a one-year horizon. EOL is the expected value of the same
distribution of potential aggregate operational losses. Under the
proposal, a bank's risk-based capital requirement for operational risk
would be the sum of EOL and UOL. A bank would be allowed to recognize
(i) certain offsets for EOL (such as certain reserves and other
internal business practices), and (ii) the effect of risk mitigants
such as insurance in calculating its regulatory capital requirement for
operational risk.
Under the proposed rule, the agencies recognized that a bank's
risk-based capital requirement for operational risk could be based on
UOL alone if the bank could demonstrate it has offset EOL with eligible
operational risk offsets. Eligible operational risk offsets were
defined as amounts, not to exceed EOL, that (i) are generated by
internal business practices to absorb highly predictable and reasonably
stable operational losses, including reserves calculated in a manner
consistent with GAAP; and (ii) are available to cover EOL with a high
degree of certainty over a one-year horizon. Eligible operational risk
offsets could only be used to offset EOL, not UOL.
The preamble to the proposed rule stated that in determining
whether to accept a proposed EOL offset, the agencies would consider
whether the proposed offset would be available to cover EOL with a high
degree of certainty over a one-year horizon. Supervisory recognition of
EOL offsets would be limited to those business lines and event types
with highly predictable, routine losses. The preamble noted that based
on discussions with the industry and supervisory experience, highly
predictable and routine losses appear to be limited to those relating
to securities processing and to credit card fraud.
The majority of commenters on this issue recommended that the
agencies should allow banks to present evidence of additional areas
with highly predictable and reasonably stable losses for which eligible
operational risk offsets could be considered. These commenters
identified fraud losses pertaining to debit or ATM cards, commercial or
business credit cards, HELOCs, and external checks in retail banking as
additional events that have highly predictable and reasonably stable
losses. Commenters also identified legal reserves set aside for small,
predictable legal loss events, budgeted funds, and forecasted funds as
other items that should be considered eligible operational risk
offsets. Several commenters also highlighted that the proposed rule was
inconsistent with the New Accord regarding the ability of budgeted
funds to serve as EOL offsets. One commenter proposed eliminating EOL
altogether because the commenter already factors it into its pricing
practices.
The New Accord permits a supervisor to accept expected loss offsets
provided a bank is ``able to demonstrate to the satisfaction of its
national supervisor that it has measured and accounted for its EL
exposure.'' \103\ To the extent a bank is permitted to adjust its
estimate of operational risk exposure to reflect potential operational
risk offsets, it is appropriate to consider the degree to which such
offsets meet U.S. accounting standards and can be viewed as regulatory
capital substitutes. The final rule retains the proposed definition
described above. The agencies believe that this definition allows for
the supervisory consideration of EOL offsets in a flexible and prudent
manner.
---------------------------------------------------------------------------
\103\ 103 New Accord, ]669(b).
---------------------------------------------------------------------------
In determining its operational risk exposure, the bank may also
take into account the effects of qualifying operational risk mitigants
such as insurance. To recognize the effects of qualifying operational
risk mitigants such as insurance for risk-based capital purposes, the
bank must estimate its operational risk exposure with and without such
effects. The reduction in a bank's risk-based capital requirement for
operational risk due to qualifying operational risk mitigants may not
exceed 20 percent of the bank's risk-based capital requirement for
operational risk, after approved adjustments for EOL offsets.
A risk mitigant must be able to absorb losses with sufficient
certainty to warrant inclusion as a qualifying operational risk
mitigant. For insurance to meet this standard, it must:
(i) be provided by an unaffiliated company that has a claims paying
ability that is rated in one of the three highest rating categories by
an NRSRO;
(ii) have an initial term of at least one year and a residual term
of more than 90 days;
(iii) have a minimum notice period for cancellation of 90 days;
(iv) have no exclusions or limitations based upon regulatory action
or for the receiver or liquidator of a failed bank; and
(v) be explicitly mapped to an actual operational risk exposure of
the bank.
A bank must receive prior written approval from its primary Federal
supervisor to recognize an operational risk mitigant other than
insurance as a qualifying operational risk mitigant. In evaluating an
operational risk mitigant other than insurance, a primary Federal
supervisor will consider whether the operational risk mitigant covers
potential operational losses in a manner equivalent to holding
regulatory capital.
The bank's methodology for incorporating the effects of insurance
must capture, through appropriate discounts in the amount of risk
mitigation, the residual term of the policy, where less than one year;
the policy's cancellation terms, where less than one year; the policy's
timeliness of payment; and the uncertainty of payment as well as
mismatches in coverage between the policy and the hedged operational
loss event. The bank may not recognize for regulatory capital purposes
insurance with a residual term of 90 days or less.
Several commenters criticized the proposal for limiting recognition
of non-insurance operational risk mitigants to those mitigants that
would cover potential operational losses in a manner equivalent to
holding regulatory capital. The commenters noted that similar
limitations are not included in the New Accord. Other commenters
asserted that qualifying operational risk mitigants should be broader
than insurance.
The New Accord discusses the use of insurance explicitly as an
operational risk mitigant and notes that the BCBS ``in due course, may
consider revising the criteria for and limits on the recognition of
operational risk mitigants
[[Page 69384]]
on the basis of growing experience.'' \104\ Similarly, under the
proposed rule, the agencies provided flexibility that recognizes the
potential for developing operational risk mitigants other than
insurance over time. The agencies continue to believe it is appropriate
to consider the degree to which such mitigants can be viewed as
regulatory capital substitutes. Therefore, under the final rule, in
evaluating such mitigants, the agencies will consider whether the
operational risk mitigant covers potential operational losses in a
manner equivalent to holding regulatory capital.
---------------------------------------------------------------------------
\104\ New Accord, footnote 110.
---------------------------------------------------------------------------
Under the final rule, as under the proposal, if a bank does not
qualify to use or does not have qualifying operational risk mitigants,
the bank's dollar risk-based capital requirement for operational risk
is its operational risk exposure minus eligible operational risk
offsets (if any). If a bank qualifies to use operational risk mitigants
and has qualifying operational risk mitigants, the bank's dollar risk-
based capital requirement for operational risk is the greater of: (i)
The bank's operational risk exposure adjusted for qualifying
operational risk mitigants minus eligible operational risk offsets (if
any); and (ii) 0.8 multiplied by the difference between the bank's
operational risk exposure and its eligible operational risk offsets (if
any). The dollar risk-based capital requirement for operational risk is
multiplied by 12.5 to convert it into an equivalent risk-weighted asset
amount. The resulting amount is added to the comparable amount for
credit risk in calculating the institution's risk-based capital
denominator.
VII. Disclosure
1. Overview
The agencies have long supported meaningful public disclosure by
banks with the objective of improving market discipline. The agencies
recognize the importance of market discipline in encouraging sound risk
management practices and fostering financial stability.
Pillar 3 of the New Accord, market discipline, complements the
minimum capital requirements and the supervisory review process by
encouraging market discipline through enhanced and meaningful public
disclosure. The public disclosure requirements in the final rule are
intended to allow market participants to assess key information about a
bank's risk profile and its associated level of capital.
The agencies view public disclosure as an important complement to
the advanced approaches to calculating minimum regulatory risk-based
capital requirements, which will be heavily based on internal systems
and methodologies. With enhanced transparency regarding banks'
experiences with the advanced approaches, investors can better evaluate
a bank's capital structure, risk exposures, and capital adequacy. With
sufficient and relevant information, market participants can better
evaluate a bank's risk management performance, earnings potential and
financial strength.
Improvements in public disclosures come not only from regulatory
standards, but also through efforts by bank management to improve
communications to public shareholders and other market participants. In
this regard, improvements to risk management processes and internal
reporting systems provide opportunities to significantly improve public
disclosures over time. Accordingly, the agencies strongly encourage the
management of each bank to regularly review its public disclosures and
enhance these disclosures, where appropriate, to clearly identify all
significant risk exposures--whether on-or off-balance sheet--and their
effects on the bank's financial condition and performance, cash flow,
and earnings potential.
Comments on the Proposed Rule
Many commenters expressed concern that the proposed disclosures
were excessive, burdensome and overly prescriptive and would hinder--
rather than facilitate--market discipline by requiring banks to
disclose items that would not be well understood or provide useful
information to market participants. In particular, commenters were
concerned that the differences between the proposed rule and the New
Accord (such as the proposed ELGD risk parameter and proposed wholesale
definition of default) would not be meaningful for cross-border
comparative purposes, and would increase compliance burden for banks
subject to the agencies' risk-based capital rules. Some commenters also
believed that the information provided in the disclosures would not be
comparable across banks because each bank would use distinct internal
methodologies to generate the disclosures. Several commenters suggested
that the agencies should delay the disclosure requirements until U.S.
implementation of the IRB approach has gained some maturity. This would
allow the agencies and banking industry sufficient time to ensure
usefulness of the public disclosure requirements and comparability
across banks.
The agencies believe that it is important to retain the vast
majority of the proposed disclosures, which are consistent with the New
Accord. These disclosures will enable market participants to gain key
insights regarding a bank's capital structure, risk exposures, risk
assessment processes, and ultimately, the capital adequacy of the
institution. The agencies also note that many of the disclosure
requirements are already required by, or are consistent with, existing
GAAP, SEC disclosure requirements, or regulatory reporting requirements
for banks. More generally, the agencies view the public disclosure
requirements as an integral part of the advanced approaches and the New
Accord and are continuing to require their implementation beginning
with a bank's first transitional floor period.
The agencies are sympathetic, however, to commenters' concerns
about cross-border comparability. The agencies believe that many of the
changes they have made to the final rule (such as eliminating the ELGD
risk parameter and adopting the New Accord's definition of default for
wholesale exposures, as discussed above) will address commenters'
concerns regarding comparability. In addition, the agencies have made
several changes to the disclosure requirements to make them more
consistent with the New Accord. These changes should increase cross-
border comparability and reduce implementation and compliance burden.
These changes are discussed in the relevant sections below.
2. General Requirements
Under the proposed rule, the public disclosure requirements would
apply to the top-tier legal entity that is a core or opt-in bank within
a consolidated banking group--the top-tier U.S. BHC or DI that is a
core or opt-in bank.
Several commenters objected to this proposal, noting that it is
inconsistent with the New Accord, which requires such disclosures at
the global top consolidated level of a banking group to which the
framework applies. Commenters asserted that public disclosure at the
U.S. BHC or DI level for U.S. banking organizations owned by a foreign
banking organization is not meaningful and could generate confusion or
misunderstanding in the market.
The agencies agree that commenters' concerns have merit and believe
that it is important to be consistent with the
[[Page 69385]]
New Accord. Accordingly, under the final rule, the public disclosure
requirements will generally be required only at the top-tier global
consolidated level. Under exceptional circumstances, a primary Federal
supervisor may require some or all of the public disclosures at the
top-tier U.S. level if the primary Federal supervisor determines that
such disclosures are important for market participants to form
appropriate insights regarding the bank's risk profile and associated
level of capital. A factor the agencies will consider, for example, is
whether a U.S. subsidiary of a foreign banking organization has debt or
equity registered and actively traded in the United States.
In addition, the proposed rule stated that, in general, a DI that
is a subsidiary of a BHC or another DI would not be subject to the
disclosure requirements except that every DI would be required to
disclose total and tier 1 capital ratios and their components, similar
to current requirements. Nonetheless, these entities must file
applicable bank regulatory reports and thrift financial reports. In
addition, as described below in the regulatory reporting section, the
agencies will require certain additional regulatory reporting from
banks applying the advanced approaches, and a limited amount of the
reported information will be publicly disclosed. If a DI that is a core
or opt-in bank and is not a subsidiary of a BHC or another DI that must
make the full set of disclosures, the DI would be required to make the
full set disclosures.
One commenter objected to the supervisory flexibility provided to
require additional disclosures at the subsidiary level. The commenter
maintained that in all cases DIs that are a subsidiary of a BHC or
another DI should not be subject to the disclosure requirements beyond
disclosing their total and tier 1 capital ratios and the ratio
components, as proposed. The commenter suggested that the agencies
clarify this issue in the final rule.
The agencies do not believe, however, that these changes are
appropriate. The agencies believe that it is important to preserve some
flexibility in the event that the primary Federal supervisor believes
that disclosures from such a DI are important for market participants
to form appropriate insights regarding the bank's risk profile and
associated level of capital.
The risks to which a bank is exposed, and the techniques that it
uses to identify, measure, monitor, and control those risks are
important factors that market participants consider in their assessment
of the bank. Accordingly, under the proposed and final rules, each bank
that is subject to the disclosure requirements must have a formal
disclosure policy approved by its board of directors that addresses the
bank's approach for determining the disclosures it should make. The
policy should address the associated internal controls and disclosure
controls and procedures. The board of directors and senior management
must ensure that appropriate review of the disclosures takes place and
that effective internal controls and disclosure controls and procedures
are maintained.
A bank should decide which disclosures are relevant for it based on
the materiality concept. Information would be regarded as material if
its omission or misstatement could change or influence the assessment
or decision of a user relying on that information for the purpose of
making investment decisions.
To the extent applicable, a bank may fulfill its disclosure
requirements under this final rule by relying on disclosures made in
accordance with accounting standards or SEC mandates that are very
similar to the disclosure requirements in this final rule. In these
situations, a bank must explain material differences between the
accounting or other disclosure and the disclosures required under this
final rule.
Frequency/Timeliness
Under the proposed rule, the agencies required that quantitative
disclosures be made quarterly. Several commenters objected to this
requirement. These commenters asserted that banks subject to the U.S.
public disclosure requirements would be placed at a competitive
disadvantage because the New Accord requires banks to make Pillar 3
public disclosures on a semiannual basis.
The agencies believe that quarterly public disclosure requirements
are important to ensure that the market has access to timely and
relevant information and therefore have decided to retain quarterly
quantitative disclosure requirements in the final rule. This disclosure
frequency is consistent with longstanding requirements in the United
States for robust quarterly disclosures in financial and regulatory
reports, and is appropriate considering the potential for rapid changes
in risk profiles. Moreover, many of the existing SEC, regulatory
reporting, and other disclosure requirements that a bank may use to
help meet its public disclosure requirements in the final rule are
already required on a quarterly basis.
The proposal stated that the disclosures must be timely and that
the agencies would consider a disclosure to be timely if it was made no
later than the reporting deadlines for regulatory reports (for example,
FR Y-9C) and financial reports (for example, SEC Forms 10-Q and 10-K).
When these deadlines differ, the later deadline should be used.
Several commenters expressed concern that the tight timeframe for
public disclosure requirements would be a burden and requested that the
agencies provide greater flexibility, such as by setting the deadline
for public disclosures at 60 days after quarter-end.
The agencies believe commenters' concerns must be balanced against
the importance of allowing market participants to have access to timely
information that is reflective of a bank's risk profile and associated
capital levels. Accordingly, the agencies have decided to interpret the
requirement for timely public disclosures for purposes of this final
rule to mean within 45 days after calendar quarter-end.
In some cases, management may determine that a significant change
has occurred, such that the most recent reported amounts do not reflect
the bank's capital adequacy and risk profile. In those cases, banks
should disclose the general nature of these changes and briefly
describe how they are likely to affect public disclosures going
forward. These interim disclosures should be made as soon as
practicable after the determination that a significant change has
occurred.
Location of Disclosures and Audit/Attestation Requirements
Under the proposed and final rules, the disclosures must be
publicly available (for example, included on a public Web site) for
each of the latest three years (12 quarters) or such shorter time
period since the bank entered its first transitional floor period.
Except as discussed below, management has discretion to determine the
appropriate medium and location of the disclosures required by this
final rule. Furthermore, banks have flexibility in formatting their
public disclosures. The agencies are not specifying a fixed format for
these disclosures.
The agencies encourage management to provide all of the required
disclosures in one place on the entity's public Web site. The public
Web site addresses are reported in the regulatory reports (for example,
the FR Y-9C).\105\
---------------------------------------------------------------------------
\105\ Alternatively, banks may provide the disclosures in more
than one place, as some of them may be included in public financial
reports (for example, in Management's Discussion and Analysis
included in SEC filings) or other regulatory reports (for example,
FR Y-9C Reports). Banks must provide a summary table on their public
Web site that specifically indicates where all the disclosures may
be found (for example, regulatory report schedules or page numbers
in annual reports).
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[[Page 69386]]
Disclosure of tier 1 and total capital ratios must be provided in
the footnotes to the year-end audited financial statements.\106\
Accordingly, these disclosures must be tested by external auditors as
part of the financial statement audit. Disclosures that are not
included in the footnotes to the audited financial statements are not
subject to external audit reports for financial statements or internal
control reports from management and the external auditor.
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\106\ These ratios are required to be disclosed in the footnotes
to the audited financial statements pursuant to existing GAAP
requirements in Chapter 17 of the ``AICPA Audit and Accounting Guide
for Depository and Lending Institutions: Banks, Savings
institutions, Credit unions, Finance companies and Mortgage
companies.''
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The preamble to the proposed rule stated that due to the importance
of reliable disclosures, the agencies would require the chief financial
officer to certify that the disclosures required by the proposed rule
were appropriate and that the board of directors and senior management
were responsible for establishing and maintaining an effective internal
control structure over financial reporting, including the information
required by the proposed rule.
Several commenters expressed uncertainty regarding the proposed
certification requirement for the chief financial officer. One
commenter asked the agencies to articulate the standard of acceptance
required for the certification of disclosure standards compared with
what is required for financial reporting purposes. Another commenter
questioned whether the chief financial officer would have sufficient
familiarity with the risk management disclosures to make such a
certification.
To address commenter uncertainty, the agencies have simplified and
clarified the final rule's accountability requirements. Specifically,
the final rule modifies the certification requirement and instead
requires one or more senior officers of the bank to attest that the
disclosures meet the requirements of the final rule. The senior officer
may be the chief financial officer, the chief risk officer, an
equivalent senior officer, or a combination thereof.
Proprietary and Confidential Information
The agencies stated in the preamble to the proposed rule that they
believed the proposed requirements strike an appropriate balance
between the need for meaningful disclosure and the protection of
proprietary and confidential information.\107\ Many commenters,
however, expressed concern that the required disclosures would result
in the release of proprietary information. Commenters expressed
particular concerns about the granularity of the credit loss history
and securitization disclosures, as well as disclosures for portfolios
subject to the IRB risk-based capital formulas.
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\107\ Proprietary information encompasses information that, if
shared with competitors, would render a bank's investment in these
products/systems less valuable, and, hence, could undermine its
competitive position. Information about customers is often
confidential, in that it is provided under the terms of a legal
agreement or counterparty relationship.
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As noted above, the final rule provides banks with considerable
discretion with regard to public disclosure requirements. Bank
management determines which disclosures are relevant based on a
materiality concept. In addition, bank management has flexibility
regarding formatting and the level of granularity of disclosures,
provided they meet certain minimum requirements. Accordingly, the
agencies believe that banks generally can provide these disclosures
without revealing proprietary and confidential information. Only in
rare circumstances might disclosure of certain items of information
required in the final rule compel a bank to reveal confidential and
proprietary information. In these unusual situations, the final rule
requires that if a bank believes that disclosure of specific commercial
or financial information would prejudice seriously the position of the
bank by making public information that is either proprietary or
confidential in nature, the bank need not disclose those specific
items, but must disclose more general information about the subject
matter of the requirement, together with the fact that, and the reason
why, the specific items of information have not been disclosed. This
provision of the final rule applies only to those disclosures required
by the final rule and does not apply to disclosure requirements imposed
by accounting standards or other regulatory agencies.
3. Summary of Specific Public Disclosure Requirements
As in the proposed rule, the public disclosure requirements are
comprised of 11 tables that provide important information to market
participants on the scope of application, capital, risk exposures, risk
assessment processes, and, hence, the capital adequacy of the
institution. The agencies are adopting the tables as proposed, with the
exceptions noted below. Again, the agencies note that the substantive
content of the tables is the focus of the disclosure requirements, not
the tables themselves. The table numbers below refer to the table
numbers in the final rule.
Table 11.1 disclosures (Scope of Application) include a description
of the level in the organization to which the disclosures apply and an
outline of any differences in consolidation for accounting and
regulatory capital purposes, as well as a description of any
restrictions on the transfer of funds and capital within the
organization. These disclosures provide the basic context underlying
regulatory capital calculations.
One commenter questioned item (e) in Table 11.1, which would
require the disclosure of the aggregate amount of capital deficiencies
in all subsidiaries and the name(s) of such subsidiaries. The commenter
asserted that the scope of this item should be limited to those legal
subsidiaries that are subject to banking, securities, or insurance
regulators' capital adequacy rules and should not include unregulated
entities that are consolidated into the top corporate entity or
unconsolidated affiliate and joint ventures.
As stated in a footnote to Table 11.1 in the proposed rule, the
agencies limited the proposed requirement to legal subsidiaries that
are subject to banking, securities, or insurance regulators' capital
adequacy rules. The agencies are further clarifying this disclosure in
Table 11.1.
Table 11.2 disclosures (Capital Structure) provide information on
various components of regulatory capital available to absorb losses and
allow for an evaluation of the quality of the capital available to
absorb losses within the bank.
Table 11.3 disclosures (Capital Adequacy) provide information about
how a bank assesses the adequacy of its capital and require that the
bank disclose its minimum capital requirements for significant risk
areas and portfolios. The table also requires disclosure of the
regulatory capital ratios of the consolidated group and each DI
subsidiary. Such disclosures provide insight into the overall adequacy
of capital based on the risk profile of the organization.
Tables 11.4, 11.5, and 11.7 disclosures (Credit Risk) provide
market participants with insight into different types and
concentrations of credit risk to which the bank is exposed and the
[[Page 69387]]
techniques the bank uses to measure, monitor, and mitigate those risks.
These disclosures are intended to enable market participants to assess
the credit risk exposures under the IRB approach, without revealing
proprietary information.
Several commenters made suggestions related to Table 11.4. One
commenter addressed item (b), which requires the disclosure of total
and average gross credit risk exposures over the period broken down by
major types of credit exposure. The commenter asked the agencies to
clarify that methods used for financial reporting purposes are allowed
for determining averages. Another commenter requested that the agencies
clarify what is meant by ``gross'' in item (b), given that a related
footnote describes net credit risk exposures in accordance with GAAP.
As with most of the disclosure requirements, the agencies are not
prescriptive regarding the methodologies a bank must use for
determining averages. Rather, the bank must choose whatever methodology
it believes to be most reflective of its risk position. That
methodology may be the one the bank uses for financial reporting
purposes. The agencies have deleted ``gross'' and otherwise simplified
the wording of item (b) in Table 11.4 to enhance clarity. Item (b) now
reads ``total credit risk exposures and average credit risk exposures,
after accounting offsets in accordance with GAAP, and without taking
into account the effects of credit risk mitigation techniques (for
example collateral and netting not included in GAAP for disclosure),
over the period broken down by major types of credit exposure.''
In addition, a commenter noted that the requirements in Table 11.4
regarding the breakdown of disclosures by ``major types of credit
exposure'' in items (b) through (e) and by ``counterparty type'' for
items (d) and (f) are unclear. Moreover, with respect to items (d),
(e), and (f), the commenter recommended that disclosures should be
provided on an annual rather than quarterly basis. The same commenter
also asserted that the disclosure of remaining contractual maturity
breakdown in item (e) should be required annually. Finally, regarding
items (f) and (g), a few commenters wanted clarification of the
definition of impaired and past due loans.
The agencies are not prescriptive with regard to what is meant by
``major types of credit exposure,'' disclosure by counterparty type, or
impaired and past due loans. Bank management has the discretion to
determine the most appropriate disclosure for the bank's risk profile
consistent with internal practice, GAAP or regulatory reports (such as
the FR Y-9C). As noted in the proposal, for major types of credit
exposure a bank could apply a breakdown similar to that used for
accounting purposes, such as (a) loans, off-balance sheet commitments,
and other non-derivative off-balance sheet exposures, (b) debt
securities, and (c) OTC derivatives. The agencies do not believe it is
appropriate to make an exception to the general quarterly requirement
for quantitative disclosures for the disclosure in Table 11.4.
Commenters provided extensive feedback on several aspects of Table
11.5 (Disclosures for Portfolios Subject to IRB Risk-Based Capital
Formulas). Several commenters were concerned that the required level of
detail may compel banks to disclose proprietary information. With
respect to item (c), a couple of commenters noted that the proposal
differs from the New Accord in requiring exposure-weighted average
capital requirements instead of risk weight percentages for groups of
wholesale and retail exposures. One commenter also suggested that the
term ``actual losses'' required in item (d) needs to be defined.
Finally, several commenters objected to the proposal in item (e) to
disclose backtesting results, asserting that such results would not be
understood by the market. Commenters suggested that disclosure of this
item be delayed beyond the proposed commencement date of year-end 2010,
to commence instead ten years after a bank exits from the parallel run
period.
As discussed above, the agencies believe that, in most cases, a
bank can make the required disclosures without revealing proprietary
information and that the rule contains appropriate provisions to deal
with specific bank concerns. With regard to item (c), the agencies
agree that there is no strong policy reason to differ from the New
Accord and have changed item (c) to require the specified disclosures
in risk weight percentages rather than weighted-average capital
requirements. With respect to item (d), the agencies are not imposing a
prescriptive definition of actual losses and believe that banks should
determine actual losses consistent with internal practice. Finally,
regarding item (e), the agencies believe that public disclosure of
backtesting results provides important information to the market and
should not be delayed. However, the agencies have slightly modified the
requirement, consistent with the New Accord, to reinforce that
disclosure of individual risk parameter backtesting is not always
required.
Commenters provided feedback on a few aspects of Table 11.7 (Credit
Risk Mitigation). One commenter asserted that the table appears to
overlap with the information on credit risk mitigation required in
Table 11.5, item (a) and requested that the agencies consolidate and
simplify the requirements. In addition, several commenters objected to
Table 11.7 item (b), which would require public disclosure of the risk-
weighted asset amount associated with credit risk exposures that are
covered by credit risk mitigation in the form of guarantees and credit
derivatives. The commenter noted that this requirement is not contained
in the New Accord, which only requires the total exposure amount of
such credit risk exposures.
The agencies recognize that there is some duplication between
Tables 11.7 and 11.5. At the same time, both requirements are part of
the New Accord. The agencies have decided to address this issue by
inserting in Table 11.5, item (a), a note that the disclosures can be
met by completing the disclosures in Table 11.7. With regard to Table
11.7, item (b), the agencies have decided that there is no strong
policy reason for requiring banks to disclose risk-weighted assets
associated with credit risk exposures that are covered by credit risk
mitigation in the form of guarantees and credit derivatives. The
agencies have removed this requirement from the final rule, consistent
with the New Accord.
Table 11.6 (General Disclosure for Counterparty Credit Risk of OTC
Derivative Contracts, Repo-Style Transaction, and Eligible Margin
Loans) provides the disclosure requirements related to credit exposures
from derivatives. See the July 2005 BCBS publication entitled ``The
Application of Basel II to Trading Activities and the Treatment of
Double Default Effects.''
Commenters raised a few issues with respect to Table 11.6. One
commenter requested that the agencies clarify item (a), which requires
a discussion of the impact of the amount of collateral the bank would
have to provide given a credit rating downgrade. The commenter asked
whether this disclosure refers to credit downgrade of the bank, the
counterparty, or some other entity. Another commenter objected to item
(b), which would require the breakdown of counterparty credit exposure
by type of exposure. The commenter asserted that this proposed
requirement is burdensome, infeasible for netted exposures and
duplicative of other information generally available in existing GAAP
and U.S. bank regulatory financial statements.
[[Page 69388]]
The agencies have decided to clarify that item (a) refers in part
to the credit rating downgrade of the bank making the disclosure. This
is consistent with the intent of this disclosure requirement in the New
Accord. With respect to item (b), the agencies recognize that this
proposed requirement may be problematic for banks that have implemented
the internal models methodology. Accordingly, the agencies have decided
to modify the rule to note that this disclosure item is only required
for banks not using the internal models methodology in section 32(d).
Table 11.8 disclosures (Securitization) provide information to
market participants on the amount of credit risk transferred and
retained by the organization through securitization transactions and
the types of products securitized by the organization. These
disclosures provide users a better understanding of how securitization
transactions impact the credit risk of the bank.
One commenter asked the agencies to explicitly acknowledge that
they will accept the definitions and interpretations of the components
of securitization exposures that a bank uses for financial reporting
purposes (FAS 140 reporting disclosures).
Generally, as noted above, the agencies expect that a bank will be
able to fulfill some of its disclosure requirements by relying on
disclosures made in accordance with accounting standards, SEC mandates,
or regulatory reports. In these situations, a bank must explain any
material differences between the accounting or other disclosure and the
disclosures required under the final rule. The agencies do not believe
any changes to the rule are necessary to accommodate the commenter's
concern.
Table 11.9 disclosures (Operational Risk) provide insight into the
bank's application of the AMA for operational risk and what internal
and external factors are considered in determining the amount of
capital allocated to operational risk.
Table 11.10 disclosures (Equities Not Subject to Market Risk Rule)
provide market participants with an understanding of the types of
equity securities held by the bank and how they are valued. The table
also provides information on the capital allocated to different equity
products and the amount of unrealized gains and losses.
Table 11.11 disclosures (Interest Rate Risk in Non-Trading
Activities) provide information about the potential risk of loss that
may result from changes in interest rates and how the bank measures
such risk.
4. Regulatory Reporting
In addition to the public disclosures required by the consolidated
banking organization subject to the advanced approaches, the agencies
will require certain additional regulatory reporting from BHCs, their
subsidiary DIs, and DIs applying the advanced approaches that are not
subsidiaries of BHCs. The agencies believe that the reporting of key
risk parameter estimates by each DI applying the advanced approaches
will provide the primary Federal supervisor and other relevant
supervisors with data important for assessing the reasonableness and
accuracy of the bank's calculation of its minimum capital requirements
under this final rule and the adequacy of the institution's capital in
relation to its risks. This information will be collected through
regulatory reports. The agencies believe that requiring certain common
reporting across banks will facilitate comparable application of the
final rule.
The agencies will publish in the Federal Register reporting
schedules based on the reporting templates issued for comment in
September 2006. Consistent with the proposed reporting schedules, these
reporting schedules will include a summary schedule with aggregate data
that will be available to the general public. It also will include
supporting schedules that will be viewed as confidential supervisory
information. These schedules will be broken out by exposure category
and will collect risk parameter and other pertinent data in a
systematic manner. Under the final rule, banks must begin reporting
this information during their parallel run on a confidential basis. The
agencies will share this information with each other for calibration
and other analytical purposes.
One commenter expressed concerns that some of the confidential
information requested in the proposed reporting templates was also
contained in the public disclosure requirements under the proposal. As
a result, some information would be classified as confidential in the
reporting templates and public under the disclosure requirements in the
final rule.
The agencies recognize that there may be some overlap between
confidential information required in the regulatory reports and public
information required in the disclosure requirements of the final rule.
The agencies will address specific comments on the reporting templates
separately. In general, the agencies believe that given the different
purposes of the regulatory reporting and public disclosure requirements
under the final rule, there may be some instances where the same or
similar disclosures may be required by both sets of requirements. Many
of the public disclosures cover only a subset of the information sought
in the proposed regulatory reporting templates. For instance, banks are
required only to disclose publicly information ``across a sufficient
number of PD grades to allow a meaningful differentiation of credit
risk,'' whereas the proposed reporting templates contemplate a much
more granular collection of data by specified PD bands. Such
aggregation of data so as to mask the confidential nature of more
granular information that is reported to regulators is not unique to
the advanced approaches reporting. In addition, the agencies believe
that a bank may be able to comply with some of the public disclosure
requirements under this final rule by publicly disclosing, at the
bank's discretion and judgment, certain information found in the
reporting templates that otherwise would be held confidential by the
agencies. A bank could disclose this information on its Web site (as
described in ``location and audit requirements'' above) if it believes
that such disclosures will meet the public disclosure requirements
required by the rule.
List of Acronyms
ABCP Asset-Backed Commercial Paper
ALLL Allowance for Loan and Lease Losses
AMA Advanced Measurement Approaches
ANPR Advance Notice of Proposed Rulemaking
AVC Asset Value Correlation
BCBS Basel Committee on Banking Supervision
BHC Bank Holding Company
CCDS Contingent Credit Default Swap
CF Conversion Factor
CEIO Credit-Enhancing Interest-Only Strip
CRM Credit Risk Mitigation
CUSIP Committee on Uniform Securities Identification Procedures
DI Depository Institution
DvP Delivery versus Payment
E Measure of Effectiveness
EAD Exposure at Default
ECL Expected Credit Loss
EE Expected Exposure
EL Expected Loss
ELGD Expected Loss Given Default
EOL Expected Operational Loss
EPE Expected Positive Exposure
EWALGD Exposure-Weighted Average Loss Given Default
FAS Financial Accounting Standard
FDIC Federal Deposit Insurance Corporation
FFIEC Federal Financial Institutions Examination Council
GAAP Generally Accepted Accounting Principles
GAO Government Accountability Office
HELOC Home Equity Line of Credit
HOLA Home Owners' Loan Act
[[Page 69389]]
HVCRE High-Volatility Commercial Real Estate
IAA Internal Assessment Approach
ICAAP Internal Capital Adequacy Assessment Process
IMA Internal Models Approach
IRB Internal Ratings-Based
KIRB Capital Requirement for Underlying Pool of Exposures
(securitizations)
LGD Loss Given Default
LTV Loan-to-Value Ratio
M Effective Maturity
NRSRO Nationally Recognized Statistical Rating Organization
OCC Office of the Comptroller of the Currency
OTC Over-the-Counter
OTS Office of Thrift Supervision
PCA Prompt Corrective Action
PD Probability of Default
PFE Potential Future Exposure
PMI Private Mortgage Insurance
PvP Payment versus Payment
QIS-3 Quantitative Impact Study 3
QIS-4 Quantitative Impact Study 4
QIS-5 Quantitative Impact Study 5
QRE Qualifying Revolving Exposure
RBA Ratings-Based Approach
RVC Ratio of Value Change
SEC Securities and Exchange Commission
SFA Supervisory Formula Approach
SME Small- and Medium-Size Enterprise
SPE Special Purpose Entity
SRWA Simple Risk-Weight Approach
TFR Thrift Financial Report
UL Unexpected Loss
UOL Unexpected Operational Loss
VaR Value-at-Risk
Regulatory Flexibility Act Analysis
The Regulatory Flexibility Act (RFA) requires an agency that is
issuing a final rule to prepare and make available a regulatory
flexibility analysis that describes the impact of the final rule on
small entities. 5 U.S.C. 603(a). The RFA provides that an agency is not
required to prepare and publish a regulatory flexibility analysis if
the agency certifies that the final rule will not have a significant
economic impact on a substantial number of small entities. 5 U.S.C.
605(b).
Pursuant to section 605(b) of the RFA (5 U.S.C. 605(b)), the
agencies certify that this final rule will not have a significant
economic impact on a substantial number of small entities. Pursuant to
regulations issued by the Small Business Administration (13 CFR
121.201), a ``small entity'' includes a bank holding company,
commercial bank, or savings association with assets of $165 million or
less (collectively, small banking organizations). The final rule
requires a bank holding company, national bank, state member bank,
state nonmember bank, or savings association to calculate its risk-
based capital requirements according to certain internal-ratings-based
and internal model approaches if the bank holding company, bank, or
savings association (i) has consolidated total assets (as reported on
its most recent year-end regulatory report) equal to $250 billion or
more; (ii) has consolidated total on-balance sheet foreign exposures at
the most recent year-end equal to $10 billion or more; or (iii) is a
subsidiary of a bank holding company, bank, or savings association that
would be required to use the proposed rule to calculate its risk-based
capital requirements.
The agencies estimate that zero small bank holding companies (out
of a total of approximately 2,919 small bank holding companies), 16
small national banks (out of a total of approximately 948 small
national banks), one small state member bank (out of a total of
approximately 468 small state member banks), one small state nonmember
bank (out of a total of approximately 3,242 small state nonmember
banks), and zero small savings associations (out of a total of
approximately 419 small savings associations) would be subject to the
final rule on a mandatory basis. In addition, each of the small banking
organizations subject to the final rule on a mandatory basis is a
subsidiary of a bank holding company with over $250 billion in
consolidated total assets or over $10 billion in consolidated total on-
balance sheet foreign exposure. Therefore, the agencies believe that
the final rule will not result in a significant economic impact on a
substantial number of small entities.
Paperwork Reduction Act
In accordance with the requirements of the Paperwork Reduction Act
of 1995, the agencies may not conduct or sponsor, and respondents are
not required to respond to, an information collection unless it
displays a currently valid Office of Management and Budget (OMB)
control number. OMB assigned the following control numbers to the
collections of information: 1557-0234 (OCC), 3064-0153 (FDIC), and
1550-0115 (OTS). The Board assigned control number 7100-0313.
In September 2006 the OCC, FDIC, and OTS submitted the information
collections contained in this rule to OMB for review and approval once
the proposed rule was published. The Board, under authority delegated
to it by OMB, also submitted the proposed information collection to
OMB.
The agencies (OCC, FDIC, the Board, and OTS) determined that
sections 21-24, 42, 44, 53, and 71 of the final rule contain
collections of information. The final rule sets forth a new risk-based
capital adequacy framework that would require some banks and allow
other qualifying banks to use an internal ratings-based approach to
calculate regulatory credit risk capital requirements and advanced
measurement approaches to calculate regulatory operational risk capital
requirements. The collections of information are necessary in order to
implement the proposed advanced capital adequacy framework. The
agencies received approximately ninety public comments. None of the
comment letters specifically addressed the proposed burden estimates;
therefore, the burden estimates will remain unchanged, as published in
the notice of proposed rulemaking (71 FR 55830).
The affected public are: national banks and Federal branches and
agencies of foreign banks (OCC); state member banks, bank holding
companies, affiliates and certain non-bank subsidiaries of bank holding
companies, uninsured state agencies and branches of foreign banks,
commercial lending companies owned or controlled by foreign banks, and
Edge and agreement corporations (Board); insured nonmember banks,
insured state branches of foreign banks, and certain subsidiaries of
these entities (FDIC); and savings associations and certain of their
subsidiaries (OTS).
Comment Request
The agencies have an ongoing interest in your comments. They should
be sent to [Agency] Desk Officer, [OMB No.], by mail to U.S. Office of
Management and Budget, 725 17th Street, NW., 10235,
Washington, DC 20503, or by fax to (202) 395-6974.
Comments submitted in response to this notice will be shared among
the agencies. All comments will become a matter of public record.
Written comments should address the accuracy of the burden estimates
and ways to minimize burden including the use of automated collection
techniques or the use of other forms of information technology as well
as other relevant aspects of the information collection request.
OCC Executive Order 12866
Executive Order 12866 requires Federal agencies to prepare a
regulatory impact analysis for agency actions that are found to be
``significant regulatory actions.'' ``Significant regulatory actions''
include, among other things, rulemakings that ``have an annual effect
on the economy of $100 million or more or adversely affect in a
material way the economy, a sector of the economy, productivity,
competition, jobs, the environment, public health or safety, or State,
local, or tribal governments or
[[Page 69390]]
communities.''\108\ Regulatory actions that satisfy one or more of
these criteria are referred to as ``economically significant regulatory
actions.''
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\108\ 108 Executive Order 12866 (September 30, 1993), 58 FR
51735 (October 4, 1993), as amended by Executive Order 13258
(February 26, 2002), 67 FR 9385 (February 28, 2002) and by Executive
Order 13422 (January 18, 2007), 72 FR 2763 (January 23, 2007). For
the complete text of the definition of ``significant regulatory
action,'' see E.O. 12866 at Sec. 3(f). A ``regulatory action'' is
``any substantive action by an agency (normally published in the
Federal Register) that promulgates or is expected to lead to the
promulgation of a final rule or regulation, including notices of
inquiry, advance notices of proposed rulemaking, and notices of
proposed rulemaking.'' E.O. 12866 at Sec. 3(e).
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The OCC anticipates that the final rule will meet the $100 million
criterion and therefore is an economically significant regulatory
action. In conducting the regulatory analysis for an economically
significant regulatory action, Executive Order 12866 requires each
Federal agency to provide to the Administrator of the Office of
Management and Budget's (OMB) Office of Information and Regulatory
Affairs (OIRA):
The text of the draft regulatory action, together with a
reasonably detailed description of the need for the regulatory action
and an explanation of how the regulatory action will meet that need;
An assessment of the potential costs and benefits of the
regulatory action, including an explanation of the manner in which the
regulatory action is consistent with a statutory mandate and, to the
extent permitted by law, promotes the President's priorities and avoids
undue interference with State, local, and tribal governments in the
exercise of their governmental functions;
An assessment, including the underlying analysis, of
benefits anticipated from the regulatory action (such as, but not
limited to, the promotion of the efficient functioning of the economy
and private markets, the enhancement of health and safety, the
protection of the natural environment, and the elimination or reduction
of discrimination or bias) together with, to the extent feasible, a
quantification of those benefits;
An assessment, including the underlying analysis, of costs
anticipated from the regulatory action (such as, but not limited to,
the direct cost both to the government in administering the regulation
and to businesses and others in complying with the regulation, and any
adverse effects on the efficient functioning of the economy, private
markets (including productivity, employment, and competitiveness),
health, safety, and the natural environment), together with, to the
extent feasible, a quantification of those costs; and
An assessment, including the underlying analysis, of costs
and benefits of potentially effective and reasonably feasible
alternatives to the planned regulation, identified by the agencies or
the public (including improving the current regulation and reasonably
viable nonregulatory actions), and an explanation why the planned
regulatory action is preferable to the identified potential
alternatives.
Set forth below is a summary of the OCC's regulatory impact analysis,
which can be found in its entirety at http://www.occ.treas.gov/law/basel.htm under the link of ``Regulatory Impact Analysis for Risk-Based
Capital Standards: Revised Capital Adequacy Guidelines (Basel II:
Advanced Approach) 2007''.
I. The Need for the Regulatory Action
Federal banking law directs Federal banking agencies including the
Office of the Comptroller of the Currency (OCC) to require banking
organizations to hold adequate capital. The law authorizes Federal
banking agencies to set minimum capital levels to ensure that banking
organizations maintain adequate capital. The law also gives Federal
banking agencies broad discretion with respect to capital regulation by
authorizing them to also use any other methods that they deem
appropriate to ensure capital adequacy.
Capital regulation seeks to address market failures that stem from
several sources. Asymmetric information about the risk in a bank's
portfolio creates a market failure by hindering the ability of
creditors and outside monitors to discern a bank's actual risk and
capital adequacy. Moral hazard creates market failure in which the
bank's creditors fail to restrain the bank from taking excessive risks
because deposit insurance either fully or partially protects them from
losses. Public policy addresses these market failures because
individual banks fail to adequately consider the positive externality
or public benefit that adequate capital brings to financial markets and
the economy as a whole.
Capital regulations cannot be static. Innovation in and
transformation of financial markets require periodic reassessments of
what may count as capital and what amount of capital is adequate.
Continuing changes in financial markets create both a need and an
opportunity to refine capital standards in banking. The Basel Committee
on Banking Supervision's ``International Convergence of Capital
Measurement and Capital Standards: A Revised Framework'' (New Accord),
and its implementation in the United States, reflects an appropriate
step forward in addressing these changes.
II. Regulatory Background
The capital regulation examined in this analysis will apply to
commercial banks and savings associations (collectively, banks). Three
banking agencies, the OCC, the Board of Governors of the Federal
Reserve System (Board), and the FDIC regulate commercial banks, while
the Office of Thrift Supervision (OTS) regulates all federally
chartered and many state-chartered savings associations. Throughout
this document, the four are jointly referred to as the Federal banking
agencies.
The New Accord comprises three mutually reinforcing ``pillars'' as
summarized below.
1. Minimum Capital Requirements (Pillar 1)
The first pillar establishes a method for calculating minimum
regulatory capital. It sets new requirements for assessing credit risk
and operational risk while retaining the approach to market risk as
developed in the 1996 amendments to the 1988 Accord.
The New Accord offers banks a choice of three methodologies for
calculating a capital charge for credit risk. The first approach,
called the Standardized Approach, essentially refines the risk-
weighting framework of the 1988 Accord. The other two approaches are
variations on an internal ratings-based (IRB) approach that leverages
banks' internal credit-rating systems: a ``foundation'' methodology in
which banks estimate the probability of borrower or obligor default,
and an ``advanced'' approach in which banks also supply other inputs
needed for the capital calculation. In addition, the new framework uses
more risk-sensitive methods for dealing with collateral, guarantees,
credit derivatives, securitizations, and receivables.
The New Accord also introduces an explicit capital requirement for
operational risk.\109\ The New Accord offers banks a choice of three
methodologies for calculating their capital charge for operational
risk. The first method, called the Basic Indicator Approach, requires
banks to hold capital for operational risk equal to 15 percent of
annual gross income (averaged over the most recent three years). The
second option, called the
[[Page 69391]]
Standardized Approach, uses a formula that divides a bank's activities
into eight business lines, calculates the capital charge for each
business line as a fixed percentage of gross income (12 percent, 15
percent, or 18 percent depending on the nature of the business, again
averaged over the most recent three years), and then sums across
business lines. The third option, called the Advanced Measurement
Approaches (AMA), uses an bank's internal operational risk measurement
system to determine the capital requirement.
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\109\ Operational risk is the risk of loss resulting from
inadequate or failed processes, people, and systems or from external
events. It includes legal risk, but excludes strategic risk and
reputation risk.
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2. Supervisory Review Process (Pillar 2)
The second pillar calls upon banks to have an internal capital
assessment process and banking supervisors to evaluate each bank's
overall risk profile as well as its risk management and internal
control processes. This pillar establishes an expectation that banks
hold capital beyond the minimums computed under Pillar 1, including
additional capital for any risks that are not adequately captured under
Pillar 1. It encourages banks to develop better risk management
techniques for monitoring and managing their risks. Pillar 2 also
charges supervisors with the responsibility to ensure that banks using
advanced Pillar 1 techniques, such as the IRB approach to credit risk
and the AMA for operational risk (collectively, advanced approaches),
comply with the minimum standards and disclosure requirements of those
methods, and take action promptly if capital is not adequate.
3. Market Discipline (Pillar 3)
The third pillar of the New Accord sets minimum disclosure
requirements for banks. The disclosures, covering the composition and
structure of the bank's capital, the nature of its risk exposures, its
risk management and internal control processes, and its capital
adequacy, are intended to improve transparency and strengthen market
discipline. By establishing a common set of disclosure requirements,
Pillar 3 seeks to provide a consistent and understandable disclosure
framework that market participants can use to assess key pieces of
information on the risks and capital adequacy of a bank.
4. U.S. Implementation
The rule for implementing the New Accord's advanced approaches in
the United States will apply the new framework to the largest and most
internationally active banks. All banks will fall into one of three
regulatory categories. The first category, called ``mandatory'' banks,
consists of banks with consolidated assets of at least $250 billion or
consolidated on-balance-sheet foreign exposures of $10 billion or more.
Mandatory banks will have to use the New Accord's most advanced methods
only: the Advanced IRB approach to determine capital for credit risk
and the AMA to determine capital for operational risk. A second
category of banks, called ``opt-in'' banks, includes banks that do not
meet either size criteria of a mandatory bank but choose voluntarily to
comply with the advanced approaches specified under the New Accord. The
third category, called ``general'' banks, encompasses all other banks,
and these will continue to operate under existing risk-based capital
rules, subject to any amendments.
Various changes to the rules that apply to non-mandatory banks are
under consideration. The Federal banking agencies have decided to issue
for comment a proposal that would allow the voluntary adoption of the
standardized approach for credit risk and the basic indicator approach
for operational risk for non-mandatory banks (referred to hereafter as
the Standardized Option). Because the Standardized Option would be a
separate rulemaking, our analysis will focus just on the implementation
of the Advanced Approaches. However, we will note how the Standardized
Option might affect the outcome of our analysis if we anticipate the
possibility that its adoption could lead to a significantly different
outcome.
While introducing many significant changes, the U.S. implementation
of the New Accord retains many components of the capital rules
currently in effect. For example, it preserves existing Prompt
Corrective Action provisions for all banks. The U.S. implementation of
the New Accord also keeps intact most elements of the definition of
what comprises regulatory capital.
III. Costs and Benefits of the Rule
This analysis considers the costs and benefits of the fully phased-
in rule. Under the rule, current capital rules will remain in effect in
2008 during a parallel run using both old and new capital rules. For
three years following the parallel run, the final rule will apply
limits on the amount by which minimum required capital may decrease.
This analysis, however, considers the costs and benefits of the rule as
fully phased in.
Cost and benefit analysis of changes in minimum capital
requirements entail considerable measurement problems. On the cost
side, it can be difficult to attribute particular expenditures incurred
by banks to the costs of implementation because banks would likely
incur some of these costs as part of their ongoing efforts to improve
risk measurement and management systems. On the benefits side,
measurement problems are even greater because the benefits of the rule
are more qualitative than quantitative. Measurement problems exist even
with an apparently measurable effect such as lower minimum capital
because lower minimum requirements do not necessarily mean lower
capital levels held by banks. Healthy banks generally hold capital well
above regulatory minimums for a variety of reasons, and the effect of
reducing the regulatory minimum is uncertain and may vary across
regulated banks.
Benefits of the Rule
1. Better allocation of capital and reduced impact of moral hazard
through reduction in the scope for regulatory arbitrage: By assessing
the amount of capital required for each exposure or pool of exposures,
the advanced approaches do away with the simplistic risk buckets of
current capital rules. Getting rid of categorical risk weighting and
assigning capital based on measured risk instead greatly curtails or
eliminates the ability of troubled banks to ``game'' regulatory capital
requirements by finding ways to comply technically with the
requirements while evading their intent and spirit.
2. Improved signal quality of capital as an indicator of solvency:
The advanced approaches are designed to more accurately align
regulatory capital with risk, which should improve the signal quality
of capital as an indicator of solvency. The improved signaling quality
of capital will enhance banking supervision and market discipline.
3. Encourages banks to improve credit risk management: One of the
principal objectives of the rule is to more closely align capital
charges and risk. For any type of credit, risk increases as either the
probability of default or the loss given default increases. Under the
final rule, the capital charge for credit risk depends on these risk
parameter measures and consequently capital requirements will more
closely reflect risk. This enhanced link between capital requirements
and risk will encourage banks to improve credit risk management.
4. More efficient use of required bank capital: Increased risk
sensitivity and improvements in risk measurement will allow prudential
objectives to be achieved more efficiently. If capital rules can better
align capital with risk across the system, a given level of capital
will be able to support a higher level of banking activity while
[[Page 69392]]
maintaining the same degree of confidence regarding the safety and
soundness of the banking system. Social welfare is enhanced by either
the stronger condition of the banking system or the increased economic
activity the additional banking services facilitate.
5. Incorporates and encourages advances in risk measurement and
risk management: The rule seeks to improve upon existing capital
regulations by incorporating advances in risk measurement and risk
management made over the past 15 years. An objective of the rule is to
speed adoption of new risk management techniques and to promote the
further development of risk measurement and management through the
regulatory process.
6. Recognizes new developments and accommodates continuing
innovation in financial products by focusing on risk: The rule also has
the benefit of facilitating recognition of new developments in
financial products by focusing on the fundamentals behind risk rather
than on static product categories.
7. Better aligns capital and operational risk and encourages banks
to mitigate operational risk: Introducing an explicit capital
calculation for operational risk eliminates the implicit and imprecise
``buffer'' that covers operational risk under current capital rules.
Introducing an explicit capital requirement for operational risk
improves assessments of the protection capital provides, particularly
at banks where operational risk dominates other risks. The explicit
treatment also increases the transparency of operational risk, which
could encourage banks to take further steps to mitigate operational
risk.
8. Enhanced supervisory feedback: Although U.S. banks have long
been subject to close supervision, aspects of all three pillars of the
rule aim to enhance supervisory feedback from Federal banking agencies
to managers of banks. Enhanced feedback could further strengthen the
safety and soundness of the banking system.
9. Enhanced disclosure promotes market discipline: The rule seeks
to aid market discipline through the regulatory framework by requiring
specific disclosures relating to risk measurement and risk management.
Market discipline could complement regulatory supervision to bolster
safety and soundness.
10. Preserves the benefits of international consistency and
coordination achieved with the 1988 Basel Accord: An important
objective of the 1988 Accord was competitive consistency of capital
requirements for banks competing in global markets. The New Accord
continues to pursue this objective. Because achieving this objective
depends on the consistency of implementation in the United States and
abroad, the Basel Committee on Banking Supervision (BCBS) has
established an Accord Implementation Group to promote consistency in
the implementation of the New Accord.
11. Ability to opt in offers long-term flexibility to nonmandatory
banks: The U.S. implementation of the New Accord allows non-mandatory
banks to individually judge when the benefits they expect to realize
from adopting the advanced approaches outweigh their costs. Even though
the cost and complexity of adopting the advanced methods may present
non-mandatory banks with a substantial hurdle to opting in at present,
the potential long-term benefits of allowing non-mandatory banks to
partake in the benefits described above may be similarly substantial.
Costs of the Rule
Because banks are constantly developing programs and systems to
improve how they measure and manage risk, it is difficult to
distinguish between expenditures explicitly caused by adoption of this
final rule and costs that would have occurred irrespective of any new
regulation. In an effort to identify how much banks expect to spend to
comply with the U.S. implementation of the New Accord's advanced
approaches, the Federal banking agencies included several questions
related to compliance costs in the fourth Quantitative Impact Study
(QIS-4).\110\
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\110\ For more information on QIS-4, see Office of the
Comptroller of the Currency, Board of Governors of the Federal
Reserve System, Federal Deposit Insurance Corporation, and Office of
Thrift Supervision, ``Summary Findings of the Fourth Quantitative
Impact Study,'' February 2006, available online at http://www.occ.treas.gov/ftp/release/2006-23a.pdf.
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1. Overall Costs: According to the 19 out of 26 QIS-4 questionnaire
respondents that provided estimates of their implementation costs,
banks will spend roughly $42 million on average to adapt to capital
requirements implementing the New Accord's advanced approaches. Not all
of these respondents are likely mandatory banks. Counting just the
likely mandatory banks, the average is approximately $46 million, so
there is little difference between banks that meet a mandatory
threshold and those that do not. Aggregating estimated expenditures
from all 19 respondents indicates that these banks will spend a total
of $791 million over several years to implement the rule. Estimated
costs for nine respondents meeting one of the mandatory thresholds come
to $412 million.
2. Estimate of costs specific to the rule: Ten QIS-4 respondents
provided estimates of the portion of costs they would have incurred
even if current capital rules remain in effect. Those ten indicated
that they would have spent 45 percent on average, or roughly half of
their advanced approaches expenditures on improving risk management
anyway. This suggests that of the $42 million banks expect to spend on
implementation, approximately $21 million may represent expenditures
each bank would have undertaken even without the New Accord. Thus, pure
implementation costs may be closer to roughly $395 million for the 19
QIS-4 respondents.
3. Ongoing costs: Seven QIS-4 respondents were able to estimate
what their recurring costs might be under the U.S implementation of the
New Accord. On average, the seven banks estimate that annual recurring
expenses attributable to the revised capital framework will be $2.4
million per bank. Banks indicated that the ongoing costs to maintain
related technology reflect costs for increased personnel and system
maintenance. The larger one-time expenditures to adopt this final rule
primarily involve money for system development and software purchases.
4. Implicit costs: In addition to explicit setup and recurring
costs, banks may also face implicit costs arising from the time and
inconvenience of having to adapt to new capital regulations. At a
minimum this involves the increased time and attention required of
senior bank management to introduce new programs and procedures and the
need to closely monitor the new activities during the inevitable rough
patches when the rule first takes effect.
5. Government Administrative Costs: OCC expenditures fall into
three broad categories: training, guidance, and supervision. Training
includes expenses for AMA and IRB workshops, and other training courses
and seminars for examiners. Guidance expenses reflect expenditures on
the development of IRB and AMA guidance. Supervision expenses reflect
bank-specific supervisory activities related to the development and
implementation of the New Accord. The largest OCC expenditures have
been on the development of IRB and AMA policy guidance. The $5.4
million spent on guidance represents 54 percent of the estimated total
OCC advanced
[[Page 69393]]
approaches-related expenditure of $10.0 million through the 2006 fiscal
year. In part, this large share reflects the absence of data for
training and supervision costs for several years, but it also is
indicative of the large guidance expenses in 2002 and 2003 when the New
Accord was in development. To date, New Accord expenditures have not
been a large part of overall OCC expenditures. The $3 million spent on
the advanced approaches in fiscal year 2006 represents less than one
percent of the OCC's $579 million budget for the year.
6. Total Cost: The OCC's estimate of the total cost of the rule
includes expenditures by banks and the OCC from the present through
2011, the final year of the transition period. Combining expenditures
by mandatory banks and the OCC provides a present value estimate of
$498.9 million for the total cost of the rule.
7. Procyclicality: Procyclicality refers to the possibility that
banks may reduce lending during economic downturns and increase lending
during economic expansions as a consequence of minimum capital
requirements. There is some concern that the risk-sensitivity of the
Advanced IRB approach may cause capital requirements for credit risk to
increase during an economic downturn. Although procyclicality may be
inherent in banking to some extent, elements of the advanced approaches
could reduce inherent procyclicality. Risk management and information
systems may provide bank managers with more forward-looking information
about risk that will allow them to adjust portfolios gradually and with
more foresight as the economic outlook changes over the business cycle.
Regulatory stress-testing requirements included in the rule also will
help ensure that banks anticipate cyclicality in capital requirements
to the greatest extent possible, reducing the potential economic impact
of changes in capital requirements.
IV. Competition Among Providers of Financial Services
One potential concern with any regulatory change is the possibility
that it might create a competitive advantage for some banks relative to
others, a possibility that certainly applies to a change with the scope
of this final rule. However, measurement difficulties described in the
preceding discussion of costs and benefits also extend to any
consideration of the impact on competition. Despite the inherent
difficulty of drawing definitive conclusions, this section considers
various ways in which competitive effects might be manifest, as well as
available evidence related to those potential effects.
1. Explicit Capital for Operational Risk: Some have noted that the
explicit computation of required capital for operational risk could
lead to an increase in total minimum regulatory capital for U.S.
``processing'' banks, generally defined as banks that tend to engage in
a variety of activities related to securities clearing, asset
management, and custodial services. Some have suggested that the
increase in required capital could place such firms at a competitive
disadvantage relative to competitors that do not face a similar capital
requirement. A careful analysis by Fontnouvelle et al.\111\ considers
the potential competitive impact of the explicit capital requirement
for operational risk. Overall, the study concludes that competitive
effects from an explicit operational risk capital requirement should
be, at most, extremely modest.
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\111\ Patrick de Fontnouvelle, Victoria Garrity, Scott Chu, and
Eric Rosengren, ``The Potential Impact of Explicit Basel II
Operational Risk Capital Charges on the Competitive Environment of
Processing Banks in the United States,'' manuscript, Federal Reserve
Bank of Boston, January 12, 2005. Available at http://www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
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2. Residential Mortgage Lending: The issue of competitive effects
has received substantial attention with respect to the residential
mortgage market. The focus on the residential mortgage market stems
from the size and importance of the market in the United States, and
the fact that the rule may lead to substantial reductions in credit-
risk capital for residential mortgages. To the extent that
corresponding operational-risk capital requirements do not offset these
credit-risk-related reductions, overall capital requirements for
residential mortgages could decline under the rule. Studies by Calem
and Follain\112\ and Hancock, Lennert, Passmore, and Sherlund \113\
suggest that banks operating under rules based on the New Accord's
advance approaches may increase their holdings of residential
mortgages. Calem and Follain argue that the increase would be
significant and come at the expense of general banks. Hancock et al.
foresee a more modest increase in residential mortgage holdings at
banks operating under the advanced approaches rule, and they see this
increase primarily as a shift away from the large government sponsored
mortgage enterprises.
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\112\ Paul S. Calem and James R. Follain, ``Regulatory Capital
Arbitrage and the Potential Competitive Impact of Basel II in the
Market for Residential Mortgages'', The Journal of Real Estate
Finance and Economics, Vol. 35, pp. 197-219, August 2007.
\113\ Diana Hancock, Andreas Lennert, Wayne Passmore, and Shane
M. Sherlund, ``An Analysis of the Potential Competitive Impact of
Basel II Capital Standards on U.S. Mortgage Rates and Mortgage
Securitization'', manuscript, Federal Reserve Board, April 2005.
Available at http://www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
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3. Small Business Lending: One potential avenue for competitive
effects is small-business lending. Smaller banks--those that are less
likely to adopt the advanced approaches to regulatory capital under the
rule--tend to rely more heavily on smaller loans within their
commercial loan portfolios. To the extent that the rule reduces
required capital for such loans, general banks not operating under the
rule might be placed at a competitive disadvantage. A study by
Berger\114\ finds some potential for a relatively small competitive
effect on smaller banks in small business lending. However, Berger
concludes that the small business market for large banks is very
different from the small business market for smaller banks. For
instance, a ``small business'' at a larger bank is usually much larger
than small businesses at community banks.
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\114\ Allen N. Berger, ``Potential Competitive Effects of Basel
II on Banks in SME Credit Markets in the United States,'' Journal of
Financial Services Research, 29:1, pp. 5-36, 2006. Also available at
http://www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
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4. Mergers and Acquisitions: Another concern related to potential
changes in competitive conditions under the rule is that bifurcation of
capital standards might change the landscape with regard to mergers and
acquisitions in banking and financial services. For example, banks
operating under this final rule might be placed in a better position to
acquire banks operating under the old rules, possibly leading to an
undesirable consolidation of the banking sector. Research by Hannan and
Pilloff \115\ suggests that the rule is unlikely to have a significant
impact on merger and acquisition activity in banking.
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\115\ Timothy H. Hannan and Steven J. Pilloff, ``Will the
Proposed Application of Basel II in the United States Encourage
Increased Bank Merger Activity? Evidence from Past Merger
Activity,'' Federal Reserve Board Finance and Economics Discussion
Series, 2004-13, February 2004. Available at http://www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
---------------------------------------------------------------------------
5. Credit Card Competition: The U.S. implementation of the New
Accord might also affect competition in the credit card market. Overall
capital requirements for credit card loans could increase under the
rule. This raises the possibility of a change in the competitive
environment among banks subject to the new rules, nonbank credit card
issuers, and banks not subject to this final rule. A study by Lang,
Mester,
[[Page 69394]]
and Vermilyea\116\ finds that implementation of a rule based on the New
Accord will not affect credit card competition at most community and
regional banks. The authors also suggest that higher capital
requirements for credit cards may only pose a modest disadvantage to
banks that are subject to this final rule.
---------------------------------------------------------------------------
\116\ William W. Lang, Loretta J. Mester, and Todd A. Vermilyea,
``Potential Competitive Effects on U.S. Bank Credit Card Lending
from the Proposed Bifurcated Application of Basel II,'' manuscript,
Federal Reserve Bank of Philadelphia, December 2005. Available at
http://www.philadelphiafed.org/files/wps/2005/wp05-29.pdf.
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Overall, the evidence regarding the impact of this final rule on
competitive equity is mixed. The body of recent economic research
discussed in the body of this report does not reveal persuasive
evidence of any sizeable competitive effects. Nonetheless, the Federal
banking agencies recognize the need to closely monitor the competitive
landscape subsequent to any regulatory change. In particular, the OCC
and other Federal banking agencies will be alert for early signs of
competitive inequities that might result from this final rule. A multi-
year transition period before full implementation of this final rule
should provide ample opportunity for the Federal banking agencies to
identify any emerging problems. In particular, after the end of the
second transition year, the agencies will conduct and publish a study
that evaluates the advanced approaches to determine if there are any
material deficiencies.\117\ The Federal banking agencies will consider
any egregious competitive effects associated with New Accord
implementation, whether domestic or international in context, to be a
material deficiency. To the extent that undesirable competitive
inequities emerge, the agencies have the power to respond to them
through many channels, including but not limited to suitable changes to
the capital adequacy regulations.
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\117\ The full text of the Regulatory Impact Analysis describes
the factors that the interagency study will consider.
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V. Analysis of Baseline and Alternatives
In order to place the costs and benefits of the rule in context,
Executive Order 12866 requires a comparison between this final rule, a
baseline of what the world would look like without this final rule, and
several reasonable alternatives to the rule. In this regulatory impact
analysis, we analyze a baseline and three alternatives to the rule. The
baseline analyzes the situation where the Federal banking agencies do
not adopt this final rule, but other countries with internationally
active banks do adopt the New Accord.\118\
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\118\ In addition to the United States, members of the BCBS
implementing Basel II are Belgium, Canada, France, Germany, Italy,
Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, and
the United Kingdom.
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1. Baseline Scenario: Current capital standards based on the 1988
Basel Accord continue to apply to banks operating in the United States,
but the rest of the world adopts the New Accord: Abandoning the New
Accord in favor of current capital rules would eliminate essentially
all of the benefits of the rule described earlier. In place of these
lost or diminished benefits, the only advantage of continuing to apply
current capital rules to all banks is that maintaining the status quo
should alleviate concerns regarding competition among domestic
financial service providers. Although the effect of the rule on
competition is uncertain in our estimation, staying with current
capital rules (or universally applying a revised rule that might emerge
from the Standardized Option) eliminates bifurcation. Concerns
regarding competition usually center on this characteristic of the
rule. However, the emergence of different capital rules across national
borders would at least partially offset this advantage. Thus, while
concerns regarding competition among U.S. financial service providers
might diminish in this scenario, concerns regarding cross-border
competition would likely increase. While continuing to use current
capital rules eliminates most of the benefits of adopting the capital
rule, it does not eliminate many costs associated with the New Accord.
Because the New Accord-related costs are difficult to separate from the
bank's ordinary development costs and ordinary supervisory costs at the
Federal banking agencies, not implementing the New Accord would reduce
but not eliminate many of these costs associated with the final
rule.\119\ Furthermore, because banks in the United States would be
operating under a set of capital rules different from the rest of the
world, U.S. banks that are internationally active may face higher costs
because they will have to track and comply with more than one set of
capital requirements.
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\119\ Cost estimates for adopting a rule that might result from
the Standardized Option are not currently available.
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2. Alternative A: Permit U.S. banks to choose among all three New
Accord credit risk approaches: The principal benefit of Alternative A
that the rule does not achieve is the increased flexibility of the
regulation for banks that would be mandatory banks under the final
rule. Banks that are not prepared for the adoption of the advanced
approach to credit risk under the final rule could choose to use the
Foundation IRB methodology or even the Standardized Approach. How
Alternative A might affect benefits depends entirely on how many banks
select each of the three available options. The most significant
drawback to Alternative A is the increased cost of applying a new set
of capital rules to all U.S. banks. The vast majority of banks in the
United States would incur no direct costs from new capital rules. Under
Alternative A, direct costs would increase for every U.S. bank that
would have continued with current capital rules. Although it is not
clear how high these costs might be, general banks would face higher
costs because they would be changing capital rules regardless of which
option they choose under Alternative A.
3. Alternative B: Permit U.S. banks to choose among all three New
Accord operational risk approaches: The operational risk approach that
banks ultimately selected would determine how the overall benefits of
the new capital regulations would change under Alternative B. Just as
Alternative A increases the flexibility of credit risk rules for
mandatory banks, Alternative B is more flexible with respect to
operational risk. Because the Standardized Approach tries to be more
sensitive to variations in operational risk than the Basic Indicator
Approach and AMA is more sensitive than the Standardized Approach, the
effect of implementing Alternative B depends on how many banks select
the more risk sensitive approaches. As was the case with Alternative A,
the most significant drawback to Alternative B is the increased cost of
applying a new set of capital rules to all U.S. banks.
Under Alternative B, direct costs would increase for every U.S.
bank that would have continued with current capital rules. It is not
clear how much it might cost banks to adopt these capital measures for
operational risk, but general banks would face higher costs because
they would be changing capital rules regardless of which option they
choose under Alternative B.
4. Alternative C: Use a different asset amount to determine a
mandatory bank: The number of mandatory banks decreases slowly as the
size thresholds increase, and the number of banks grows more quickly as
the thresholds decrease. Under Alternative C, the framework of the
final rule would remain the same and only the number of mandatory banks
would change. Because the structure of the
[[Page 69395]]
implementation would remain intact, Alternative C would capture all of
the benefits of the final rule. However, because these benefits derive
from applying the final rule to individual banks, changing the number
of banks affected by the rule will change the cumulative level of the
benefits achieved. Generally, the benefits associated with the rule
will rise and fall with the number of mandatory banks. Because
Alternative C would change the number of mandatory banks subject to the
rule, aggregate costs will also rise or fall with the number of
mandatory banks.
Overall Comparison of the Rule With Baselines and Alternatives
The New Accord and its U.S. implementation seek to incorporate risk
measurement and risk management advances into capital requirements.
Risk-sensitive capital requirements are integral to ensuring an
adequate capital cushion to absorb financial losses at large complex
financial banks. In implementing the New Accord's advanced approaches
in the United States, the agencies' intent is to achieve risk-
sensitivity while maintaining a regulatory capital regime that is as
rigorous as the current system. Total capital requirements under the
advanced approaches, including capital for operational risk, will
better allocate capital in the system. This will occur regardless of
whether the minimum required capital at a particular bank is greater or
less than it would be under current capital rules. In order to ensure
that we achieve our goal of increased risk sensitivity without loss of
rigor, the final rule provides a means for the agencies to identify and
address deficiencies in the capital requirements that may become
apparent during the transition period.
Although the anticipated benefits of the final rule are difficult
to quantify in dollar terms because of measurement problems, the OCC is
confident that the anticipated benefits well exceed the anticipated
costs of this regulation. On the basis of our analysis, we believe that
the benefits of the final rule are significant, durable, and hold the
potential to increase with time. The offsetting costs of implementing
the final rule are also significant, but appear to be largely because
of considerable start-up costs. However, much of the apparent start-up
costs reflect activities that the banks would undertake as part of
their ongoing efforts to improve the quality of their internal risk
measurement and management, even in the absence of the New Accord and
this final rule. The advanced approaches seem to have fairly modest
ongoing expenses. Against these costs, the significant benefits of the
New Accord suggest that the final rule offers an improvement over the
baseline scenario.
With regard to the three alternative approaches we consider, the
final rule offers an important degree of flexibility while
significantly restricting costs by limiting its application to large,
internationally active banks. Alternatives A and B introduce more
flexibility from the perspective of the large mandatory banks, but each
is less flexible with respect to other banks. Either Alternative A or B
would compel these non-mandatory banks to select a new set of capital
rules and require them to undertake the time and expense of adjusting
to this final rule. Alternative C would change the number of mandatory
banks. If the number of mandatory banks increases, then the new rule
would lose some of the flexibility it achieves with the opt-in option.
Furthermore, costs would increase as the final rule would compel more
banks to incur the expense of adopting the advanced approaches.
Decreasing the number of mandatory banks would decrease the aggregate
social good of each benefit achieved with the final rule. The final
rule offers a better balance between costs and benefits than any of the
three alternatives.
OTS Executive Order 12866 Determination
OTS commented on the development of, and concurs with, OCC's RIA.
Rather than replicate that analysis, OTS drafted an RIA incorporating
OCC's analysis by reference and adding appropriate material reflecting
the unique aspects of the thrift industry. The full text of OTS's RIA
is available at the locations for viewing the OTS docket indicated in
the ADDRESSES section above. OTS believes that its analysis meets the
requirements of Executive Order 12866.
The following discussion supplements OCC's summary of its RIA.
The final rule will apply to approximately six mandatory and
potential opt-in savings associations representing approximately 52
percent of total thrift industry assets. Approximately 76 percent of
the total assets in these six institutions are concentrated in
residential mortgage-related assets. By contrast, national banks tend
to concentrate their assets in commercial loans and other kinds of non-
mortgage loans. Only about 35 percent of national bank's total assets
are residential mortgage-related assets. As a result, the costs and
benefits of the final rule for OTS-regulated savings associations will
differ in important ways from OCC-regulated national banks. These
differences are the focus of OTS's analysis.
Benefits. Among the benefits of the final rule, OCC cites: (i)
Better allocation of capital and reduced impact of moral hazard through
reduction in the scope for regulatory arbitrage; (ii) improved signal
quality of capital as an indicator of institution solvency; and (iii)
more efficient use of required bank capital. From OTS's perspective,
however, the final rule may not provide the degree of benefits
anticipated by OCC from these sources.
Because of the typically low credit risk associated with
residential mortgage-related assets, OTS believes that the risk-
insensitive leverage ratio, rather than the risk-based capital ratio,
may be more binding on savings association institutions.\120\ As a
result, these institutions may be required to hold more capital than
would be required under Basel II risk-based standards alone. Therefore,
the final rule may cause these institutions to incur much the same
implementation costs as banks with riskier assets, but with reduced
benefits.
---------------------------------------------------------------------------
\120\ The leverage ratio is the ratio of core capital to
adjusted total assets. Under prompt corrective action requirements,
savings associations must maintain a leverage ratio of at least five
percent to be well capitalized and at least four percent to be
adequately capitalized. Basel II will primarily affect the
calculation of risk-weighted assets, rather than the calculation of
total assets and will have only a modest impact on the calculation
of core capital. Thus, the proposed Basel II changes should not
significantly affect the calculated leverage ratio and a savings
association that is currently constrained by the leverage ratio
would not significantly benefit from the Basel II changes.
---------------------------------------------------------------------------
Costs. OTS adopts the OCC cost analysis with the following
supplemental information on OTS's administrative costs. OTS did not
incur a meaningful amount of direct expenditures until 2002 when it
transitioned from a monitoring role to active involvement in Basel II.
Thereafter, expenditures increased rapidly. The OTS expenditures fall
into two broad categories: policymaking expenses incurred in the
development of the ANPR, the NPR, the final rule and related guidance;
and supervision expenses that reflect institution-specific supervisory
activities. OTS estimates that it incurred total expenses of $6,420,000
for fiscal years 2002 through 2006, including $4,080,000 in
policymaking expenses and $2,340,000 in supervision expenses. OTS
anticipates that supervision expenses will continue to grow as a
percentage of the total expense as it moves from policy development to
implementation
[[Page 69396]]
and training. To date, Basel II expenditures have not been a large part
of overall expenditures.
Competition. OTS agrees with OCC's analysis of competition among
providers of financial services. OTS adds, however, that some
institutions with low credit risk portfolios face an existing
competitive disadvantage because they are bound by a non-risk-based
capital requirement--the leverage ratio. Thus, the agencies regulate a
class of institutions that currently receive fewer capital benefits
from risk-based capital rules because they are bound by the risk-
insensitive leverage ratio. This anomaly will likely continue under the
final rule.
In addition, the results from QIS-3 and QIS-4 suggest that the
largest reductions in regulatory credit-risk capital requirements from
the application of revised rules would occur in the residential
mortgage loan area. Thus, to the extent regulatory credit-risk capital
requirements affect pricing of such loans, it is possible that core and
opt-in institutions who are not constrained by the leverage ratio may
experience an improvement in their competitive standing vis-[agrave]-
vis non-adopters and vis-[agrave]-vis adopters who are bound by the
leverage ratio. Two research papers--one by Calem and Follain,\121\ and
another by Hancock, Lenhert, Passmore, and Sherlund\122\ addressed this
topic. The Calem and Follain paper argues that Basel II will
significantly affect the competitive environment in mortgage lending;
Hancock, et al. argue that it will not. Both papers are predicated,
however, on the current capital regime for non-adopters. The agencies
recently announced that they have agreed to issue a proposed rule that
would provide non-core banks with the option to adopt an approach
consistent with the standardized approach included in the Basel II
framework. The standardized proposal will replace the earlier proposed
rule (the Basel IA proposed rule), and would be available as an
alternative to the existing risk-based capital rules for all U.S. banks
other than banks that adopt the final Basel II rule. Such
modifications, if implemented, would likely reduce the competitive
advantage of Basel II adopters.
---------------------------------------------------------------------------
\121\ Paul S. Calem and James R. Follain, ``An Examination of
How the Proposed Bifurcated Implementation of Basel II in the U.S.
May Affect Competition Among Banking Organizations for Residential
Mortgages,'' manuscript, January 14, 2005.
\122\ Diana Hancock, Andreas Lenhert, Wayne Passmore, and Shane
M Sherlund, ``An Analysis of the Competitive Impacts of Basel II
Capital Standards on U.S. Mortgage Rates and Mortgage
Securitization, March 7, 2005, Board of Governors of the Federal
Reserve System, working paper.
---------------------------------------------------------------------------
The final rule also has a ten percent floor on loss given default
parameter estimates for residential mortgage segments that persists
beyond the two-year period articulated in the international Basel II
framework, providing a disincentive for core institutions to hold the
least risky residential mortgages. This may have the effect of reducing
the core banks'' advantage vis-[agrave]-vis both non-adopters and their
international competitors.
Further, residential mortgages are subject to substantial interest
rate risk. The agencies will retain the authority to require additional
capital to cover interest rate risk. If regulatory capital requirements
affect asset pricing, a substantial regulatory capital interest rate
risk component could mitigate any competitive advantages of the
proposed rule. Moreover, the capital requirement for interest rate risk
would be subject to interpretation by each agency. A consistent
evaluation of interest rate risk by the supervisory agencies would
present a level playing field among the adopters--an important
consideration given the potential size of the capital requirement.
OCC Unfunded Mandates Reform Act of 1995 Determination
The Unfunded Mandates Reform Act of 1995 (Pub. L. 104-4) (UMRA)
requires cost-benefit and other analyses for a rule that would include
any Federal mandate that may result in the expenditure by State, local,
and tribal governments, in the aggregate, or by the private sector of
$100 million or more (adjusted annually for inflation) in any one year.
The current inflation-adjusted expenditure threshold is $119.6 million.
The requirements of the UMRA include assessing a rule's effects on
future compliance costs; particular regions or State, local, or tribal
governments; communities; segments of the private sector; productivity;
economic growth; full employment; creation of productive jobs; and the
international competitiveness of U.S. goods and services. The final
rule qualifies as a significant regulatory action under the UMRA
because its Federal mandates may result in the expenditure by the
private sector of $119.6 million or more in any one year. As permitted
by section 202(c) of the UMRA, the required analyses have been prepared
in conjunction with the Executive Order 12866 analysis document titled
Regulatory Impact Analysis for Risk-Based Capital Standards: Revised
Capital Adequacy Guidelines. The analysis is available on the Internet
at http://www.occ.treas.gov/law/basel.htm under the link of
``Regulatory Impact Analysis for Risk-Based Capital Standards: Revised
Capital Adequacy Guidelines (Basel II: Advanced Approach) 2007''.
OTS Unfunded Mandates Reform Act of 1995 Determination
The Unfunded Mandates Reform Act of 1995 (Pub. L. 104-4) (UMRA)
requires cost-benefit and other analyses for a rule that would include
any Federal mandate that may result in the expenditure by State, local,
and tribal governments, in the aggregate, or by the private sector of
$100 million or more (adjusted annually for inflation) in any one year.
The current inflation-adjusted expenditure threshold is $119.6 million.
The requirements of the UMRA include assessing a rule's effects on
future compliance costs; particular regions or State, local, or tribal
governments; communities; segments of the private sector; productivity;
economic growth; full employment; creation of productive jobs; and the
international competitiveness of U.S. goods and services. The final
rule qualifies as a significant regulatory action under the UMRA
because its Federal mandates may result in the expenditure by the
private sector of $119.6 or more in any one year. As permitted by
section 202(c) of the UMRA, the required analyses have been prepared in
conjunction with the Executive Order 12866 analysis document titled
Regulatory Impact Analysis for Risk-Based Capital Standards: Revised
Capital Adequacy Guidelines. The analysis is available at the locations
for viewing the OTS docket indicated in the ADDRESSES section above.
Text of Common Appendix (All Agencies)
The text of the agencies'' common appendix appears below:
[Appendix -- to Part --]--Capital Adequacy Guidelines for [Banks]:
Internal-Ratings-Based and Advanced Measurement Approaches
Part I General Provisions
Section 1 Purpose, Applicability, Reservation of Authority, and
Principle of Conservatism
Section 2 Definitions
Section 3 Minimum Risk-Based Capital Requirements
Part II Qualifying Capital
Section 11 Additional Deductions
Section 12 Deductions and Limitations Not Required
Section 13 Eligible Credit Reserves
Part III Qualification
Section 21 Qualification Process
Section 22 Qualification Requirements
Section 23 Ongoing Qualification
[[Page 69397]]
Section 24 Merger and Acquisition Transitional Arrangements
Part IV Risk-Weighted Assets for General Credit Risk
Section 31 Mechanics for Calculating Total Wholesale and Retail
Risk-Weighted Assets
Section 32 Counterparty Credit Risk of Repo-Style Transactions,
Eligible Margin Loans, and OTC Derivative Contracts
Section 33 Guarantees and Credit Derivatives: PD Substitution
and LGD Adjustment Approaches
Section 34 Guarantees and Credit Derivatives: Double Default
Treatment
Section 35 Risk-Based Capital Requirement for Unsettled
Transactions
Part V Risk-Weighted Assets for Securitization Exposures
Section 41 Operational Criteria for Recognizing the Transfer of
Risk
Section 42 Risk-Based Capital Requirement for Securitization
Exposures
Section 43 Ratings-Based Approach (RBA)
Section 44 Internal Assessment Approach (IAA)
Section 45 Supervisory Formula Approach (SFA)
Section 46 Recognition of Credit Risk Mitigants for
Securitization Exposures
Section 47 Risk-Based Capital Requirement for Early Amortization
Provisions
Part VI Risk-Weighted Assets for Equity Exposures
Section 51 Introduction and Exposure Measurement
Section 52 Simple Risk Weight Approach (SRWA)
Section 53 Internal Models Approach (IMA)
Section 54 Equity Exposures to Investment Funds
Section 55 Equity Derivative Contracts
Part VII Risk-Weighted Assets for Operational Risk
Section 61 Qualification Requirements for Incorporation of
Operational Risk Mitigants
Section 62 Mechanics of Risk-Weighted Asset Calculation
Part VIII Disclosure
Section 71 Disclosure Requirements
Part I. General Provisions
Section 1. Purpose, Applicability, Reservation of Authority, and
Principle of Conservatism
(a) Purpose. This appendix establishes:
(1) Minimum qualifying criteria for [banks] using [bank]-
specific internal risk measurement and management processes for
calculating risk-based capital requirements;
(2) Methodologies for such [banks] to calculate their risk-based
capital requirements; and
(3) Public disclosure requirements for such [banks].
(b) Applicability. (1) This appendix applies to a [bank] that:
(i) Has consolidated total assets, as reported on the most
recent year-end Consolidated Report of Condition and Income (Call
Report) or Thrift Financial Report (TFR), equal to $250 billion or
more;
(ii) Has consolidated total on-balance sheet foreign exposure at
the most recent year-end equal to $10 billion or more (where total
on-balance sheet foreign exposure equals total cross-border claims
less claims with head office or guarantor located in another country
plus redistributed guaranteed amounts to the country of head office
or guarantor plus local country claims on local residents plus
revaluation gains on foreign exchange and derivative products,
calculated in accordance with the Federal Financial Institutions
Examination Council (FFIEC) 009 Country Exposure Report);
(iii) Is a subsidiary of a depository institution that uses 12
CFR part 3, Appendix C, 12 CFR part 208, Appendix F, 12 CFR part
325, Appendix D, or 12 CFR part 567, Appendix C, to calculate its
risk-based capital requirements; or
(iv) Is a subsidiary of a bank holding company that uses 12 CFR
part 225, Appendix G, to calculate its risk-based capital
requirements.
(2) Any [bank] may elect to use this appendix to calculate its
risk-based capital requirements.
(3) A [bank] that is subject to this appendix must use this
appendix unless the [AGENCY] determines in writing that application
of this appendix is not appropriate in light of the [bank]'s asset
size, level of complexity, risk profile, or scope of operations. In
making a determination under this paragraph, the [AGENCY] will apply
notice and response procedures in the same manner and to the same
extent as the notice and response procedures in 12 CFR 3.12 (for
national banks), 12 CFR 263.202 (for bank holding companies and
state member banks), 12 CFR 325.6(c) (for state nonmember banks),
and 12 CFR 567.3(d) (for savings associations).
(c) Reservation of authority--(1) Additional capital in the
aggregate. The [AGENCY] may require a [bank] to hold an amount of
capital greater than otherwise required under this appendix if the
[AGENCY] determines that the [bank]'s risk-based capital requirement
under this appendix is not commensurate with the [bank]'s credit,
market, operational, or other risks. In making a determination under
this paragraph, the [AGENCY] will apply notice and response
procedures in the same manner and to the same extent as the notice
and response procedures in 12 CFR 3.12 (for national banks), 12 CFR
263.202 (for bank holding companies and state member banks), 12 CFR
325.6(c) (for state nonmember banks), and 12 CFR 567.3(d) (for
savings associations).
(2) Specific risk-weighted asset amounts. (i) If the [AGENCY]
determines that the risk-weighted asset amount calculated under this
appendix by the [bank] for one or more exposures is not commensurate
with the risks associated with those exposures, the [AGENCY] may
require the [bank] to assign a different risk-weighted asset amount
to the exposures, to assign different risk parameters to the
exposures (if the exposures are wholesale or retail exposures), or
to use different model assumptions for the exposures (if relevant),
all as specified by the [AGENCY].
(ii) If the [AGENCY] determines that the risk-weighted asset
amount for operational risk produced by the [bank] under this
appendix is not commensurate with the operational risks of the
[bank], the [AGENCY] may require the [bank] to assign a different
risk-weighted asset amount for operational risk, to change elements
of its operational risk analytical framework, including
distributional and dependence assumptions, or to make other changes
to the [bank]'s operational risk management processes, data and
assessment systems, or quantification systems, all as specified by
the [AGENCY].
(3) Other supervisory authority. Nothing in this appendix limits
the authority of the [AGENCY] under any other provision of law or
regulation to take supervisory or enforcement action, including
action to address unsafe or unsound practices or conditions,
deficient capital levels, or violations of law.
(d) Principle of conservatism. Notwithstanding the requirements
of this appendix, a [bank] may choose not to apply a provision of
this appendix to one or more exposures, provided that:
(1) The [bank] can demonstrate on an ongoing basis to the
satisfaction of the [AGENCY] that not applying the provision would,
in all circumstances, unambiguously generate a risk-based capital
requirement for each such exposure greater than that which would
otherwise be required under this appendix;
(2) The [bank] appropriately manages the risk of each such
exposure;
(3) The [bank] notifies the [AGENCY] in writing prior to
applying this principle to each such exposure; and
(4) The exposures to which the [bank] applies this principle are
not, in the aggregate, material to the [bank].
Section 2. Definitions
Advanced internal ratings-based (IRB) systems means a [bank]'s
internal risk rating and segmentation system; risk parameter
quantification system; data management and maintenance system; and
control, oversight, and validation system for credit risk of
wholesale and retail exposures.
Advanced systems means a [bank]'s advanced IRB systems,
operational risk management processes, operational risk data and
assessment systems, operational risk quantification systems, and, to
the extent the [bank] uses the following systems, the internal
models methodology, double default excessive correlation detection
process, IMA for equity exposures, and IAA for securitization
exposures to ABCP programs.
Affiliate with respect to a company means any company that
controls, is controlled by, or is under common control with, the
company.
Applicable external rating means:
(1) With respect to an exposure that has multiple external
ratings assigned by NRSROs, the lowest solicited external rating
assigned to the exposure by any NRSRO; and
(2) With respect to an exposure that has a single external
rating assigned by an NRSRO, the external rating assigned to the
exposure by the NRSRO.
Applicable inferred rating means:
[[Page 69398]]
(1) With respect to an exposure that has multiple inferred
ratings, the lowest inferred rating based on a solicited external
rating; and
(2) With respect to an exposure that has a single inferred
rating, the inferred rating.
Asset-backed commercial paper (ABCP) program means a program
that primarily issues commercial paper that:
(1) Has an external rating; and
(2) Is backed by underlying exposures held in a bankruptcy-
remote SPE.
Asset-backed commercial paper (ABCP) program sponsor means a
[bank] that:
(1) Establishes an ABCP program;
(2) Approves the sellers permitted to participate in an ABCP
program;
(3) Approves the exposures to be purchased by an ABCP program;
or
(4) Administers the ABCP program by monitoring the underlying
exposures, underwriting or otherwise arranging for the placement of
debt or other obligations issued by the program, compiling monthly
reports, or ensuring compliance with the program documents and with
the program's credit and investment policy.
Backtesting means the comparison of a [bank]'s internal
estimates with actual outcomes during a sample period not used in
model development. In this context, backtesting is one form of out-
of-sample testing.
Bank holding company is defined in section 2 of the Bank Holding
Company Act (12 U.S.C. 1841).
Benchmarking means the comparison of a [bank]'s internal
estimates with relevant internal and external data or with estimates
based on other estimation techniques.
Business environment and internal control factors means the
indicators of a [bank]'s operational risk profile that reflect a
current and forward-looking assessment of the [bank]'s underlying
business risk factors and internal control environment.
Carrying value means, with respect to an asset, the value of the
asset on the balance sheet of the [bank], determined in accordance
with GAAP.
Clean-up call means a contractual provision that permits an
originating [bank] or servicer to call securitization exposures
before their stated maturity or call date. See also eligible clean-
up call.
Commodity derivative contract means a commodity-linked swap,
purchased commodity-linked option, forward commodity-linked
contract, or any other instrument linked to commodities that gives
rise to similar counterparty credit risks.
Company means a corporation, partnership, limited liability
company, depository institution, business trust, special purpose
entity, association, or similar organization.
Control. A person or company controls a company if it:
(1) Owns, controls, or holds with power to vote 25 percent or
more of a class of voting securities of the company; or
(2) Consolidates the company for financial reporting purposes.
Controlled early amortization provision means an early
amortization provision that meets all the following conditions:
(1) The originating [bank] has appropriate policies and
procedures to ensure that it has sufficient capital and liquidity
available in the event of an early amortization;
(2) Throughout the duration of the securitization (including the
early amortization period), there is the same pro rata sharing of
interest, principal, expenses, losses, fees, recoveries, and other
cash flows from the underlying exposures based on the originating
[bank]'s and the investors' relative shares of the underlying
exposures outstanding measured on a consistent monthly basis;
(3) The amortization period is sufficient for at least 90
percent of the total underlying exposures outstanding at the
beginning of the early amortization period to be repaid or
recognized as in default; and
(4) The schedule for repayment of investor principal is not more
rapid than would be allowed by straight-line amortization over an
18-month period.
Credit derivative means a financial contract executed under
standard industry credit derivative documentation that allows one
party (the protection purchaser) to transfer the credit risk of one
or more exposures (reference exposure) to another party (the
protection provider). See also eligible credit derivative.
Credit-enhancing interest-only strip (CEIO) means an on-balance
sheet asset that, in form or in substance:
(1) Represents a contractual right to receive some or all of the
interest and no more than a minimal amount of principal due on the
underlying exposures of a securitization; and
(2) Exposes the holder to credit risk directly or indirectly
associated with the underlying exposures that exceeds a pro rata
share of the holder's claim on the underlying exposures, whether
through subordination provisions or other credit-enhancement
techniques.
Credit-enhancing representations and warranties means
representations and warranties that are made or assumed in
connection with a transfer of underlying exposures (including loan
servicing assets) and that obligate a [bank] to protect another
party from losses arising from the credit risk of the underlying
exposures. Credit-enhancing representations and warranties include
provisions to protect a party from losses resulting from the default
or nonperformance of the obligors of the underlying exposures or
from an insufficiency in the value of the collateral backing the
underlying exposures. Credit-enhancing representations and
warranties do not include:
(1) Early default clauses and similar warranties that permit the
return of, or premium refund clauses that cover, first-lien
residential mortgage exposures for a period not to exceed 120 days
from the date of transfer, provided that the date of transfer is
within one year of origination of the residential mortgage exposure;
(2) Premium refund clauses that cover underlying exposures
guaranteed, in whole or in part, by the U.S. government, a U.S.
government agency, or a U.S. government sponsored enterprise,
provided that the clauses are for a period not to exceed 120 days
from the date of transfer; or
(3) Warranties that permit the return of underlying exposures in
instances of misrepresentation, fraud, or incomplete documentation.
Credit risk mitigant means collateral, a credit derivative, or a
guarantee.
Credit-risk-weighted assets means 1.06 multiplied by the sum of:
(1) Total wholesale and retail risk-weighted assets;
(2) Risk-weighted assets for securitization exposures; and
(3) Risk-weighted assets for equity exposures.
Current exposure means, with respect to a netting set, the
larger of zero or the market value of a transaction or portfolio of
transactions within the netting set that would be lost upon default
of the counterparty, assuming no recovery on the value of the
transactions. Current exposure is also called replacement cost.
Default--(1) Retail. (i) A retail exposure of a [bank] is in
default if:
(A) The exposure is 180 days past due, in the case of a
residential mortgage exposure or revolving exposure;
(B) The exposure is 120 days past due, in the case of all other
retail exposures; or
(C) The [bank] has taken a full or partial charge-off, write-
down of principal, or material negative fair value adjustment of
principal on the exposure for credit-related reasons.
(ii) Notwithstanding paragraph (1)(i) of this definition, for a
retail exposure held by a non-U.S. subsidiary of the [bank] that is
subject to an internal ratings-based approach to capital adequacy
consistent with the Basel Committee on Banking Supervision's
``International Convergence of Capital Measurement and Capital
Standards: A Revised Framework'' in a non-U.S. jurisdiction, the
[bank] may elect to use the definition of default that is used in
that jurisdiction, provided that the [bank] has obtained prior
approval from the [AGENCY] to use the definition of default in that
jurisdiction.
(iii) A retail exposure in default remains in default until the
[bank] has reasonable assurance of repayment and performance for all
contractual principal and interest payments on the exposure.
(2) Wholesale. (i) A [bank]'s wholesale obligor is in default
if:
(A) The [bank] determines that the obligor is unlikely to pay
its credit obligations to the [bank] in full, without recourse by
the [bank] to actions such as realizing collateral (if held); or
(B) The obligor is past due more than 90 days on any material
credit obligation(s) to the [bank].\1\
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\1\ Overdrafts are past due once the obligor has breached an
advised limit or been advised of a limit smaller than the current
outstanding balance.
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(ii) An obligor in default remains in default until the [bank]
has reasonable assurance of repayment and performance for all
contractual principal and interest payments on all exposures of the
[bank] to the obligor (other than exposures that have been fully
written-down or charged-off).
[[Page 69399]]
Dependence means a measure of the association among operational
losses across and within units of measure.
Depository institution is defined in section 3 of the Federal
Deposit Insurance Act (12 U.S.C. 1813).
Derivative contract means a financial contract whose value is
derived from the values of one or more underlying assets, reference
rates, or indices of asset values or reference rates. Derivative
contracts include interest rate derivative contracts, exchange rate
derivative contracts, equity derivative contracts, commodity
derivative contracts, credit derivatives, and any other instrument
that poses similar counterparty credit risks. Derivative contracts
also include unsettled securities, commodities, and foreign exchange
transactions with a contractual settlement or delivery lag that is
longer than the lesser of the market standard for the particular
instrument or five business days.
Early amortization provision means a provision in the
documentation governing a securitization that, when triggered,
causes investors in the securitization exposures to be repaid before
the original stated maturity of the securitization exposures, unless
the provision:
(1) Is triggered solely by events not directly related to the
performance of the underlying exposures or the originating [bank]
(such as material changes in tax laws or regulations); or
(2) Leaves investors fully exposed to future draws by obligors
on the underlying exposures even after the provision is triggered.
Economic downturn conditions means, with respect to an exposure
held by the [bank], those conditions in which the aggregate default
rates for that exposure's wholesale or retail exposure subcategory
(or subdivision of such subcategory selected by the [bank]) in the
exposure's national jurisdiction (or subdivision of such
jurisdiction selected by the [bank]) are significantly higher than
average.
Effective maturity (M) of a wholesale exposure means:
(1) For wholesale exposures other than repo-style transactions,
eligible margin loans, and OTC derivative contracts described in
paragraph (2) or (3) of this definition:
(i) The weighted-average remaining maturity (measured in years,
whole or fractional) of the expected contractual cash flows from the
exposure, using the undiscounted amounts of the cash flows as
weights; or
(ii) The nominal remaining maturity (measured in years, whole or
fractional) of the exposure.
(2) For repo-style transactions, eligible margin loans, and OTC
derivative contracts subject to a qualifying master netting
agreement for which the [bank] does not apply the internal models
approach in paragraph (d) of section 32 of this appendix, the
weighted-average remaining maturity (measured in years, whole or
fractional) of the individual transactions subject to the qualifying
master netting agreement, with the weight of each individual
transaction set equal to the notional amount of the transaction.
(3) For repo-style transactions, eligible margin loans, and OTC
derivative contracts for which the [bank] applies the internal
models approach in paragraph (d) of section 32 of this appendix, the
value determined in paragraph (d)(4) of section 32 of this appendix.
Effective notional amount means, for an eligible guarantee or
eligible credit derivative, the lesser of the contractual notional
amount of the credit risk mitigant and the EAD of the hedged
exposure, multiplied by the percentage coverage of the credit risk
mitigant. For example, the effective notional amount of an eligible
guarantee that covers, on a pro rata basis, 40 percent of any losses
on a $100 bond would be $40.
Eligible clean-up call means a clean-up call that:
(1) Is exercisable solely at the discretion of the originating
[bank] or servicer;
(2) Is not structured to avoid allocating losses to
securitization exposures held by investors or otherwise structured
to provide credit enhancement to the securitization; and
(3) (i) For a traditional securitization, is only exercisable
when 10 percent or less of the principal amount of the underlying
exposures or securitization exposures (determined as of the
inception of the securitization) is outstanding; or
(ii) For a synthetic securitization, is only exercisable when 10
percent or less of the principal amount of the reference portfolio
of underlying exposures (determined as of the inception of the
securitization) is outstanding.
Eligible credit derivative means a credit derivative in the form
of a credit default swap, n\th\-to-default swap, total return swap,
or any other form of credit derivative approved by the [AGENCY],
provided that:
(1) The contract meets the requirements of an eligible guarantee
and has been confirmed by the protection purchaser and the
protection provider;
(2) Any assignment of the contract has been confirmed by all
relevant parties;
(3) If the credit derivative is a credit default swap or n\th\-
to-default swap, the contract includes the following credit events:
(i) Failure to pay any amount due under the terms of the
reference exposure, subject to any applicable minimal payment
threshold that is consistent with standard market practice and with
a grace period that is closely in line with the grace period of the
reference exposure; and
(ii) Bankruptcy, insolvency, or inability of the obligor on the
reference exposure to pay its debts, or its failure or admission in
writing of its inability generally to pay its debts as they become
due, and similar events;
(4) The terms and conditions dictating the manner in which the
contract is to be settled are incorporated into the contract;
(5) If the contract allows for cash settlement, the contract
incorporates a robust valuation process to estimate loss reliably
and specifies a reasonable period for obtaining post-credit event
valuations of the reference exposure;
(6) If the contract requires the protection purchaser to
transfer an exposure to the protection provider at settlement, the
terms of at least one of the exposures that is permitted to be
transferred under the contract provides that any required consent to
transfer may not be unreasonably withheld;
(7) If the credit derivative is a credit default swap or n\th\-
to-default swap, the contract clearly identifies the parties
responsible for determining whether a credit event has occurred,
specifies that this determination is not the sole responsibility of
the protection provider, and gives the protection purchaser the
right to notify the protection provider of the occurrence of a
credit event; and
(8) If the credit derivative is a total return swap and the
[bank] records net payments received on the swap as net income, the
[bank] records offsetting deterioration in the value of the hedged
exposure (either through reductions in fair value or by an addition
to reserves).
Eligible credit reserves means all general allowances that have
been established through a charge against earnings to absorb credit
losses associated with on- or off-balance sheet wholesale and retail
exposures, including the allowance for loan and lease losses (ALLL)
associated with such exposures but excluding allocated transfer risk
reserves established pursuant to 12 U.S.C. 3904 and other specific
reserves created against recognized losses.
Eligible double default guarantor, with respect to a guarantee
or credit derivative obtained by a [bank], means:
(1) U.S.-based entities. A depository institution, a bank
holding company, a savings and loan holding company (as defined in
12 U.S.C. 1467a) provided all or substantially all of the holding
company's activities are permissible for a financial holding company
under 12 U.S.C. 1843(k), a securities broker or dealer registered
with the SEC under the Securities Exchange Act of 1934 (15 U.S.C.
78o et seq.), or an insurance company in the business of providing
credit protection (such as a monoline bond insurer or re-insurer)
that is subject to supervision by a State insurance regulator, if:
(i) At the time the guarantor issued the guarantee or credit
derivative or at any time thereafter, the [bank] assigned a PD to
the guarantor's rating grade that was equal to or lower than the PD
associated with a long-term external rating in the third-highest
investment-grade rating category; and
(ii) The [bank] currently assigns a PD to the guarantor's rating
grade that is equal to or lower than the PD associated with a long-
term external rating in the lowest investment-grade rating category;
or
(2) Non-U.S.-based entities. A foreign bank (as defined in Sec.
211.2 of the Federal Reserve Board's Regulation K (12 CFR 211.2)), a
non-U.S.-based securities firm, or a non-U.S.-based insurance
company in the business of providing credit protection, if:
(i) The [bank] demonstrates that the guarantor is subject to
consolidated supervision and regulation comparable to that imposed
on U.S. depository institutions, securities broker-dealers, or
insurance companies (as the case may be), or has issued and
outstanding an unsecured long-term debt security without credit
enhancement that has a long-term applicable external rating of at
least investment grade;
[[Page 69400]]
(ii) At the time the guarantor issued the guarantee or credit
derivative or at any time thereafter, the [bank] assigned a PD to
the guarantor's rating grade that was equal to or lower than the PD
associated with a long-term external rating in the third-highest
investment-grade rating category; and
(iii) The [bank] currently assigns a PD to the guarantor's
rating grade that is equal to or lower than the PD associated with a
long-term external rating in the lowest investment-grade rating
category.
Eligible guarantee means a guarantee that:
(1) Is written and unconditional;
(2) Covers all or a pro rata portion of all contractual payments
of the obligor on the reference exposure;
(3) Gives the beneficiary a direct claim against the protection
provider;
(4) Is not unilaterally cancelable by the protection provider
for reasons other than the breach of the contract by the
beneficiary;
(5) Is legally enforceable against the protection provider in a
jurisdiction where the protection provider has sufficient assets
against which a judgment may be attached and enforced;
(6) Requires the protection provider to make payment to the
beneficiary on the occurrence of a default (as defined in the
guarantee) of the obligor on the reference exposure in a timely
manner without the beneficiary first having to take legal actions to
pursue the obligor for payment;
(7) Does not increase the beneficiary's cost of credit
protection on the guarantee in response to deterioration in the
credit quality of the reference exposure; and
(8) Is not provided by an affiliate of the [bank], unless the
affiliate is an insured depository institution, bank, securities
broker or dealer, or insurance company that:
(i) Does not control the [bank]; and
(ii) Is subject to consolidated supervision and regulation
comparable to that imposed on U.S. depository institutions,
securities broker-dealers, or insurance companies (as the case may
be).
Eligible margin loan means an extension of credit where:
(1) The extension of credit is collateralized exclusively by
liquid and readily marketable debt or equity securities, gold, or
conforming residential mortgages;
(2) The collateral is marked to market daily, and the
transaction is subject to daily margin maintenance requirements;
(3) The extension of credit is conducted under an agreement that
provides the [bank] the right to accelerate and terminate the
extension of credit and to liquidate or set off collateral promptly
upon an event of default (including upon an event of bankruptcy,
insolvency, or similar proceeding) of the counterparty, provided
that, in any such case, any exercise of rights under the agreement
will not be stayed or avoided under applicable law in the relevant
jurisdictions; \2\ and
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\2\ This requirement is met where all transactions under the
agreement are (i) executed under U.S. law and (ii) constitute
``securities contracts'' under section 555 of the Bankruptcy Code
(11 U.S.C. 555), qualified financial contracts under section
11(e)(8) of the Federal Deposit Insurance Act (12 U.S.C.
1821(e)(8)), or netting contracts between or among financial
institutions under sections 401-407 of the Federal Deposit Insurance
Corporation Improvement Act of 1991 (12 U.S.C. 4401-4407) or the
Federal Reserve Board's Regulation EE (12 CFR part 231).
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(4) The [bank] has conducted sufficient legal review to conclude
with a well-founded basis (and maintains sufficient written
documentation of that legal review) that the agreement meets the
requirements of paragraph (3) of this definition and is legal,
valid, binding, and enforceable under applicable law in the relevant
jurisdictions.
Eligible operational risk offsets means amounts, not to exceed
expected operational loss, that:
(1) Are generated by internal business practices to absorb
highly predictable and reasonably stable operational losses,
including reserves calculated consistent with GAAP; and
(2) Are available to cover expected operational losses with a
high degree of certainty over a one-year horizon.
Eligible purchased wholesale exposure means a purchased
wholesale exposure that:
(1) The [bank] or securitization SPE purchased from an
unaffiliated seller and did not directly or indirectly originate;
(2) Was generated on an arm's-length basis between the seller
and the obligor (intercompany accounts receivable and receivables
subject to contra-accounts between firms that buy and sell to each
other do not satisfy this criterion);
(3) Provides the [bank] or securitization SPE with a claim on
all proceeds from the exposure or a pro rata interest in the
proceeds from the exposure;
(4) Has an M of less than one year; and
(5) When consolidated by obligor, does not represent a
concentrated exposure relative to the portfolio of purchased
wholesale exposures.
Eligible securitization guarantor means:
(1) A sovereign entity, the Bank for International Settlements,
the International Monetary Fund, the European Central Bank, the
European Commission, a Federal Home Loan Bank, Federal Agricultural
Mortgage Corporation (Farmer Mac), a multilateral development bank,
a depository institution, a bank holding company, a savings and loan
holding company (as defined in 12 U.S.C. 1467a) provided all or
substantially all of the holding company's activities are
permissible for a financial holding company under 12 U.S.C. 1843(k),
a foreign bank (as defined in Sec. 211.2 of the Federal Reserve
Board's Regulation K (12 CFR 211.2)), or a securities firm;
(2) Any other entity (other than a securitization SPE) that has
issued and outstanding an unsecured long-term debt security without
credit enhancement that has a long-term applicable external rating
in one of the three highest investment-grade rating categories; or
(3) Any other entity (other than a securitization SPE) that has
a PD assigned by the [bank] that is lower than or equal to the PD
associated with a long-term external rating in the third highest
investment-grade rating category.
Eligible servicer cash advance facility means a servicer cash
advance facility in which:
(1) The servicer is entitled to full reimbursement of advances,
except that a servicer may be obligated to make non-reimbursable
advances for a particular underlying exposure if any such advance is
contractually limited to an insignificant amount of the outstanding
principal balance of that exposure;
(2) The servicer's right to reimbursement is senior in right of
payment to all other claims on the cash flows from the underlying
exposures of the securitization; and
(3) The servicer has no legal obligation to, and does not, make
advances to the securitization if the servicer concludes the
advances are unlikely to be repaid.
Equity derivative contract means an equity-linked swap,
purchased equity-linked option, forward equity-linked contract, or
any other instrument linked to equities that gives rise to similar
counterparty credit risks.
Equity exposure means:
(1) A security or instrument (whether voting or non-voting) that
represents a direct or indirect ownership interest in, and is a
residual claim on, the assets and income of a company, unless:
(i) The issuing company is consolidated with the [bank] under
GAAP;
(ii) The [bank] is required to deduct the ownership interest
from tier 1 or tier 2 capital under this appendix;
(iii) The ownership interest incorporates a payment or other
similar obligation on the part of the issuing company (such as an
obligation to make periodic payments); or
(iv) The ownership interest is a securitization exposure;
(2) A security or instrument that is mandatorily convertible
into a security or instrument described in paragraph (1) of this
definition;
(3) An option or warrant that is exercisable for a security or
instrument described in paragraph (1) of this definition; or
(4) Any other security or instrument (other than a
securitization exposure) to the extent the return on the security or
instrument is based on the performance of a security or instrument
described in paragraph (1) of this definition.
Excess spread for a period means:
(1) Gross finance charge collections and other income received
by a securitization SPE (including market interchange fees) over a
period minus interest paid to the holders of the securitization
exposures, servicing fees, charge-offs, and other senior trust or
similar expenses of the SPE over the period; divided by
(2) The principal balance of the underlying exposures at the end
of the period.
Exchange rate derivative contract means a cross-currency
interest rate swap, forward foreign-exchange contract, currency
option purchased, or any other instrument linked to exchange rates
that gives rise to similar counterparty credit risks.
Excluded mortgage exposure means any one-to four-family
residential pre-sold construction loan for a residence for which the
purchase contract is cancelled that would receive a 100 percent risk
weight under
[[Page 69401]]
section 618(a)(2) of the Resolution Trust Corporation Refinancing,
Restructuring, and Improvement Act and under 12 CFR part 3, Appendix
A, section 3(a)(3)(iii) (for national banks), 12 CFR part 208,
Appendix A, section III.C.3. (for state member banks), 12 CFR part
225, Appendix A, section III.C.3. (for bank holding companies), 12
CFR part 325, Appendix A, section II.C.a. (for state nonmember
banks), or 12 CFR 567.1 (definition of ``qualifying residential
construction loan'') and 12 CFR 567.6(a)(1)(iv) (for savings
associations).
Expected credit loss (ECL) means:
(1) For a wholesale exposure to a non-defaulted obligor or
segment of non-defaulted retail exposures that is carried at fair
value with gains and losses flowing through earnings or that is
classified as held-for-sale and is carried at the lower of cost or
fair value with losses flowing through earnings, zero.
(2) For all other wholesale exposures to non-defaulted obligors
or segments of non-defaulted retail exposures, the product of PD
times LGD times EAD for the exposure or segment.
(3) For a wholesale exposure to a defaulted obligor or segment
of defaulted retail exposures, the [bank]'s impairment estimate for
allowance purposes for the exposure or segment.
(4) Total ECL is the sum of expected credit losses for all
wholesale and retail exposures other than exposures for which the
[bank] has applied the double default treatment in section 34 of
this appendix.
Expected exposure (EE) means the expected value of the
probability distribution of non-negative credit risk exposures to a
counterparty at any specified future date before the maturity date
of the longest term transaction in the netting set. Any negative
market values in the probability distribution of market values to a
counterparty at a specified future date are set to zero to convert
the probability distribution of market values to the probability
distribution of credit risk exposures.
Expected operational loss (EOL) means the expected value of the
distribution of potential aggregate operational losses, as generated
by the [bank]'s operational risk quantification system using a one-
year horizon.
Expected positive exposure (EPE) means the weighted average over
time of expected (non-negative) exposures to a counterparty where
the weights are the proportion of the time interval that an
individual expected exposure represents. When calculating risk-based
capital requirements, the average is taken over a one-year horizon.
Exposure at default (EAD). (1) For the on-balance sheet
component of a wholesale exposure or segment of retail exposures
(other than an OTC derivative contract, or a repo-style transaction
or eligible margin loan for which the [bank] determines EAD under
section 32 of this appendix), EAD means:
(i) If the exposure or segment is a security classified as
available-for-sale, the [bank]'s carrying value (including net
accrued but unpaid interest and fees) for the exposure or segment
less any allocated transfer risk reserve for the exposure or
segment, less any unrealized gains on the exposure or segment, and
plus any unrealized losses on the exposure or segment; or
(ii) If the exposure or segment is not a security classified as
available-for-sale, the [bank]'s carrying value (including net
accrued but unpaid interest and fees) for the exposure or segment
less any allocated transfer risk reserve for the exposure or
segment.
(2) For the off-balance sheet component of a wholesale exposure
or segment of retail exposures (other than an OTC derivative
contract, or a repo-style transaction or eligible margin loan for
which the [bank] determines EAD under section 32 of this appendix)
in the form of a loan commitment, line of credit, trade-related
letter of credit, or transaction-related contingency, EAD means the
[bank]'s best estimate of net additions to the outstanding amount
owed the [bank], including estimated future additional draws of
principal and accrued but unpaid interest and fees, that are likely
to occur over a one-year horizon assuming the wholesale exposure or
the retail exposures in the segment were to go into default. This
estimate of net additions must reflect what would be expected during
economic downturn conditions. Trade-related letters of credit are
short-term, self-liquidating instruments that are used to finance
the movement of goods and are collateralized by the underlying
goods. Transaction-related contingencies relate to a particular
transaction and include, among other things, performance bonds and
performance-based letters of credit.
(3) For the off-balance sheet component of a wholesale exposure
or segment of retail exposures (other than an OTC derivative
contract, or a repo-style transaction or eligible margin loan for
which the [bank] determines EAD under section 32 of this appendix)
in the form of anything other than a loan commitment, line of
credit, trade-related letter of credit, or transaction-related
contingency, EAD means the notional amount of the exposure or
segment.
(4) EAD for OTC derivative contracts is calculated as described
in section 32 of this appendix. A [bank] also may determine EAD for
repo-style transactions and eligible margin loans as described in
section 32 of this appendix.
(5) For wholesale or retail exposures in which only the drawn
balance has been securitized, the [bank] must reflect its share of
the exposures' undrawn balances in EAD. Undrawn balances of
revolving exposures for which the drawn balances have been
securitized must be allocated between the seller's and investors'
interests on a pro rata basis, based on the proportions of the
seller's and investors' shares of the securitized drawn balances.
Exposure category means any of the wholesale, retail,
securitization, or equity exposure categories.
External operational loss event data means, with respect to a
[bank], gross operational loss amounts, dates, recoveries, and
relevant causal information for operational loss events occurring at
organizations other than the [bank].
External rating means a credit rating that is assigned by an
NRSRO to an exposure, provided:
(1) The credit rating fully reflects the entire amount of credit
risk with regard to all payments owed to the holder of the exposure.
If a holder is owed principal and interest on an exposure, the
credit rating must fully reflect the credit risk associated with
timely repayment of principal and interest. If a holder is owed only
principal on an exposure, the credit rating must fully reflect only
the credit risk associated with timely repayment of principal; and
(2) The credit rating is published in an accessible form and is
or will be included in the transition matrices made publicly
available by the NRSRO that summarize the historical performance of
positions rated by the NRSRO.
Financial collateral means collateral:
(1) In the form of:
(i) Cash on deposit with the [bank] (including cash held for the
[bank] by a third-party custodian or trustee);
(ii) Gold bullion;
(iii) Long-term debt securities that have an applicable external
rating of one category below investment grade or higher;
(iv) Short-term debt instruments that have an applicable
external rating of at least investment grade;
(v) Equity securities that are publicly traded;
(vi) Convertible bonds that are publicly traded;
(vii) Money market mutual fund shares and other mutual fund
shares if a price for the shares is publicly quoted daily; or (viii)
Conforming residential mortgages; and
(2) In which the [bank] has a perfected, first priority security
interest or, outside of the United States, the legal equivalent
thereof (with the exception of cash on deposit and notwithstanding
the prior security interest of any custodial agent).
GAAP means generally accepted accounting principles as used in
the United States.
Gain-on-sale means an increase in the equity capital (as
reported on Schedule RC of the Call Report, Schedule HC of the FR Y-
9C Report, or Schedule SC of the Thrift Financial Report) of a
[bank] that results from a securitization (other than an increase in
equity capital that results from the [bank]'s receipt of cash in
connection with the securitization).
Guarantee means a financial guarantee, letter of credit,
insurance, or other similar financial instrument (other than a
credit derivative) that allows one party (beneficiary) to transfer
the credit risk of one or more specific exposures (reference
exposure) to another party (protection provider). See also eligible
guarantee.
High volatility commercial real estate (HVCRE) exposure means a
credit facility that finances or has financed the acquisition,
development, or construction (ADC) of real property, unless the
facility finances:
(1) One- to four-family residential properties; or
(2) Commercial real estate projects in which:
(i) The loan-to-value ratio is less than or equal to the
applicable maximum
[[Page 69402]]
supervisory loan-to-value ratio in the [AGENCY]'s real estate
lending standards at 12 CFR part 34, Subpart D (OCC); 12 CFR part
208, Appendix C (Board); 12 CFR part 365, Subpart D (FDIC); and 12
CFR 560.100-560.101 (OTS);
(ii) The borrower has contributed capital to the project in the
form of cash or unencumbered readily marketable assets (or has paid
development expenses out-of-pocket) of at least 15 percent of the
real estate's appraised ``as completed'' value; and
(iii) The borrower contributed the amount of capital required by
paragraph (2)(ii) of this definition before the [bank] advances
funds under the credit facility, and the capital contributed by the
borrower, or internally generated by the project, is contractually
required to remain in the project throughout the life of the
project. The life of a project concludes only when the credit
facility is converted to permanent financing or is sold or paid in
full. Permanent financing may be provided by the [bank] that
provided the ADC facility as long as the permanent financing is
subject to the [bank]'s underwriting criteria for long-term mortgage
loans.
Inferred rating. A securitization exposure has an inferred
rating equal to the external rating referenced in paragraph (2)(i)
of this definition if:
(1) The securitization exposure does not have an external
rating; and
(2) Another securitization exposure issued by the same issuer
and secured by the same underlying exposures:
(i) Has an external rating;
(ii) Is subordinated in all respects to the unrated
securitization exposure;
(iii) Does not benefit from any credit enhancement that is not
available to the unrated securitization exposure; and
(iv) Has an effective remaining maturity that is equal to or
longer than that of the unrated securitization exposure.
Interest rate derivative contract means a single-currency
interest rate swap, basis swap, forward rate agreement, purchased
interest rate option, when-issued securities, or any other
instrument linked to interest rates that gives rise to similar
counterparty credit risks.
Internal operational loss event data means, with respect to a
[bank], gross operational loss amounts, dates, recoveries, and
relevant causal information for operational loss events occurring at
the [bank].
Investing [bank] means, with respect to a securitization, a
[bank] that assumes the credit risk of a securitization exposure
(other than an originating [bank] of the securitization). In the
typical synthetic securitization, the investing [bank] sells credit
protection on a pool of underlying exposures to the originating
[bank].
Investment fund means a company:
(1) All or substantially all of the assets of which are
financial assets; and
(2) That has no material liabilities.
Investors' interest EAD means, with respect to a securitization,
the EAD of the underlying exposures multiplied by the ratio of:
(1) The total amount of securitization exposures issued by the
securitization SPE to investors; divided by
(2) The outstanding principal amount of underlying exposures.
Loss given default (LGD) means:
(1) For a wholesale exposure, the greatest of:
(i) Zero;
(ii) The [bank]'s empirically based best estimate of the long-
run default-weighted average economic loss, per dollar of EAD, the
[bank] would expect to incur if the obligor (or a typical obligor in
the loss severity grade assigned by the [bank] to the exposure) were
to default within a one-year horizon over a mix of economic
conditions, including economic downturn conditions; or
(iii) The [bank]'s empirically based best estimate of the
economic loss, per dollar of EAD, the [bank] would expect to incur
if the obligor (or a typical obligor in the loss severity grade
assigned by the [bank] to the exposure) were to default within a
one-year horizon during economic downturn conditions.
(2) For a segment of retail exposures, the greatest of:
(i) Zero;
(ii) The [bank]'s empirically based best estimate of the long-
run default-weighted average economic loss, per dollar of EAD, the
[bank] would expect to incur if the exposures in the segment were to
default within a one-year horizon over a mix of economic conditions,
including economic downturn conditions; or
(iii) The [bank]'s empirically based best estimate of the
economic loss, per dollar of EAD, the [bank] would expect to incur
if the exposures in the segment were to default within a one-year
horizon during economic downturn conditions.
(3) The economic loss on an exposure in the event of default is
all material credit-related losses on the exposure (including
accrued but unpaid interest or fees, losses on the sale of
collateral, direct workout costs, and an appropriate allocation of
indirect workout costs). Where positive or negative cash flows on a
wholesale exposure to a defaulted obligor or a defaulted retail
exposure (including proceeds from the sale of collateral, workout
costs, additional extensions of credit to facilitate repayment of
the exposure, and draw-downs of unused credit lines) occur after the
date of default, the economic loss must reflect the net present
value of cash flows as of the default date using a discount rate
appropriate to the risk of the defaulted exposure.
Main index means the Standard & Poor's 500 Index, the FTSE All-
World Index, and any other index for which the [bank] can
demonstrate to the satisfaction of the [AGENCY] that the equities
represented in the index have comparable liquidity, depth of market,
and size of bid-ask spreads as equities in the Standard & Poor's 500
Index and FTSE All-World Index.
Multilateral development bank means the International Bank for
Reconstruction and Development, the International Finance
Corporation, the Inter-American Development Bank, the Asian
Development Bank, the African Development Bank, the European Bank
for Reconstruction and Development, the European Investment Bank,
the European Investment Fund, the Nordic Investment Bank, the
Caribbean Development Bank, the Islamic Development Bank, the
Council of Europe Development Bank, and any other multilateral
lending institution or regional development bank in which the U.S.
government is a shareholder or contributing member or which the
[AGENCY] determines poses comparable credit risk.
Nationally recognized statistical rating organization (NRSRO)
means an entity registered with the SEC as a nationally recognized
statistical rating organization under section 15E of the Securities
Exchange Act of 1934 (15 U.S.C. 78o-7).
Netting set means a group of transactions with a single
counterparty that are subject to a qualifying master netting
agreement or qualifying cross-product master netting agreement. For
purposes of the internal models methodology in paragraph (d) of
section 32 of this appendix, each transaction that is not subject to
such a master netting agreement is its own netting set.
N\th\-to-default credit derivative means a credit derivative
that provides credit protection only for the n\th\-defaulting
reference exposure in a group of reference exposures.
Obligor means the legal entity or natural person contractually
obligated on a wholesale exposure, except that a [bank] may treat
the following exposures as having separate obligors:
(1) Exposures to the same legal entity or natural person
denominated in different currencies;
(2) (i) An income-producing real estate exposure for which all
or substantially all of the repayment of the exposure is reliant on
the cash flows of the real estate serving as collateral for the
exposure; the [bank], in economic substance, does not have recourse
to the borrower beyond the real estate collateral; and no cross-
default or cross-acceleration clauses are in place other than
clauses obtained solely out of an abundance of caution; and
(ii) Other credit exposures to the same legal entity or natural
person; and
(3) (i) A wholesale exposure authorized under section 364 of the
U.S. Bankruptcy Code (11 U.S.C. 364) to a legal entity or natural
person who is a debtor-in-possession for purposes of Chapter 11 of
the Bankruptcy Code; and
(ii) Other credit exposures to the same legal entity or natural
person.
Operational loss means a loss (excluding insurance or tax
effects) resulting from an operational loss event. Operational loss
includes all expenses associated with an operational loss event
except for opportunity costs, forgone revenue, and costs related to
risk management and control enhancements implemented to prevent
future operational losses.
Operational loss event means an event that results in loss and
is associated with any of the following seven operational loss event
type categories:
(1) Internal fraud, which means the operational loss event type
category that comprises operational losses resulting from an act
involving at least one internal party of a type intended to defraud,
misappropriate
[[Page 69403]]
property, or circumvent regulations, the law, or company policy,
excluding diversity- and discrimination-type events.
(2) External fraud, which means the operational loss event type
category that comprises operational losses resulting from an act by
a third party of a type intended to defraud, misappropriate
property, or circumvent the law. Retail credit card losses arising
from non-contractual, third-party initiated fraud (for example,
identity theft) are external fraud operational losses. All other
third-party initiated credit losses are to be treated as credit risk
losses.
(3) Employment practices and workplace safety, which means the
operational loss event type category that comprises operational
losses resulting from an act inconsistent with employment, health,
or safety laws or agreements, payment of personal injury claims, or
payment arising from diversity- and discrimination-type events.
(4) Clients, products, and business practices, which means the
operational loss event type category that comprises operational
losses resulting from the nature or design of a product or from an
unintentional or negligent failure to meet a professional obligation
to specific clients (including fiduciary and suitability
requirements).
(5) Damage to physical assets, which means the operational loss
event type category that comprises operational losses resulting from
the loss of or damage to physical assets from natural disaster or
other events.
(6) Business disruption and system failures, which means the
operational loss event type category that comprises operational
losses resulting from disruption of business or system failures.
(7) Execution, delivery, and process management, which means the
operational loss event type category that comprises operational
losses resulting from failed transaction processing or process
management or losses arising from relations with trade
counterparties and vendors.
Operational risk means the risk of loss resulting from
inadequate or failed internal processes, people, and systems or from
external events (including legal risk but excluding strategic and
reputational risk).
Operational risk exposure means the 99.9\th\ percentile of the
distribution of potential aggregate operational losses, as generated
by the [bank]'s operational risk quantification system over a one-
year horizon (and not incorporating eligible operational risk
offsets or qualifying operational risk mitigants).
Originating [bank], with respect to a securitization, means a
[bank] that:
(1) Directly or indirectly originated or securitized the
underlying exposures included in the securitization; or
(2) Serves as an ABCP program sponsor to the securitization.
Other retail exposure means an exposure (other than a
securitization exposure, an equity exposure, a residential mortgage
exposure, an excluded mortgage exposure, a qualifying revolving
exposure, or the residual value portion of a lease exposure) that is
managed as part of a segment of exposures with homogeneous risk
characteristics, not on an individual-exposure basis, and is either:
(1) An exposure to an individual for non-business purposes; or
(2) An exposure to an individual or company for business
purposes if the [bank]'s consolidated business credit exposure to
the individual or company is $1 million or less.
Over-the-counter (OTC) derivative contract means a derivative
contract that is not traded on an exchange that requires the daily
receipt and payment of cash-variation margin.
Probability of default (PD) means:
(1) For a wholesale exposure to a non-defaulted obligor, the
[bank]'s empirically based best estimate of the long-run average
one-year default rate for the rating grade assigned by the [bank] to
the obligor, capturing the average default experience for obligors
in the rating grade over a mix of economic conditions (including
economic downturn conditions) sufficient to provide a reasonable
estimate of the average one-year default rate over the economic
cycle for the rating grade.
(2) For a segment of non-defaulted retail exposures, the
[bank]'s empirically based best estimate of the long-run average
one-year default rate for the exposures in the segment, capturing
the average default experience for exposures in the segment over a
mix of economic conditions (including economic downturn conditions)
sufficient to provide a reasonable estimate of the average one-year
default rate over the economic cycle for the segment and adjusted
upward as appropriate for segments for which seasoning effects are
material. For purposes of this definition, a segment for which
seasoning effects are material is a segment where there is a
material relationship between the time since origination of
exposures within the segment and the [bank]'s best estimate of the
long-run average one-year default rate for the exposures in the
segment.
(3) For a wholesale exposure to a defaulted obligor or segment
of defaulted retail exposures, 100 percent.
Protection amount (P) means, with respect to an exposure hedged
by an eligible guarantee or eligible credit derivative, the
effective notional amount of the guarantee or credit derivative,
reduced to reflect any currency mismatch, maturity mismatch, or lack
of restructuring coverage (as provided in section 33 of this
appendix).
Publicly traded means traded on:
(1) Any exchange registered with the SEC as a national
securities exchange under section 6 of the Securities Exchange Act
of 1934 (15 U.S.C. 78f); or
(2) Any non-U.S.-based securities exchange that:
(i) Is registered with, or approved by, a national securities
regulatory authority; and
(ii) Provides a liquid, two-way market for the instrument in
question, meaning that there are enough independent bona fide offers
to buy and sell so that a sales price reasonably related to the last
sales price or current bona fide competitive bid and offer
quotations can be determined promptly and a trade can be settled at
such a price within five business days.
Qualifying central counterparty means a counterparty (for
example, a clearinghouse) that:
(1) Facilitates trades between counterparties in one or more
financial markets by either guaranteeing trades or novating
contracts;
(2) Requires all participants in its arrangements to be fully
collateralized on a daily basis; and
(3) The [bank] demonstrates to the satisfaction of the [AGENCY]
is in sound financial condition and is subject to effective
oversight by a national supervisory authority.
Qualifying cross-product master netting agreement means a
qualifying master netting agreement that provides for termination
and close-out netting across multiple types of financial
transactions or qualifying master netting agreements in the event of
a counterparty's default, provided that:
(1) The underlying financial transactions are OTC derivative
contracts, eligible margin loans, or repo-style transactions; and
(2) The [bank] obtains a written legal opinion verifying the
validity and enforceability of the agreement under applicable law of
the relevant jurisdictions if the counterparty fails to perform upon
an event of default, including upon an event of bankruptcy,
insolvency, or similar proceeding.
Qualifying master netting agreement means any written, legally
enforceable bilateral agreement, provided that:
(1) The agreement creates a single legal obligation for all
individual transactions covered by the agreement upon an event of
default, including bankruptcy, insolvency, or similar proceeding, of
the counterparty;
(2) The agreement provides the [bank] the right to accelerate,
terminate, and close-out on a net basis all transactions under the
agreement and to liquidate or set off collateral promptly upon an
event of default, including upon an event of bankruptcy, insolvency,
or similar proceeding, of the counterparty, provided that, in any
such case, any exercise of rights under the agreement will not be
stayed or avoided under applicable law in the relevant
jurisdictions;
(3) The [bank] has conducted sufficient legal review to conclude
with a well-founded basis (and maintains sufficient written
documentation of that legal review) that:
(i) The agreement meets the requirements of paragraph (2) of
this definition; and
(ii) In the event of a legal challenge (including one resulting
from default or from bankruptcy, insolvency, or similar proceeding)
the relevant court and administrative authorities would find the
agreement to be legal, valid, binding, and enforceable under the law
of the relevant jurisdictions;
(4) The [bank] establishes and maintains procedures to monitor
possible changes in relevant law and to ensure that the agreement
continues to satisfy the requirements of this definition; and
(5) The agreement does not contain a walkaway clause (that is, a
provision that permits a non-defaulting counterparty to make a lower
payment than it would make otherwise under the agreement, or no
[[Page 69404]]
payment at all, to a defaulter or the estate of a defaulter, even if
the defaulter or the estate of the defaulter is a net creditor under
the agreement).
Qualifying revolving exposure (QRE) means an exposure (other
than a securitization exposure or equity exposure) to an individual
that is managed as part of a segment of exposures with homogeneous
risk characteristics, not on an individual-exposure basis, and:
(1) Is revolving (that is, the amount outstanding fluctuates,
determined largely by the borrower's decision to borrow and repay,
up to a pre-established maximum amount);
(2) Is unsecured and unconditionally cancelable by the [bank] to
the fullest extent permitted by Federal law; and
(3) Has a maximum exposure amount (drawn plus undrawn) of up to
$100,000.
Repo-style transaction means a repurchase or reverse repurchase
transaction, or a securities borrowing or securities lending
transaction, including a transaction in which the [bank] acts as
agent for a customer and indemnifies the customer against loss,
provided that:
(1) The transaction is based solely on liquid and readily
marketable securities, cash, gold, or conforming residential
mortgages;
(2) The transaction is marked-to-market daily and subject to
daily margin maintenance requirements;
(3)(i) The transaction is a ``securities contract'' or
``repurchase agreement'' under section 555 or 559, respectively, of
the Bankruptcy Code (11 U.S.C. 555 or 559), a qualified financial
contract under section 11(e)(8) of the Federal Deposit Insurance Act
(12 U.S.C. 1821(e)(8)), or a netting contract between or among
financial institutions under sections 401-407 of the Federal Deposit
Insurance Corporation Improvement Act of 1991 (12 U.S.C. 4401-4407)
or the Federal Reserve Board's Regulation EE (12 CFR part 231); or
(ii) If the transaction does not meet the criteria set forth in
paragraph (3)(i) of this definition, then either:
(A) The transaction is executed under an agreement that provides
the [bank] the right to accelerate, terminate, and close-out the
transaction on a net basis and to liquidate or set off collateral
promptly upon an event of default (including upon an event of
bankruptcy, insolvency, or similar proceeding) of the counterparty,
provided that, in any such case, any exercise of rights under the
agreement will not be stayed or avoided under applicable law in the
relevant jurisdictions; or
(B) The transaction is:
(1) Either overnight or unconditionally cancelable at any time
by the [bank]; and
(2) Executed under an agreement that provides the [bank] the
right to accelerate, terminate, and close-out the transaction on a
net basis and to liquidate or set off collateral promptly upon an
event of counterparty default; and
(4) The [bank] has conducted sufficient legal review to conclude
with a well-founded basis (and maintains sufficient written
documentation of that legal review) that the agreement meets the
requirements of paragraph (3) of this definition and is legal,
valid, binding, and enforceable under applicable law in the relevant
jurisdictions.
Residential mortgage exposure means an exposure (other than a
securitization exposure, equity exposure, or excluded mortgage
exposure) that is managed as part of a segment of exposures with
homogeneous risk characteristics, not on an individual-exposure
basis, and is:
(1) An exposure that is primarily secured by a first or
subsequent lien on one- to four-family residential property; or
(2) An exposure with an original and outstanding amount of $1
million or less that is primarily secured by a first or subsequent
lien on residential property that is not one to four family.
Retail exposure means a residential mortgage exposure, a
qualifying revolving exposure, or an other retail exposure.
Retail exposure subcategory means the residential mortgage
exposure, qualifying revolving exposure, or other retail exposure
subcategory.
Risk parameter means a variable used in determining risk-based
capital requirements for wholesale and retail exposures,
specifically probability of default (PD), loss given default (LGD),
exposure at default (EAD), or effective maturity (M).
Scenario analysis means a systematic process of obtaining expert
opinions from business managers and risk management experts to
derive reasoned assessments of the likelihood and loss impact of
plausible high-severity operational losses. Scenario analysis may
include the well-reasoned evaluation and use of external operational
loss event data, adjusted as appropriate to ensure relevance to a
[bank]'s operational risk profile and control structure.
SEC means the U.S. Securities and Exchange Commission.
Securitization means a traditional securitization or a synthetic
securitization.
Securitization exposure means an on-balance sheet or off-balance
sheet credit exposure that arises from a traditional or synthetic
securitization (including credit-enhancing representations and
warranties).
Securitization special purpose entity (securitization SPE) means
a corporation, trust, or other entity organized for the specific
purpose of holding underlying exposures of a securitization, the
activities of which are limited to those appropriate to accomplish
this purpose, and the structure of which is intended to isolate the
underlying exposures held by the entity from the credit risk of the
seller of the underlying exposures to the entity.
Senior securitization exposure means a securitization exposure
that has a first priority claim on the cash flows from the
underlying exposures. When determining whether a securitization
exposure has a first priority claim on the cash flows from the
underlying exposures, a [bank] is not required to consider amounts
due under interest rate or currency derivative contracts, fees due,
or other similar payments. Both the most senior commercial paper
issued by an ABCP program and a liquidity facility that supports the
ABCP program may be senior securitization exposures if the liquidity
facility provider's right to reimbursement of the drawn amounts is
senior to all claims on the cash flows from the underlying exposures
except amounts due under interest rate or currency derivative
contracts, fees due, or other similar payments.
Servicer cash advance facility means a facility under which the
servicer of the underlying exposures of a securitization may advance
cash to ensure an uninterrupted flow of payments to investors in the
securitization, including advances made to cover foreclosure costs
or other expenses to facilitate the timely collection of the
underlying exposures. See also eligible servicer cash advance
facility.
Sovereign entity means a central government (including the U.S.
government) or an agency, department, ministry, or central bank of a
central government.
Sovereign exposure means:
(1) A direct exposure to a sovereign entity; or
(2) An exposure directly and unconditionally backed by the full
faith and credit of a sovereign entity.
Subsidiary means, with respect to a company, a company
controlled by that company.
Synthetic securitization means a transaction in which:
(1) All or a portion of the credit risk of one or more
underlying exposures is transferred to one or more third parties
through the use of one or more credit derivatives or guarantees
(other than a guarantee that transfers only the credit risk of an
individual retail exposure);
(2) The credit risk associated with the underlying exposures has
been separated into at least two tranches reflecting different
levels of seniority;
(3) Performance of the securitization exposures depends upon the
performance of the underlying exposures; and
(4) All or substantially all of the underlying exposures are
financial exposures (such as loans, commitments, credit derivatives,
guarantees, receivables, asset-backed securities, mortgage-backed
securities, other debt securities, or equity securities).
Tier 1 capital is defined in [the general risk-based capital
rules], as modified in part II of this appendix.
Tier 2 capital is defined in [the general risk-based capital
rules], as modified in part II of this appendix.
Total qualifying capital means the sum of tier 1 capital and
tier 2 capital, after all deductions required in this appendix.
Total risk-weighted assets means:
(1) The sum of:
(i) Credit risk-weighted assets; and
(ii) Risk-weighted assets for operational risk; minus
(2) Excess eligible credit reserves not included in tier 2
capital.
Total wholesale and retail risk-weighted assets means the sum of
risk-weighted assets for wholesale exposures to non-defaulted
obligors and segments of non-defaulted retail exposures; risk-
weighted assets for wholesale exposures to defaulted obligors and
segments of defaulted retail exposures; risk-weighted assets for
assets not defined by an exposure category; and risk-weighted assets
for non-
[[Page 69405]]
material portfolios of exposures (all as determined in section 31 of
this appendix) and risk-weighted assets for unsettled transactions
(as determined in section 35 of this appendix) minus the amounts
deducted from capital pursuant to [the general risk-based capital
rules] (excluding those deductions reversed in section 12 of this
appendix).
Traditional securitization means a transaction in which:
(1) All or a portion of the credit risk of one or more
underlying exposures is transferred to one or more third parties
other than through the use of credit derivatives or guarantees;
(2) The credit risk associated with the underlying exposures has
been separated into at least two tranches reflecting different
levels of seniority;
(3) Performance of the securitization exposures depends upon the
performance of the underlying exposures;
(4) All or substantially all of the underlying exposures are
financial exposures (such as loans, commitments, credit derivatives,
guarantees, receivables, asset-backed securities, mortgage-backed
securities, other debt securities, or equity securities);
(5) The underlying exposures are not owned by an operating
company;
(6) The underlying exposures are not owned by a small business
investment company described in section 302 of the Small Business
Investment Act of 1958 (15 U.S.C. 682); and
(7) The underlying exposures are not owned by a firm an
investment in which qualifies as a community development investment
under 12 U.S.C. 24(Eleventh).
(8) The [AGENCY] may determine that a transaction in which the
underlying exposures are owned by an investment firm that exercises
substantially unfettered control over the size and composition of
its assets, liabilities, and off-balance sheet exposures is not a
traditional securitization based on the transaction's leverage, risk
profile, or economic substance.
(9) The [AGENCY] may deem a transaction that meets the
definition of a traditional securitization, notwithstanding
paragraph (5), (6), or (7) of this definition, to be a traditional
securitization based on the transaction's leverage, risk profile, or
economic substance.
Tranche means all securitization exposures associated with a
securitization that have the same seniority level.
Underlying exposures means one or more exposures that have been
securitized in a securitization transaction.
Unexpected operational loss (UOL) means the difference between
the [bank]'s operational risk exposure and the [bank]'s expected
operational loss.
Unit of measure means the level (for example, organizational
unit or operational loss event type) at which the [bank]'s
operational risk quantification system generates a separate
distribution of potential operational losses.
Value-at-Risk (VaR) means the estimate of the maximum amount
that the value of one or more exposures could decline due to market
price or rate movements during a fixed holding period within a
stated confidence interval.
Wholesale exposure means a credit exposure to a company, natural
person, sovereign entity, or governmental entity (other than a
securitization exposure, retail exposure, excluded mortgage
exposure, or equity exposure). Examples of a wholesale exposure
include:
(1) A non-tranched guarantee issued by a [bank] on behalf of a
company;
(2) A repo-style transaction entered into by a [bank] with a
company and any other transaction in which a [bank] posts collateral
to a company and faces counterparty credit risk;
(3) An exposure that a [bank] treats as a covered position under
[the market risk rule] for which there is a counterparty credit risk
capital requirement;
(4) A sale of corporate loans by a [bank] to a third party in
which the [bank] retains full recourse;
(5) An OTC derivative contract entered into by a [bank] with a
company;
(6) An exposure to an individual that is not managed by a [bank]
as part of a segment of exposures with homogeneous risk
characteristics; and
(7) A commercial lease.
Wholesale exposure subcategory means the HVCRE or non-HVCRE
wholesale exposure subcategory.
Section 3. Minimum Risk-Based Capital Requirements
(a) Except as modified by paragraph (c) of this section or by
section 23 of this appendix, each [bank] must meet a minimum ratio
of:
(1) Total qualifying capital to total risk-weighted assets of
8.0 percent; and
(2) Tier 1 capital to total risk-weighted assets of 4.0 percent.
(b) Each [bank] must hold capital commensurate with the level
and nature of all risks to which the [bank] is exposed.
(c) When a [bank] subject to [the market risk rule] calculates
its risk-based capital requirements under this appendix, the [bank]
must also refer to [the market risk rule] for supplemental rules to
calculate risk-based capital requirements adjusted for market risk.
Part II. Qualifying Capital
Section 11. Additional Deductions
(a) General. A [bank] that uses this appendix must make the same
deductions from its tier 1 capital and tier 2 capital required in
[the general risk-based capital rules], except that:
(1) A [bank] is not required to deduct certain equity
investments and CEIOs (as provided in section 12 of this appendix);
and
(2) A [bank] also must make the deductions from capital required
by paragraphs (b) and (c) of this section.
(b) Deductions from tier 1 capital. A [bank] must deduct from
tier 1 capital any gain-on-sale associated with a securitization
exposure as provided in paragraph (a) of section 41 and paragraphs
(a)(1), (c), (g)(1), and (h)(1) of section 42 of this appendix.
(c) Deductions from tier 1 and tier 2 capital. A [bank] must
deduct the exposures specified in paragraphs (c)(1) through (c)(7)
in this section 50 percent from tier 1 capital and 50 percent from
tier 2 capital. If the amount deductible from tier 2 capital exceeds
the [bank]'s actual tier 2 capital, however, the [bank] must deduct
the excess from tier 1 capital.
(1) Credit-enhancing interest-only strips (CEIOs). In accordance
with paragraphs (a)(1) and (c) of section 42 of this appendix, any
CEIO that does not constitute gain-on-sale.
(2) Non-qualifying securitization exposures. In accordance with
paragraphs (a)(4) and (c) of section 42 of this appendix, any
securitization exposure that does not qualify for the Ratings-Based
Approach, the Internal Assessment Approach, or the Supervisory
Formula Approach under sections 43, 44, and 45 of this appendix,
respectively.
(3) Securitizations of non-IRB exposures. In accordance with
paragraphs (c) and (g)(4) of section 42 of this appendix, certain
exposures to a securitization any underlying exposure of which is
not a wholesale exposure, retail exposure, securitization exposure,
or equity exposure.
(4) Low-rated securitization exposures. In accordance with
section 43 and paragraph (c) of section 42 of this appendix, any
securitization exposure that qualifies for and must be deducted
under the Ratings-Based Approach.
(5) High-risk securitization exposures subject to the
Supervisory Formula Approach. In accordance with paragraphs (b) and
(c) of section 45 of this appendix and paragraph (c) of section 42
of this appendix, certain high-risk securitization exposures (or
portions thereof) that qualify for the Supervisory Formula Approach.
(6) Eligible credit reserves shortfall. In accordance with
paragraph (a)(1) of section 13 of this appendix, any eligible credit
reserves shortfall.
(7) Certain failed capital markets transactions. In accordance
with paragraph (e)(3) of section 35 of this appendix, the [bank]'s
exposure on certain failed capital markets transactions.
Section 12. Deductions and Limitations Not Required
(a) Deduction of CEIOs. A [bank] is not required to make the
deductions from capital for CEIOs in 12 CFR part 3, Appendix A,
section 2(c) (for national banks), 12 CFR part 208, Appendix A,
section II.B.1.e. (for state member banks), 12 CFR part 225,
Appendix A, section II.B.1.e. (for bank holding companies), 12 CFR
part 325, Appendix A, section II.B.5. (for state nonmember banks),
and 12 CFR 567.5(a)(2)(iii) and 567.12(e) (for savings
associations).
(b) Deduction of certain equity investments. A [bank] is not
required to make the deductions from capital for nonfinancial equity
investments in 12 CFR part 3, Appendix A, section 2(c) (for national
banks), 12 CFR part 208, Appendix A, section II.B.5. (for state
member banks), 12 CFR part 225, Appendix A, section II.B.5. (for
bank holding companies), and 12 CFR part 325, Appendix A, section
II.B. (for state nonmember banks).
Section 13. Eligible Credit Reserves
(a) Comparison of eligible credit reserves to expected credit
losses--(1) Shortfall of
[[Page 69406]]
eligible credit reserves. If a [bank]'s eligible credit reserves are
less than the [bank]'s total expected credit losses, the [bank] must
deduct the shortfall amount 50 percent from tier 1 capital and 50
percent from tier 2 capital. If the amount deductible from tier 2
capital exceeds the [bank]'s actual tier 2 capital, the [bank] must
deduct the excess amount from tier 1 capital.
(2) Excess eligible credit reserves. If a [bank]'s eligible
credit reserves exceed the [bank]'s total expected credit losses,
the [bank] may include the excess amount in tier 2 capital to the
extent that the excess amount does not exceed 0.6 percent of the
[bank]'s credit-risk-weighted assets.
(b) Treatment of allowance for loan and lease losses. Regardless
of any provision in [the general risk-based capital rules], the ALLL
is included in tier 2 capital only to the extent provided in
paragraph (a)(2) of this section and in section 24 of this appendix.
Part III. Qualification
Section 21. Qualification Process
(a) Timing. (1) A [bank] that is described in paragraph (b)(1)
of section 1 of this appendix must adopt a written implementation
plan no later than six months after the later of April 1, 2008, or
the date the [bank] meets a criterion in that section. The
implementation plan must incorporate an explicit first floor period
start date no later than 36 months after the later of April 1, 2008,
or the date the [bank] meets at least one criterion under paragraph
(b)(1) of section 1 of this appendix. The [AGENCY] may extend the
first floor period start date.
(2) A [bank] that elects to be subject to this appendix under
paragraph (b)(2) of section 1 of this appendix must adopt a written
implementation plan.
(b) Implementation plan. (1) The [bank]'s implementation plan
must address in detail how the [bank] complies, or plans to comply,
with the qualification requirements in section 22 of this appendix.
The [bank] also must maintain a comprehensive and sound planning and
governance process to oversee the implementation efforts described
in the plan. At a minimum, the plan must:
(i) Comprehensively address the qualification requirements in
section 22 of this appendix for the [bank] and each consolidated
subsidiary (U.S. and foreign-based) of the [bank] with respect to
all portfolios and exposures of the [bank] and each of its
consolidated subsidiaries;
(ii) Justify and support any proposed temporary or permanent
exclusion of business lines, portfolios, or exposures from
application of the advanced approaches in this appendix (which
business lines, portfolios, and exposures must be, in the aggregate,
immaterial to the [bank]);
(iii) Include the [bank]'s self-assessment of:
(A) The [bank]'s current status in meeting the qualification
requirements in section 22 of this appendix; and
(B) The consistency of the [bank]'s current practices with the
[AGENCY]'s supervisory guidance on the qualification requirements;
(iv) Based on the [bank]'s self-assessment, identify and
describe the areas in which the [bank] proposes to undertake
additional work to comply with the qualification requirements in
section 22 of this appendix or to improve the consistency of the
[bank]'s current practices with the [AGENCY]'s supervisory guidance
on the qualification requirements (gap analysis);
(v) Describe what specific actions the [bank] will take to
address the areas identified in the gap analysis required by
paragraph (b)(1)(iv) of this section;
(vi) Identify objective, measurable milestones, including
delivery dates and a date when the [bank]'s implementation of the
methodologies described in this appendix will be fully operational;
(vii) Describe resources that have been budgeted and are
available to implement the plan; and
(viii) Receive approval of the [bank]'s board of directors.
(2) The [bank] must submit the implementation plan, together
with a copy of the minutes of the board of directors' approval, to
the [AGENCY] at least 60 days before the [bank] proposes to begin
its parallel run, unless the [AGENCY] waives prior notice.
(c) Parallel run. Before determining its risk-based capital
requirements under this appendix and following adoption of the
implementation plan, the [bank] must conduct a satisfactory parallel
run. A satisfactory parallel run is a period of no less than four
consecutive calendar quarters during which the [bank] complies with
the qualification requirements in section 22 of this appendix to the
satisfaction of the [AGENCY]. During the parallel run, the [bank]
must report to the [AGENCY] on a calendar quarterly basis its risk-
based capital ratios using [the general risk-based capital rules]
and the risk-based capital requirements described in this appendix.
During this period, the [bank] is subject to [the general risk-based
capital rules].
(d) Approval to calculate risk-based capital requirements under
this appendix. The [AGENCY] will notify the [bank] of the date that
the [bank] may begin its first floor period if the [AGENCY]
determines that:
(1) The [bank] fully complies with all the qualification
requirements in section 22 of this appendix;
(2) The [bank] has conducted a satisfactory parallel run under
paragraph (c) of this section; and
(3) The [bank] has an adequate process to ensure ongoing
compliance with the qualification requirements in section 22 of this
appendix.
(e) Transitional floor periods. Following a satisfactory
parallel run, a [bank] is subject to three transitional floor
periods.
(1) Risk-based capital ratios during the transitional floor
periods--(i) Tier 1 risk-based capital ratio. During a [bank]'s
transitional floor periods, the [bank]'s tier 1 risk-based capital
ratio is equal to the lower of:
(A) The [bank]'s floor-adjusted tier 1 risk-based capital ratio;
or
(B) The [bank]'s advanced approaches tier 1 risk-based capital
ratio.
(ii) Total risk-based capital ratio. During a [bank]'s
transitional floor periods, the [bank]'s total risk-based capital
ratio is equal to the lower of:
(A) The [bank]'s floor-adjusted total risk-based capital ratio;
or
(B) The [bank]'s advanced approaches total risk-based capital
ratio.
(2) Floor-adjusted risk-based capital ratios. (i) A [bank]'s
floor-adjusted tier 1 risk-based capital ratio during a transitional
floor period is equal to the [bank]'s tier 1 capital as calculated
under [the general risk-based capital rules], divided by the product
of:
(A) The [bank]'s total risk-weighted assets as calculated under
[the general risk-based capital rules]; and
(B) The appropriate transitional floor percentage in Table 1.
(ii) A [bank]'s floor-adjusted total risk-based capital ratio
during a transitional floor period is equal to the sum of the
[bank]'s tier 1 and tier 2 capital as calculated under [the general
risk-based capital rules], divided by the product of:
(A) The [bank]'s total risk-weighted assets as calculated under
[the general risk-based capital rules]; and
(B) The appropriate transitional floor percentage in Table 1.
(iii) A [bank] that meets the criteria in paragraph (b)(1) or
(b)(2) of section 1 of this appendix as of April 1, 2008, must use
[the general risk-based capital rules] during the parallel run and
as the basis for its transitional floors.
Table 1.--Transitional Floors
------------------------------------------------------------------------
Transitional floor
Transitional floor period percentage
------------------------------------------------------------------------
First floor period........................ 95 percent.
Second floor period....................... 90 percent.
Third floor period........................ 85 percent.
------------------------------------------------------------------------
(3) Advanced approaches risk-based capital ratios. (i) A
[bank]'s advanced approaches tier 1 risk-based capital ratio equals
the [bank]'s tier 1 risk-based capital ratio as calculated under
this appendix (other than this section on transitional floor
periods).
(ii) A [bank]'s advanced approaches total risk-based capital
ratio equals the [bank]'s total risk-based capital ratio as
calculated under this appendix (other than this section on
transitional floor periods).
(4) Reporting. During the transitional floor periods, a [bank]
must report to the [AGENCY] on a calendar quarterly basis both
floor-adjusted risk-based capital ratios and both advanced
approaches risk-based capital ratios.
(5) Exiting a transitional floor period. A [bank] may not exit a
transitional floor period until the [bank] has spent a minimum of
four consecutive calendar quarters in the period and the [AGENCY]
has determined that the [bank] may exit the floor period. The
[AGENCY]'s determination will be based on an assessment of the
[bank]'s ongoing compliance with the qualification requirements in
section 22 of this appendix.
(6) Interagency study. After the end of the second transition
year (2010), the Federal banking agencies will publish a study that
evaluates the advanced approaches to determine if there are any
material deficiencies. For any primary Federal
[[Page 69407]]
supervisor to authorize any institution to exit the third
transitional floor period, the study must determine that there are
no such material deficiencies that cannot be addressed by then-
existing tools, or, if such deficiencies are found, they are first
remedied by changes to this appendix. Notwithstanding the preceding
sentence, a primary Federal supervisor that disagrees with the
finding of material deficiency may not authorize any institution
under its jurisdiction to exit the third transitional floor period
unless it provides a public report explaining its reasoning.
Section 22. Qualification Requirements
(a) Process and systems requirements. (1) A [bank] must have a
rigorous process for assessing its overall capital adequacy in
relation to its risk profile and a comprehensive strategy for
maintaining an appropriate level of capital.
(2) The systems and processes used by a [bank] for risk-based
capital purposes under this appendix must be consistent with the
[bank]'s internal risk management processes and management
information reporting systems.
(3) Each [bank] must have an appropriate infrastructure with
risk measurement and management processes that meet the
qualification requirements of this section and are appropriate given
the [bank]'s size and level of complexity. Regardless of whether the
systems and models that generate the risk parameters necessary for
calculating a [bank]'s risk-based capital requirements are located
at any affiliate of the [bank], the [bank] itself must ensure that
the risk parameters and reference data used to determine its risk-
based capital requirements are representative of its own credit risk
and operational risk exposures.
(b) Risk rating and segmentation systems for wholesale and
retail exposures. (1) A [bank] must have an internal risk rating and
segmentation system that accurately and reliably differentiates
among degrees of credit risk for the [bank]'s wholesale and retail
exposures.
(2) For wholesale exposures:
(i) A [bank] must have an internal risk rating system that
accurately and reliably assigns each obligor to a single rating
grade (reflecting the obligor's likelihood of default). A [bank] may
elect, however, not to assign to a rating grade an obligor to whom
the [bank] extends credit based solely on the financial strength of
a guarantor, provided that all of the [bank]'s exposures to the
obligor are fully covered by eligible guarantees, the [bank] applies
the PD substitution approach in paragraph (c)(1) of section 33 of
this appendix to all exposures to that obligor, and the [bank]
immediately assigns the obligor to a rating grade if a guarantee can
no longer be recognized under this appendix. The [bank]'s wholesale
obligor rating system must have at least seven discrete rating
grades for non-defaulted obligors and at least one rating grade for
defaulted obligors.
(ii) Unless the [bank] has chosen to directly assign LGD
estimates to each wholesale exposure, the [bank] must have an
internal risk rating system that accurately and reliably assigns
each wholesale exposure to a loss severity rating grade (reflecting
the [bank]'s estimate of the LGD of the exposure). A [bank]
employing loss severity rating grades must have a sufficiently
granular loss severity grading system to avoid grouping together
exposures with widely ranging LGDs.
(3) For retail exposures, a [bank] must have an internal system
that groups retail exposures into the appropriate retail exposure
subcategory, groups the retail exposures in each retail exposure
subcategory into separate segments with homogeneous risk
characteristics, and assigns accurate and reliable PD and LGD
estimates for each segment on a consistent basis. The [bank]'s
system must identify and group in separate segments by subcategories
exposures identified in paragraphs (c)(2)(ii) and (iii) of section
31 of this appendix.
(4) The [bank]'s internal risk rating policy for wholesale
exposures must describe the [bank]'s rating philosophy (that is,
must describe how wholesale obligor rating assignments are affected
by the [bank]'s choice of the range of economic, business, and
industry conditions that are considered in the obligor rating
process).
(5) The [bank]'s internal risk rating system for wholesale
exposures must provide for the review and update (as appropriate) of
each obligor rating and (if applicable) each loss severity rating
whenever the [bank] receives new material information, but no less
frequently than annually. The [bank]'s retail exposure segmentation
system must provide for the review and update (as appropriate) of
assignments of retail exposures to segments whenever the [bank]
receives new material information, but generally no less frequently
than quarterly.
(c) Quantification of risk parameters for wholesale and retail
exposures. (1) The [bank] must have a comprehensive risk parameter
quantification process that produces accurate, timely, and reliable
estimates of the risk parameters for the [bank]'s wholesale and
retail exposures.
(2) Data used to estimate the risk parameters must be relevant
to the [bank]'s actual wholesale and retail exposures, and of
sufficient quality to support the determination of risk-based
capital requirements for the exposures.
(3) The [bank]'s risk parameter quantification process must
produce appropriately conservative risk parameter estimates where
the [bank] has limited relevant data, and any adjustments that are
part of the quantification process must not result in a pattern of
bias toward lower risk parameter estimates.
(4) The [bank]'s risk parameter estimation process should not
rely on the possibility of U.S. government financial assistance,
except for the financial assistance that the U.S. government has a
legally binding commitment to provide.
(5) Where the [bank]'s quantifications of LGD directly or
indirectly incorporate estimates of the effectiveness of its credit
risk management practices in reducing its exposure to troubled
obligors prior to default, the [bank] must support such estimates
with empirical analysis showing that the estimates are consistent
with its historical experience in dealing with such exposures during
economic downturn conditions.
(6) PD estimates for wholesale obligors and retail segments must
be based on at least five years of default data. LGD estimates for
wholesale exposures must be based on at least seven years of loss
severity data, and LGD estimates for retail segments must be based
on at least five years of loss severity data. EAD estimates for
wholesale exposures must be based on at least seven years of
exposure amount data, and EAD estimates for retail segments must be
based on at least five years of exposure amount data.
(7) Default, loss severity, and exposure amount data must
include periods of economic downturn conditions, or the [bank] must
adjust its estimates of risk parameters to compensate for the lack
of data from periods of economic downturn conditions.
(8) The [bank]'s PD, LGD, and EAD estimates must be based on the
definition of default in this appendix.
(9) The [bank] must review and update (as appropriate) its risk
parameters and its risk parameter quantification process at least
annually.
(10) The [bank] must at least annually conduct a comprehensive
review and analysis of reference data to determine relevance of
reference data to the [bank]'s exposures, quality of reference data
to support PD, LGD, and EAD estimates, and consistency of reference
data to the definition of default contained in this appendix.
(d) Counterparty credit risk model. A [bank] must obtain the
prior written approval of the [AGENCY] under section 32 of this
appendix to use the internal models methodology for counterparty
credit risk.
(e) Double default treatment. A [bank] must obtain the prior
written approval of the [AGENCY] under section 34 of this appendix
to use the double default treatment.
(f) Securitization exposures. A [bank] must obtain the prior
written approval of the [AGENCY] under section 44 of this appendix
to use the Internal Assessment Approach for securitization exposures
to ABCP programs.
(g) Equity exposures model. A [bank] must obtain the prior
written approval of the [AGENCY] under section 53 of this appendix
to use the Internal Models Approach for equity exposures.
(h) Operational risk--(1) Operational risk management processes.
A [bank] must:
(i) Have an operational risk management function that:
(A) Is independent of business line management; and
(B) Is responsible for designing, implementing, and overseeing
the [bank]'s operational risk data and assessment systems,
operational risk quantification systems, and related processes;
(ii) Have and document a process (which must capture business
environment and internal control factors affecting the [bank]'s
operational risk profile) to identify, measure, monitor, and control
operational risk in [bank] products, activities, processes, and
systems; and
(iii) Report operational risk exposures, operational loss
events, and other relevant operational risk information to business
unit management, senior management, and the
[[Page 69408]]
board of directors (or a designated committee of the board).
(2) Operational risk data and assessment systems. A [bank] must
have operational risk data and assessment systems that capture
operational risks to which the [bank] is exposed. The [bank]'s
operational risk data and assessment systems must:
(i) Be structured in a manner consistent with the [bank]'s
current business activities, risk profile, technological processes,
and risk management processes; and
(ii) Include credible, transparent, systematic, and verifiable
processes that incorporate the following elements on an ongoing
basis:
(A) Internal operational loss event data. The [bank] must have a
systematic process for capturing and using internal operational loss
event data in its operational risk data and assessment systems.
(1) The [bank]'s operational risk data and assessment systems
must include a historical observation period of at least five years
for internal operational loss event data (or such shorter period
approved by the [AGENCY] to address transitional situations, such as
integrating a new business line).
(2) The [bank] must be able to map its internal operational loss
event data into the seven operational loss event type categories.
(3) The [bank] may refrain from collecting internal operational
loss event data for individual operational losses below established
dollar threshold amounts if the [bank] can demonstrate to the
satisfaction of the [AGENCY] that the thresholds are reasonable, do
not exclude important internal operational loss event data, and
permit the [bank] to capture substantially all the dollar value of
the [bank]'s operational losses.
(B) External operational loss event data. The [bank] must have a
systematic process for determining its methodologies for
incorporating external operational loss event data into its
operational risk data and assessment systems.
(C) Scenario analysis. The [bank] must have a systematic process
for determining its methodologies for incorporating scenario
analysis into its operational risk data and assessment systems.
(D) Business environment and internal control factors. The
[bank] must incorporate business environment and internal control
factors into its operational risk data and assessment systems. The
[bank] must also periodically compare the results of its prior
business environment and internal control factor assessments against
its actual operational losses incurred in the intervening period.
(3) Operational risk quantification systems. (i) The [bank]'s
operational risk quantification systems:
(A) Must generate estimates of the [bank]'s operational risk
exposure using its operational risk data and assessment systems;
(B) Must employ a unit of measure that is appropriate for the
[bank]'s range of business activities and the variety of operational
loss events to which it is exposed, and that does not combine
business activities or operational loss events with demonstrably
different risk profiles within the same loss distribution;
(C) Must include a credible, transparent, systematic, and
verifiable approach for weighting each of the four elements,
described in paragraph (h)(2)(ii) of this section, that a [bank] is
required to incorporate into its operational risk data and
assessment systems;
(D) May use internal estimates of dependence among operational
losses across and within units of measure if the [bank] can
demonstrate to the satisfaction of the [AGENCY] that its process for
estimating dependence is sound, robust to a variety of scenarios,
and implemented with integrity, and allows for the uncertainty
surrounding the estimates. If the [bank] has not made such a
demonstration, it must sum operational risk exposure estimates
across units of measure to calculate its total operational risk
exposure; and
(E) Must be reviewed and updated (as appropriate) whenever the
[bank] becomes aware of information that may have a material effect
on the [bank]'s estimate of operational risk exposure, but the
review and update must occur no less frequently than annually.
(ii) With the prior written approval of the [AGENCY], a [bank]
may generate an estimate of its operational risk exposure using an
alternative approach to that specified in paragraph (h)(3)(i) of
this section. A [bank] proposing to use such an alternative
operational risk quantification system must submit a proposal to the
[AGENCY]. In determining whether to approve a [bank]'s proposal to
use an alternative operational risk quantification system, the
[AGENCY] will consider the following principles:
(A) Use of the alternative operational risk quantification
system will be allowed only on an exception basis, considering the
size, complexity, and risk profile of the [bank];
(B) The [bank] must demonstrate that its estimate of its
operational risk exposure generated under the alternative
operational risk quantification system is appropriate and can be
supported empirically; and
(C) A [bank] must not use an allocation of operational risk
capital requirements that includes entities other than depository
institutions or the benefits of diversification across entities.
(i) Data management and maintenance. (1) A [bank] must have data
management and maintenance systems that adequately support all
aspects of its advanced systems and the timely and accurate
reporting of risk-based capital requirements.
(2) A [bank] must retain data using an electronic format that
allows timely retrieval of data for analysis, validation, reporting,
and disclosure purposes.
(3) A [bank] must retain sufficient data elements related to key
risk drivers to permit adequate monitoring, validation, and
refinement of its advanced systems.
(j) Control, oversight, and validation mechanisms. (1) The
[bank]'s senior management must ensure that all components of the
[bank]'s advanced systems function effectively and comply with the
qualification requirements in this section.
(2) The [bank]'s board of directors (or a designated committee
of the board) must at least annually review the effectiveness of,
and approve, the [bank]'s advanced systems.
(3) A [bank] must have an effective system of controls and
oversight that:
(i) Ensures ongoing compliance with the qualification
requirements in this section;
(ii) Maintains the integrity, reliability, and accuracy of the
[bank]'s advanced systems; and
(iii) Includes adequate governance and project management
processes.
(4) The [bank] must validate, on an ongoing basis, its advanced
systems. The [bank]'s validation process must be independent of the
advanced systems' development, implementation, and operation, or the
validation process must be subjected to an independent review of its
adequacy and effectiveness. Validation must include:
(i) An evaluation of the conceptual soundness of (including
developmental evidence supporting) the advanced systems;
(ii) An ongoing monitoring process that includes verification of
processes and benchmarking; and
(iii) An outcomes analysis process that includes back-testing.
(5) The [bank] must have an internal audit function independent
of business-line management that at least annually assesses the
effectiveness of the controls supporting the [bank]'s advanced
systems and reports its findings to the [bank]'s board of directors
(or a committee thereof).
(6) The [bank] must periodically stress test its advanced
systems. The stress testing must include a consideration of how
economic cycles, especially downturns, affect risk-based capital
requirements (including migration across rating grades and segments
and the credit risk mitigation benefits of double default
treatment).
(k) Documentation. The [bank] must adequately document all
material aspects of its advanced systems.
Section 23. Ongoing Qualification
(a) Changes to advanced systems. A [bank] must meet all the
qualification requirements in section 22 of this appendix on an
ongoing basis. A [bank] must notify the [AGENCY] when the [bank]
makes any change to an advanced system that would result in a
material change in the [bank]'s risk-weighted asset amount for an
exposure type, or when the [bank] makes any significant change to
its modeling assumptions.
(b) Failure to comply with qualification requirements. (1) If
the [AGENCY] determines that a [bank] that uses this appendix and
has conducted a satisfactory parallel run fails to comply with the
qualification requirements in section 22 of this appendix, the
[AGENCY] will notify the [bank] in writing of the [bank]'s failure
to comply.
(2) The [bank] must establish and submit a plan satisfactory to
the [AGENCY] to return to compliance with the qualification
requirements.
(3) In addition, if the [AGENCY] determines that the [bank]'s
risk-based capital requirements are not commensurate with the
[bank]'s credit, market, operational, or other risks, the [AGENCY]
may require such a [bank] to calculate its risk-based capital
requirements:
(i) Under [the general risk-based capital rules]; or
[[Page 69409]]
(ii) Under this appendix with any modifications provided by the
[AGENCY].
Section 24. Merger and Acquisition Transitional Arrangements
(a) Mergers and acquisitions of companies without advanced
systems. If a [bank] merges with or acquires a company that does not
calculate its risk-based capital requirements using advanced
systems, the [bank] may use [the general risk-based capital rules]
to determine the risk-weighted asset amounts for, and deductions
from capital associated with, the merged or acquired company's
exposures for up to 24 months after the calendar quarter during
which the merger or acquisition consummates. The [AGENCY] may extend
this transition period for up to an additional 12 months. Within 90
days of consummating the merger or acquisition, the [bank] must
submit to the [AGENCY] an implementation plan for using its advanced
systems for the acquired company. During the period when [the
general risk-based capital rules] apply to the merged or acquired
company, any ALLL, net of allocated transfer risk reserves
established pursuant to 12 U.S.C. 3904, associated with the merged
or acquired company's exposures may be included in the acquiring
[bank]'s tier 2 capital up to 1.25 percent of the acquired company's
risk-weighted assets. All general allowances of the merged or
acquired company must be excluded from the [bank]'s eligible credit
reserves. In addition, the risk-weighted assets of the merged or
acquired company are not included in the [bank]'s credit-risk-
weighted assets but are included in total risk-weighted assets. If a
[bank] relies on this paragraph, the [bank] must disclose publicly
the amounts of risk-weighted assets and qualifying capital
calculated under this appendix for the acquiring [bank] and under
[the general risk-based capital rules] for the acquired company.
(b) Mergers and acquisitions of companies with advanced
systems--(1) If a [bank] merges with or acquires a company that
calculates its risk-based capital requirements using advanced
systems, the [bank] may use the acquired company's advanced systems
to determine the risk-weighted asset amounts for, and deductions
from capital associated with, the merged or acquired company's
exposures for up to 24 months after the calendar quarter during
which the acquisition or merger consummates. The [AGENCY] may extend
this transition period for up to an additional 12 months. Within 90
days of consummating the merger or acquisition, the [bank] must
submit to the [AGENCY] an implementation plan for using its advanced
systems for the merged or acquired company.
(2) If the acquiring [bank] is not subject to the advanced
approaches in this appendix at the time of acquisition or merger,
during the period when [the general risk-based capital rules] apply
to the acquiring [bank], the ALLL associated with the exposures of
the merged or acquired company may not be directly included in tier
2 capital. Rather, any excess eligible credit reserves associated
with the merged or acquired company's exposures may be included in
the [bank]'s tier 2 capital up to 0.6 percent of the credit-risk-
weighted assets associated with those exposures.
Part IV. Risk-Weighted Assets for General Credit Risk
Section 31. Mechanics for Calculating Total Wholesale and Retail
Risk-Weighted Assets
(a) Overview. A [bank] must calculate its total wholesale and
retail risk-weighted asset amount in four distinct phases:
(1) Phase 1--categorization of exposures;
(2) Phase 2--assignment of wholesale obligors and exposures to
rating grades and segmentation of retail exposures;
(3) Phase 3--assignment of risk parameters to wholesale
exposures and segments of retail exposures; and
(4) Phase 4--calculation of risk-weighted asset amounts.
(b) Phase 1--Categorization. The [bank] must determine which of
its exposures are wholesale exposures, retail exposures,
securitization exposures, or equity exposures. The [bank] must
categorize each retail exposure as a residential mortgage exposure,
a QRE, or an other retail exposure. The [bank] must identify which
wholesale exposures are HVCRE exposures, sovereign exposures, OTC
derivative contracts, repo-style transactions, eligible margin
loans, eligible purchased wholesale exposures, unsettled
transactions to which section 35 of this appendix applies, and
eligible guarantees or eligible credit derivatives that are used as
credit risk mitigants. The [bank] must identify any on-balance sheet
asset that does not meet the definition of a wholesale, retail,
equity, or securitization exposure, as well as any non-material
portfolio of exposures described in paragraph (e)(4) of this
section.
(c) Phase 2--Assignment of wholesale obligors and exposures to
rating grades and retail exposures to segments--(1) Assignment of
wholesale obligors and exposures to rating grades.
(i) The [bank] must assign each obligor of a wholesale exposure
to a single obligor rating grade and must assign each wholesale
exposure to which it does not directly assign an LGD estimate to a
loss severity rating grade.
(ii) The [bank] must identify which of its wholesale obligors
are in default.
(2) Segmentation of retail exposures. (i) The [bank] must group
the retail exposures in each retail subcategory into segments that
have homogeneous risk characteristics.
(ii) The [bank] must identify which of its retail exposures are
in default. The [bank] must segment defaulted retail exposures
separately from non-defaulted retail exposures.
(iii) If the [bank] determines the EAD for eligible margin loans
using the approach in paragraph (b) of section 32 of this appendix,
the [bank] must identify which of its retail exposures are eligible
margin loans for which the [bank] uses this EAD approach and must
segment such eligible margin loans separately from other retail
exposures.
(3) Eligible purchased wholesale exposures. A [bank] may group
its eligible purchased wholesale exposures into segments that have
homogeneous risk characteristics. A [bank] must use the wholesale
exposure formula in Table 2 in this section to determine the risk-
based capital requirement for each segment of eligible purchased
wholesale exposures.
(d) Phase 3--Assignment of risk parameters to wholesale
exposures and segments of retail exposures--(1) Quantification
process. Subject to the limitations in this paragraph (d), the
[bank] must:
(i) Associate a PD with each wholesale obligor rating grade;
(ii) Associate an LGD with each wholesale loss severity rating
grade or assign an LGD to each wholesale exposure;
(iii) Assign an EAD and M to each wholesale exposure; and
(iv) Assign a PD, LGD, and EAD to each segment of retail
exposures.
(2) Floor on PD assignment. The PD for each wholesale obligor or
retail segment may not be less than 0.03 percent, except for
exposures to or directly and unconditionally guaranteed by a
sovereign entity, the Bank for International Settlements, the
International Monetary Fund, the European Commission, the European
Central Bank, or a multilateral development bank, to which the
[bank] assigns a rating grade associated with a PD of less than 0.03
percent.
(3) Floor on LGD estimation. The LGD for each segment of
residential mortgage exposures (other than segments of residential
mortgage exposures for which all or substantially all of the
principal of each exposure is directly and unconditionally
guaranteed by the full faith and credit of a sovereign entity) may
not be less than 10 percent.
(4) Eligible purchased wholesale exposures. A [bank] must assign
a PD, LGD, EAD, and M to each segment of eligible purchased
wholesale exposures. If the [bank] can estimate ECL (but not PD or
LGD) for a segment of eligible purchased wholesale exposures, the
[bank] must assume that the LGD of the segment equals 100 percent
and that the PD of the segment equals ECL divided by EAD. The
estimated ECL must be calculated for the exposures without regard to
any assumption of recourse or guarantees from the seller or other
parties.
(5) Credit risk mitigation--credit derivatives, guarantees, and
collateral. (i) A [bank] may take into account the risk reducing
effects of eligible guarantees and eligible credit derivatives in
support of a wholesale exposure by applying the PD substitution or
LGD adjustment treatment to the exposure as provided in section 33
of this appendix or, if applicable, applying double default
treatment to the exposure as provided in section 34 of this
appendix. A [bank] may decide separately for each wholesale exposure
that qualifies for the double default treatment under section 34 of
this appendix whether to apply the double default treatment or to
use the PD substitution or LGD adjustment treatment without
recognizing double default effects.
(ii) A [bank] may take into account the risk reducing effects of
guarantees and credit derivatives in support of retail exposures in
a segment when quantifying the PD and LGD of the segment.
(iii) Except as provided in paragraph (d)(6) of this section, a
[bank] may take into account the risk reducing effects of collateral
in support of a wholesale exposure when quantifying the LGD of the
exposure and may
[[Page 69410]]
take into account the risk reducing effects of collateral in support
of retail exposures when quantifying the PD and LGD of the segment.
(6) EAD for OTC derivative contracts, repo-style transactions,
and eligible margin loans. (i) A [bank] must calculate its EAD for
an OTC derivative contract as provided in paragraphs (c) and (d) of
section 32 of this appendix. A [bank] may take into account the
risk-reducing effects of financial collateral in support of a repo-
style transaction or eligible margin loan and of any collateral in
support of a repo-style transaction that is included in the [bank]'s
VaR-based measure under [the market risk rule] through an adjustment
to EAD as provided in paragraphs (b) and (d) of section 32 of this
appendix. A [bank] that takes collateral into account through such
an adjustment to EAD under section 32 of this appendix may not
reflect such collateral in LGD.
(ii) A [bank] may attribute an EAD of zero to:
(A) Derivative contracts that are publicly traded on an exchange
that requires the daily receipt and payment of cash-variation
margin;
(B) Derivative contracts and repo-style transactions that are
outstanding with a qualifying central counterparty (but not for
those transactions that a qualifying central counterparty has
rejected); and
(C) Credit risk exposures to a qualifying central counterparty
in the form of clearing deposits and posted collateral that arise
from transactions described in paragraph (d)(6)(ii)(B) of this
section.
(7) Effective maturity. An exposure's M must be no greater than
five years and no less than one year, except that an exposure's M
must be no less than one day if the exposure has an original
maturity of less than one year and is not part of a [bank]'s ongoing
financing of the obligor. An exposure is not part of a [bank]'s
ongoing financing of the obligor if the [bank]:
(i) Has a legal and practical ability not to renew or roll over
the exposure in the event of credit deterioration of the obligor;
(ii) Makes an independent credit decision at the inception of
the exposure and at every renewal or roll over; and
(iii) Has no substantial commercial incentive to continue its
credit relationship with the obligor in the event of credit
deterioration of the obligor.
(e) Phase 4--Calculation of risk-weighted assets--(1) Non-
defaulted exposures. (i) A [bank] must calculate the dollar risk-
based capital requirement for each of its wholesale exposures to a
non-defaulted obligor (except eligible guarantees and eligible
credit derivatives that hedge another wholesale exposure and
exposures to which the [bank] applies the double default treatment
in section 34 of this appendix) and segments of non-defaulted retail
exposures by inserting the assigned risk parameters for the
wholesale obligor and exposure or retail segment into the
appropriate risk-based capital formula specified in Table 2 and
multiplying the output of the formula (K) by the EAD of the exposure
or segment. Alternatively, a [bank] may apply a 300 percent risk
weight to the EAD of an eligible margin loan if the [bank] is not
able to meet the agencies'' requirements for estimation of PD and
LGD for the margin loan.
BILLING CODE 4810-33-P; 6210-01-P; 6714-01-P; 6720-01-P
[[Page 69411]]
[GRAPHIC] [TIFF OMITTED] TR07DE07.005
BILLING CODE 4810-33-C; 6210-01-C; 6714-01-C; 6720-01-C
(ii) The sum of all the dollar risk-based capital requirements
for each wholesale exposure to a non-defaulted obligor and segment
of non-defaulted retail exposures calculated in paragraph (e)(1)(i)
of this section and in paragraph (e) of section 34 of this appendix
equals the total dollar risk-based capital requirement for those
exposures and segments.
(iii) The aggregate risk-weighted asset amount for wholesale
exposures to non-defaulted obligors and segments of non-defaulted
retail exposures equals the total dollar risk-based capital
requirement calculated in paragraph (e)(1)(ii) of this section
multiplied by 12.5.
(2) Wholesale exposures to defaulted obligors and segments of
defaulted retail exposures. (i) The dollar risk-based capital
requirement for each wholesale exposure to a defaulted obligor
equals 0.08 multiplied by the EAD of the exposure.
(ii) The dollar risk-based capital requirement for a segment of
defaulted retail exposures equals 0.08 multiplied by the EAD of the
segment.
(iii) The sum of all the dollar risk-based capital requirements
for each wholesale exposure to a defaulted obligor calculated in
paragraph (e)(2)(i) of this section plus the dollar risk-based
capital requirements for each segment of defaulted retail exposures
calculated in paragraph (e)(2)(ii) of this section equals the total
dollar risk-based capital requirement for those exposures and
segments.
(iv) The aggregate risk-weighted asset amount for wholesale
exposures to defaulted obligors and segments of defaulted retail
exposures equals the total dollar risk-based capital requirement
calculated in paragraph (e)(2)(iii) of this section multiplied by
12.5.
[[Page 69412]]
(3) Assets not included in a defined exposure category. (i) A
[bank] may assign a risk-weighted asset amount of zero to cash owned
and held in all offices of the [bank] or in transit and for gold
bullion held in the [bank]'s own vaults, or held in another [bank]'s
vaults on an allocated basis, to the extent the gold bullion assets
are offset by gold bullion liabilities.
(ii) The risk-weighted asset amount for the residual value of a
retail lease exposure equals such residual value.
(iii) The risk-weighted asset amount for any other on-balance-
sheet asset that does not meet the definition of a wholesale,
retail, securitization, or equity exposure equals the carrying value
of the asset.
(4) Non-material portfolios of exposures. The risk-weighted
asset amount of a portfolio of exposures for which the [bank] has
demonstrated to the [AGENCY]'s satisfaction that the portfolio (when
combined with all other portfolios of exposures that the [bank]
seeks to treat under this paragraph) is not material to the [bank]
is the sum of the carrying values of on-balance sheet exposures plus
the notional amounts of off-balance sheet exposures in the
portfolio. For purposes of this paragraph (e)(4), the notional
amount of an OTC derivative contract that is not a credit derivative
is the EAD of the derivative as calculated in section 32 of this
appendix.
Section 32. Counterparty Credit Risk of Repo-Style Transactions,
Eligible Margin Loans, and OTC Derivative Contracts
(a) In General. (1) This section describes two methodologies--a
collateral haircut approach and an internal models methodology--that
a [bank] may use instead of an LGD estimation methodology to
recognize the benefits of financial collateral in mitigating the
counterparty credit risk of repo-style transactions, eligible margin
loans, collateralized OTC derivative contracts, and single product
netting sets of such transactions and to recognize the benefits of
any collateral in mitigating the counterparty credit risk of repo-
style transactions that are included in a [bank]'s VaR-based measure
under [the market risk rule]. A third methodology, the simple VaR
methodology, is available for single product netting sets of repo-
style transactions and eligible margin loans.
(2) This section also describes the methodology for calculating
EAD for an OTC derivative contract or a set of OTC derivative
contracts subject to a qualifying master netting agreement. A [bank]
also may use the internal models methodology to estimate EAD for
qualifying cross-product master netting agreements.
(3) A [bank] may only use the standard supervisory haircut
approach with a minimum 10-business-day holding period to recognize
in EAD the benefits of conforming residential mortgage collateral
that secures repo-style transactions (other than repo-style
transactions included in the [bank]'s VaR-based measure under [the
market risk rule]), eligible margin loans, and OTC derivative
contracts.
(4) A [bank] may use any combination of the three methodologies
for collateral recognition; however, it must use the same
methodology for similar exposures.
(b) EAD for eligible margin loans and repo-style transactions--
(1) General. A [bank] may recognize the credit risk mitigation
benefits of financial collateral that secures an eligible margin
loan, repo-style transaction, or single-product netting set of such
transactions by factoring the collateral into its LGD estimates for
the exposure. Alternatively, a [bank] may estimate an unsecured LGD
for the exposure, as well as for any repo-style transaction that is
included in the [bank]'s VaR-based measure under [the market risk
rule], and determine the EAD of the exposure using:
(i) The collateral haircut approach described in paragraph
(b)(2) of this section;
(ii) For netting sets only, the simple VaR methodology described
in paragraph (b)(3) of this section; or
(iii) The internal models methodology described in paragraph (d)
of this section.
(2) Collateral haircut approach--(i) EAD equation. A [bank] may
determine EAD for an eligible margin loan, repo-style transaction,
or netting set by setting EAD equal to max {0, [([Sigma]E-[Sigma]C)
+ [Sigma](Es x Hs) + [Sigma](Efx x Hfx)]{time} , where:
(A) [Sigma]E equals the value of the exposure (the sum of the
current market values of all instruments, gold, and cash the [bank]
has lent, sold subject to repurchase, or posted as collateral to the
counterparty under the transaction (or netting set));
(B) [Sigma]C equals the value of the collateral (the sum of the
current market values of all instruments, gold, and cash the [bank]
has borrowed, purchased subject to resale, or taken as collateral
from the counterparty under the transaction (or netting set));
(C) Es equals the absolute value of the net position in a given
instrument or in gold (where the net position in a given instrument
or in gold equals the sum of the current market values of the
instrument or gold the [bank] has lent, sold subject to repurchase,
or posted as collateral to the counterparty minus the sum of the
current market values of that same instrument or gold the [bank] has
borrowed, purchased subject to resale, or taken as collateral from
the counterparty);
(D) Hs equals the market price volatility haircut appropriate to
the instrument or gold referenced in Es;
(E) Efx equals the absolute value of the net position of
instruments and cash in a currency that is different from the
settlement currency (where the net position in a given currency
equals the sum of the current market values of any instruments or
cash in the currency the [bank] has lent, sold subject to
repurchase, or posted as collateral to the counterparty minus the
sum of the current market values of any instruments or cash in the
currency the [bank] has borrowed, purchased subject to resale, or
taken as collateral from the counterparty); and
(F) Hfx equals the haircut appropriate to the mismatch between
the currency referenced in Efx and the settlement currency.
(ii) Standard supervisory haircuts. (A) Under the standard
supervisory haircuts approach:
(1) A [bank] must use the haircuts for market price volatility
(Hs) in Table 3, as adjusted in certain circumstances as provided in
paragraph (b)(2)(ii)(A)(3) and (4) of this section;
Table 3.--Standard Supervisory Market Price Volatility Haircuts \1\
----------------------------------------------------------------------------------------------------------------
Issuers exempt
Applicable external rating grade Residual maturity for debt securities from the 3 basis Other issuers
category for debt securities point floor
----------------------------------------------------------------------------------------------------------------
Two highest investment-grade <= 1 year............................. 0.005 0.01
rating categories for long-term >1 year, <= 5 years................... 0.02 0.04
ratings/highest investment-grade > 5 years............................. 0.04 0.08
rating category for short-term
ratings.
----------------------------------------------------------------------------------------------------------------
Two lowest investment-grade rating <= 1 year............................. 0.01 0.02
categories for both short- and > 1 year, <= 5 years.................. 0.03 0.06
long-term ratings. > 5 years............................. 0.06 0.12
----------------------------------------------------------------------------------------------------------------
One rating category below All................................... 0.15 0.25
investment grade.
----------------------------------------------------------------------------------------------------------------
Main index equities (including convertible bonds) and gold.....0.15.......
----------------------------------------------------------------------------------------------------------------
Other publicly traded equities (including convertible bonds), c0.25rming
residential mortgages, and nonfinancial collateral.
----------------------------------------------------------------------------------------------------------------
[[Page 69413]]
Mutual funds.........................Highest haircut applicable to any security in which the
fund can invest.
----------------------------------------------------------------------------------------------------------------
Cash on deposit with the [bank] (including a certificate of depo0it issued
by the [bank]).
----------------------------------------------------------------------------------------------------------------
\1\ The market price volatility haircuts in Table 3 are based on a ten-business-day holding period.
(2) For currency mismatches, a [bank] must use a haircut for
foreign exchange rate volatility (Hfx) of 8 percent, as adjusted in
certain circumstances as provided in paragraph (b)(2)(ii)(A)(3) and
(4) of this section.
(3) For repo-style transactions, a [bank] may multiply the
supervisory haircuts provided in paragraphs (b)(2)(ii)(A)(1) and (2)
of this section by the square root of \1/2\ (which equals 0.707107).
(4) A [bank] must adjust the supervisory haircuts upward on the
basis of a holding period longer than ten business days (for
eligible margin loans) or five business days (for repo-style
transactions) where and as appropriate to take into account the
illiquidity of an instrument.
(iii) Own internal estimates for haircuts. With the prior
written approval of the [AGENCY], a [bank] may calculate haircuts
(Hs and Hfx) using its own internal estimates of the volatilities of
market prices and foreign exchange rates.
(A) To receive [AGENCY] approval to use its own internal
estimates, a [bank] must satisfy the following minimum quantitative
standards:
(1) A [bank] must use a 99th percentile one-tailed confidence
interval.
(2) The minimum holding period for a repo-style transaction is
five business days and for an eligible margin loan is ten business
days. When a [bank] calculates an own-estimates haircut on a
TN-day holding period, which is different from the
minimum holding period for the transaction type, the applicable
haircut (HM) is calculated using the following square
root of time formula:
[GRAPHIC] [TIFF OMITTED] TR07DE07.014
(i) TM equals 5 for repo-style transactions and 10 for
eligible margin loans;
(ii) TN equals the holding period used by the [bank] to
derive HN; and
(iii) HN equals the haircut based on the holding period
TN.
(3) A [bank] must adjust holding periods upwards where and as
appropriate to take into account the illiquidity of an instrument.
(4) The historical observation period must be at least one year.
(5) A [bank] must update its data sets and recompute haircuts no
less frequently than quarterly and must also reassess data sets and
haircuts whenever market prices change materially.
(B) With respect to debt securities that have an applicable
external rating of investment grade, a [bank] may calculate haircuts
for categories of securities. For a category of securities, the
[bank] must calculate the haircut on the basis of internal
volatility estimates for securities in that category that are
representative of the securities in that category that the [bank]
has lent, sold subject to repurchase, posted as collateral,
borrowed, purchased subject to resale, or taken as collateral. In
determining relevant categories, the [bank] must at a minimum take
into account:
(1) The type of issuer of the security;
(2) The applicable external rating of the security;
(3) The maturity of the security; and
(4) The interest rate sensitivity of the security.
(C) With respect to debt securities that have an applicable
external rating of below investment grade and equity securities, a
[bank] must calculate a separate haircut for each individual
security.
(D) Where an exposure or collateral (whether in the form of cash
or securities) is denominated in a currency that differs from the
settlement currency, the [bank] must calculate a separate currency
mismatch haircut for its net position in each mismatched currency
based on estimated volatilities of foreign exchange rates between
the mismatched currency and the settlement currency.
(E) A [bank]'s own estimates of market price and foreign
exchange rate volatilities may not take into account the
correlations among securities and foreign exchange rates on either
the exposure or collateral side of a transaction (or netting set) or
the correlations among securities and foreign exchange rates between
the exposure and collateral sides of the transaction (or netting
set).
(3) Simple VaR methodology. With the prior written approval of
the [AGENCY], a [bank] may estimate EAD for a netting set using a
VaR model that meets the requirements in paragraph (b)(3)(iii) of
this section. In such event, the [bank] must set EAD equal to max
{0, [([Sigma]E--[Sigma]C) + PFE]{time} , where:
(i) [Sigma]E equals the value of the exposure (the sum of the
current market values of all instruments, gold, and cash the [bank]
has lent, sold subject to repurchase, or posted as collateral to the
counterparty under the netting set);
(ii) [Sigma]C equals the value of the collateral (the sum of the
current market values of all instruments, gold, and cash the [bank]
has borrowed, purchased subject to resale, or taken as collateral
from the counterparty under the netting set); and
(iii) PFE (potential future exposure) equals the [bank]'s
empirically based best estimate of the 99th percentile, one-tailed
confidence interval for an increase in the value of ([Sigma]E--
[Sigma]C) over a five-business-day holding period for repo-style
transactions or over a ten-business-day holding period for eligible
margin loans using a minimum one-year historical observation period
of price data representing the instruments that the [bank] has lent,
sold subject to repurchase, posted as collateral, borrowed,
purchased subject to resale, or taken as collateral. The [bank] must
validate its VaR model, including by establishing and maintaining a
rigorous and regular back-testing regime.
(c) EAD for OTC derivative contracts. (1) A [bank] must
determine the EAD for an OTC derivative contract that is not subject
to a qualifying master netting agreement using the current exposure
methodology in paragraph (c)(5) of this section or using the
internal models methodology described in paragraph (d) of this
section.
(2) A [bank] must determine the EAD for multiple OTC derivative
contracts that are subject to a qualifying master netting agreement
using the current exposure methodology in paragraph (c)(6) of this
section or using the internal models methodology described in
paragraph (d) of this section.
(3) Counterparty credit risk for credit derivatives.
Notwithstanding the above, (i) A [bank] that purchases a credit
derivative that is recognized under section 33 or 34 of this
appendix as a credit risk mitigant for an exposure that is not a
covered position under [the market risk rule] need not compute a
separate counterparty credit risk capital requirement under this
section so long as the [bank] does so consistently for all such
credit derivatives and either includes all or excludes all such
credit derivatives that are subject to a master netting agreement
from any measure used to determine counterparty credit risk exposure
to all relevant counterparties for risk-based capital purposes.
(ii) A [bank] that is the protection provider in a credit
derivative must treat the credit derivative as a wholesale exposure
to the reference obligor and need not compute a counterparty credit
risk capital requirement for the credit derivative under this
section, so long as it does so consistently for all such credit
derivatives and either includes all or excludes all such credit
derivatives that are subject to a master netting agreement from any
measure used to determine counterparty credit risk exposure to all
relevant counterparties for risk-based capital purposes (unless the
[bank] is treating the credit derivative as a covered position under
[the
[[Page 69414]]
market risk rule], in which case the [bank] must compute a
supplemental counterparty credit risk capital requirement under this
section).
(4) Counterparty credit risk for equity derivatives. A [bank]
must treat an equity derivative contract as an equity exposure and
compute a risk-weighted asset amount for the equity derivative
contract under part VI (unless the [bank] is treating the contract
as a covered position under [the market risk rule]). In addition, if
the [bank] is treating the contract as a covered position under [the
market risk rule] and in certain other cases described in section 55
of this appendix, the [bank] must also calculate a risk-based
capital requirement for the counterparty credit risk of an equity
derivative contract under this part.
(5) Single OTC derivative contract. Except as modified by
paragraph (c)(7) of this section, the EAD for a single OTC
derivative contract that is not subject to a qualifying master
netting agreement is equal to the sum of the [bank]'s current credit
exposure and potential future credit exposure (PFE) on the
derivative contract.
(i) Current credit exposure. The current credit exposure for a
single OTC derivative contract is the greater of the mark-to-market
value of the derivative contract or zero.
(ii) PFE. The PFE for a single OTC derivative contract,
including an OTC derivative contract with a negative mark-to-market
value, is calculated by multiplying the notional principal amount of
the derivative contract by the appropriate conversion factor in
Table 4. For purposes of calculating either the PFE under this
paragraph or the gross PFE under paragraph (c)(6) of this section
for exchange rate contracts and other similar contracts in which the
notional principal amount is equivalent to the cash flows, notional
principal amount is the net receipts to each party falling due on
each value date in each currency. For any OTC derivative contract
that does not fall within one of the specified categories in Table
4, the PFE must be calculated using the ``other'' conversion
factors. A [bank] must use an OTC derivative contract's effective
notional principal amount (that is, its apparent or stated notional
principal amount multiplied by any multiplier in the OTC derivative
contract) rather than its apparent or stated notional principal
amount in calculating PFE. PFE of the protection provider of a
credit derivative is capped at the net present value of the amount
of unpaid premiums.
Table 4.--Conversion Factor Matrix for OTC Derivative Contracts \1\
--------------------------------------------------------------------------------------------------------------------------------------------------------
Credit Credit (non-
Foreign (investment- investment- Precious
Remaining maturity \2\ Interest rate exchange rate grade grade Equity metals (except Other
and gold reference reference gold)
obligor)\3\ obligor)
--------------------------------------------------------------------------------------------------------------------------------------------------------
One year or less........................ 0.00 0.01 0.05 0.10 0.06 0.07 0.10
Over one to five years.................. 0.005 0.05 0.05 0.10 0.08 0.07 0.12
Over five years......................... 0.015 0.075 0.05 0.10 0.10 0.08 0.15
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ For an OTC derivative contract with multiple exchanges of principal, the conversion factor is multiplied by the number of remaining payments in the
derivative contract.
\2\ For an OTC derivative contract that is structured such that on specified dates any outstanding exposure is settled and the terms are reset so that
the market value of the contract is zero, the remaining maturity equals the time until the next reset date. For an interest rate derivative contract
with a remaining maturity of greater than one year that meets these criteria, the minimum conversion factor is 0.005.
\3\ A [bank] must use the column labeled ``Credit (investment-grade reference obligor)'' for a credit derivative whose reference obligor has an
outstanding unsecured long-term debt security without credit enhancement that has a long-term applicable external rating of at least investment grade.
A [bank] must use the column labeled ``Credit (non-investment-grade reference obligor)'' for all other credit derivatives.
(6) Multiple OTC derivative contracts subject to a qualifying
master netting agreement. Except as modified by paragraph (c)(7) of
this section, the EAD for multiple OTC derivative contracts subject
to a qualifying master netting agreement is equal to the sum of the
net current credit exposure and the adjusted sum of the PFE exposure
for all OTC derivative contracts subject to the qualifying master
netting agreement.
(i) Net current credit exposure. The net current credit exposure
is the greater of:
(A) The net sum of all positive and negative mark-to-market
values of the individual OTC derivative contracts subject to the
qualifying master netting agreement; or
(B) zero.
(ii) Adjusted sum of the PFE. The adjusted sum of the PFE, Anet,
is calculated as Anet = (0.4xAgross)+(0.6xNGRxAgross), where:
(A) Agross = the gross PFE (that is, the sum of the PFE amounts
(as determined under paragraph (c)(5)(ii) of this section) for each
individual OTC derivative contract subject to the qualifying master
netting agreement); and
(B) NGR = the net to gross ratio (that is, the ratio of the net
current credit exposure to the gross current credit exposure). In
calculating the NGR, the gross current credit exposure equals the
sum of the positive current credit exposures (as determined under
paragraph (c)(5)(i) of this section) of all individual OTC
derivative contracts subject to the qualifying master netting
agreement.
(7) Collateralized OTC derivative contracts. A [bank] may
recognize the credit risk mitigation benefits of financial
collateral that secures an OTC derivative contract or single-product
netting set of OTC derivatives by factoring the collateral into its
LGD estimates for the contract or netting set. Alternatively, a
[bank] may recognize the credit risk mitigation benefits of
financial collateral that secures such a contract or netting set
that is marked to market on a daily basis and subject to a daily
margin maintenance requirement by estimating an unsecured LGD for
the contract or netting set and adjusting the EAD calculated under
paragraph (c)(5) or (c)(6) of this section using the collateral
haircut approach in paragraph (b)(2) of this section. The [bank]
must substitute the EAD calculated under paragraph (c)(5) or (c)(6)
of this section for [Sigma]E in the equation in paragraph (b)(2)(i)
of this section and must use a ten-business-day minimum holding
period (TM = 10).
(d) Internal models methodology. (1) With prior written approval
from the [AGENCY], a [bank] may use the internal models methodology
in this paragraph (d) to determine EAD for counterparty credit risk
for OTC derivative contracts (collateralized or uncollateralized)
and single-product netting sets thereof, for eligible margin loans
and single-product netting sets thereof, and for repo-style
transactions and single-product netting sets thereof. A [bank] that
uses the internal models methodology for a particular transaction
type (OTC derivative contracts, eligible margin loans, or repo-style
transactions) must use the internal models methodology for all
transactions of that transaction type. A [bank] may choose to use
the internal models methodology for one or two of these three types
of exposures and not the other types. A [bank] may also use the
internal models methodology for OTC derivative contracts, eligible
margin loans, and repo-style transactions subject to a qualifying
cross-product netting agreement if:
(i) The [bank] effectively integrates the risk mitigating
effects of cross-product netting into its risk management and other
information technology systems; and
(ii) The [bank] obtains the prior written approval of the
[AGENCY]. A [bank] that uses the internal models methodology for a
transaction type must receive approval from the [AGENCY] to cease
using the methodology for that transaction type or to make a
material change to its internal model.
(2) Under the internal models methodology, a [bank] uses an
internal model to estimate the expected exposure (EE) for a netting
set and then calculates EAD based on that EE.
(i) The [bank] must use its internal model's probability
distribution for changes in the market value of a netting set that
are attributable to changes in market variables to determine EE.
[[Page 69415]]
(ii) Under the internal models methodology, EAD = [alpha] x
effective EPE, or, subject to [AGENCY] approval as provided in
paragraph (d)(7), a more conservative measure of EAD.
[GRAPHIC] [TIFF OMITTED] TR07DE07.026
(that is, effective EPE is the time-weighted average of effective EE
where the weights are the proportion that an individual effective EE
represents in a one-year time interval) where:
(1) Effective EEtk = max (Effective EEtk-
1, EEtk) (that is, for a specific datetk,
effective EE is the greater of EE at that date or the effective EE
at the previous date); and
(2) tk represents the kth future time period in the
model and there are n time periods represented in the model over the
first year; and
(B) [alpha] = 1.4 except as provided in paragraph (d)(6), or
when the [AGENCY] has determined that the [bank] must set [alpha]
higher based on the [bank]'s specific characteristics of
counterparty credit risk.
(iii) A [bank] may include financial collateral currently posted
by the counterparty as collateral (but may not include other forms
of collateral) when calculating EE.
(iv) If a [bank] hedges some or all of the counterparty credit
risk associated with a netting set using an eligible credit
derivative, the [bank] may take the reduction in exposure to the
counterparty into account when estimating EE. If the [bank]
recognizes this reduction in exposure to the counterparty in its
estimate of EE, it must also use its internal model to estimate a
separate EAD for the [bank]'s exposure to the protection provider of
the credit derivative.
(3) To obtain [AGENCY] approval to calculate the distributions
of exposures upon which the EAD calculation is based, the [bank]
must demonstrate to the satisfaction of the [AGENCY] that it has
been using for at least one year an internal model that broadly
meets the following minimum standards, with which the [bank] must
maintain compliance:
(i) The model must have the systems capability to estimate the
expected exposure to the counterparty on a daily basis (but is not
expected to estimate or report expected exposure on a daily basis).
(ii) The model must estimate expected exposure at enough future
dates to reflect accurately all the future cash flows of contracts
in the netting set.
(iii) The model must account for the possible non-normality of
the exposure distribution, where appropriate.
(iv) The [bank] must measure, monitor, and control current
counterparty exposure and the exposure to the counterparty over the
whole life of all contracts in the netting set.
(v) The [bank] must be able to measure and manage current
exposures gross and net of collateral held, where appropriate. The
[bank] must estimate expected exposures for OTC derivative contracts
both with and without the effect of collateral agreements.
(vi) The [bank] must have procedures to identify, monitor, and
control specific wrong-way risk throughout the life of an exposure.
Wrong-way risk in this context is the risk that future exposure to a
counterparty will be high when the counterparty's probability of
default is also high.
(vii) The model must use current market data to compute current
exposures. When estimating model parameters based on historical
data, at least three years of historical data that cover a wide
range of economic conditions must be used and must be updated
quarterly or more frequently if market conditions warrant. The
[bank] should consider using model parameters based on forward-
looking measures, where appropriate.
(viii) A [bank] must subject its internal model to an initial
validation and annual model review process. The model review should
consider whether the inputs and risk factors, as well as the model
outputs, are appropriate.
(4) Maturity. (i) If the remaining maturity of the exposure or
the longest-dated contract in the netting set is greater than one
year, the [bank] must set M for the exposure or netting set equal to
the lower of five years or M(EPE),\3\ where:
---------------------------------------------------------------------------
\3\ Alternatively, a [bank] that uses an internal model to
calculate a one-sided credit valuation adjustment may use the
effective credit duration estimated by the model as M(EPE) in place
of the formula in paragraph (d)(4).
[GRAPHIC] [TIFF OMITTED] TR07DE07.015
(B) dfk is the risk-free discount factor for future
time period tk; and
(C) [Delta]tk = tk-tk-1.
(ii) If the remaining maturity of the exposure or the longest-
dated contract in the netting set is one year or less, the [bank]
must set M for the exposure or netting set equal to one year, except
as provided in paragraph (d)(7) of section 31 of this appendix.
(5) Collateral agreements. A [bank] may capture the effect on
EAD of a collateral agreement that requires receipt of collateral
when exposure to the counterparty increases but may not capture the
effect on EAD of a collateral agreement that requires receipt of
collateral when counterparty credit quality deteriorates. For this
purpose, a collateral agreement means a legal contract that
specifies the time when, and circumstances under which, the
counterparty is required to pledge collateral to the [bank] for a
single financial contract or for all financial contracts in a
netting set and confers upon the [bank] a perfected, first priority
security interest (notwithstanding the prior security interest of
any custodial agent), or the legal equivalent thereof, in the
collateral posted by the counterparty under the agreement. This
security interest must provide the [bank] with a right to close out
the financial positions and liquidate the collateral upon an event
of default of, or failure to perform by, the counterparty under the
collateral agreement. A contract would not satisfy this requirement
if the [bank]'s exercise of rights under the agreement may be stayed
or avoided under applicable law in the relevant jurisdictions. Two
methods are available to capture the effect of a collateral
agreement:
(i) With prior written approval from the [AGENCY], a [bank] may
include the effect of a collateral agreement within its internal
model used to calculate EAD. The [bank] may set EAD equal to the
expected exposure at the end of the margin period of risk. The
margin period of risk means, with respect to a netting set subject
to a collateral agreement, the time period from the most recent
exchange of collateral with a counterparty until the next required
exchange of collateral plus the period of time required to sell and
realize the proceeds of the least liquid collateral that can be
delivered under the terms of the collateral agreement and, where
applicable, the period of time required to re-hedge the resulting
market risk, upon the default of the counterparty. The minimum
margin period of risk is five business days for repo-style
transactions and ten business days for other transactions when
liquid financial collateral is posted under a daily margin
maintenance requirement. This period should be extended to cover any
additional time between margin calls; any potential closeout
difficulties; any delays in selling collateral, particularly if the
collateral is illiquid; and any impediments to prompt re-hedging of
any market risk.
(ii) A [bank] that can model EPE without collateral agreements
but cannot achieve the higher level of modeling sophistication to
model EPE with collateral agreements can set effective EPE for a
collateralized netting set equal to the lesser of:
(A) The threshold, defined as the exposure amount at which the
counterparty is required to post collateral under the collateral
agreement, if the threshold is positive, plus an add-on that
reflects the potential increase in exposure of the netting set over
the margin period of risk. The add-on is computed as the
[[Page 69416]]
expected increase in the netting set's exposure beginning from
current exposure of zero over the margin period of risk. The margin
period of risk must be at least five business days for netting sets
consisting only of repo-style transactions subject to daily re-
margining and daily marking-to-market, and ten business days for all
other netting sets; or
(B) Effective EPE without a collateral agreement.
(6) Own estimate of alpha. With prior written approval of the
[AGENCY], a [bank] may calculate alpha as the ratio of economic
capital from a full simulation of counterparty exposure across
counterparties that incorporates a joint simulation of market and
credit risk factors (numerator) and economic capital based on EPE
(denominator), subject to a floor of 1.2. For purposes of this
calculation, economic capital is the unexpected losses for all
counterparty credit risks measured at a 99.9 percent confidence
level over a one-year horizon. To receive approval, the [bank] must
meet the following minimum standards to the satisfaction of the
[AGENCY]:
(i) The [bank]'s own estimate of alpha must capture in the
numerator the effects of:
(A) The material sources of stochastic dependency of
distributions of market values of transactions or portfolios of
transactions across counterparties;
(B) Volatilities and correlations of market risk factors used in
the joint simulation, which must be related to the credit risk
factor used in the simulation to reflect potential increases in
volatility or correlation in an economic downturn, where
appropriate; and
(C) The granularity of exposures (that is, the effect of a
concentration in the proportion of each counterparty's exposure that
is driven by a particular risk factor).
(ii) The [bank] must assess the potential model uncertainty in
its estimates of alpha.
(iii) The [bank] must calculate the numerator and denominator of
alpha in a consistent fashion with respect to modeling methodology,
parameter specifications, and portfolio composition.
(iv) The [bank] must review and adjust as appropriate its
estimates of the numerator and denominator of alpha on at least a
quarterly basis and more frequently when the composition of the
portfolio varies over time.
(7) Other measures of counterparty exposure. With prior written
approval of the [AGENCY], a [bank] may set EAD equal to a measure of
counterparty credit risk exposure, such as peak EAD, that is more
conservative than an alpha of 1.4 (or higher under the terms of
paragraph (d)(2)(ii)(B) of this section) times EPE for every
counterparty whose EAD will be measured under the alternative
measure of counterparty exposure. The [bank] must demonstrate the
conservatism of the measure of counterparty credit risk exposure
used for EAD. For material portfolios of new OTC derivative
products, the [bank] may assume that the current exposure
methodology in paragraphs (c)(5) and (c)(6) of this section meets
the conservatism requirement of this paragraph for a period not to
exceed 180 days. For immaterial portfolios of OTC derivative
contracts, the [bank] generally may assume that the current exposure
methodology in paragraphs (c)(5) and (c)(6) of this section meets
the conservatism requirement of this paragraph.
Section 33. Guarantees and Credit Derivatives: PD Substitution and
LGD Adjustment Approaches
(a) Scope. (1) This section applies to wholesale exposures for
which:
(i) Credit risk is fully covered by an eligible guarantee or
eligible credit derivative; or
(ii) Credit risk is covered on a pro rata basis (that is, on a
basis in which the [bank] and the protection provider share losses
proportionately) by an eligible guarantee or eligible credit
derivative.
(2) Wholesale exposures on which there is a tranching of credit
risk (reflecting at least two different levels of seniority) are
securitization exposures subject to the securitization framework in
part V.
(3) A [bank] may elect to recognize the credit risk mitigation
benefits of an eligible guarantee or eligible credit derivative
covering an exposure described in paragraph (a)(1) of this section
by using the PD substitution approach or the LGD adjustment approach
in paragraph (c) of this section or, if the transaction qualifies,
using the double default treatment in section 34 of this appendix. A
[bank]'s PD and LGD for the hedged exposure may not be lower than
the PD and LGD floors described in paragraphs (d)(2) and (d)(3) of
section 31 of this appendix.
(4) If multiple eligible guarantees or eligible credit
derivatives cover a single exposure described in paragraph (a)(1) of
this section, a [bank] may treat the hedged exposure as multiple
separate exposures each covered by a single eligible guarantee or
eligible credit derivative and may calculate a separate risk-based
capital requirement for each separate exposure as described in
paragraph (a)(3) of this section.
(5) If a single eligible guarantee or eligible credit derivative
covers multiple hedged wholesale exposures described in paragraph
(a)(1) of this section, a [bank] must treat each hedged exposure as
covered by a separate eligible guarantee or eligible credit
derivative and must calculate a separate risk-based capital
requirement for each exposure as described in paragraph (a)(3) of
this section.
(6) A [bank] must use the same risk parameters for calculating
ECL as it uses for calculating the risk-based capital requirement
for the exposure.
(b) Rules of recognition. (1) A [bank] may only recognize the
credit risk mitigation benefits of eligible guarantees and eligible
credit derivatives.
(2) A [bank] may only recognize the credit risk mitigation
benefits of an eligible credit derivative to hedge an exposure that
is different from the credit derivative's reference exposure used
for determining the derivative's cash settlement value, deliverable
obligation, or occurrence of a credit event if:
(i) The reference exposure ranks pari passu (that is, equally)
with or is junior to the hedged exposure; and
(ii) The reference exposure and the hedged exposure are
exposures to the same legal entity, and legally enforceable cross-
default or cross-acceleration clauses are in place to assure
payments under the credit derivative are triggered when the obligor
fails to pay under the terms of the hedged exposure.
(c) Risk parameters for hedged exposures--(1) PD substitution
approach--(i) Full coverage. If an eligible guarantee or eligible
credit derivative meets the conditions in paragraphs (a) and (b) of
this section and the protection amount (P) of the guarantee or
credit derivative is greater than or equal to the EAD of the hedged
exposure, a [bank] may recognize the guarantee or credit derivative
in determining the [bank]'s risk-based capital requirement for the
hedged exposure by substituting the PD associated with the rating
grade of the protection provider for the PD associated with the
rating grade of the obligor in the risk-based capital formula
applicable to the guarantee or credit derivative in Table 2 and
using the appropriate LGD as described in paragraph (c)(1)(iii) of
this section. If the [bank] determines that full substitution of the
protection provider's PD leads to an inappropriate degree of risk
mitigation, the [bank] may substitute a higher PD than that of the
protection provider.
(ii) Partial coverage. If an eligible guarantee or eligible
credit derivative meets the conditions in paragraphs (a) and (b) of
this section and the protection amount (P) of the guarantee or
credit derivative is less than the EAD of the hedged exposure, the
[bank] must treat the hedged exposure as two separate exposures
(protected and unprotected) in order to recognize the credit risk
mitigation benefit of the guarantee or credit derivative.
(A) The [bank] must calculate its risk-based capital requirement
for the protected exposure under section 31 of this appendix, where
PD is the protection provider's PD, LGD is determined under
paragraph (c)(1)(iii) of this section, and EAD is P. If the [bank]
determines that full substitution leads to an inappropriate degree
of risk mitigation, the [bank] may use a higher PD than that of the
protection provider.
(B) The [bank] must calculate its risk-based capital requirement
for the unprotected exposure under section 31 of this appendix,
where PD is the obligor's PD, LGD is the hedged exposure's LGD (not
adjusted to reflect the guarantee or credit derivative), and EAD is
the EAD of the original hedged exposure minus P.
(C) The treatment in this paragraph (c)(1)(ii) is applicable
when the credit risk of a wholesale exposure is covered on a partial
pro rata basis or when an adjustment is made to the effective
notional amount of the guarantee or credit derivative under
paragraph (d), (e), or (f) of this section.
(iii) LGD of hedged exposures. The LGD of a hedged exposure
under the PD substitution approach is equal to:
(A) The lower of the LGD of the hedged exposure (not adjusted to
reflect the guarantee or credit derivative) and the LGD of the
guarantee or credit derivative, if the guarantee or credit
derivative provides the [bank] with the option to receive immediate
payout upon triggering the protection; or
(B) The LGD of the guarantee or credit derivative, if the
guarantee or credit
[[Page 69417]]
derivative does not provide the [bank] with the option to receive
immediate payout upon triggering the protection.
(2) LGD adjustment approach--(i) Full coverage. If an eligible
guarantee or eligible credit derivative meets the conditions in
paragraphs (a) and (b) of this section and the protection amount (P)
of the guarantee or credit derivative is greater than or equal to
the EAD of the hedged exposure, the [bank]'s risk-based capital
requirement for the hedged exposure is the greater of:
(A) The risk-based capital requirement for the exposure as
calculated under section 31 of this appendix, with the LGD of the
exposure adjusted to reflect the guarantee or credit derivative; or
(B) The risk-based capital requirement for a direct exposure to
the protection provider as calculated under section 31 of this
appendix, using the PD for the protection provider, the LGD for the
guarantee or credit derivative, and an EAD equal to the EAD of the
hedged exposure.
(ii) Partial coverage. If an eligible guarantee or eligible
credit derivative meets the conditions in paragraphs (a) and (b) of
this section and the protection amount (P) of the guarantee or
credit derivative is less than the EAD of the hedged exposure, the
[bank] must treat the hedged exposure as two separate exposures
(protected and unprotected) in order to recognize the credit risk
mitigation benefit of the guarantee or credit derivative.
(A) The [bank]'s risk-based capital requirement for the
protected exposure would be the greater of:
(1) The risk-based capital requirement for the protected
exposure as calculated under section 31 of this appendix, with the
LGD of the exposure adjusted to reflect the guarantee or credit
derivative and EAD set equal to P; or
(2) The risk-based capital requirement for a direct exposure to
the guarantor as calculated under section 31 of this appendix, using
the PD for the protection provider, the LGD for the guarantee or
credit derivative, and an EAD set equal to P.
(B) The [bank] must calculate its risk-based capital requirement
for the unprotected exposure under section 31 of this appendix,
where PD is the obligor's PD, LGD is the hedged exposure's LGD (not
adjusted to reflect the guarantee or credit derivative), and EAD is
the EAD of the original hedged exposure minus P.
(3) M of hedged exposures. The M of the hedged exposure is the
same as the M of the exposure if it were unhedged.
(d) Maturity mismatch. (1) A [bank] that recognizes an eligible
guarantee or eligible credit derivative in determining its risk-
based capital requirement for a hedged exposure must adjust the
effective notional amount of the credit risk mitigant to reflect any
maturity mismatch between the hedged exposure and the credit risk
mitigant.
(2) A maturity mismatch occurs when the residual maturity of a
credit risk mitigant is less than that of the hedged exposure(s).
(3) The residual maturity of a hedged exposure is the longest
possible remaining time before the obligor is scheduled to fulfill
its obligation on the exposure. If a credit risk mitigant has
embedded options that may reduce its term, the [bank] (protection
purchaser) must use the shortest possible residual maturity for the
credit risk mitigant. If a call is at the discretion of the
protection provider, the residual maturity of the credit risk
mitigant is at the first call date. If the call is at the discretion
of the [bank] (protection purchaser), but the terms of the
arrangement at origination of the credit risk mitigant contain a
positive incentive for the [bank] to call the transaction before
contractual maturity, the remaining time to the first call date is
the residual maturity of the credit risk mitigant. For example,
where there is a step-up in cost in conjunction with a call feature
or where the effective cost of protection increases over time even
if credit quality remains the same or improves, the residual
maturity of the credit risk mitigant will be the remaining time to
the first call.
(4) A credit risk mitigant with a maturity mismatch may be
recognized only if its original maturity is greater than or equal to
one year and its residual maturity is greater than three months.
(5) When a maturity mismatch exists, the [bank] must apply the
following adjustment to the effective notional amount of the credit
risk mitigant: Pm = E x (t - 0.25)/(T - 0.25), where:
(i) Pm = effective notional amount of the credit risk mitigant,
adjusted for maturity mismatch;
(ii) E = effective notional amount of the credit risk mitigant;
(iii) t = the lesser of T or the residual maturity of the credit
risk mitigant, expressed in years; and
(iv) T = the lesser of five or the residual maturity of the
hedged exposure, expressed in years.
(e) Credit derivatives without restructuring as a credit event.
If a [bank] recognizes an eligible credit derivative that does not
include as a credit event a restructuring of the hedged exposure
involving forgiveness or postponement of principal, interest, or
fees that results in a credit loss event (that is, a charge-off,
specific provision, or other similar debit to the profit and loss
account), the [bank] must apply the following adjustment to the
effective notional amount of the credit derivative: Pr = Pm x 0.60,
where:
(1) Pr = effective notional amount of the credit risk mitigant,
adjusted for lack of restructuring event (and maturity mismatch, if
applicable); and
(2) Pm = effective notional amount of the credit risk mitigant
adjusted for maturity mismatch (if applicable).
(f) Currency mismatch. (1) If a [bank] recognizes an eligible
guarantee or eligible credit derivative that is denominated in a
currency different from that in which the hedged exposure is
denominated, the [bank] must apply the following formula to the
effective notional amount of the guarantee or credit derivative: Pc
= Pr x (1 - HFX), where:
(i) Pc = effective notional amount of the credit risk mitigant,
adjusted for currency mismatch (and maturity mismatch and lack of
restructuring event, if applicable);
(ii) Pr = effective notional amount of the credit risk mitigant
(adjusted for maturity mismatch and lack of restructuring event, if
applicable); and
(iii) HFX = haircut appropriate for the currency
mismatch between the credit risk mitigant and the hedged exposure.
(2) A [bank] must set HFX equal to 8 percent unless
it qualifies for the use of and uses its own internal estimates of
foreign exchange volatility based on a ten-business-day holding
period and daily marking-to-market and remargining. A [bank]
qualifies for the use of its own internal estimates of foreign
exchange volatility if it qualifies for:
(i) The own-estimates haircuts in paragraph (b)(2)(iii) of
section 32 of this appendix;
(ii) The simple VaR methodology in paragraph (b)(3) of section
32 of this appendix; or
(iii) The internal models methodology in paragraph (d) of
section 32 of this appendix.
(3) A [bank] must adjust HFX calculated in paragraph
(f)(2) of this section upward if the [bank] revalues the guarantee
or credit derivative less frequently than once every ten business
days using the square root of time formula provided in paragraph
(b)(2)(iii)(A)(2) of section 32 of this appendix.
Section 34. Guarantees and Credit Derivatives: Double Default
Treatment
(a) Eligibility and operational criteria for double default
treatment. A [bank] may recognize the credit risk mitigation
benefits of a guarantee or credit derivative covering an exposure
described in paragraph (a)(1) of section 33 of this appendix by
applying the double default treatment in this section if all the
following criteria are satisfied.
(1) The hedged exposure is fully covered or covered on a pro
rata basis by:
(i) An eligible guarantee issued by an eligible double default
guarantor; or
(ii) An eligible credit derivative that meets the requirements
of paragraph (b)(2) of section 33 of this appendix and is issued by
an eligible double default guarantor.
(2) The guarantee or credit derivative is:
(i) An uncollateralized guarantee or uncollateralized credit
derivative (for example, a credit default swap) that provides
protection with respect to a single reference obligor; or
(ii) An nth-to-default credit derivative (subject to the
requirements of paragraph (m) of section 42 of this appendix).
(3) The hedged exposure is a wholesale exposure (other than a
sovereign exposure).
(4) The obligor of the hedged exposure is not:
(i) An eligible double default guarantor or an affiliate of an
eligible double default guarantor; or
(ii) An affiliate of the guarantor.
(5) The [bank] does not recognize any credit risk mitigation
benefits of the guarantee or credit derivative for the hedged
exposure other than through application of the double default
treatment as provided in this section.
(6) The [bank] has implemented a process (which has received the
prior, written approval of the [AGENCY]) to detect excessive
correlation between the creditworthiness of the obligor of the
hedged exposure and the protection provider. If excessive
correlation is present, the [bank] may not use the double default
treatment for the hedged exposure.
[[Page 69418]]
(b) Full coverage. If the transaction meets the criteria in
paragraph (a) of this section and the protection amount (P) of the
guarantee or credit derivative is at least equal to the EAD of the
hedged exposure, the [bank] may determine its risk-weighted asset
amount for the hedged exposure under paragraph (e) of this section.
(c) Partial coverage. If the transaction meets the criteria in
paragraph (a) of this section and the protection amount (P) of the
guarantee or credit derivative is less than the EAD of the hedged
exposure, the [bank] must treat the hedged exposure as two separate
exposures (protected and unprotected) in order to recognize double
default treatment on the protected portion of the exposure.
(1) For the protected exposure, the [bank] must set EAD equal to
P and calculate its risk-weighted asset amount as provided in
paragraph (e) of this section.
(2) For the unprotected exposure, the [bank] must set EAD equal
to the EAD of the original exposure minus P and then calculate its
risk-weighted asset amount as provided in section 31 of this
appendix.
(d) Mismatches. For any hedged exposure to which a [bank]
applies double default treatment, the [bank] must make applicable
adjustments to the protection amount as required in paragraphs (d),
(e), and (f) of section 33 of this appendix.
(e) The double default dollar risk-based capital requirement.
The dollar risk-based capital requirement for a hedged exposure to
which a [bank] has applied double default treatment is
KDD multiplied by the EAD of the exposure. KDD
is calculated according to the following formula: KDD =
Ko x (0.15 + 160 x PDg),
Where:
(1)
[GRAPHIC] [TIFF OMITTED] TR07DE07.016
(2) PDg = PD of the protection provider.
(3) PDo = PD of the obligor of the hedged exposure.
(4) LGDg = (i) The lower of the LGD of the hedged
exposure (not adjusted to reflect the guarantee or credit
derivative) and the LGD of the guarantee or credit derivative, if
the guarantee or credit derivative provides the [bank] with the
option to receive immediate payout on triggering the protection; or
(ii) The LGD of the guarantee or credit derivative, if the guarantee
or credit derivative does not provide the [bank] with the option to
receive immediate payout on triggering the protection.
(5) [rho]OS (asset value correlation of the obligor) is
calculated according to the appropriate formula for (R) provided in
Table 2 in section 31 of this appendix, with PD equal to
PDo.
(6) b (maturity adjustment coefficient) is calculated according to
the formula for b provided in Table 2 in section 31 of this
appendix, with PD equal to the lesser of PDo and
PDg.
(7) M (maturity) is the effective maturity of the guarantee or
credit derivative, which may not be less than one year or greater
than five years.
Section 35. Risk-Based Capital Requirement for Unsettled
Transactions
(a) Definitions. For purposes of this section:
(1) Delivery-versus-payment (DvP) transaction means a securities
or commodities transaction in which the buyer is obligated to make
payment only if the seller has made delivery of the securities or
commodities and the seller is obligated to deliver the securities or
commodities only if the buyer has made payment.
(2) Payment-versus-payment (PvP) transaction means a foreign
exchange transaction in which each counterparty is obligated to make
a final transfer of one or more currencies only if the other
counterparty has made a final transfer of one or more currencies.
(3) Normal settlement period. A transaction has a normal
settlement period if the contractual settlement period for the
transaction is equal to or less than the market standard for the
instrument underlying the transaction and equal to or less than five
business days.
(4) Positive current exposure. The positive current exposure of
a [bank] for a transaction is the difference between the transaction
value at the agreed settlement price and the current market price of
the transaction, if the difference results in a credit exposure of
the [bank] to the counterparty.
(b) Scope. This section applies to all transactions involving
securities, foreign exchange instruments, and commodities that have
a risk of delayed settlement or delivery. This section does not
apply to:
(1) Transactions accepted by a qualifying central counterparty
that are subject to daily marking-to-market and daily receipt and
payment of variation margin;
(2) Repo-style transactions, including unsettled repo-style
transactions (which are addressed in sections 31 and 32 of this
appendix);
(3) One-way cash payments on OTC derivative contracts (which are
addressed in sections 31 and 32 of this appendix); or
(4) Transactions with a contractual settlement period that is
longer than the normal settlement period (which are treated as OTC
derivative contracts and addressed in sections 31 and 32 of this
appendix).
(c) System-wide failures. In the case of a system-wide failure
of a settlement or clearing system, the [AGENCY] may waive risk-
based capital requirements for unsettled and failed transactions
until the situation is rectified.
(d) Delivery-versus-payment (DvP) and payment-versus-payment
(PvP) transactions. A [bank] must hold risk-based capital against
any DvP or PvP transaction with a normal settlement period if the
[bank]'s counterparty has not made delivery or payment within five
business days after the settlement date. The [bank] must determine
its risk-weighted asset amount for such a transaction by multiplying
the positive current exposure of the transaction for the [bank] by
the appropriate risk weight in Table 5.
Table 5.--Risk Weights for Unsettled DvP and PvP Transactions
------------------------------------------------------------------------
Risk weight to be
Number of business days after contractual settlement applied to
date positive current
exposure (percent)
------------------------------------------------------------------------
From 5 to 15........................................ 100
From 16 to 30....................................... 625
From 31 to 45....................................... 937.5
46 or more.......................................... 1,250
------------------------------------------------------------------------
(e) Non-DvP/non-PvP (non-delivery-versus-payment/non-payment-
versus-payment) transactions. (1) A [bank] must hold risk-based
capital against any non-DvP/non-PvP transaction with a normal
settlement period if the [bank] has delivered cash, securities,
commodities, or currencies to its counterparty but has not received
its corresponding deliverables by the end of the same business day.
The [bank] must continue to hold risk-based capital against the
transaction until the [bank] has received its corresponding
deliverables.
(2) From the business day after the [bank] has made its delivery
until five business days after the counterparty delivery is due, the
[bank] must calculate its risk-based capital requirement for the
transaction by treating the current market value of the deliverables
owed to the [bank] as a wholesale exposure.
(i) A [bank] may assign an obligor rating to a counterparty for
which it is not otherwise required under this appendix to assign an
obligor rating on the basis of the applicable external rating of any
outstanding unsecured long-term debt security without credit
enhancement issued by the counterparty.
(ii) A [bank] may use a 45 percent LGD for the transaction
rather than estimating LGD for the transaction provided the [bank]
uses the 45 percent LGD for all transactions described in paragraphs
(e)(1) and (e)(2) of this section.
(iii) A [bank] may use a 100 percent risk weight for the
transaction provided the [bank] uses this risk weight for all
transactions described in paragraphs (e)(1) and (e)(2) of this
section.
[[Page 69419]]
(3) If the [bank] has not received its deliverables by the fifth
business day after the counterparty delivery was due, the [bank]
must deduct the current market value of the deliverables owed to the
[bank] 50 percent from tier 1 capital and 50 percent from tier 2
capital.
(f) Total risk-weighted assets for unsettled transactions. Total
risk-weighted assets for unsettled transactions is the sum of the
risk-weighted asset amounts of all DvP, PvP, and non-DvP/non-PvP
transactions.
Part V. Risk-Weighted Assets for Securitization Exposures
Section 41. Operational Criteria for Recognizing the Transfer of
Risk
(a) Operational criteria for traditional securitizations. A
[bank] that transfers exposures it has originated or purchased to a
securitization SPE or other third party in connection with a
traditional securitization may exclude the exposures from the
calculation of its risk-weighted assets only if each of the
conditions in this paragraph (a) is satisfied. A [bank] that meets
these conditions must hold risk-based capital against any
securitization exposures it retains in connection with the
securitization. A [bank] that fails to meet these conditions must
hold risk-based capital against the transferred exposures as if they
had not been securitized and must deduct from tier 1 capital any
after-tax gain-on-sale resulting from the transaction. The
conditions are:
(1) The transfer is considered a sale under GAAP;
(2) The [bank] has transferred to third parties credit risk
associated with the underlying exposures; and
(3) Any clean-up calls relating to the securitization are
eligible clean-up calls.
(b) Operational criteria for synthetic securitizations. For
synthetic securitizations, a [bank] may recognize for risk-based
capital purposes the use of a credit risk mitigant to hedge
underlying exposures only if each of the conditions in this
paragraph (b) is satisfied. A [bank] that fails to meet these
conditions must hold risk-based capital against the underlying
exposures as if they had not been synthetically securitized. The
conditions are:
(1) The credit risk mitigant is financial collateral, an
eligible credit derivative from an eligible securitization guarantor
or an eligible guarantee from an eligible securitization guarantor;
(2) The [bank] transfers credit risk associated with the
underlying exposures to third parties, and the terms and conditions
in the credit risk mitigants employed do not include provisions
that:
(i) Allow for the termination of the credit protection due to
deterioration in the credit quality of the underlying exposures;
(ii) Require the [bank] to alter or replace the underlying
exposures to improve the credit quality of the pool of underlying
exposures;
(iii) Increase the [bank]'s cost of credit protection in
response to deterioration in the credit quality of the underlying
exposures;
(iv) Increase the yield payable to parties other than the [bank]
in response to a deterioration in the credit quality of the
underlying exposures; or
(v) Provide for increases in a retained first loss position or
credit enhancement provided by the [bank] after the inception of the
securitization;
(3) The [bank] obtains a well-reasoned opinion from legal
counsel that confirms the enforceability of the credit risk mitigant
in all relevant jurisdictions; and
(4) Any clean-up calls relating to the securitization are
eligible clean-up calls.
Section 42. Risk-Based Capital Requirement for Securitization
Exposures
(a) Hierarchy of approaches. Except as provided elsewhere in
this section:
(1) A [bank] must deduct from tier 1 capital any after-tax gain-
on-sale resulting from a securitization and must deduct from total
capital in accordance with paragraph (c) of this section the portion
of any CEIO that does not constitute gain-on-sale.
(2) If a securitization exposure does not require deduction
under paragraph (a)(1) of this section and qualifies for the
Ratings-Based Approach in section 43 of this appendix, a [bank] must
apply the Ratings-Based Approach to the exposure.
(3) If a securitization exposure does not require deduction
under paragraph (a)(1) of this section and does not qualify for the
Ratings-Based Approach, the [bank] may either apply the Internal
Assessment Approach in section 44 of this appendix to the exposure
(if the [bank], the exposure, and the relevant ABCP program qualify
for the Internal Assessment Approach) or the Supervisory Formula
Approach in section 45 of this appendix to the exposure (if the
[bank] and the exposure qualify for the Supervisory Formula
Approach).
(4) If a securitization exposure does not require deduction
under paragraph (a)(1) of this section and does not qualify for the
Ratings-Based Approach, the Internal Assessment Approach, or the
Supervisory Formula Approach, the [bank] must deduct the exposure
from total capital in accordance with paragraph (c) of this section.
(5) If a securitization exposure is an OTC derivative contract
(other than a credit derivative) that has a first priority claim on
the cash flows from the underlying exposures (notwithstanding
amounts due under interest rate or currency derivative contracts,
fees due, or other similar payments), with approval of the [AGENCY],
a [bank] may choose to set the risk-weighted asset amount of the
exposure equal to the amount of the exposure as determined in
paragraph (e) of this section rather than apply the hierarchy of
approaches described in paragraphs (a) (1) through (4) of this
section.
(b) Total risk-weighted assets for securitization exposures. A
[bank]'s total risk-weighted assets for securitization exposures is
equal to the sum of its risk-weighted assets calculated using the
Ratings-Based Approach in section 43 of this appendix, the Internal
Assessment Approach in section 44 of this appendix, and the
Supervisory Formula Approach in section 45 of this appendix, and its
risk-weighted assets amount for early amortization provisions
calculated in section 47 of this appendix.
(c) Deductions. (1) If a [bank] must deduct a securitization
exposure from total capital, the [bank] must take the deduction 50
percent from tier 1 capital and 50 percent from tier 2 capital. If
the amount deductible from tier 2 capital exceeds the [bank]'s tier
2 capital, the [bank] must deduct the excess from tier 1 capital.
(2) A [bank] may calculate any deduction from tier 1 capital and
tier 2 capital for a securitization exposure net of any deferred tax
liabilities associated with the securitization exposure.
(d) Maximum risk-based capital requirement. Regardless of any
other provisions of this part, unless one or more underlying
exposures does not meet the definition of a wholesale, retail,
securitization, or equity exposure, the total risk-based capital
requirement for all securitization exposures held by a single [bank]
associated with a single securitization (including any risk-based
capital requirements that relate to an early amortization provision
of the securitization but excluding any risk-based capital
requirements that relate to the [bank]'s gain-on-sale or CEIOs
associated with the securitization) may not exceed the sum of:
(1) The [bank]'s total risk-based capital requirement for the
underlying exposures as if the [bank] directly held the underlying
exposures; and
(2) The total ECL of the underlying exposures.
(e) Amount of a securitization exposure. (1) The amount of an
on-balance sheet securitization exposure that is not a repo-style
transaction, eligible margin loan, or OTC derivative contract (other
than a credit derivative) is:
(i) The [bank]'s carrying value minus any unrealized gains and
plus any unrealized losses on the exposure, if the exposure is a
security classified as available-for-sale; or
(ii) The [bank]'s carrying value, if the exposure is not a
security classified as available-for-sale.
(2) The amount of an off-balance sheet securitization exposure
that is not an OTC derivative contract (other than a credit
derivative) is the notional amount of the exposure. For an off-
balance-sheet securitization exposure to an ABCP program, such as a
liquidity facility, the notional amount may be reduced to the
maximum potential amount that the [bank] could be required to fund
given the ABCP program's current underlying assets (calculated
without regard to the current credit quality of those assets).
(3) The amount of a securitization exposure that is a repo-style
transaction, eligible margin loan, or OTC derivative contract (other
than a credit derivative) is the EAD of the exposure as calculated
in section 32 of this appendix.
(f) Overlapping exposures. If a [bank] has multiple
securitization exposures that provide duplicative coverage of the
underlying exposures of a securitization (such as when a [bank]
provides a program-wide credit enhancement and multiple pool-
specific liquidity facilities to an ABCP program), the [bank] is not
required to hold duplicative risk-based capital against the
[[Page 69420]]
overlapping position. Instead, the [bank] may apply to the
overlapping position the applicable risk-based capital treatment
that results in the highest risk-based capital requirement.
(g) Securitizations of non-IRB exposures. If a [bank] has a
securitization exposure where any underlying exposure is not a
wholesale exposure, retail exposure, securitization exposure, or
equity exposure, the [bank] must:
(1) If the [bank] is an originating [bank], deduct from tier 1
capital any after-tax gain-on-sale resulting from the securitization
and deduct from total capital in accordance with paragraph (c) of
this section the portion of any CEIO that does not constitute gain-
on-sale;
(2) If the securitization exposure does not require deduction
under paragraph (g)(1), apply the RBA in section 43 of this appendix
to the securitization exposure if the exposure qualifies for the
RBA;
(3) If the securitization exposure does not require deduction
under paragraph (g)(1) and does not qualify for the RBA, apply the
IAA in section 44 of this appendix to the exposure (if the [bank],
the exposure, and the relevant ABCP program qualify for the IAA);
and
(4) If the securitization exposure does not require deduction
under paragraph (g)(1) and does not qualify for the RBA or the IAA,
deduct the exposure from total capital in accordance with paragraph
(c) of this section.
(h) Implicit support. If a [bank] provides support to a
securitization in excess of the [bank]'s contractual obligation to
provide credit support to the securitization (implicit support):
(1) The [bank] must hold regulatory capital against all of the
underlying exposures associated with the securitization as if the
exposures had not been securitized and must deduct from tier 1
capital any after-tax gain-on-sale resulting from the
securitization; and
(2) The [bank] must disclose publicly:
(i) That it has provided implicit support to the securitization;
and
(ii) The regulatory capital impact to the [bank] of providing
such implicit support.
(i) Eligible servicer cash advance facilities. Regardless of any
other provisions of this part, a [bank] is not required to hold
risk-based capital against the undrawn portion of an eligible
servicer cash advance facility.
(j) Interest-only mortgage-backed securities. Regardless of any
other provisions of this part, the risk weight for a non-credit-
enhancing interest-only mortgage-backed security may not be less
than 100 percent.
(k) Small-business loans and leases on personal property
transferred with recourse. (1) Regardless of any other provisions of
this appendix, a [bank] that has transferred small-business loans
and leases on personal property (small-business obligations) with
recourse must include in risk-weighted assets only the contractual
amount of retained recourse if all the following conditions are met:
(i) The transaction is a sale under GAAP.
(ii) The [bank] establishes and maintains, pursuant to GAAP, a
non-capital reserve sufficient to meet the [bank]'s reasonably
estimated liability under the recourse arrangement.
(iii) The loans and leases are to businesses that meet the
criteria for a small-business concern established by the Small
Business Administration under section 3(a) of the Small Business Act
(15 U.S.C. 632).
(iv) The [bank] is well capitalized, as defined in the
[AGENCY]'s prompt corrective action regulation--12 CFR part 6 (for
national banks), 12 CFR part 208, subpart D (for state member banks
or bank holding companies), 12 CFR part 325, subpart B (for state
nonmember banks), and 12 CFR part 565 (for savings associations).
For purposes of determining whether a [bank] is well capitalized for
purposes of this paragraph, the [bank]'s capital ratios must be
calculated without regard to the capital treatment for transfers of
small-business obligations with recourse specified in paragraph
(k)(1) of this section.
(2) The total outstanding amount of recourse retained by a
[bank] on transfers of small-business obligations receiving the
capital treatment specified in paragraph (k)(1) of this section
cannot exceed 15 percent of the [bank]'s total qualifying capital.
(3) If a [bank] ceases to be well capitalized or exceeds the 15
percent capital limitation, the preferential capital treatment
specified in paragraph (k)(1) of this section will continue to apply
to any transfers of small-business obligations with recourse that
occurred during the time that the [bank] was well capitalized and
did not exceed the capital limit.
(4) The risk-based capital ratios of the [bank] must be
calculated without regard to the capital treatment for transfers of
small-business obligations with recourse specified in paragraph
(k)(1) of this section as provided in 12 CFR part 3, Appendix A (for
national banks), 12 CFR part 208, Appendix A (for state member
banks), 12 CFR part 225, Appendix A (for bank holding companies), 12
CFR part 325, Appendix A (for state nonmember banks), and 12 CFR
567.6(b)(5)(v) (for savings associations).
(l) Consolidated ABCP programs. (1) A [bank] that qualifies as a
primary beneficiary and must consolidate an ABCP program as a
variable interest entity under GAAP may exclude the consolidated
ABCP program assets from risk-weighted assets if the [bank] is the
sponsor of the ABCP program. If a [bank] excludes such consolidated
ABCP program assets from risk-weighted assets, the [bank] must hold
risk-based capital against any securitization exposures of the
[bank] to the ABCP program in accordance with this part.
(2) If a [bank] either is not permitted, or elects not, to
exclude consolidated ABCP program assets from its risk-weighted
assets, the [bank] must hold risk-based capital against the
consolidated ABCP program assets in accordance with this appendix
but is not required to hold risk-based capital against any
securitization exposures of the [bank] to the ABCP program.
(m) N th-to-default credit derivatives--(1) First-to-default
credit derivatives--(i) Protection purchaser. A [bank] that obtains
credit protection on a group of underlying exposures through a
first-to-default credit derivative must determine its risk-based
capital requirement for the underlying exposures as if the [bank]
synthetically securitized the underlying exposure with the lowest
risk-based capital requirement and had obtained no credit risk
mitigant on the other underlying exposures.
(ii) Protection provider. A [bank] that provides credit
protection on a group of underlying exposures through a first-to-
default credit derivative must determine its risk-weighted asset
amount for the derivative by applying the RBA in section 43 of this
appendix (if the derivative qualifies for the RBA) or, if the
derivative does not qualify for the RBA, by setting its risk-
weighted asset amount for the derivative equal to the product of:
(A) The protection amount of the derivative;
(B) 12.5; and
(C) The sum of the risk-based capital requirements of the
individual underlying exposures, up to a maximum of 100 percent.
(2) Second-or-subsequent-to-default credit derivatives--(i)
Protection purchaser. (A) A [bank] that obtains credit protection on
a group of underlying exposures through a n\th\-to-default credit
derivative (other than a first-to-default credit derivative) may
recognize the credit risk mitigation benefits of the derivative only
if:
(1) The [bank] also has obtained credit protection on the same
underlying exposures in the form of first-through-(n-1)-to-default
credit derivatives; or
(2) If n-1 of the underlying exposures have already defaulted.
(B) If a [bank] satisfies the requirements of paragraph
(m)(2)(i)(A) of this section, the [bank] must determine its risk-
based capital requirement for the underlying exposures as if the
[bank] had only synthetically securitized the underlying exposure
with the nth lowest risk-based capital requirement and
had obtained no credit risk mitigant on the other underlying
exposures.
(ii) Protection provider. A [bank] that provides credit
protection on a group of underlying exposures through a
nth-to-default credit derivative (other than a first-to-
default credit derivative) must determine its risk-weighted asset
amount for the derivative by applying the RBA in section 43 of this
appendix (if the derivative qualifies for the RBA) or, if the
derivative does not qualify for the RBA, by setting its risk-
weighted asset amount for the derivative equal to the product of:
(A) The protection amount of the derivative;
(B) 12.5; and
(C) The sum of the risk-based capital requirements of the
individual underlying exposures (excluding the n-1 underlying
exposures with the lowest risk-based capital requirements), up to a
maximum of 100 percent.
Section 43. Ratings-Based Approach (RBA)
(a) Eligibility requirements for use of the RBA--(1) Originating
[bank]. An originating [bank] must use the RBA to calculate its
risk-based capital requirement for a securitization exposure if the
exposure has two or more external ratings or inferred ratings (and
may not use the RBA if the exposure has fewer than two external
ratings or inferred ratings).
[[Page 69421]]
(2) Investing [bank]. An investing [bank] must use the RBA to
calculate its risk-based capital requirement for a securitization
exposure if the exposure has one or more external or inferred
ratings (and may not use the RBA if the exposure has no external or
inferred rating).
(b) Ratings-based approach. (1) A [bank] must determine the
risk-weighted asset amount for a securitization exposure by
multiplying the amount of the exposure (as defined in paragraph (e)
of section 42 of this appendix) by the appropriate risk weight
provided in Table 6 and Table 7.
(2) A [bank] must apply the risk weights in Table 6 when the
securitization exposure's applicable external or applicable inferred
rating represents a long-term credit rating, and must apply the risk
weights in Table 7 when the securitization exposure's applicable
external or applicable inferred rating represents a short-term
credit rating.
(i) A [bank] must apply the risk weights in column 1 of Table 6
or Table 7 to the securitization exposure if:
(A) N (as calculated under paragraph (e)(6) of section 45 of
this appendix) is six or more (for purposes of this section only, if
the notional number of underlying exposures is 25 or more or if all
of the underlying exposures are retail exposures, a [bank] may
assume that N is six or more unless the [bank] knows or has reason
to know that N is less than six); and
(B) The securitization exposure is a senior securitization
exposure.
(ii) A [bank] must apply the risk weights in column 3 of Table 6
or Table 7 to the securitization exposure if N is less than six,
regardless of the seniority of the securitization exposure.
(iii) Otherwise, a [bank] must apply the risk weights in column
2 of Table 6 or Table 7.
Table 6.--Long-Term Credit Rating Risk Weights Under RBA and IAA
----------------------------------------------------------------------------------------------------------------
Column 1 Column 2 Column 3
----------------------------------------------- Applicable
Risk weights Risk weights Risk weights external or
Applicable external or inferred rating for senior for non-senior for inferred
(Illustrative rating example) securitization securitization securitization rating
exposures exposures exposures (Illustrative
backed by backed by backed by non- rating
granular pools granular pools granular pools example)
--------------------------------------------------------------------------------------------------- ---------------
Highest investment grade (for example, AAA)........ 7% 12% 20%
Second highest investment grade (for example, AA).. 8% 15% 25%
Third-highest investment grade--positive 10% 18% 35%
designation (for example, A+).....................
Third-highest investment grade (for example, A).... 12% 20%
Third-highest investment grade--negative 20% 35%
designation (for example, A-).....................
--------------------------------------------
Lowest investment grade--positive designation (for 35% 50%
example, BBB+)....................................
Lowest investment grade (for example, BBB)......... 60% 75%
------------------------------------------------------------
Lowest investment grade--negative designation (for
example, BBB-).................................... 100%
One category below investment grade--positive
designation (for example, BB+).................... 250%
One category below investment grade (for example,
BB)............................................... 425%
One category below investment grade--negative
designation (for example, BB-).................... 650%
More than one category below investment grade...... Deduction from tier 1 and tier 2 capital.
----------------------------------------------------------------------------------------------------------------
Table 7.--Short-Term Credit Rating Risk Weights Under RBA and IAA
----------------------------------------------------------------------------------------------------------------
Column 1 Column 2 Column 3
----------------------------------------------- Applicable
Risk weights Risk weights Risk weights external or
Applicable external or inferred rating for senior for non-senior for inferred
(Illustrative rating example) securitization securitization securitization rating
exposures exposures exposures (Illustrative
backed by backed by backed by non- rating
granular pools granular pools granular pools example)
--------------------------------------------------------------------------------------------------- ---------------
Highest investment grade (for example, A1)......... 7% 12% 20%
Second highest investment grade (for example, A2).. 12% 20% 35%
Third highest investment grade (for example, A3)... 60% 75% 75%
All other ratings.................................. Deduction from tier 1 and tier 2 capital.
----------------------------------------------------------------------------------------------------------------
Section 44. Internal Assessment Approach (IAA)
(a) Eligibility requirements. A [bank] may apply the IAA to
calculate the risk-weighted asset amount for a securitization
exposure that the [bank] has to an ABCP program (such as a liquidity
facility or credit enhancement) if the [bank], the ABCP program, and
the exposure qualify for use of the IAA.
(1) [Bank] qualification criteria. A [bank] qualifies for use of
the IAA if the [bank] has received the prior written approval of the
[AGENCY]. To receive such approval, the [bank] must demonstrate to
the [AGENCY]'s satisfaction that the [bank]'s internal assessment
process meets the following criteria:
(i) The [bank]'s internal credit assessments of securitization
exposures must be based on publicly available rating criteria used
by an NRSRO.
(ii) The [bank]'s internal credit assessments of securitization
exposures used for risk-based capital purposes must be consistent
with those used in the [bank]'s internal risk management process,
management information reporting systems, and capital adequacy
assessment process.
(iii) The [bank]'s internal credit assessment process must have
sufficient granularity to identify gradations of risk. Each of the
[bank]'s internal credit assessment categories must correspond to an
external rating of an NRSRO.
(iv) The [bank]'s internal credit assessment process,
particularly the stress test factors for determining credit
enhancement requirements, must be at least as conservative as the
most conservative of the publicly available rating criteria of the
NRSROs that have provided external ratings to the commercial paper
issued by the ABCP program.
(A) Where the commercial paper issued by an ABCP program has an
external rating from
[[Page 69422]]
two or more NRSROs and the different NRSROs'' benchmark stress
factors require different levels of credit enhancement to achieve
the same external rating equivalent, the [bank] must apply the NRSRO
stress factor that requires the highest level of credit enhancement.
(B) If any NRSRO that provides an external rating to the ABCP
program's commercial paper changes its methodology (including stress
factors), the [bank] must evaluate whether to revise its internal
assessment process.
(v) The [bank] must have an effective system of controls and
oversight that ensures compliance with these operational
requirements and maintains the integrity and accuracy of the
internal credit assessments. The [bank] must have an internal audit
function independent from the ABCP program business line and
internal credit assessment process that assesses at least annually
whether the controls over the internal credit assessment process
function as intended.
(vi) The [bank] must review and update each internal credit
assessment whenever new material information is available, but no
less frequently than annually.
(vii) The [bank] must validate its internal credit assessment
process on an ongoing basis and at least annually.
(2) ABCP-program qualification criteria. An ABCP program
qualifies for use of the IAA if all commercial paper issued by the
ABCP program has an external rating.
(3) Exposure qualification criteria. A securitization exposure
qualifies for use of the IAA if the exposure meets the following
criteria:
(i) The [bank] initially rated the exposure at least the
equivalent of investment grade.
(ii) The ABCP program has robust credit and investment
guidelines (that is, underwriting standards) for the exposures
underlying the securitization exposure.
(iii) The ABCP program performs a detailed credit analysis of
the sellers of the exposures underlying the securitization exposure.
(iv) The ABCP program's underwriting policy for the exposures
underlying the securitization exposure establishes minimum asset
eligibility criteria that include the prohibition of the purchase of
assets that are significantly past due or of assets that are
defaulted (that is, assets that have been charged off or written
down by the seller prior to being placed into the ABCP program or
assets that would be charged off or written down under the program's
governing contracts), as well as limitations on concentration to
individual obligors or geographic areas and the tenor of the assets
to be purchased.
(v) The aggregate estimate of loss on the exposures underlying
the securitization exposure considers all sources of potential risk,
such as credit and dilution risk.
(vi) Where relevant, the ABCP program incorporates structural
features into each purchase of exposures underlying the
securitization exposure to mitigate potential credit deterioration
of the underlying exposures. Such features may include wind-down
triggers specific to a pool of underlying exposures.
(b) Mechanics. A [bank] that elects to use the IAA to calculate
the risk-based capital requirement for any securitization exposure
must use the IAA to calculate the risk-based capital requirements
for all securitization exposures that qualify for the IAA approach.
Under the IAA, a [bank] must map its internal assessment of such a
securitization exposure to an equivalent external rating from an
NRSRO. Under the IAA, a [bank] must determine the risk-weighted
asset amount for such a securitization exposure by multiplying the
amount of the exposure (as defined in paragraph (e) of section 42 of
this appendix) by the appropriate risk weight in Table 6 and Table 7
in paragraph (b) of section 43 of this appendix.
Section 45. Supervisory Formula Approach (SFA)
(a) Eligibility requirements. A [bank] may use the SFA to
determine its risk-based capital requirement for a securitization
exposure only if the [bank] can calculate on an ongoing basis each
of the SFA parameters in paragraph (e) of this section.
(b) Mechanics. Under the SFA, a securitization exposure incurs a
deduction from total capital (as described in paragraph (c) of
section 42 of this appendix) and/or an SFA risk-based capital
requirement, as determined in paragraph (c) of this section. The
risk-weighted asset amount for the securitization exposure equals
the SFA risk-based capital requirement for the exposure multiplied
by 12.5.
(c) The SFA risk-based capital requirement. (1) If
KIRB is greater than or equal to L + T, the entire
exposure must be deducted from total capital.
(2) If KIRB is less than or equal to L, the
exposure's SFA risk-based capital requirement is UE multiplied by TP
multiplied by the greater of:
(i) 0.0056 * T; or
(ii) S[L + T] - S[L].
(3) If KIRB is greater than L and less than L + T,
the [bank] must deduct from total capital an amount equal to
UE*TP*(KIRB - L), and the exposure's SFA risk-based
capital requirement is UE multiplied by TP multiplied by the greater
of:
(i) 0.0056 * (T - (KIRB - L)); or
(ii) S[L + T] - S[KIRB].
(d) The supervisory formula:
[[Page 69423]]
[GRAPHIC] [TIFF OMITTED] TR07DE07.017
(11) In these expressions, [beta][Y; a, b] refers to the
cumulative beta distribution with parameters a and b evaluated at Y.
In the case where N = 1 and EWALGD = 100 percent, S[Y] in formula
(1) must be calculated with K[Y] set equal to the product of
KIRB and Y, and d set equal to 1 - KIRB.
(e) SFA parameters--(1) Amount of the underlying exposures (UE).
UE is the EAD of any underlying exposures that are wholesale and
retail exposures (including the amount of any funded spread
accounts, cash collateral accounts, and other similar funded credit
enhancements) plus the amount of any underlying exposures that are
securitization exposures (as defined in paragraph (e) of section 42
of this appendix) plus the adjusted carrying value of any underlying
exposures that are equity exposures (as defined in paragraph (b) of
section 51 of this appendix).
(2) Tranche percentage (TP). TP is the ratio of the amount of
the [bank]'s securitization exposure to the amount of the tranche
that contains the securitization exposure.
(3) Capital requirement on underlying exposures (KIRB). (i)
KIRB is the ratio of:
(A) The sum of the risk-based capital requirements for the
underlying exposures plus the expected credit losses of the
underlying exposures (as determined under this appendix as if the
underlying exposures were directly held by the [bank]); to
(B) UE.
(ii) The calculation of KIRB must reflect the effects
of any credit risk mitigant applied to the underlying exposures
(either to an individual underlying exposure, to a group of
underlying exposures, or to the entire pool of underlying
exposures).
(iii) All assets related to the securitization are treated as
underlying exposures, including assets in a reserve account (such as
a cash collateral account).
(4) Credit enhancement level (L). (i) L is the ratio of:
(A) The amount of all securitization exposures subordinated to
the tranche that contains the [bank]'s securitization exposure; to
(B) UE.
(ii) A [bank] must determine L before considering the effects of
any tranche-specific credit enhancements.
(iii) Any gain-on-sale or CEIO associated with the
securitization may not be included in L.
(iv) Any reserve account funded by accumulated cash flows from
the underlying exposures that is subordinated to the tranche that
contains the [bank]'s securitization exposure may be included in the
numerator and denominator of L to the extent cash has accumulated in
the account. Unfunded reserve accounts (that is, reserve accounts
that are to be funded from future cash flows from the underlying
exposures) may not be included in the calculation of L.
(v) In some cases, the purchase price of receivables will
reflect a discount that provides credit enhancement (for example,
first loss protection) for all or certain tranches of the
securitization. When this arises, L should be calculated inclusive
of this discount if the discount provides credit enhancement for the
securitization exposure.
[[Page 69424]]
(5) Thickness of tranche (T). T is the ratio of:
(i) The amount of the tranche that contains the [bank]'s
securitization exposure; to
(ii) UE.
(6) Effective number of exposures (N). (i) Unless the [bank]
elects to use the formula provided in paragraph (f) of this section,
[GRAPHIC] [TIFF OMITTED] TR07DE07.018
where EADi represents the EAD associated with the ith
instrument in the pool of underlying exposures.
(ii) Multiple exposures to one obligor must be treated as a
single underlying exposure.
(iii) In the case of a re-securitization (that is, a
securitization in which some or all of the underlying exposures are
themselves securitization exposures), the [bank] must treat each
underlying exposure as a single underlying exposure and must not
look through to the originally securitized underlying exposures.
(7) Exposure-weighted average loss given default (EWALGD).
EWALGD is calculated as:
[GRAPHIC] [TIFF OMITTED] TR07DE07.019
where LGDi represents the average LGD associated with all
exposures to the ith obligor. In the case of a re-securitization, an
LGD of 100 percent must be assumed for the underlying exposures that
are themselves securitization exposures.
(f) Simplified method for computing N and EWALGD. (1) If all
underlying exposures of a securitization are retail exposures, a
[bank] may apply the SFA using the following simplifications:
(i) h = 0; and
(ii) v = 0.
(2) Under the conditions in paragraphs (f)(3) and (f)(4) of this
section, a [bank] may employ a simplified method for calculating N
and EWALGD.
(3) If C1 is no more than 0.03, a [bank] may set
EWALGD = 0.50 if none of the underlying exposures is a
securitization exposure or EWALGD = 1 if one or more of the
underlying exposures is a securitization exposure, and may set N
equal to the following amount:
[GRAPHIC] [TIFF OMITTED] TR07DE07.020
where:
(i) Cm is the ratio of the sum of the amounts of the
`m' largest underlying exposures to UE; and
(ii) The level of m is to be selected by the [bank].
(4) Alternatively, if only C1 is available and
C1 is no more than 0.03, the [bank] may set EWALGD = 0.50
if none of the underlying exposures is a securitization exposure or
EWALGD = 1 if one or more of the underlying exposures is a
securitization exposure and may set N = 1/C1.
Section 46. Recognition of Credit Risk Mitigants for Securitization
Exposures
(a) General. An originating [bank] that has obtained a credit
risk mitigant to hedge its securitization exposure to a synthetic or
traditional securitization that satisfies the operational criteria
in section 41 of this appendix may recognize the credit risk
mitigant, but only as provided in this section. An investing [bank]
that has obtained a credit risk mitigant to hedge a securitization
exposure may recognize the credit risk mitigant, but only as
provided in this section. A [bank] that has used the RBA in section
43 of this appendix or the IAA in section 44 of this appendix to
calculate its risk-based capital requirement for a securitization
exposure whose external or inferred rating (or equivalent internal
rating under the IAA) reflects the benefits of a credit risk
mitigant provided to the associated securitization or that supports
some or all of the underlying exposures may not use the credit risk
mitigation rules in this section to further reduce its risk-based
capital requirement for the exposure to reflect that credit risk
mitigant.
(b) Collateral--(1) Rules of recognition. A [bank] may recognize
financial collateral in determining the [bank]'s risk-based capital
requirement for a securitization exposure (other than a repo-style
transaction, an eligible margin loan, or an OTC derivative contract
for which the [bank] has reflected collateral in its determination
of exposure amount under section 32 of this appendix) as follows.
The [bank]'s risk-based capital requirement for the collateralized
securitization exposure is equal to the risk-based capital
requirement for the securitization exposure as calculated under the
RBA in section 43 of this appendix or under the SFA in section 45 of
this appendix multiplied by the ratio of adjusted exposure amount
(SE*) to original exposure amount (SE), where:
(i) SE* = max {0, [SE--C x (1-Hs-Hfx)]{time} ;
(ii) SE = the amount of the securitization exposure calculated
under paragraph (e) of section 42 of this appendix;
(iii) C = the current market value of the collateral;
(iv) Hs = the haircut appropriate to the collateral type; and
(v) Hfx = the haircut appropriate for any currency mismatch
between the collateral and the exposure.
(2) Mixed collateral. Where the collateral is a basket of
different asset types or a basket of assets denominated in different
currencies, the haircut on the basket will be
[GRAPHIC] [TIFF OMITTED] TR07DE07.023
where ai is the current market value of the asset in the
basket divided by the current market value of all assets in the
basket and Hi is the haircut applicable to that asset.
(3) Standard supervisory haircuts. Unless a [bank] qualifies for
use of and uses own-estimates haircuts in paragraph (b)(4) of this
section:
(i) A [bank] must use the collateral type haircuts (Hs) in Table
3;
(ii) A [bank] must use a currency mismatch haircut (Hfx) of 8
percent if the exposure and the collateral are denominated in
different currencies;
(iii) A [bank] must multiply the supervisory haircuts obtained
in paragraphs (b)(3)(i) and (ii) by the square root of 6.5 (which
equals 2.549510); and
(iv) A [bank] must adjust the supervisory haircuts upward on the
basis of a holding period longer than 65 business days where and as
appropriate to take into account the illiquidity of the collateral.
(4) Own estimates for haircuts. With the prior written approval
of the [AGENCY], a [bank] may calculate haircuts using its own
internal estimates of market price volatility and foreign exchange
volatility, subject to paragraph (b)(2)(iii) of section 32 of this
appendix. The minimum holding period (TM) for securitization
exposures is 65 business days.
(c) Guarantees and credit derivatives--(1) Limitations on
recognition. A [bank] may only recognize an eligible guarantee or
eligible credit derivative provided by an eligible securitization
guarantor in determining the [bank]'s risk-based capital requirement
for a securitization exposure.
(2) ECL for securitization exposures. When a [bank] recognizes
an eligible guarantee or eligible credit derivative provided by an
eligible securitization guarantor in determining the [bank]'s risk-
based capital requirement for a securitization exposure, the [bank]
must also:
(i) Calculate ECL for the protected portion of the exposure
using the same risk parameters that it uses for calculating the
risk-weighted asset amount of the exposure as described in paragraph
(c)(3) of this section; and
(ii) Add the exposure's ECL to the [bank]'s total ECL.
(3) Rules of recognition. A [bank] may recognize an eligible
guarantee or eligible credit derivative provided by an eligible
securitization guarantor in determining the
[[Page 69425]]
[bank]'s risk-based capital requirement for the securitization
exposure as follows:
(i) Full coverage. If the protection amount of the eligible
guarantee or eligible credit derivative equals or exceeds the amount
of the securitization exposure, the [bank] may set the risk-weighted
asset amount for the securitization exposure equal to the risk-
weighted asset amount for a direct exposure to the eligible
securitization guarantor (as determined in the wholesale risk weight
function described in section 31 of this appendix), using the
[bank]'s PD for the guarantor, the [bank]'s LGD for the guarantee or
credit derivative, and an EAD equal to the amount of the
securitization exposure (as determined in paragraph (e) of section
42 of this appendix).
(ii) Partial coverage. If the protection amount of the eligible
guarantee or eligible credit derivative is less than the amount of
the securitization exposure, the [bank] may set the risk-weighted
asset amount for the securitization exposure equal to the sum of:
(A) Covered portion. The risk-weighted asset amount for a direct
exposure to the eligible securitization guarantor (as determined in
the wholesale risk weight function described in section 31 of this
appendix), using the [bank]'s PD for the guarantor, the [bank]'s LGD
for the guarantee or credit derivative, and an EAD equal to the
protection amount of the credit risk mitigant; and
(B) Uncovered portion. (1) 1.0 minus the ratio of the protection
amount of the eligible guarantee or eligible credit derivative to
the amount of the securitization exposure); multiplied by
(2) The risk-weighted asset amount for the securitization
exposure without the credit risk mitigant (as determined in sections
42-45 of this appendix).
(4) Mismatches. The [bank] must make applicable adjustments to
the protection amount as required in paragraphs (d), (e), and (f) of
section 33 of this appendix for any hedged securitization exposure
and any more senior securitization exposure that benefits from the
hedge. In the context of a synthetic securitization, when an
eligible guarantee or eligible credit derivative covers multiple
hedged exposures that have different residual maturities, the [bank]
must use the longest residual maturity of any of the hedged
exposures as the residual maturity of all the hedged exposures.
Section 47. Risk-Based Capital Requirement for Early Amortization
Provisions
(a) General. (1) An originating [bank] must hold risk-based
capital against the sum of the originating [bank]'s interest and the
investors' interest in a securitization that:
(i) Includes one or more underlying exposures in which the
borrower is permitted to vary the drawn amount within an agreed
limit under a line of credit; and
(ii) Contains an early amortization provision.
(2) For securitizations described in paragraph (a)(1) of this
section, an originating [bank] must calculate the risk-based capital
requirement for the originating [bank]'s interest under sections 42-
45 of this appendix, and the risk-based capital requirement for the
investors' interest under paragraph (b) of this section.
(b) Risk-weighted asset amount for investors' interest. The
originating [bank]'s risk-weighted asset amount for the investors'
interest in the securitization is equal to the product of the
following 5 quantities:
(1) The investors' interest EAD;
(2) The appropriate conversion factor in paragraph (c) of this
section;
(3) KIRB (as defined in paragraph (e)(3) of section
45 of this appendix);
(4) 12.5; and
(5) The proportion of the underlying exposures in which the
borrower is permitted to vary the drawn amount within an agreed
limit under a line of credit.
(c) Conversion factor. (1) (i) Except as provided in paragraph
(c)(2) of this section, to calculate the appropriate conversion
factor, a [bank] must use Table 8 for a securitization that contains
a controlled early amortization provision and must use Table 9 for a
securitization that contains a non-controlled early amortization
provision. In circumstances where a securitization contains a mix of
retail and nonretail exposures or a mix of committed and uncommitted
exposures, a [bank] may take a pro rata approach to determining the
conversion factor for the securitization's early amortization
provision. If a pro rata approach is not feasible, a [bank] must
treat the mixed securitization as a securitization of nonretail
exposures if a single underlying exposure is a nonretail exposure
and must treat the mixed securitization as a securitization of
committed exposures if a single underlying exposure is a committed
exposure.
(ii) To find the appropriate conversion factor in the tables, a
[bank] must divide the three-month average annualized excess spread
of the securitization by the excess spread trapping point in the
securitization structure. In securitizations that do not require
excess spread to be trapped, or that specify trapping points based
primarily on performance measures other than the three-month average
annualized excess spread, the excess spread trapping point is 4.5
percent.
Table 8.--Controlled Early Amortization Provisions
------------------------------------------------------------------------
Uncommitted Committed
------------------------------------------------------------------------
Retail Credit Lines............ Three-month average 90% CF
annualized excess
spread Conversion
Factor (CF).
133.33% of trapping
point or more, 0% CF.
less than 133.33% to
100% of trapping
point, 1% CF.
less than 100% to 75%
of trapping point, 2%
CF.
less than 75% to 50%
of trapping point,
10% CF.
less than 50% to 25%
of trapping point,
20% CF.
less than 25% of
trapping point, 40%
CF.
Non-retail Credit Lines........ 90% CF................ 90% CF
------------------------------------------------------------------------
Table 9.--Non-Controlled Early Amortization Provisions
------------------------------------------------------------------------
Uncommitted Committed
------------------------------------------------------------------------
Retail Credit Lines............ Three-month average 100% CF
annualized excess
spread Conversion
Factor (CF).
133.33% of trapping
point or more, 0% CF.
less than 133.33% to
100% of trapping
point, 5% CF.
less than 100% to 75%
of trapping point,
15% CF.
less than 75% to 50%
of trapping point,
50% CF.
less than 50% of
trapping point, 100%
CF.
Non-retail Credit Lines........ 100% CF............... 100% CF
------------------------------------------------------------------------
(2) For a securitization for which all or substantially all of
the underlying exposures are residential mortgage exposures, a
[bank] may calculate the appropriate conversion factor using
paragraph (c)(1) of this section or may use a conversion factor of
10 percent. If the [bank] chooses to use a conversion factor of 10
percent, it must use that conversion factor for all securitizations
for which all or substantially all of the underlying exposures are
residential mortgage exposures.
[[Page 69426]]
Part VI. Risk-Weighted Assets for Equity Exposures
Section 51. Introduction and Exposure Measurement
(a) General. To calculate its risk-weighted asset amounts for
equity exposures that are not equity exposures to investment funds,
a [bank] may apply either the Simple Risk Weight Approach (SRWA) in
section 52 of this appendix or, if it qualifies to do so, the
Internal Models Approach (IMA) in section 53 of this appendix. A
[bank] must use the look-through approaches in section 54 of this
appendix to calculate its risk-weighted asset amounts for equity
exposures to investment funds.
(b) Adjusted carrying value. For purposes of this part, the
adjusted carrying value of an equity exposure is:
(1) For the on-balance sheet component of an equity exposure,
the [bank]'s carrying value of the exposure reduced by any
unrealized gains on the exposure that are reflected in such carrying
value but excluded from the [bank]'s tier 1 and tier 2 capital; and
(2) For the off-balance sheet component of an equity exposure,
the effective notional principal amount of the exposure, the size of
which is equivalent to a hypothetical on-balance sheet position in
the underlying equity instrument that would evidence the same change
in fair value (measured in dollars) for a given small change in the
price of the underlying equity instrument, minus the adjusted
carrying value of the on-balance sheet component of the exposure as
calculated in paragraph (b)(1) of this section. For unfunded equity
commitments that are unconditional, the effective notional principal
amount is the notional amount of the commitment. For unfunded equity
commitments that are conditional, the effective notional principal
amount is the [bank]'s best estimate of the amount that would be
funded under economic downturn conditions.
Section 52. Simple Risk Weight Approach (SRWA)
(a) General. Under the SRWA, a [bank]'s aggregate risk-weighted
asset amount for its equity exposures is equal to the sum of the
risk-weighted asset amounts for each of the [bank]'s individual
equity exposures (other than equity exposures to an investment fund)
as determined in this section and the risk-weighted asset amounts
for each of the [bank]'s individual equity exposures to an
investment fund as determined in section 54 of this appendix.
(b) SRWA computation for individual equity exposures. A [bank]
must determine the risk-weighted asset amount for an individual
equity exposure (other than an equity exposure to an investment
fund) by multiplying the adjusted carrying value of the equity
exposure or the effective portion and ineffective portion of a hedge
pair (as defined in paragraph (c) of this section) by the lowest
applicable risk weight in this paragraph (b).
(1) 0 percent risk weight equity exposures. An equity exposure
to an entity whose credit exposures are exempt from the 0.03 percent
PD floor in paragraph (d)(2) of section 31 of this appendix is
assigned a 0 percent risk weight.
(2) 20 percent risk weight equity exposures. An equity exposure
to a Federal Home Loan Bank or Farmer Mac is assigned a 20 percent
risk weight.
(3) 100 percent risk weight equity exposures. The following
equity exposures are assigned a 100 percent risk weight:
(i) Community development equity exposures. An equity exposure
that qualifies as a community development investment under 12 U.S.C.
24 (Eleventh), excluding equity exposures to an unconsolidated small
business investment company and equity exposures held through a
consolidated small business investment company described in section
302 of the Small Business Investment Act of 1958 (15 U.S.C. 682).
(ii) Effective portion of hedge pairs. The effective portion of
a hedge pair.
(iii) Non-significant equity exposures. Equity exposures,
excluding exposures to an investment firm that would meet the
definition of a traditional securitization were it not for the
[AGENCY]'s application of paragraph (8) of that definition and has
greater than immaterial leverage, to the extent that the aggregate
adjusted carrying value of the exposures does not exceed 10 percent
of the [bank]'s tier 1 capital plus tier 2 capital.
(A) To compute the aggregate adjusted carrying value of a
[bank]'s equity exposures for purposes of this paragraph
(b)(3)(iii), the [bank] may exclude equity exposures described in
paragraphs (b)(1), (b)(2), (b)(3)(i), and (b)(3)(ii) of this
section, the equity exposure in a hedge pair with the smaller
adjusted carrying value, and a proportion of each equity exposure to
an investment fund equal to the proportion of the assets of the
investment fund that are not equity exposures or that meet the
criterion of paragraph (b)(3)(i) of this section. If a [bank] does
not know the actual holdings of the investment fund, the [bank] may
calculate the proportion of the assets of the fund that are not
equity exposures based on the terms of the prospectus, partnership
agreement, or similar contract that defines the fund's permissible
investments. If the sum of the investment limits for all exposure
classes within the fund exceeds 100 percent, the [bank] must assume
for purposes of this paragraph (b)(3)(iii) that the investment fund
invests to the maximum extent possible in equity exposures.
(B) When determining which of a [bank]'s equity exposures
qualify for a 100 percent risk weight under this paragraph, a [bank]
first must include equity exposures to unconsolidated small business
investment companies or held through consolidated small business
investment companies described in section 302 of the Small Business
Investment Act of 1958 (15 U.S.C. 682), then must include publicly
traded equity exposures (including those held indirectly through
investment funds), and then must include non-publicly traded equity
exposures (including those held indirectly through investment
funds).
(4) 300 percent risk weight equity exposures. A publicly traded
equity exposure (other than an equity exposure described in
paragraph (b)(6) of this section and including the ineffective
portion of a hedge pair) is assigned a 300 percent risk weight.
(5) 400 percent risk weight equity exposures. An equity exposure
(other than an equity exposure described in paragraph (b)(6) of this
section) that is not publicly traded is assigned a 400 percent risk
weight.
(6) 600 percent risk weight equity exposures. An equity exposure
to an investment firm that:
(i) Would meet the definition of a traditional securitization
were it not for the [AGENCY]'s application of paragraph (8) of that
definition; and
(ii) Has greater than immaterial leverage is assigned a 600
percent risk weight.
(c) Hedge transactions--(1) Hedge pair. A hedge pair is two
equity exposures that form an effective hedge so long as each equity
exposure is publicly traded or has a return that is primarily based
on a publicly traded equity exposure.
(2) Effective hedge. Two equity exposures form an effective
hedge if the exposures either have the same remaining maturity or
each has a remaining maturity of at least three months; the hedge
relationship is formally documented in a prospective manner (that
is, before the [bank] acquires at least one of the equity
exposures); the documentation specifies the measure of effectiveness
(E) the [bank] will use for the hedge relationship throughout the
life of the transaction; and the hedge relationship has an E greater
than or equal to 0.8. A [bank] must measure E at least quarterly and
must use one of three alternative measures of E:
(i) Under the dollar-offset method of measuring effectiveness,
the [bank] must determine the ratio of value change (RVC). The RVC
is the ratio of the cumulative sum of the periodic changes in value
of one equity exposure to the cumulative sum of the periodic changes
in the value of the other equity exposure. If RVC is positive, the
hedge is not effective and E equals 0. If RVC is negative and
greater than or equal to -1 (that is, between zero and -1), then E
equals the absolute value of RVC. If RVC is negative and less than -
1, then E equals 2 plus RVC.
(ii) Under the variability-reduction method of measuring
effectiveness:
[[Page 69427]]
[GRAPHIC] [TIFF OMITTED] TR07DE07.021
(A) Xt = At - Bt;
(B) At = the value at time t of one exposure in a hedge
pair; and
(C) Bt = the value at time t of the other exposure in a
hedge pair.
(iii) Under the regression method of measuring effectiveness, E
equals the coefficient of determination of a regression in which the
change in value of one exposure in a hedge pair is the dependent
variable and the change in value of the other exposure in a hedge
pair is the independent variable. However, if the estimated
regression coefficient is positive, then the value of E is zero.
(3) The effective portion of a hedge pair is E multiplied by the
greater of the adjusted carrying values of the equity exposures
forming a hedge pair.
(4) The ineffective portion of a hedge pair is (1-E) multiplied
by the greater of the adjusted carrying values of the equity
exposures forming a hedge pair.
Section 53. Internal Models Approach (IMA)
(a) General. A [bank] may calculate its risk-weighted asset
amount for equity exposures using the IMA by modeling publicly
traded and non-publicly traded equity exposures (in accordance with
paragraph (c) of this section) or by modeling only publicly traded
equity exposures (in accordance with paragraph (d) of this section).
(b) Qualifying criteria. To qualify to use the IMA to calculate
risk-based capital requirements for equity exposures, a [bank] must
receive prior written approval from the [AGENCY]. To receive such
approval, the [bank] must demonstrate to the [AGENCY]'s satisfaction
that the [bank] meets the following criteria:
(1) The [bank] must have one or more models that:
(i) Assess the potential decline in value of its modeled equity
exposures;
(ii) Are commensurate with the size, complexity, and composition
of the [bank]'s modeled equity exposures; and
(iii) Adequately capture both general market risk and
idiosyncratic risk.
(2) The [bank]'s model must produce an estimate of potential
losses for its modeled equity exposures that is no less than the
estimate of potential losses produced by a VaR methodology employing
a 99.0 percent, one-tailed confidence interval of the distribution
of quarterly returns for a benchmark portfolio of equity exposures
comparable to the [bank]'s modeled equity exposures using a long-
term sample period.
(3) The number of risk factors and exposures in the sample and
the data period used for quantification in the [bank]'s model and
benchmarking exercise must be sufficient to provide confidence in
the accuracy and robustness of the [bank]'s estimates.
(4) The [bank]'s model and benchmarking process must incorporate
data that are relevant in representing the risk profile of the
[bank]'s modeled equity exposures, and must include data from at
least one equity market cycle containing adverse market movements
relevant to the risk profile of the [bank]'s modeled equity
exposures. In addition, the [bank]'s benchmarking exercise must be
based on daily market prices for the benchmark portfolio. If the
[bank]'s model uses a scenario methodology, the [bank] must
demonstrate that the model produces a conservative estimate of
potential losses on the [bank]'s modeled equity exposures over a
relevant long-term market cycle. If the [bank] employs risk factor
models, the [bank] must demonstrate through empirical analysis the
appropriateness of the risk factors used.
(5) The [bank] must be able to demonstrate, using theoretical
arguments and empirical evidence, that any proxies used in the
modeling process are comparable to the [bank]'s modeled equity
exposures and that the [bank] has made appropriate adjustments for
differences. The [bank] must derive any proxies for its modeled
equity exposures and benchmark portfolio using historical market
data that are relevant to the [bank]'s modeled equity exposures and
benchmark portfolio (or, where not, must use appropriately adjusted
data), and such proxies must be robust estimates of the risk of the
[bank]'s modeled equity exposures.
(c) Risk-weighted assets calculation for a [bank] modeling
publicly traded and non-publicly traded equity exposures. If a
[bank] models publicly traded and non-publicly traded equity
exposures, the [bank]'s aggregate risk-weighted asset amount for its
equity exposures is equal to the sum of:
(1) The risk-weighted asset amount of each equity exposure that
qualifies for a 0 percent, 20 percent, or 100 percent risk weight
under paragraphs (b)(1) through (b)(3)(i) of section 52 (as
determined under section 52 of this appendix) and each equity
exposure to an investment fund (as determined under section 54 of
this appendix); and
(2) The greater of:
(i) The estimate of potential losses on the [bank]'s equity
exposures (other than equity exposures referenced in paragraph
(c)(1) of this section) generated by the [bank]'s internal equity
exposure model multiplied by 12.5; or
(ii) The sum of:
(A) 200 percent multiplied by the aggregate adjusted carrying
value of the [bank]'s publicly traded equity exposures that do not
belong to a hedge pair, do not qualify for a 0 percent, 20 percent,
or 100 percent risk weight under paragraphs (b)(1) through (b)(3)(i)
of section 52 of this appendix, and are not equity exposures to an
investment fund;
(B) 200 percent multiplied by the aggregate ineffective portion
of all hedge pairs; and
(C) 300 percent multiplied by the aggregate adjusted carrying
value of the [bank]'s equity exposures that are not publicly traded,
do not qualify for a 0 percent, 20 percent, or 100 percent risk
weight under paragraphs (b)(1) through (b)(3)(i) of section 52 of
this appendix, and are not equity exposures to an investment fund.
(d) Risk-weighted assets calculation for a [bank] using the IMA
only for publicly traded equity exposures. If a [bank] models only
publicly traded equity exposures, the [bank]'s aggregate risk-
weighted asset amount for its equity exposures is equal to the sum
of:
(1) The risk-weighted asset amount of each equity exposure that
qualifies for a 0 percent, 20 percent, or 100 percent risk weight
under paragraphs (b)(1) through (b)(3)(i) of section 52 (as
determined under section 52 of this appendix), each equity exposure
that qualifies for a 400 percent risk weight under paragraph (b)(5)
of section 52 or a 600 percent risk weight under paragraph (b)(6) of
section 52 (as determined under section 52 of this appendix), and
each equity exposure to an investment fund (as determined under
section 54 of this appendix); and
(2) The greater of:
(i) The estimate of potential losses on the [bank]'s equity
exposures (other than equity exposures referenced in paragraph
(d)(1) of this section) generated by the [bank]'s internal equity
exposure model multiplied by 12.5; or
(ii) The sum of:
(A) 200 percent multiplied by the aggregate adjusted carrying
value of the [bank]'s publicly traded equity exposures that do not
belong to a hedge pair, do not qualify for a 0 percent, 20 percent,
or 100 percent risk weight under paragraphs (b)(1) through (b)(3)(i)
of section 52 of this appendix, and are not equity exposures to an
investment fund; and
(B) 200 percent multiplied by the aggregate ineffective portion
of all hedge pairs.
Section 54. Equity Exposures to Investment Funds
(a) Available approaches. (1) Unless the exposure meets the
requirements for a community development equity exposure in
paragraph (b)(3)(i) of section 52 of this appendix, a [bank] must
determine the risk-weighted asset amount of an equity exposure to an
investment fund under the Full Look-Through Approach in paragraph
(b) of this section, the Simple Modified Look-Through Approach in
paragraph (c) of this section, the Alternative Modified Look-Through
Approach in paragraph (d) of this section, or, if the investment
fund qualifies for the Money Market Fund Approach, the Money Market
Fund Approach in paragraph (e) of this section.
(2) The risk-weighted asset amount of an equity exposure to an
investment fund that
[[Page 69428]]
meets the requirements for a community development equity exposure
in paragraph (b)(3)(i) of section 52 of this appendix is its
adjusted carrying value.
(3) If an equity exposure to an investment fund is part of a
hedge pair and the [bank] does not use the Full Look-Through
Approach, the [bank] may use the ineffective portion of the hedge
pair as determined under paragraph (c) of section 52 of this
appendix as the adjusted carrying value for the equity exposure to
the investment fund. The risk-weighted asset amount of the effective
portion of the hedge pair is equal to its adjusted carrying value.
(b) Full Look-Through Approach. A [bank] that is able to
calculate a risk-weighted asset amount for its proportional
ownership share of each exposure held by the investment fund (as
calculated under this appendix as if the proportional ownership
share of each exposure were held directly by the [bank]) may either:
(1) Set the risk-weighted asset amount of the [bank]'s exposure
to the fund equal to the product of:
(i) The aggregate risk-weighted asset amounts of the exposures
held by the fund as if they were held directly by the [bank]; and
(ii) The [bank]'s proportional ownership share of the fund; or
(2) Include the [bank]'s proportional ownership share of each
exposure held by the fund in the [bank]'s IMA.
(c) Simple Modified Look-Through Approach. Under this approach,
the risk-weighted asset amount for a [bank]'s equity exposure to an
investment fund equals the adjusted carrying value of the equity
exposure multiplied by the highest risk weight in Table 10 that
applies to any exposure the fund is permitted to hold under its
prospectus, partnership agreement, or similar contract that defines
the fund's permissible investments (excluding derivative contracts
that are used for hedging rather than speculative purposes and that
do not constitute a material portion of the fund's exposures).
Table 10.--Modified Look-Through Approaches for Equity Exposures to
Investment Funds
------------------------------------------------------------------------
Risk weight Exposure class
------------------------------------------------------------------------
0 percent................................ Sovereign exposures with a
long-term applicable
external rating in the
highest investment-grade
rating category and
sovereign exposures of the
United States.
20 percent............................... Non-sovereign exposures with
a long-term applicable
external rating in the
highest or second-highest
investment-grade rating
category; exposures with a
short-term applicable
external rating in the
highest investment-grade
rating category; and
exposures to, or guaranteed
by, depository institutions,
foreign banks (as defined in
12 CFR 211.2), or securities
firms subject to
consolidated supervision and
regulation comparable to
that imposed on U.S.
securities broker-dealers
that are repo-style
transactions or bankers'
acceptances.
50 percent............................... Exposures with a long-term
applicable external rating
in the third-highest
investment-grade rating
category or a short-term
applicable external rating
in the second-highest
investment-grade rating
category.
100 percent.............................. Exposures with a long-term or
short-term applicable
external rating in the
lowest investment-grade
rating category.
200 percent.............................. Exposures with a long-term
applicable external rating
one rating category below
investment grade.
300 percent.............................. Publicly traded equity
exposures.
400 percent.............................. Non-publicly traded equity
exposures; exposures with a
long-term applicable
external rating two rating
categories or more below
investment grade; and
exposures without an
external rating (excluding
publicly traded equity
exposures).
1,250 percent............................ OTC derivative contracts and
exposures that must be
deducted from regulatory
capital or receive a risk
weight greater than 400
percent under this appendix.
------------------------------------------------------------------------
(d) Alternative Modified Look-Through Approach. Under this
approach, a [bank] may assign the adjusted carrying value of an
equity exposure to an investment fund on a pro rata basis to
different risk weight categories in Table 10 based on the investment
limits in the fund's prospectus, partnership agreement, or similar
contract that defines the fund's permissible investments. The risk-
weighted asset amount for the [bank]'s equity exposure to the
investment fund equals the sum of each portion of the adjusted
carrying value assigned to an exposure class multiplied by the
applicable risk weight. If the sum of the investment limits for
exposure classes within the fund exceeds 100 percent, the [bank]
must assume that the fund invests to the maximum extent permitted
under its investment limits in the exposure class with the highest
risk weight under Table 10, and continues to make investments in
order of the exposure class with the next highest risk weight under
Table 10 until the maximum total investment level is reached. If
more than one exposure class applies to an exposure, the [bank] must
use the highest applicable risk weight. A [bank] may exclude
derivative contracts held by the fund that are used for hedging
rather than for speculative purposes and do not constitute a
material portion of the fund's exposures.
(e) Money Market Fund Approach. The risk-weighted asset amount
for a [bank]'s equity exposure to an investment fund that is a money
market fund subject to 17 CFR 270.2a-7 and that has an applicable
external rating in the highest investment-grade rating category
equals the adjusted carrying value of the equity exposure multiplied
by 7 percent.
Section 55. Equity Derivative Contracts
Under the IMA, in addition to holding risk-based capital against
an equity derivative contract under this part, a [bank] must hold
risk-based capital against the counterparty credit risk in the
equity derivative contract by also treating the equity derivative
contract as a wholesale exposure and computing a supplemental risk-
weighted asset amount for the contract under part IV. Under the
SRWA, a [bank] may choose not to hold risk-based capital against the
counterparty credit risk of equity derivative contracts, as long as
it does so for all such contracts. Where the equity derivative
contracts are subject to a qualified master netting agreement, a
[bank] using the SRWA must either include all or exclude all of the
contracts from any measure used to determine counterparty credit
risk exposure.
Part VII. Risk-Weighted Assets for Operational Risk
Section 61. Qualification Requirements for Incorporation of
Operational Risk Mitigants
(a) Qualification to use operational risk mitigants. A [bank]
may adjust its estimate of operational risk exposure to reflect
qualifying operational risk mitigants if:
(1) The [bank]'s operational risk quantification system is able
to generate an estimate of the [bank]'s operational risk exposure
(which does not incorporate qualifying operational risk mitigants)
and an estimate of the [bank]'s operational risk exposure adjusted
to incorporate qualifying operational risk mitigants; and
(2) The [bank]'s methodology for incorporating the effects of
insurance, if the [bank] uses insurance as an operational risk
mitigant, captures through appropriate discounts to the amount of
risk mitigation:
(i) The residual term of the policy, where less than one year;
(ii) The cancellation terms of the policy, where less than one
year;
(iii) The policy's timeliness of payment;
(iv) The uncertainty of payment by the provider of the policy;
and
(v) Mismatches in coverage between the policy and the hedged
operational loss event.
(b) Qualifying operational risk mitigants. Qualifying
operational risk mitigants are:
(1) Insurance that:
(i) Is provided by an unaffiliated company that has a claims
payment ability that is rated in one of the three highest rating
categories by a NRSRO;
(ii) Has an initial term of at least one year and a residual
term of more than 90 days;
[[Page 69429]]
(iii) Has a minimum notice period for cancellation by the
provider of 90 days;
(iv) Has no exclusions or limitations based upon regulatory
action or for the receiver or liquidator of a failed depository
institution; and
(v) Is explicitly mapped to a potential operational loss event;
and
(2) Operational risk mitigants other than insurance for which
the [AGENCY] has given prior written approval. In evaluating an
operational risk mitigant other than insurance, the [AGENCY] will
consider whether the operational risk mitigant covers potential
operational losses in a manner equivalent to holding regulatory
capital.
Section 62. Mechanics of Risk-Weighted Asset Calculation
(a) If a [bank] does not qualify to use or does not have
qualifying operational risk mitigants, the [bank]'s dollar risk-
based capital requirement for operational risk is its operational
risk exposure minus eligible operational risk offsets (if any).
(b) If a [bank] qualifies to use operational risk mitigants and
has qualifying operational risk mitigants, the [bank]'s dollar risk-
based capital requirement for operational risk is the greater of:
(1) The [bank]'s operational risk exposure adjusted for
qualifying operational risk mitigants minus eligible operational
risk offsets (if any); or
(2) 0.8 multiplied by the difference between:
(i) The [bank]'s operational risk exposure; and
(ii) Eligible operational risk offsets (if any).
(c) The [bank]'s risk-weighted asset amount for operational risk
equals the [bank]'s dollar risk-based capital requirement for
operational risk determined under paragraph (a) or (b) of this
section multiplied by 12.5.
Part VIII. Disclosure
Section 71. Disclosure Requirements
(a) Each [bank] must publicly disclose each quarter its total
and tier 1 risk-based capital ratios and their components (that is,
tier 1 capital, tier 2 capital, total qualifying capital, and total
risk-weighted assets).\4\
---------------------------------------------------------------------------
\4\ Other public disclosure requirements continue to apply--for
example, Federal securities law and regulatory reporting
requirements.
---------------------------------------------------------------------------
[Disclosure paragraph (b)]
[Disclosure paragraph (c)] *****************
END OF COMMON RULE
[END OF COMMON TEXT]
List of Subjects
12 CFR Part 3
Administrative practices and procedure, Capital, National banks,
Reporting and recordkeeping requirements, Risk.
12 CFR Part 208
Confidential business information, Crime, Currency, Federal Reserve
System, Mortgages, reporting and recordkeeping requirements,
Securities.
12 CFR Part 225
Administrative practice and procedure, Banks, banking, Federal
Reserve System, Holding companies, Reporting and recordkeeping
requirements, Securities.
12 CFR Part 325
Administrative practice and procedure, Banks, banking, Capital
Adequacy, Reporting and recordkeeping requirements, Savings
associations, State nonmember banks.
12 CFR Part 559
Reporting and recordkeeping requirements, Savings associations,
Subsidiaries.
12 CFR Part 560
Consumer protection, Investments, Manufactured homes, Mortgages,
Reporting and recordkeeping requirements, Savings associations,
Securities.
12 CFR Part 563
Accounting, Administrative practice and procedure, Advertising,
Conflict of interest, Crime, Currency, Holding companies, Investments,
Mortgages, Reporting and recordkeeping requirements, Savings
associations, Securities, Surety bond.
12 CFR Part 567
Capital, Reporting and recordkeeping requirements, Savings
associations.
Adoption of Common Appendix
0
The adoption of the final common rules by the agencies, as modified by
agency-specific text, is set forth below:
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Chapter I
Authority and Issuance
For the reasons stated in the common preamble, the Office of the
Comptroller of the Currency amends part 3 of chapter I of Title 12,
Code of Federal Regulations as follows:
PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES
0
1. The authority citation for part 3 continues to read as follows:
Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n
note, 1835, 3907, and 3909.
0
2. New Appendix C to part 3 is added as set forth at the end of the
common preamble.
0
3. Appendix C to part 3 is amended as set forth below:
0
a. Remove ``[AGENCY]'' and add ``OCC'' in its place wherever it
appears.
0
b. Remove ``[bank]'' and add ``bank'' in its place wherever it appears,
remove ``[banks]'' and add ``banks'' in its place wherever it appears,
remove ``[Banks]'' and add ``Banks'' in its place wherever it appears,
and remove ``[Bank]'' and add ``Bank'' in its place wherever it
appears.
0
c. Remove ``[Appendix-- to Part --]'' and add ``Appendix C to Part 3''
in its place wherever it appears.
0
d. Remove ``[the general risk-based capital rules]'' and add ``12 CFR
part 3, Appendix A'' in its place wherever it appears.
0
e. Remove ``[the market risk rule]'' and add ``12 CFR part 3, Appendix
B'' in its place wherever it appears.
0
f. In section 1, revise paragraph (b)(1)(i), the last sentence in
paragraph (b)(3), and the last sentence in paragraph (c)(1) to read as
follows:
Section 1. Purpose, Applicability, Reservation of Authority, and
Principle of Conservatism
* * * * *
(b) Applicability. (1) * * *
(i) Has consolidated assets, as reported on the most recent year-
end Consolidated Report of Condition and Income (Call Report) equal to
$250 billion or more; * * *
(3) * * * In making a determination under this paragraph, the OCC
will apply notice and response procedures in the same manner and to the
same extent as the notice and response procedures in 12 CFR 3.12.
(c) Reservation of authority--(1) * * * In making a determination
under this paragraph, the OCC will apply notice and response procedures
in the same manner and to the same extent as the notice and response
procedures in 12 CFR 3.12.
* * * * *
0
g. In section 2, revise the definition of excluded mortgage exposure,
the definition of gain-on-sale, and paragraph (2)(i) of the definition
of high volatility commercial real estate (HVCRE) exposure to read as
follows:
Section 2. Definitions
* * * * *
Excluded mortgage exposure means any one- to four-family
residential pre-sold construction loan for a residence for which the
purchase contract is cancelled that would receive a 100 percent risk
weight under section 618(a)(2) of the Resolution Trust Corporation
Refinancing, Restructuring, and Improvement Act and under and 12
[[Page 69430]]
CFR part 3, Appendix A, section 3(a)(3)(iii).
* * * * *
Gain-on-sale means an increase in the equity capital (as reported
on Schedule RC of the Call Report) of a bank that results from a
securitization (other than an increase in equity capital that results
from the bank's receipt of cash in connection with the securitization).
* * * * *
High volatility commercial real estate (HVCRE) exposure * * *
(2) * * *
(i) The loan-to-value ratio is less than or equal to the applicable
maximum supervisory loan-to-value ratio in the OCC's real estate
lending standards at 12 CFR part 34, Subpart D;
* * * * *
0
h. Revise section 12 to read as follows:
Section 12. Deductions and Limitations Not Required
(a) Deduction of CEIOs. A bank is not required to make the
deductions from capital for CEIOs in 12 CFR part 3, Appendix A, section
2(c).
(b) Deduction of certain equity investments. A bank is not required
to make the deductions from capital for nonfinancial equity investments
in 12 CFR part 3, Appendix A, section 2(c).
* * * * *
0
i. Revise the first sentence of paragraph (k)(1)(iv) and paragraph
(k)(4) of section 42 to read as follows:
Section 42. Risk-Based Capital Requirement for Securitization Exposures
* * * * *
(k) * * *
(1) * * *
(iv) The bank is well capitalized, as defined in the OCC's prompt
corrective action regulation at 12 CFR part 6. * * *
* * * * *
(4) The risk-based capital ratios of the bank must be calculated
without regard to the capital treatment for transfers of small-business
obligations with recourse specified in paragraph (k)(1) of this section
as provided in 12 CFR part 3, Appendix A.
* * * * *
0
j. Remove ``[Disclosure paragraph (b)]'' and add in its place ``(b) A
bank must comply with paragraph (b) of section 71 of appendix G to the
Federal Reserve Board's Regulation Y (12 CFR part 225, appendix G)
unless it is a consolidated subsidiary of a bank holding company or
depository institution that is subject to these requirements.''
0
k. Remove ``[Disclosure paragraph (c)].''
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
12 CFR Chapter II
Authority and Issuance
0
For the reasons stated in the common preamble, the Board of Governors
of the Federal Reserve System amends parts 208 and 225 of chapter II of
title 12 of the Code of Federal Regulations as follows:
PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL
RESERVE SYSTEM (REGULATION H)
0
1. The authority citation for part 208 continues to read as follows:
Authority: 12 U.S.C. 24, 36, 92a, 93a, 248(a), 248(c), 321-338a,
371d, 461, 481-486, 601, 611, 1814, 1816, 1818, 1820(d)(9), 1823(j),
1828(o), 1831, 1831o, 1831p-1, 1831r-1, 1835a, 1882, 2901-2907,
3105, 3310, 3331-3351, and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g),
78l(i), 78o-4(c)(5), 78q, 78q-1, and 78w, 6801, and 6805; 31 U.S.C.
5318; 42 U.S.C. 4012a, 4104a, 4104b, 4106, and 4128.
0
2. New Appendix F to part 208 is added as set forth at the end of the
common preamble.
0
3. Appendix F to part 208 is amended as set forth below:
0
a. Remove ``[AGENCY]'' and add ``Federal Reserve'' in its place
wherever it appears.
0
b. Remove ``[bank]'' and add ``bank'' in its place wherever it appears,
remove ``[banks]'' and add ``banks'' in its place wherever it appears,
remove ``[Banks]'' and add ``Banks'' in its place wherever it appears,
and remove ``[Bank]'' and add ``Bank'' in its place wherever it
appears.
0
c. Remove ``[Appendix -- to Part --]'' and add ``Appendix F to part
208'' in its place wherever it appears.
0
d. Remove ``[the general risk-based capital rules]'' and add ``12 CFR
part 208, Appendix A'' in its place wherever it appears.
0
e. Remove ``[the market risk rule]'' and add ``12 CFR part 208,
Appendix E'' in its place wherever it appears.
0
f. In section 1, revise paragraph (b)(1)(i), the last sentence in
paragraph (b)(3), and the last sentence in paragraph (c)(1) to read as
follows:
Section 1. Purpose, Applicability, Reservation of Authority, and
Principle of Conservatism
* * * * *
(b) Applicability. (1) * * *
(i) Has consolidated assets, as reported on the most recent year-
end Consolidated Report of Condition and Income (Call Report) equal to
$250 billion or more; * * *
(3) * * * In making a determination under this paragraph, the
Federal Reserve will apply notice and response procedures in the same
manner and to the same extent as the notice and response procedures in
12 CFR 263.202.
(c) Reservation of authority--(1) * * * In making a determination
under this paragraph, the Federal Reserve will apply notice and
response procedures in the same manner and to the same extent as the
notice and response procedures in 12 CFR 263.202.
* * * * *
0
g. In section 2, revise the definition of excluded mortgage exposure,
the definition of gain-on-sale, and paragraph (2)(i) of the definition
of high volatility commercial real estate (HVCRE) exposure to read as
follows:
Section 2. Definitions
* * * * *
Excluded mortgage exposure means any one- to four-family
residential pre-sold construction loan for a residence for which the
purchase contract is cancelled that would receive a 100 percent risk
weight under section 618(a)(2) of the Resolution Trust Corporation
Refinancing, Restructuring, and Improvement Act and under and 12 CFR
part 208, Appendix A, section III.C.3.
* * * * *
Gain-on-sale means an increase in the equity capital (as reported
on Schedule RC of the Call Report) of a bank that results from a
securitization (other than an increase in equity capital that results
from the bank's receipt of cash in connection with the securitization).
* * * * *
High volatility commercial real estate (HVCRE) exposure * * *
(2) * * *
(i) The loan-to-value ratio is less than or equal to the applicable
maximum supervisory loan-to-value ratio in the Federal Reserve's real
estate lending standards at 12 CFR part 208, Appendix C;
* * * * *
0
h. Revise section 12 to read as follows:
Section 12. Deductions and Limitations Not Required
(a) Deduction of CEIOs. A bank is not required to make the
deductions from capital for CEIOs in 12 CFR part 208, Appendix A,
section II.B.1.e.
(b) Deduction of certain equity investments. A bank is not required
to make the deductions from capital for nonfinancial equity investments
in 12
[[Page 69431]]
CFR part 208, Appendix A, section II.B.5.
* * * * *
0
i. Revise the first sentence of paragraph (k)(1)(iv) and paragraph
(k)(4) of section 42 to read as follows:
Section 42. Risk-Based Capital Requirement for Securitization Exposures
* * * * *
(k) * * *
(1) * * *
(iv) The bank is well capitalized, as defined in the Federal
Reserve's prompt corrective action regulation at 12 CFR part 208,
Subpart D.* * *
* * * * *
(4) The risk-based capital ratios of the bank must be calculated
without regard to the capital treatment for transfers of small-business
obligations with recourse specified in paragraph (k)(1) of this section
as provided in 12 CFR part 208, Appendix A.
* * * * *
0
j. Remove ``[Disclosure paragraph (b)]'' and add in its place ``(b) A
bank must comply with paragraph (b) of section 71 of appendix G to the
Federal Reserve Board's Regulation (12 CFR part 225, appendix G) unless
it is a consolidated subsidiary of a bank holding company or depository
institution that is subject to these requirements.''
0
k. Remove ``[Disclosure paragraph (c)].''
PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL
(REGULATION Y)
0
1. The authority citation for part 225 continues to read as follows:
Authority: 12 U.S.C. 1817(j)(13), 1818, 1828(o), 1831i, 1831p-1,
1843(c)(8), 1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 3907, and
3909; 15 U.S.C. 6801 and 6805.
0
2. New Appendix G to part 225 is added as set forth at the end of the
common preamble.
0
3. Appendix G to part 225 is amended as set forth below:
0
a. Remove ``[AGENCY]'' and add ``Federal Reserve'' in its place
wherever it appears.
0
b. Remove ``[bank]'' and add in its place ``bank holding company''
wherever it appears, remove ``[banks]'' and add ``bank holding
companies'' in its place wherever it appears, remove ``[Banks]'' and
add ``Bank holding companies'' in its place wherever it appears, and
remove ``[Bank]'' and add ``Bank holding company'' in its place
wherever it appears.
0
c. Remove ``[Appendix--to Part--]'' and add ``Appendix G to Part 225''
in its place wherever it appears.
0
d. Remove ``[the general risk-based capital rules]'' and add ``12 CFR
part 225, Appendix A'' in its place wherever it appears.
0
e. Remove ``[the market risk rule]'' and add ``12 CFR part 225,
Appendix E'' in its place wherever it appears.
0
f. In section 1, revise paragraph (b)(1), the last sentence in
paragraph (b)(3), and the last sentence in paragraph (c)(1) to read as
follows:
Section 1. Purpose, Applicability, Reservation of Authority, and
Principle of Conservatism
* * * * *
(b) * * *
(1) This appendix applies to a bank holding company that:
(i) Is not a consolidated subsidiary of another bank holding
company that uses this appendix to calculate its risk-based capital
requirements; and
(ii) That:
(A) Is a U.S.-based bank holding company that has total
consolidated assets (excluding assets held by an insurance underwriting
subsidiary), as reported on the most recent year-end FR Y-9C Report,
equal to $250 billion or more;
(B) Has consolidated total on-balance sheet foreign exposure at the
most recent year-end equal to $10 billion or more (where total on-
balance sheet foreign exposure equals total cross-border claims less
claims with head office or guarantor located in another country plus
redistributed guaranteed amounts to the country of head office or
guarantor plus local country claims on local residents plus revaluation
gains on foreign exchange and derivative products, calculated in
accordance with the Federal Financial Institutions Examination Council
(FFIEC) 009 Country Exposure Report); or
(C) Has a subsidiary depository institution that is required, or
has elected, to use 12 CFR part 3, Appendix C, 12 CFR part 208,
Appendix F, 12 CFR part 325, Appendix F, or 12 CFR part 567, Appendix C
to calculate its risk-based capital requirements.
* * * * *
(3) * * * In making a determination under this paragraph, the
Federal Reserve will apply notice and response procedures in the same
manner and to the same extent as the notice and response procedures in
12 CFR 263.202.
(c) Reservation of authority--(1) * * * In making a determination
under this paragraph, the Federal Reserve will apply notice and
response procedures in the same manner and to the same extent as the
notice and response procedures in 12 CFR 263.202.
* * * * *
0
g. In section 2, revise the definition of excluded mortgage exposure,
the definition of gain-on-sale, and paragraph (2)(i) of the definition
of high volatility commercial real estate (HVCRE) exposure to read as
follows:
Section 2. Definitions
* * * * *
Excluded mortgage exposure means any one- to four-family
residential pre-sold construction loan for a residence for which the
purchase contract is cancelled that would receive a 100 percent risk
weight under section 618(a)(2) of the Resolution Trust Corporation
Refinancing, Restructuring, and Improvement Act and under 12 CFR part
225, Appendix A, section III.C.3.
* * * * *
Gain-on-sale means an increase in the equity capital (as reported
on Schedule HC of the FR Y-9C Report) of a bank holding company that
results from a securitization (other than an increase in equity capital
that results from the bank holding company's receipt of cash in
connection with the securitization).
* * * * *
High volatility commercial real estate (HVCRE) exposure * * *
(2) * * *
(i) The loan-to-value ratio is less than or equal to the applicable
maximum supervisory loan-to-value ratio in the relevant agency's real
estate lending standards at 12 CFR part 34, Subpart D (OCC), 12 CFR
part 208, Appendix C (Federal Reserve); 12 CFR part 365, Subpart D
(FDIC); and 12 CFR 560.100-560.101 (OTS).
* * * * *
0
h. Add a new paragraph (c)(8) to section 11 to read as follows:
Section 11. Additional Deductions.
* * * * *
(c) * * *
(8) A bank holding company must also deduct an amount equal to the
minimum regulatory capital requirement established by the regulator of
any insurance underwriting subsidiary of the holding company. For U.S.-
based insurance underwriting subsidiaries, this amount generally would
be 200 percent of the subsidiary's Authorized Control Level as
established by the appropriate state regulator of the insurance
company.
* * * * *
0
i. Revise section 12 to read as follows:
[[Page 69432]]
Section 12. Deductions and Limitations Not Required.
(a) Deduction of CEIOs. A bank holding company is not required to
make the deductions from capital for CEIOs in 12 CFR part 225, Appendix
A, section II.B.1.e.
(b) Deduction for certain equity investments. A bank holding
company is not required to make the deductions from capital for
nonfinancial equity investments in 12 CFR part 225, Appendix A, section
II.B.5.
* * * * *
0
j. Remove and reserve section 22(h)(3)(ii).
0
k. In section 31(e)(3)(i), remove ``A [bank] may assign a risk-weighted
asset amount of zero to cash owned and held in all offices of the
[bank] or in transit and to gold bullion held in the [bank]'s own
vaults, or held in another [bank]'s vaults on an allocated basis, to
the extent the gold bullion assets are offset by gold bullion
liabilities'' and add in its place ``A bank holding company may assign
a risk-weighted asset amount of zero to cash owned and held in all
offices of subsidiary depository institutions or in transit and for
gold bullion held in either a subsidiary depository institution's own
vaults, or held in another depository institution's vaults on an
allocated basis, to the extent the gold bullion assets are offset by
gold bullion liabilities.''
* * * * *
0
l. Revise the first sentence of paragraph (k)(1)(iv) and revise
paragraph (k)(4) of section 42 to read as follows:
Section 42. Risk-Based Capital Requirement for Securitization Exposures
* * * * *
(k) * * *
(1) * * *
(iv) The bank holding company is well capitalized, as defined in
the Federal Reserve's prompt corrective action regulation at 12 CFR
part 208, Subpart D.* * *
* * * * *
(4) The risk-based capital ratios of the bank holding company must
be calculated without regard to the capital treatment for transfers of
small-business obligations with recourse specified in paragraph (k)(1)
of this section as provided in 12 CFR part 225, Appendix A.
* * * * *
0
m. In section 71, remove ``[Disclosure paragraph (b)].''
0
n. In section 71, remove ``[Disclosure paragraph (c)].''
0
o. In section 71, add new paragraph (b) and Tables 11.1 through 11.11
to read as follows:
Section 71. Disclosure Requirements
* * * * *
(b)(1) Each consolidated bank holding company that is not a
subsidiary of a non-U.S. banking organization that is subject to
comparable public disclosure requirements in its home jurisdiction and
has successfully completed its parallel run must provide timely public
disclosures each calendar quarter of the information in tables 11.1-
11.11 below. If a significant change occurs, such that the most recent
reported amounts are no longer reflective of the bank holding company's
capital adequacy and risk profile, then a brief discussion of this
change and its likely impact must be provided as soon as practicable
thereafter. Qualitative disclosures that typically do not change each
quarter (for example, a general summary of the bank holding company's
risk management objectives and policies, reporting system, and
definitions) may be disclosed annually, provided any significant
changes to these are disclosed in the interim. Management is encouraged
to provide all of the disclosures required by this appendix in one
place on the bank holding company's public Web site.\5\ The bank
holding company must make these disclosures publicly available for each
of the last three years (that is, twelve quarters) or such shorter
period since it began its first floor period.
---------------------------------------------------------------------------
\5\ Alternatively, a bank holding company may provide the
disclosures in more than one place, as some of them may be included
in public financial reports (for example, in Management's Discussion
and Analysis included in SEC filings) or other regulatory reports.
The bank holding company must provide a summary table on its public
Web site that specifically indicates where all the disclosures may
be found (for example, regulatory report schedules, page numbers in
annual reports).
---------------------------------------------------------------------------
(2) Each bank holding company is required to have a formal
disclosure policy approved by the board of directors that addresses its
approach for determining the disclosures it makes. The policy must
address the associated internal controls and disclosure controls and
procedures. The board of directors and senior management are
responsible for establishing and maintaining an effective internal
control structure over financial reporting, including the disclosures
required by this appendix, and must ensure that appropriate review of
the disclosures takes place. One or more senior officers of the bank
holding company must attest that the disclosures meet the requirements
of this appendix.
(3) If a bank holding company believes that disclosure of specific
commercial or financial information would prejudice seriously its
position by making public information that is either proprietary or
confidential in nature, the bank holding company need not disclose
those specific items, but must disclose more general information about
the subject matter of the requirement, together with the fact that, and
the reason why, the specific items of information have not been
disclosed.
Table 11.1.--Scope of Application
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The name of the top corporate
entity in the group to which the
appendix applies.
(b) An outline of differences in the
basis of consolidation for
accounting and regulatory purposes,
with a brief description of the
entities \6\ within the group that
are fully consolidated; that are
deconsolidated and deducted; for
which the regulatory capital
requirement is deducted; and that
are neither consolidated nor
deducted (for example, where the
investment is risk-weighted).
(c) Any restrictions, or other major
impediments, on transfer of funds
or regulatory capital within the
group.
Quantitative Disclosures.......... (d) The aggregate amount of surplus
capital of insurance subsidiaries
(whether deducted or subjected to
an alternative method) included in
the regulatory capital of the
consolidated group.
(e) The aggregate amount by which
actual regulatory capital is less
than the minimum regulatory capital
requirement in all subsidiaries
with regulatory capital
requirements and the name(s) of the
subsidiaries with such
deficiencies.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\6\ Entities include securities, insurance and other financial
subsidiaries, commercial subsidiaries (where permitted), and
significant minority equity investments in insurance, financial and
commercial entities.
[[Page 69433]]
Table 11.2.--Capital Structure
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) Summary information on the terms
and conditions of the main features
of all capital instruments,
especially in the case of
innovative, complex or hybrid
capital instruments.
Quantitative Disclosures.......... (b) The amount of tier 1 capital,
with separate disclosure of:
Common stock/surplus;
Retained earnings;
Minority interests in the
equity of subsidiaries;
Restricted core capital
elements as defined in 12 CFR
part 225, Appendix A;
Regulatory calculation
differences deducted from tier 1
capital; \7\ and
Other amounts deducted
from tier 1 capital, including
goodwill and certain intangibles.
(c) The total amount of tier 2
capital.
(d) Other deductions from capital.
\8\
(e) Total eligible capital.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\7\ Representing 50 percent of the amount, if any, by which
total expected credit losses as calculated within the IRB approach
exceed eligible credit reserves, which must be deducted from tier 1
capital.
\8\ Including 50 percent of the amount, if any, by which total
expected credit losses as calculated within the IRB approach exceed
eligible credit reserves, which must be deducted from tier 2
capital.
Table 11.3.--Capital Adequacy
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) A summary discussion of the bank
holding company's approach to
assessing the adequacy of its
capital to support current and
future activities.
Quantitative disclosures.......... (b) Risk-weighted assets for credit
risk from:
Wholesale exposures;
Residential mortgage
exposures;
Qualifying revolving
exposures;
Other retail exposures;
Securitization exposures;
Equity exposures
Equity exposures subject
to the simple risk weight
approach; and
Equity exposures subject
to the internal models approach.
(c) Risk-weighted assets for market
risk as calculated under [the
market risk rule]: \9\
Standardized approach for
specific risk; and
Internal models approach
for specific risk.
(d) Risk-weighted assets for
operational risk.
(e) Total and tier 1 risk-based
capital ratios: \10\
For the top consolidated
group; and
For each DI subsidiary.
------------------------------------------------------------------------
General Qualitative Disclosure Requirement
For each separate risk area described in tables 11.4 through 11.11,
the bank holding company must describe its risk management objectives
and policies, including:
---------------------------------------------------------------------------
\9\ Risk-weighted assets determined under [the market risk rule]
are to be disclosed only for the approaches used.
\10\ Total risk-weighted assets should also be disclosed.
---------------------------------------------------------------------------
Strategies and processes;
The structure and organization of the relevant risk
management function;
The scope and nature of risk reporting and/or measurement
systems;
Policies for hedging and/or mitigating risk and strategies
and processes for monitoring the continuing effectiveness of hedges/
mitigants.
Table 11.4.\11\--Credit Risk: General Disclosures
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to credit risk (excluding
counterparty credit risk disclosed
in accordance with Table 11.6),
including:
Definitions of past due
and impaired (for accounting
purposes);
Description of approaches
followed for allowances,
including statistical methods
used where applicable; and
Discussion of the bank
holding company's credit risk
management policy.
Quantitative Disclosures.......... (b) Total credit risk exposures and
average credit risk exposures,
after accounting offsets in
accordance with GAAP,\12\ and
without taking into account the
effects of credit risk mitigation
techniques (for example, collateral
and netting), over the period
broken down by major types of
credit exposure.\13\
(c) Geographic \14\ distribution of
exposures, broken down in
significant areas by major types of
credit exposure.
(d) Industry or counterparty type
distribution of exposures, broken
down by major types of credit
exposure.
(e) Remaining contractual maturity
breakdown (for example, one year or
less) of the whole portfolio,
broken down by major types of
credit exposure.
(f) By major industry or
counterparty type:
Amount of impaired loans;
Amount of past due loans;
\15\
Allowances; and
[[Page 69434]]
Charge-offs during the
period.
(g) Amount of impaired loans and, if
available, the amount of past due
loans broken down by significant
geographic areas including, if
practical, the amounts of
allowances related to each
geographical area.\16\
(h) Reconciliation of changes in the
allowance for loan and lease
losses.\17\
------------------------------------------------------------------------
---------------------------------------------------------------------------
\11\ Table 4 does not include equity exposures.
\12\ For example, FASB Interpretations 39 and 41.
\13\ For example, bank holding companies could apply a breakdown
similar to that used for accounting purposes. Such a breakdown
might, for instance, be (a) loans, off-balance sheet commitments,
and other non-derivative off-balance sheet exposures, (b) debt
securities, and (c) OTC derivatives.
\14\ Geographical areas may comprise individual countries,
groups of countries, or regions within countries. A bank holding
company might choose to define the geographical areas based on the
way the company's portfolio is geographically managed. The criteria
used to allocate the loans to geographical areas must be specified.
\15\ A bank holding company is encouraged also to provide an
analysis of the aging of past-due loans.
\16\ The portion of general allowance that is not allocated to a
geographical area should be disclosed separately.
\17\ The reconciliation should include the following: A
description of the allowance; the opening balance of the allowance;
charge-offs taken against the allowance during the period; amounts
provided (or reversed) for estimated probable loan losses during the
period; any other adjustments (for example, exchange rate
differences, business combinations, acquisitions and disposals of
subsidiaries), including transfers between allowances; and the
closing balance of the allowance. Charge-offs and recoveries that
have been recorded directly to the income statement should be
disclosed separately.
Table 11.5.--Credit Risk: Disclosures for Portfolios Subject to IRB Risk-
Based Capital Formulas
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) Explanation and review of the:
Structure of internal
rating systems and relation
between internal and external
ratings;
Use of risk parameter
estimates other than for
regulatory capital purposes;
Process for managing and
recognizing credit risk
mitigation (see table 11.7); and
Control mechanisms for
the rating system, including
discussion of independence,
accountability, and rating
systems review.
(b) Description of the internal
ratings process, provided
separately for the following:
Wholesale category;
Retail subcategories;
Residential mortgage
exposures;
Qualifying revolving
exposures; and
Other retail exposures.
For each category and subcategory
the description should include:
The types of exposure
included in the category/
subcategories; and
The definitions, methods
and data for estimation and
validation of PD, LGD, and EAD,
including assumptions employed in
the derivation of these
variables.\18\
Quantitative disclosures: Risk (c) For wholesale exposures, present
assessment. the following information across a
sufficient number of PD grades
(including default) to allow for a
meaningful differentiation of
credit risk: \19\
Total EAD; \20\
Exposure-weighted average
LGD (percentage);
Exposure-weighted average
risk weight; and
Amount of undrawn
commitments and exposure-weighted
average EAD for wholesale
exposures.
For each retail subcategory,
present the disclosures outlined
above across a sufficient number
of segments to allow for a
meaningful differentiation of
credit risk.
Quantitative disclosures: (d) Actual losses in the preceding
Historical results. period for each category and
subcategory and how this differs
from past experience. A discussion
of the factors that impacted the
loss experience in the preceding
period--for example, has the bank
holding company experienced higher
than average default rates, loss
rates or EADs.
(e) Bank holding company's estimates
compared against actual outcomes
over a longer period.\21\ At a
minimum, this should include
information on estimates of losses
against actual losses in the
wholesale category and each retail
subcategory over a period
sufficient to allow for a
meaningful assessment of the
performance of the internal rating
processes for each category/
subcategory.\22\ Where appropriate,
the bank holding company should
further decompose this to provide
analysis of PD, LGD, and EAD
outcomes against estimates provided
in the quantitative risk assessment
disclosures above.\23\
------------------------------------------------------------------------
---------------------------------------------------------------------------
\18\ This disclosure does not require a detailed description of
the model in full--it should provide the reader with a broad
overview of the model approach, describing definitions of the
variables and methods for estimating and validating those variables
set out in the quantitative risk disclosures below. This should be
done for each of the four category/subcategories. The bank holding
company should disclose any significant differences in approach to
estimating these variables within each category/subcategories.
\19\ The PD, LGD and EAD disclosures in Table 11.5(c) should
reflect the effects of collateral, qualifying master netting
agreements, eligible guarantees and eligible credit derivatives as
defined in part I. Disclosure of each PD grade should include the
exposure-weighted average PD for each grade. Where a bank holding
company aggregates PD grades for the purposes of disclosure, this
should be a representative breakdown of the distribution of PD
grades used for regulatory capital purposes.
\20\ Outstanding loans and EAD on undrawn commitments can be
presented on a combined basis for these disclosures.
\21\ These disclosures are a way of further informing the reader
about the reliability of the information provided in the
``quantitative disclosures: risk assessment'' over the long run. The
disclosures are requirements from year-end 2010; in the meantime,
early adoption is encouraged. The phased implementation is to allow
a bank holding company sufficient time to build up a longer run of
data that will make these disclosures meaningful.
\22\ This regulation is not prescriptive about the period used
for this assessment. Upon implementation, it might be expected that
a bank holding company would provide these disclosures for as long
run of data as possible--for example, if a bank holding company has
10 years of data, it might choose to disclose the average default
rates for each PD grade over that 10-year period. Annual amounts
need not be disclosed.
\23\ A bank holding company should provide this further
decomposition where it will allow users greater insight into the
reliability of the estimates provided in the ``quantitative
disclosures: risk assessment.'' In particular, it should provide
this information where there are material differences between its
estimates of PD, LGD or EAD compared to actual outcomes over the
long run. The bank holding company should also provide explanations
for such differences.
[[Page 69435]]
Table 11.6.--General Disclosure for Counterparty Credit Risk of OTC
Derivative Contracts, Repo-Style Transactions, and Eligible Margin Loans
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to OTC derivatives, eligible margin
loans, and repo-style transactions,
including:
Discussion of methodology
used to assign economic capital
and credit limits for
counterparty credit exposures;
Discussion of policies
for securing collateral, valuing
and managing collateral, and
establishing credit reserves;
Discussion of the primary
types of collateral taken;
Discussion of policies
with respect to wrong-way risk
exposures; and
Discussion of the impact
of the amount of collateral the
bank holding company would have
to provide if the bank holding
company were to receive a credit
rating downgrade.
Quantitative Disclosures.......... (b) Gross positive fair value of
contracts, netting benefits, netted
current credit exposure, collateral
held (including type, for example,
cash, government securities), and
net unsecured credit exposure.\24\
Also report measures for EAD used
for regulatory capital for these
transactions, the notional value of
credit derivative hedges purchased
for counterparty credit risk
protection, and, for bank holding
companies not using the internal
models methodology in section 32(d)
of this appendix, the distribution
of current credit exposure by types
of credit exposure.\25\
(c) Notional amount of purchased and
sold credit derivatives, segregated
between use for the bank holding
company's own credit portfolio and
for its intermediation activities,
including the distribution of the
credit derivative products used,
broken down further by protection
bought and sold within each product
group.
(d) The estimate of alpha if the
bank holding company has received
supervisory approval to estimate
alpha.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\24\ Net unsecured credit exposure is the credit exposure after
considering the benefits from legally enforceable netting agreements
and collateral arrangements, without taking into account haircuts
for price volatility, liquidity, etc.
\25\ This may include interest rate derivative contracts,
foreign exchange derivative contracts, equity derivative contracts,
credit derivatives, commodity or other derivative contracts, repo-
style transactions, and eligible margin loans.
Table 11.7.--Credit Risk Mitigation 26 27 28
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to credit risk mitigation
including:
Policies and processes
for, and an indication of the
extent to which the bank holding
company uses, on- and off-balance
sheet netting;
Policies and processes
for collateral valuation and
management;
A description of the main
types of collateral taken by the
bank holding company;
The main types of
guarantors/credit derivative
counterparties and their
creditworthiness; and
Information about (market
or credit) risk concentrations
within the mitigation taken.
Quantitative Disclosures.......... (b) For each separately disclosed
portfolio, the total exposure
(after, where applicable, on-or off-
balance sheet netting) that is
covered by guarantees/credit
derivatives.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\26\ At a minimum, a bank holding company must provide the
disclosures in Table 11.7 in relation to credit risk mitigation that
has been recognized for the purposes of reducing capital
requirements under this appendix. Where relevant, bank holding
companies are encouraged to give further information about mitigants
that have not been recognized for that purpose.
\27\ Credit derivatives that are treated, for the purposes of
this appendix, as synthetic securitization exposures should be
excluded from the credit risk mitigation disclosures and included
within those relating to securitization.
\28\ Counterparty credit risk-related exposures disclosed
pursuant to Table 11.6 should be excluded from the credit risk
mitigation disclosures in Table 11.7.
Table 11.8.--Securitization
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) The general qualitative
disclosure requirement with respect
to securitization (including
synthetics), including a discussion
of:
The bank holding
company's objectives relating to
securitization activity,
including the extent to which
these activities transfer credit
risk of the underlying exposures
away from the bank holding
company to other entities;
The roles played by the
bank holding company in the
securitization process \29\ and
an indication of the extent of
the bank holding company's
involvement in each of them; and
The regulatory capital
approaches (for example, RBA, IAA
and SFA) that the bank holding
company follows for its
securitization activities.
(b) Summary of the bank holding
company's accounting policies for
securitization activities,
including:
Whether the transactions
are treated as sales or
financings;
Recognition of gain-on-
sale;
Key assumptions for
valuing retained interests,
including any significant changes
since the last reporting period
and the impact of such changes;
and
Treatment of synthetic
securitizations.
[[Page 69436]]
(c) Names of NRSROs used for
securitizations and the types of
securitization exposure for which
each agency is used.
Quantitative disclosures.......... (d) The total outstanding exposures
securitized by the bank holding
company in securitizations that
meet the operational criteria in
section 41 of this appendix (broken
down into traditional/synthetic),
by underlying exposure type.30 31
32
(e) For exposures securitized by the
bank holding company in
securitizations that meet the
operational criteria in Section 41
of this appendix:
Amount of securitized
assets that are impaired/past
due; and
Losses recognized by the
bank holding company during the
current period \33\ broken down
by exposure type.
(f) Aggregate amount of
securitization exposures broken
down by underlying exposure type.
(g) Aggregate amount of
securitization exposures and the
associated IRB capital requirements
for these exposures broken down
into a meaningful number of risk
weight bands. Exposures that have
been deducted from capital should
be disclosed separately by type of
underlying asset.
(h) For securitizations subject to
the early amortization treatment,
the following items by underlying
asset type for securitized
facilities:
The aggregate drawn
exposures attributed to the
seller's and investors'
interests; and
The aggregate IRB capital
charges incurred by the bank
holding company against the
investors' shares of drawn
balances and undrawn lines.
(i) Summary of current year's
securitization activity, including
the amount of exposures securitized
(by exposure type), and recognized
gain or loss on sale by asset type.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\29\ For example: originator, investor, servicer, provider of
credit enhancement, sponsor of asset backed commercial paper
facility, liquidity provider, or swap provider.
\30\ Underlying exposure types may include, for example, one- to
four-family residential loans, home equity lines, credit card
receivables, and auto loans.
\31\ Securitization transactions in which the originating bank
holding company does not retain any securitization exposure should
be shown separately but need only be reported for the year of
inception.
\32\ Where relevant, a bank holding company is encouraged to
differentiate between exposures resulting from activities in which
they act only as sponsors, and exposures that result from all other
bank holding company securitization activities.
\33\ For example, charge-offs/allowances (if the assets remain
on the bank holding company's balance sheet) or write-downs of I/O
strips and other residual interests.
Table 11.9.--Operational Risk
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) The general qualitative
disclosure requirement for
operational risk.
(b) Description of the AMA,
including a discussion of relevant
internal and external factors
considered in the bank holding
company's measurement approach.
(c) A description of the use of
insurance for the purpose of
mitigating operational risk.
------------------------------------------------------------------------
Table 11.10.--Equities Not Subject to Market Risk Rule
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to equity risk, including:
Differentiation between
holdings on which capital gains
are expected and those held for
other objectives, including for
relationship and strategic
reasons; and
Discussion of important
policies covering the valuation
of and accounting for equity
holdings in the banking book.
This includes the accounting
techniques and valuation
methodologies used, including key
assumptions and practices
affecting valuation as well as
significant changes in these
practices.
Quantitative Disclosures.......... (b) Value disclosed in the balance
sheet of investments, as well as
the fair value of those
investments; for quoted securities,
a comparison to publicly-quoted
share values where the share price
is materially different from fair
value.
(c) The types and nature of
investments, including the amount
that is:
Publicly traded; and
Non-publicly traded.
(d) The cumulative realized gains
(losses) arising from sales and
liquidations in the reporting
period.
(e) Total unrealized gains
(losses) \34\
Total latent revaluation
gains (losses) \35\
Any amounts of the above
included in tier 1 and/or tier 2
capital.
(f) Capital requirements broken down
by appropriate equity groupings,
consistent with the bank holding
company's methodology, as well as
the aggregate amounts and the type
of equity investments subject to
any supervisory transition
regarding regulatory capital
requirements.\36\
------------------------------------------------------------------------
---------------------------------------------------------------------------
\34\ Unrealized gains (losses) recognized in the balance sheet
but not through earnings.
\35\ Unrealized gains (losses) not recognized either in the
balance sheet or through earnings.
\36\ This disclosure should include a breakdown of equities that
are subject to the 0 percent, 20 percent, 100 percent, 300 percent,
400 percent, and 600 percent risk weights, as applicable.
[[Page 69437]]
Table 11.11.--Interest Rate Risk for Non-trading Activities
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) The general qualitative
disclosure requirement, including
the nature of interest rate risk
for non-trading activities and key
assumptions, including assumptions
regarding loan prepayments and
behavior of non-maturity deposits,
and frequency of measurement of
interest rate risk for non-trading
activities.
Quantitative disclosures.......... (b) The increase (decline) in
earnings or economic value (or
relevant measure used by
management) for upward and downward
rate shocks according to
management's method for measuring
interest rate risk for non-trading
activities, broken down by currency
(as appropriate).
------------------------------------------------------------------------
* * * * *
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Chapter III
Authority and Issuance
0
For the reasons stated in the common preamble, the Federal Deposit
Insurance Corporation amends part 325 of chapter III of title 12 of the
Code of Federal Regulations as follows:
PART 325--CAPITAL MAINTENANCE
0
1. The authority citation for part 325 continues to read as follows:
Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b),
1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n),
1828(o), 1831o, 1835, 3907, 3909, 4808; Pub. L. 102-233, 105 Stat.
1761, 1789, 1790 (12 U.S.C. 1831n note); Pub. L. 102-242, 105 Stat.
2236, 2355, 2386 (12 U.S.C. 1828 note).
0
2. New Appendix D to part 325 is added as set forth at the end of the
common preamble.
0
3. Appendix D to part 325 is amended as set forth below:
0
a. Remove ``[AGENCY]'' and add ``FDIC'' in its place wherever it
appears.
0
b. Remove ``[bank]'' and add ``bank'' in its place wherever it appears,
remove ``[banks]'' and add ``banks'' in its place wherever it appears,
remove ``[Banks]'' and add ``Banks'' in its place wherever it appears,
and remove ``[Bank]'' and add ``Bank'' in its place wherever it
appears.
0
c. Remove ``[Appendix -- to Part --]'' and add ``Appendix D to Part
325'' in its place wherever it appears.
0
d. Remove ``[the general risk-based capital rules]'' and add ``12 CFR
part 325, Appendix A'' in its place wherever it appears.
0
e. Remove ``[the market risk rule]'' and add ``12 CFR part 325,
Appendix C'' in its place wherever it appears.
0
f. In section 1, revise paragraph (b)(1)(i), the last sentence in
paragraph (b)(3), and the last sentence in paragraph (c)(1) to read as
follows:
Section 1. Purpose, Applicability, Reservation of Authority, and
Principle of Conservatism
* * * * *
(b) Applicability. (1) * * *
(i) Has consolidated assets, as reported on the most recent year-
end Consolidated Report of Condition and Income (Call Report) equal to
$250 billion or more;
* * * * *
(3) * * * In making a determination under this paragraph, the FDIC
will apply notice and response procedures in the same manner and to the
same extent as the notice and response procedures in 12 CFR 325.6(c).
(c) Reservation of authority--(1) * * * In making a determination
under this paragraph, the FDIC will apply notice and response
procedures in the same manner and to the same extent as the notice and
response procedures in 12 CFR 325.6(c).
* * * * *
0
g. In section 2, revise the definition of excluded mortgage exposure,
the definition of gain-on-sale, and paragraph (2)(i) of the definition
of high volatility commercial real estate (HVCRE) exposure to read as
follows:
Section 2. Definitions
* * * * *
Excluded mortgage exposure means any one- to four-family
residential pre-sold construction loan for a residence for which the
purchase contract is cancelled that would receive a 100 percent risk
weight under section 618(a)(2) of the Resolution Trust Corporation
Refinancing, Restructuring, and Improvement Act and under 12 CFR part
325, Appendix A, section II.C.
* * * * *
Gain-on-sale means an increase in the equity capital (as reported
on Schedule RC of the Call Report) of a bank that results from a
securitization (other than an increase in equity capital that results
from the bank's receipt of cash in connection with the securitization).
* * * * *
High volatility commercial real estate (HVCRE) exposure * * *
(2) * * *
(i) The loan-to-value ratio is less than or equal to the applicable
maximum supervisory loan-to-value ratio in the FDIC's real estate
lending standards at 12 CFR part 365, Appendix A.
* * * * *
0
h. Revise section 12 to read as follows:
Section 12. Deductions and Limitations Not Required
(a) Deduction of CEIOs. A bank is not required to make the
deductions from capital for CEIOs in 12 CFR part 325, Appendix A,
section II.B.5.
(b) Deduction for certain equity investments. A bank is not
required to make the deductions from capital for nonfinancial equity
investments in 12 CFR part 325, Appendix A, section II.B.
* * * * *
0
i. Revise the first sentence of paragraph (k)(1)(iv) and paragraph
(k)(4) of section 42 to read as follows:
Section 42. Risk-Based Capital Requirement for Securitization Exposures
* * * * *
(k) * * *
(1) * * *
(iv) The bank is well capitalized, as defined in the FDIC 's prompt
corrective action regulation at 12 CFR part 325, Subpart B. For
purposes of determining whether a bank is well capitalized for purposes
of this paragraph, the bank's capital ratios must be calculated without
regard to the capital treatment for transfers of small-business
obligations with recourse specified in paragraph (k)(1) of this
section. * * *
* * * * *
(4) The risk-based capital ratios of the bank must be calculated
without regard to the capital treatment for transfers of small-business
obligations with recourse specified in paragraph (k)(1) of this section
as provided in 12 CFR part 325, Appendix A.
* * * * *
0
j. Remove ``[Disclosure paragraph (b)]'' and add in its place ``(b) A
bank must comply with paragraph (b) of section 71 of appendix G to the
Federal Reserve Board's Regulation Y (12 CFR part 225, appendix G)
unless it is a consolidated subsidiary of a bank holding company or
depository institution that is subject to these requirements.''
0
k. Remove ``[Disclosure paragraph (c)].''
[[Page 69438]]
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
12 CFR Chapter V
Authority and Issuance
0
For the reasons set out in the preamble, the Office of Thrift
Supervision amends Chapter V of title 12 of the Code of Federal
Regulations to read as follows:
PART 559--SUBORDINATE ORGANIZATIONS
0
1. The authority citation for part 559 continues to read as follows:
Authority: 12 U.S.C. 1462, 1462a, 1463, 1464, 1467a, 1828.
0
2. Revise Sec. 559.5(b)(1) to read as follows:
Sec. 559.5 How much may a savings association invest in service
corporations or lower tier entities?
* * * * *
(b) * * *
(1) You and your GAAP-consolidated subsidiaries may, in the
aggregate, make loans of up to 15% of your total capital, as described
in part 567 of this chapter to each subordinate organization that does
not qualify as a GAAP-consolidated subsidiary. All loans made under
this paragraph (b)(1) may not, in the aggregate, exceed 50% of your
total capital, as described in part 567 of this chapter.
* * * * *
PART 560--LENDING AND INVESTMENT
0
3. The authority citation for part 560 continues to read as follows:
Authority: 12 U.S.C. 1462, 1462a, 1463, 1464, 1467a, 1701j-3,
1828, 3803, 3806, 42 U.S.C. 4106.
Sec. 560.101 [Amended]
0
4. In footnote 2 to the appendix to Sec. 560.101, remove the phrase
``as defined at 12 CFR 567.5(c)'' and add the phrase ``as described in
part 567 of this chapter'' in its place.
PART 563--SAVINGS ASSOCIATIONS--OPERATIONS
0
5. The authority citation for part 563 continues to read as follows:
Authority: 12 U.S.C. 375b, 1462, 1462a, 1463, 1464, 1467a, 1468,
1817, 1820, 1828, 1831o, 3806; 31 U.S.C. 5318; 42 U.S.C. 4106.
Sec. 563.74 [Amended]
0
6. Amend Sec. 563.74 as follows:
0
a. In paragraph (i)(2)(iv), remove the phrase ``regulatory capital
requirement under Sec. 567.2 of this chapter'' and add the phrase
``regulatory capital requirements under part 567 of this chapter'' in
its place.
0
b. In paragraph (i)(2)(v) remove the phrase ``regulatory capital
requirement under Sec. 567.2 of this chapter'' and add the phrase
``regulatory capital requirements under part 567 of this chapter'' in
its place.
Sec. 563.81 [Amended]
0
7. Amend Sec. 563.81 as follows:
0
a. In paragraph (a), remove the phrase ``in supplementary capital under
12 CFR 567.5(b)'' and add the phrase ``in supplementary capital (tier 2
capital) under part 567 of this chapter'' in its place.
0
b. In paragraph (d)(2)(ii), remove the phrase ``regulatory capital
requirements at Sec. 567.2 of this chapter'' and add the phrase
``regulatory capital requirements at part 567 of this chapter'' in its
place.
Sec. 563.141 [Amended]
0
8. In Sec. 563.141(b), remove the phrase ``in your total capital under
Sec. 567.5 of this chapter'' and add the phrase ``in your total
capital under part 567 of this chapter'' in its place.
Sec. 563.142 [Amended]
0
9. In Sec. 563.142, amend the definition of ``capital'' by removing
the phrase ``total capital, as described under Sec. 567.5(c) of this
chapter'' and adding the phrase ``total capital, as computed under part
567 of this chapter'' in its place.
PART 567--CAPITAL
0
10. The authority citation for part 567 continues to read as follows:
Authority: 12 U.S.C. 1462, 1462a, 1463, 1464, 1467a, 1828(note).
0
11. Add a new subpart A to read as follows:
Subpart A--Scope
Sec. 567.0 Scope.
(a) This part prescribes the minimum regulatory capital
requirements for savings associations. Subpart B of this part applies
to all savings associations, except as described in paragraph (b) of
this section.
(b)(1) A savings association that uses Appendix C of this part must
comply with the minimum qualifying criteria for internal risk
measurement and management processes for calculating risk-based capital
requirements, utilize the methodologies for calculating risk-based
capital requirements, and make the required disclosures described in
that appendix.
(2) Subpart B of this part does not apply to the computation of
risk-based capital requirements by a savings association that uses
Appendix C of this part. However, these savings associations:
(i) Must compute the components of capital under Sec. 567.5,
subject to the modifications in sections 11 and 12 of Appendix C of
this part.
(ii) Must meet the leverage ratio requirement at Sec. Sec.
567.2(a)(2) and 567.8 with tier 1 capital, as computed under sections
11 and 12 of Appendix C of this part.
(iii) Must meet the tangible capital requirement described at
Sec. Sec. 567.2(a)(3) and 567.9.
(iv) Are subject to Sec. Sec. 567.3 (individual minimum capital
requirement), 567.4 (capital directives); and 567.10 (consequences of
failure to meet capital requirements).
(v) Are subject to the reservations of authority at Sec. 567.11,
which supplement the reservations of authority at section 1 of Appendix
C of this part.
0
12. Designate Sec. Sec. 567.1 through 567.6 and Sec. Sec. 567.8
through 567.12 as subpart B and add a heading for subpart B to read as
follows:
Subpart B--Regulatory Capital Requirements
0
13. Revise the introductory sentence to Sec. 567.1 to read as follows:
Sec. 567.1 Definitions.
For the purposes of this subpart:
* * * * *
0
14. In Sec. 567.3, revise paragraphs (a), (b) introductory text, and
(d)(1) to read as follows:
Sec. 567.3 Individual minimum capital requirements.
(a) Purpose and scope. The rules and procedures specified in this
section apply to the establishment of an individual minimum capital
requirement for a savings association that varies from the risk-based
capital requirement, the leverage ratio requirement or the tangible
capital requirement that would otherwise apply to the savings
association under this part.
(b) Appropriate considerations for establishing individual minimum
capital requirements. Minimum capital levels higher than the risk-based
capital requirement, the leverage ratio requirement or the tangible
capital requirement required under this part may be appropriate for
individual savings associations. Increased individual minimum capital
requirements may be established upon a
[[Page 69439]]
determination that the savings association's capital is or may become
inadequate in view of its circumstances. For example, higher capital
levels may be appropriate for:
* * * * *
(d) Procedures--(1) Notification. When the OTS determines that a
minimum capital requirement is necessary or appropriate for a
particular savings association, it shall notify the savings association
in writing of its proposed individual minimum capital requirement; the
schedule for compliance with the new requirement; and the specific
causes for determining that the higher individual minimum capital
requirement is necessary or appropriate for the savings association.
The OTS shall forward the notifying letter to the appropriate state
supervisor if a state-chartered savings association would be subject to
an individual minimum capital requirement.
* * * * *
0
15. Revise paragraph (a)(1) introductory text of Sec. 567.4 to read as
follows:
Sec. 567.4 Capital directives.
(a) Issuance of a Capital Directive--(1) Purpose. In addition to
any other action authorized by law, the Office, may issue a capital
directive to a savings association that does not have an amount of
capital satisfying its minimum capital requirement. Issuance of such a
capital directive may be based on a savings association's noncompliance
with the risk-based capital requirement, the leverage ratio
requirement, the tangible capital requirement, or individual minimum
capital requirement established under this part, by a written agreement
under 12 U.S.C. 1464(s), or as a condition for approval of an
application. A capital directive may order a savings association to:
* * * * *
0
16. Revise paragraph (e) introductory text of Sec. 567.10 to read as
follows:
Sec. 567.10 Consequences of failure to meet capital requirements.
* * * * *
(e) If a savings association fails to meet the risk-based capital
requirement, the leverage ratio requirement, or the tangible capital
requirement established under this part, the Director may, through
enforcement proceedings or otherwise, require such savings association
to take one or more of the following corrective actions:
* * * * *
0
17. Appendices A and B are added to part 567, and are reserved.
0
18. Appendix C is added to part 567 as set forth at the end of the
common preamble.
0
19. Amend Appendix C of part 567 as follows:
0
a. Revise the heading of Appendix C to read as follows:
Risk-Based Capital Requirements--Internal-Ratings-Based and Advanced
Measurement Approaches
0
b. Remove [AGENCY] and add ``OTS'' in its place wherever it appears.
0
c. Remove ``[bank]'' and add ``savings association'' in its place
wherever it appears, remove ``[banks]'' and add ``savings
associations'' in its place wherever it appears, remove ``[Banks]'' and
add ``Savings associations'' in its place wherever it appears, and
remove ``[Bank]'' and add ``Savings association'' in its place wherever
it appears.
0
d. Remove ``[Appendix--to Part--]'' and add ``Appendix C to Part 567''
in its place wherever it appears.
0
e. Remove ``[the general risk-based capital rules]'' and add ``subpart
B of part 567'' in its place wherever it appears.
0
f. Remove ``[the market risk rule]'' and add ``any applicable market
risk rule'' in its place wherever it appears.
0
g. In section 1, revise paragraph (b)(1)(i), the last sentence in
paragraph (b)(3), and the last sentence in paragraph (c)(1) to read as
follows:
Section 1 Purpose, Applicability, Reservation of Authority, and
Principle of Conservatism
* * * * *
(b) Applicability. (1) * * *
(i) Has consolidated assets, as reported on the most recent year-
end Thrift Financial Report (TFR) equal to $250 billion or more;
* * * * *
(3) * * * In making a determination under this paragraph, the OTS
will apply notice and response procedures in the same manner and to the
same extent as the notice and response procedures in Sec. 567.3(d).
(c) Reservation of authority--(1) * * * In making a determination
under this paragraph, the OTS will apply notice and response procedures
in the same manner and to the same extent as the notice and response
procedures in Sec. 567.3(d).
* * * * *
0
h. In section 2, revise the definition of eligible credit reserves, the
definition of excluded mortgage exposure, paragraph (1) of the
definition of exposure at default (EAD), the definition of gain-on-
sale, paragraph (2)(i) of the definition of high volatility commercial
real estate (HVCRE) exposure, and paragraph (7) of the definition of
traditional securitization, to read as follows:
Section 2 Definitions
* * * * *
Eligible credit reserves means all general allowances that have
been established through a charge against earnings to absorb credit
losses associated with on- or off-balance sheet wholesale and retail
exposures, including the allowance for loan and lease losses (ALLL)
associated with such exposures but excluding specific reserves created
against recognized losses.
* * * * *
Excluded mortgage exposure means any one- to four-family
residential pre-sold construction loan for a residence for which the
purchase contract is cancelled that would receive a 100 percent risk
weight under section 618(a)(2) of the Resolution Trust Corporation
Refinancing, Restructuring, and Improvement Act and under 12 CFR 567.1
(definition of ``qualifying residential construction loan'') and 12 CFR
567.6(a)(1)(iv).
* * * * *
Exposure at default (EAD). (1) For the on-balance sheet component
of a wholesale exposure or segment of retail exposures (other than an
OTC derivative contract, or a repo-style transaction, or eligible
margin loan for which the savings association determines EAD under
section 32 of this appendix), EAD means:
(i) If the exposure or segment is a security classified as
available-for-sale, the savings associations carrying value (including
net accrued but unpaid interest and fees) for the exposure or segment
less any unrealized gains on the exposure or segment and plus any
unrealized losses on the exposure or segment; or
(ii) If the exposure or segment is not a security classified as
available-for-sale, the savings association's carrying value (including
net accrued but unpaid interest and fees) for the exposure or segment.
* * * * *
Gain-on-sale means an increase in the equity capital (as reported
on Schedule SC of the Thrift Financial Report) of a savings association
that results from a securitization (other than an increase in equity
capital that results from the savings association's receipt of cash in
connection with the securitization).
* * * * *
High volatility commercial real estate (HVCRE) exposure * * *
(2) * * *
[[Page 69440]]
(i) The loan-to-value ratio is less than or equal to the applicable
maximum supervisory loan-to-value ratio in the OTS's real estate
lending standards at 12 CFR 560.100-560.101;
* * * * *
Traditional securitization * * *
(7) The underlying exposures are not owned by a firm an investment
in which is designed primarily to promote community welfare, including
the welfare of low- and moderate-income communities or families, such
as by providing services or jobs.
* * * * *
0
i. Revise section 12 to read as follows:
Section 12 Deductions and limitations not required
(a) Deduction of CEIOs. A savings association is not required to
make the deduction from capital for CEIOs in 12 CFR 567.5(a)(2)(iii)
and 567.12(e).
(b) Deduction for certain equity investments. A savings association
is not required to deduct equity securities from capital under 12 CFR
567.5(c)(2)(ii). However, it must continue to deduct equity investments
in real estate under that section. See 12 CFR 567.1, which defines
equity investments, including equity securities and equity investments
in real estate.
0
j. Revise the fourth sentence of section 24(a) to read as follows:
Section 24 Merger and Acquisition Transition Arrangements
(a) Mergers and acquisitions of companies without advanced systems.
* * * During the period when subpart A of this part applies to the
merged or acquired company, any ALLL associated with the merged or
acquired company's exposures may be included in the savings
association's tier 2 capital up to 1.25 percent of the acquired
company's risk-weighted assets. * * *
* * * * *
0
k. Revise the first sentence of paragraph (k)(1)(iv) and paragraph
(k)(4) of section 42 to read as follows:
Section 42 Risk-Based Capital Requirement for Securitization Exposures
* * * * *
(k) * * *
(1) * * *
(iv) The savings association is well capitalized, as defined in the
OTS's prompt corrective action regulation at 12 CFR part 565. * * *
* * * * *
(4) The risk-based capital ratios of the savings association must
be calculated without regard to the capital treatment for transfers of
small-business obligations with recourse specified in paragraph (k)(1)
of this section as provided in 12 CFR 567.6(b)(5)(v).
* * * * *
0
l. Revise paragraph (b)(3)(i) of section 52 to read as follows:
Section 52 Simple Risk Weight Approach (SRWA)
* * * * *
(b) * * *
(3) * * *
(i) An equity exposure that is designed primarily to promote
community welfare, including the welfare of low- and moderate-income
communities or families, such as by providing services or jobs,
excluding equity exposures to an unconsolidated small business
investment company and equity exposures held through a consolidated
small business investment company described in section 302 of the Small
Business Investment Act of 1958 (15 U.S.C. 682).
* * * * *
0
m. Remove ``[Disclosure paragraph (b)]'' and add in its place ``(b) A
savings association must comply with paragraph (c) of section 71 of
this appendix unless it is a consolidated subsidiary of a depository
institution or bank holding company that is subject to these
requirements.''
0
n. Remove ``[Disclosure paragraph (c)].''
0
o. In section 71, add new paragraph (c) and Tables 11.1 through 11.11
to read as follows:
Section 71 Disclosure Requirements
* * * * *
(c)(1) Each consolidated savings association described in paragraph
(b) of this section that is not a subsidiary of a non-U.S. banking
organization that is subject to comparable public disclosure
requirements in its home jurisdiction and has successfully completed
its parallel run must provide timely public disclosures each calendar
quarter of the information in tables 11.1-11.11 below. If a significant
change occurs, such that the most recent reported amounts are no longer
reflective of the savings association's capital adequacy and risk
profile, then a brief discussion of this change and its likely impact
must be provided as soon as practicable thereafter. Qualitative
disclosures that typically do not change each quarter (for example, a
general summary of the savings association's risk management objectives
and policies, reporting system, and definitions) may be disclosed
annually, provided any significant changes to these are disclosed in
the interim. Management is encouraged to provide all of the disclosures
required by this appendix in one place on the savings association's
public Web site.\5\ The savings association must make these disclosures
publicly available for each of the last three years (twelve quarters)
or such shorter period since it began its first floor period.
---------------------------------------------------------------------------
\5\ Alternatively, a savings association may provide the
disclosures in more than one place, as some of them may be included
in public financial reports (for example, in Management's Discussion
and Analysis included in SEC filings) or other regulatory reports.
The savings association must provide a summary table on its public
Web site that specifically indicates where all the disclosures may
be found (for example, regulatory report schedules, page numbers in
annual reports).
---------------------------------------------------------------------------
(2) Each savings association is required to have a formal
disclosure policy approved by the board of directors that addresses its
approach for determining the disclosures it makes. The policy must
address the associated internal controls and disclosure controls and
procedures. The board of directors and senior management are
responsible for establishing and maintaining an effective internal
control structure over financial reporting, including the disclosures
required by this appendix, and must ensure that appropriate review of
the disclosures takes place. One or more senior officers of the savings
association must attest that the disclosures required by this appendix
meet the requirements of this appendix.
(3) If a savings association believes that disclosure of specific
commercial or financial information would prejudice seriously its
position by making public information that is either proprietary or
confidential in nature, the savings association need not disclose those
specific items, but must disclose more general information about the
subject matter of the requirement, together with the fact that, and the
reason why, the specific items of information have not been disclosed.
[[Page 69441]]
Table 11.1.--Scope of Application
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The name of the top corporate
entity in the group to which the
appendix applies.
(b) An outline of differences in the
basis of consolidation for
accounting and regulatory purposes,
with a brief description of the
entities\6\ within the group that
are fully consolidated; that are
deconsolidated and deducted; for
which the regulatory capital
requirement is deducted; and that
are neither consolidated nor
deducted (for example, where the
investment is risk-weighted).
(c) Any restrictions, or other major
impediments, on transfer of funds
or regulatory capital within the
group.
Quantitative Disclosures.......... (d) The aggregate amount of surplus
capital of insurance subsidiaries
(whether deducted or subjected to
an alternative method) included in
the regulatory capital of the
consolidated group.
(e) The aggregate amount by which
actual regulatory capital is less
than the minimum regulatory capital
requirement in all subsidiaries
with regulatory capital
requirements and the name(s) of the
subsidiaries with such
deficiencies.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\6\ Entities include securities, insurance and other financial
subsidiaries, commercial subsidiaries (where permitted), and
significant minority equity investments in insurance, financial and
commercial entities.
Table 11.2.--Capital Structure
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) Summary information on the terms
and conditions of the main features
of all capital instruments,
especially in the case of
innovative, complex or hybrid
capital instruments.
Quantitative Disclosures.......... (b) The amount of tier 1 capital,
with separate disclosure of:
Common stock/surplus;
Retained earnings;
Minority interests in the
equity of subsidiaries;
Regulatory calculation
differences deducted from tier 1
capital;\7\ and
Other amounts deducted
from tier 1 capital, including
goodwill and certain intangibles.
(c) The total amount of tier 2
capital.
(d) Other deductions from
capital.\8\
(e) Total eligible capital.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\7\ Representing 50 percent of the amount, if any, by which
total expected credit losses as calculated within the IRB approach
exceed eligible credit reserves, which must be deducted from tier 1
capital.
\8\ Including 50 percent of the amount, if any, by which total
expected credit losses as calculated within the IRB approach exceed
eligible credit reserves, which must be deducted from tier 2
capital.
Table 11.3.--Capital Adequacy
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) A summary discussion of the
savings association's approach to
assessing the adequacy of its
capital to support current and
future activities.
Quantitative disclosures.......... (b) Risk-weighted assets for credit
risk from:
Wholesale exposures;
Residential mortgage
exposures;
Qualifying revolving
exposures;
Other retail exposures;
Securitization exposures;
Equity exposures
Equity exposures
subject to the simple risk
weight approach; and
Equity exposures
subject to the internal models
approach.
(c) Risk-weighted assets for market
risk as calculated under [the
market risk rule]:\9\
Standardized approach for
specific risk; and
Internal models approach
for specific risk.
(d) Risk-weighted assets for
operational risk.
(e) Total and tier 1 risk-based
capital ratios:\10\
For the top consolidated
group; and
For each DI subsidiary.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\9\ Risk-weighted assets determined under [the market risk rule]
are to be disclosed only for the approaches used.
\10\ Total risk-weighted assets should also be disclosed.
---------------------------------------------------------------------------
General qualitative disclosure requirement
For each separate risk area described in tables 11.4 through 11.11,
the savings association must describe its risk management objectives
and policies, including:
strategies and processes;
the structure and organization of the relevant risk
management function;
the scope and nature of risk reporting and/or measurement
systems;
policies for hedging and/or mitigating risk and strategies
and processes for monitoring the continuing effectiveness of hedges/
mitigants.
[[Page 69442]]
Table 11.4.\11\--Credit Risk: General Disclosures
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to credit risk (excluding
counterparty credit risk disclosed
in accordance with Table 11.6),
including:
Definitions of past due
and impaired (for accounting
purposes);
Description of approaches
followed for allowances,
including statistical methods
used where applicable; and
Discussion of the savings
association's credit risk
management policy.
Quantitative Disclosures.......... (b) Total credit risk exposures and
average credit risk exposures,
after accounting offsets in
accordance with GAAP,\12\ and
without taking into account the
effects of credit risk mitigation
techniques (for example, collateral
and netting), over the period
broken down by major types of
credit exposure.\13\
(c) Geographic\14\ distribution of
exposures, broken down in
significant areas by major types of
credit exposure.
(d) Industry or counterparty type
distribution of exposures, broken
down by major types of credit
exposure.
(e) Remaining contractual maturity
breakdown (for example, one year or
less) of the whole portfolio,
broken down by major types of
credit exposure.
(f) By major industry or
counterparty type:
Amount of impaired loans;
Amount of past due loans;
\15\
Allowances; and
Charge-offs during the
period.
(g) Amount of impaired loans and, if
available, the amount of past due
loans broken down by significant
geographic areas including, if
practical, the amounts of
allowances related to each
geographical area.\16\
(h) Reconciliation of changes in the
allowance for loan and lease
losses.\17\
------------------------------------------------------------------------
---------------------------------------------------------------------------
\11\ Table 4 does not include equity exposures.
\12\ For example, FASB Interpretations 39 and 41.
\13\ For example, savings associations could apply a breakdown
similar to that used for accounting purposes.
Such a breakdown might, for instance, be (a) loans, off-balance
sheet commitments, and other non-derivative off-balance sheet
exposures, (b) debt securities, and (c) OTC derivatives.
\14\ Geographical areas may comprise individual countries,
groups of countries, or regions within countries.
A savings association might choose to define the geographical
areas based on the way the company's portfolio is geographically
managed. The criteria used to allocate the loans to geographical
areas must be specified.
\15\ A savings association is encouraged also to provide an
analysis of the aging of past-due loans.
\16\ The portion of general allowance that is not allocated to a
geographical area should be disclosed separately.
\17\ The reconciliation should include the following: a
description of the allowance; the opening balance of the allowance;
charge-offs taken against the allowance during the period; amounts
provided (or reversed) for estimated probable loan losses during the
period; any other adjustments (for example, exchange rate
differences, business combinations, acquisitions and disposals of
subsidiaries), including transfers between allowances; and the
closing balance of the allowance. Charge-offs and recoveries that
have been recorded directly to the income statement should be
disclosed separately.
Table 11.5.--Credit Risk: Disclosures for Portfolios Subject to IRB Risk-
Based Capital Formulas
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) Explanation and review of the:
Structure of internal
rating systems and relation
between internal and external
ratings;
Use of risk parameter
estimates other than for
regulatory capital purposes;
Process for managing and
recognizing credit risk
mitigation (see table 11.7); and
Control mechanisms for
the rating system, including
discussion of independence,
accountability, and rating
systems review.
(b) Description of the internal
ratings process, provided
separately for the following:
Wholesale category;
Retail subcategories;
Residential mortgage
exposures;
Qualifying revolving
exposures; and
Other retail exposures.
For each category and subcategory
the description should include:
The types of exposure
included in the category/
subcategories; and
The definitions, methods
and data for estimation and
validation of PD, LGD, and EAD,
including assumptions employed in
the derivation of these
variables.\18\
Quantitative disclosures: risk (c) For wholesale exposures, present
assessment. the following information across a
sufficient number of PD grades
(including default) to allow for a
meaningful differentiation of
credit risk:\19\
Total EAD; \20\
Exposure-weighted average
LGD (percentage);
Exposure-weighted average
risk weight; and
Amount of undrawn
commitments and exposure-weighted
average EAD for wholesale
exposures.
For each retail subcategory, present
the disclosures outlined above
across a sufficient number of
segments to allow for a meaningful
differentiation of credit risk.
Quantitative disclosures: (d) Actual losses in the preceding
historical results. period for each category and
subcategory and how this differs
from past experience. A discussion
of the factors that impacted the
loss experience in the preceding
period--for example, has the
savings association experienced
higher than average default rates,
loss rates or EADs.
[[Page 69443]]
(e) Savings association's estimates
compared against actual outcomes
over a longer period.\21\ At a
minimum, this should include
information on estimates of losses
against actual losses in the
wholesale category and each retail
subcategory over a period
sufficient to allow for a
meaningful assessment of the
performance of the internal rating
processes for each category/
subcategory.\22\ Where appropriate,
the savings association should
further decompose this to provide
analysis of PD, LGD, and EAD
outcomes against estimates provided
in the quantitative risk assessment
disclosures above.\23\
------------------------------------------------------------------------
---------------------------------------------------------------------------
\18\ This disclosure does not require a detailed description of
the model in full--it should provide the reader with a broad
overview of the model approach, describing definitions of the
variables and methods for estimating and validating those variables
set out in the quantitative risk disclosures below. This should be
done for each of the four category/subcategories. The savings
association should disclose any significant differences in approach
to estimating these variables within each category/subcategories.
\19\ The PD, LGD and EAD disclosures in Table 11.5(c) should
reflect the effects of collateral, qualifying master netting
agreements, eligible guarantees and eligible credit derivatives as
defined in part I. Disclosure of each PD grade should include the
exposure-weighted average PD for each grade. Where a savings
association aggregates PD grades for the purposes of disclosure,
this should be a representative breakdown of the distribution of PD
grades used for regulatory capital purposes.
\20\ Outstanding loans and EAD on undrawn commitments can be
presented on a combined basis for these disclosures.
\21\ These disclosures are a way of further informing the reader
about the reliability of the information provided in the
``quantitative disclosures: risk assessment'' over the long run. The
disclosures are requirements from year-end 2010; in the meantime,
early adoption is encouraged. The phased implementation is to allow
a savings association sufficient time to build up a longer run of
data that will make these disclosures meaningful.
\22\ This regulation is not prescriptive about the period used
for this assessment. Upon implementation, it might be expected that
a savings association would provide these disclosures for as long a
run of data as possible--for example, if a savings association has
10 years of data, it might choose to disclose the average default
rates for each PD grade over that 10-year period. Annual amounts
need not be disclosed.
\23\ A savings association should provide this further
decomposition where it will allow users greater insight into the
reliability of the estimates provided in the ``quantitative
disclosures: risk assessment.'' In particular, it should provide
this information where there are material differences between its
estimates of PD, LGD or EAD compared to actual outcomes over the
long run. The savings association should also provide explanations
for such differences.
Table 11.6.--General Disclosure for Counterparty Credit Risk of OTC
Derivative Contracts, Repo-Style Transactions, and Eligible Margin Loans
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to OTC derivatives, eligible margin
loans, and repo-style transactions,
including:
Discussion of methodology
used to assign economic capital
and credit limits for
counterparty credit exposures;
Discussion of policies
for securing collateral, valuing
and managing collateral, and
establishing credit reserves;
Discussion of the primary
types of collateral taken;
Discussion of policies
with respect to wrong-way risk
exposures; and
Discussion of the impact
of the amount of collateral the
savings association would have to
provide if the savings
association were to receive a
credit rating downgrade.
Quantitative Disclosures.......... (b) Gross positive fair value of
contracts, netting benefits, netted
current credit exposure, collateral
held (including type, for example,
cash, government securities), and
net unsecured credit exposure.\24\
Also report measures for EAD used
for regulatory capital for these
transactions, the notional value of
credit derivative hedges purchased
for counterparty credit risk
protection, and, for savings
associations not using the internal
models methodology in section 32(d)
of this appendix, the distribution
of current credit exposure by types
of credit exposure.\25\
(c) Notional amount of purchased and
sold credit derivatives, segregated
between use for the savings
association's own credit portfolio
and for its intermediation
activities, including the
distribution of the credit
derivative products used, broken
down further by protection bought
and sold within each product group.
(d) The estimate of alpha if the
savings association has received
supervisory approval to estimate
alpha.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\24\ Net unsecured credit exposure is the credit exposure after
considering the benefits from legally enforceable netting agreements
and collateral arrangements, without taking into account haircuts
for price volatility, liquidity, etc.
\25\ This may include interest rate derivative contracts,
foreign exchange derivative contracts, equity derivative contracts,
credit derivatives, commodity or other derivative contracts, repo-
style transactions, and eligible margin loans.
Table 11.7.--Credit Risk Mitigation 26 27 28
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to credit risk mitigation
including:
Policies and processes
for, and an indication of the
extent to which the savings
association uses, on- and off-
balance sheet netting;
Policies and processes
for collateral valuation and
management;
A description of the main
types of collateral taken by the
savings association;
The main types of
guarantors/credit derivative
counterparties and their
creditworthiness; and
Information about (market
or credit) risk concentrations
within the mitigation taken.
Quantitative Disclosures.......... (b) For each separately disclosed
portfolio, the total exposure
(after, where applicable, on-or off-
balance sheet netting) that is
covered by guarantees/credit
derivatives.
------------------------------------------------------------------------
[[Page 69444]]
---------------------------------------------------------------------------
\26\ At a minimum, a savings associagtion must provide the
disclosures in Table 11.7 in relation to credit risk mitigation that
has been recognized for the purposes of reducing capital
requirements under this appendix. Where relevant, savings
associations are encouraged to give further information about
mitigants that have not been recognized for that purpose.
\27\ Credit derivatives that are treated, for the purposes of
this appendix, as synthetic securitization exposures should be
excluded from the credit risk mitigation disclosures and included
within those relating to securitization.
\28\ Counterparty credit risk-related exposures disclosed
pursuant to Table 11.6 should be excluded from the credit risk
mitigation disclosures in Table 11.7.
Table 11.8.--Securitization
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to securitization (including
synthetics), including a discussion
of:
The savings association's
objectives relating to
securitization activity,
including the extent to which
these activities transfer credit
risk of the underlying exposures
away from the savings association
to other entities;
The roles played by the
savings association in the
securitization process \29\ and
an indication of the extent of
the savings association's
involvement in each of them; and
The regulatory capital
approaches (for example, RBA, IAA
and SFA) that the savings
association follows for its
securitization activities.
(b) Summary of the savings
association's accounting policies
for securitization activities,
including:
Whether the transactions
are treated as sales or
financings;
Recognition of gain-on-
sale;
Key assumptions for
valuing retained interests,
including any significant changes
since the last reporting period
and the impact of such changes;
and
Treatment of synthetic
securitizations.
(c) Names of NRSROs used for
securitizations and the types of
securitization exposure for which
each agency is used.
Quantitative Disclosures.......... (d) The total outstanding exposures
securitized by the savings
association in securitizations that
meet the operational criteria in
section 41 of this appendix (broken
down into traditional/synthetic),
by underlying exposure type.30 31
32
(e) For exposures securitized by the
savings association in
securitizations that meet the
operational criteria in Section 41
of this appendix:
Amount of securitized
assets that are impaired/past
due; and
Losses recognized by the
savings association during the
current period \33\ broken down
by exposure type.
(f) Aggregate amount of
securitization exposures broken
down by underlying exposure type.
(g) Aggregate amount of
securitization exposures and the
associated IRB capital requirements
for these exposures broken down
into a meaningful number of risk
weight bands. Exposures that have
been deducted from capital should
be disclosed separately by type of
underlying asset.
(h) For securitizations subject to
the early amortization treatment,
the following items by underlying
asset type for securitized
facilities:
The aggregate drawn
exposures attributed to the
seller's and investors'
interests; and
The aggregate IRB capital
charges incurred by the savings
association against the
investors' shares of drawn
balances and undrawn lines.
(i) Summary of current year's
securitization activity, including
the amount of exposures securitized
(by exposure type), and recognized
gain or loss on sale by asset type.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\29\ For example: originator, investor, servicer, provider of
credit enhancement, sponsor of asset backed commercial paper
facility, liquidity provider, or swap provider.
\30\ Underlying exposure types may include, for example, one- to
four-family residential loans, home equity lines, credit card
receivables, and auto loans.
\31\ Securitization transactions in which the originating
savings association does not retain any securitization exposure
should be shown separately but need only be reported for the year of
inception.
\32\ Where relevant, a savings association is encouraged to
differentiate between exposures resulting from activities in which
they act only as sponsors, and exposures that result from all other
savings association securitization activities.
\33\ For example, charge-offs/allowances (if the assets remain
on the savings association's balance sheet) or write-downs of I/O
strips and other residual interests.
Table 11.9.--Operational Risk
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement for
operational risk.
(b) Description of the AMA,
including a discussion of relevant
internal and external factors
considered in the savings
association's measurement approach.
(c) A description of the use of
insurance for the purpose of
mitigating operational risk.
------------------------------------------------------------------------
Table 11.10.--Equities Not Subject to Market Risk Rule
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to equity risk, including:
Differentiation between
holdings on which capital gains
are expected and those held for
other objectives, including for
relationship and strategic
reasons; and
Discussion of important
policies covering the valuation
of and accounting for equity
holdings in the banking book.
This includes the accounting
techniques and valuation
methodologies used, including key
assumptions and practices
affecting valuation as well as
significant changes in these
practices.
[[Page 69445]]
Quantitative Disclosures.......... (b) Value disclosed in the balance
sheet of investments, as well as
the fair value of those
investments; for quoted securities,
a comparison to publicly-quoted
share values where the share price
is materially different from fair
value.
(c) The types and nature of
investments, including the amount
that is:
Publicly traded; and
Non-publicly traded.
(d) The cumulative realized gains
(losses) arising from sales and
liquidations in the reporting
period.
(e) Total unrealized
gains (losses)\34\
Total latent revaluation
gains (losses)\35\
Any amounts of the above
included in tier 1 and/or tier 2
capital.
(f) Capital requirements broken down
by appropriate equity groupings,
consistent with the savings
association's methodology, as well
as the aggregate amounts and the
type of equity investments subject
to any supervisory transition
regarding regulatory capital
requirements.\36\
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\34\ Unrealized gains (losses) recognized in the balance sheet
but not through earnings.
\35\ Unrealized gains (losses) not recognized either in the
balance sheet or through earnings.
\36\ This disclosure should include a breakdown of equities that
are subject to the 0 percent, 20 percent, 100 percent, 300 percent,
400 percent, and 600 percent risk weights, as applicable.
Table 11.11.--Interest Rate Risk for Non-trading Activities
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Qualitative Disclosures........... (a) The general qualitative
disclosure requirement, including
the nature of interest rate risk
for non-trading activities and key
assumptions, including assumptions
regarding loan prepayments and
behavior of non-maturity deposits,
and frequency of measurement of
interest rate risk for non-trading
activities.
Quantitative Disclosures.......... (b) The increase (decline) in
earnings or economic value (or
relevant measure used by
management) for upward and downward
rate shocks according to
management's method for measuring
interest rate risk for non-trading
activities, broken down by currency
(as appropriate).
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* * * * *
Dated: November 8, 2007.
John C. Dugan,
Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System, November 13, 2007.
Robert deV. Frierson,
Deputy Secretary of the Board.
Dated at Washington, DC, this 5th day of November, 2007.
By Order of the Board of Directors. Federal Deposit Insurance
Corporation.
Valerie J. Best,
Assistant Executive Secretary.
Dated: October 29, 2007.
By the Office of Thrift Supervision.
John M. Reich,
Director.
[FR Doc. 07-5729 Filed 12-6-07; 8:45 am]
BILLING CODE 4810-33-P, 6210-01-P, 6714-01-P, 6720-01-P