[Federal Register: December 7, 2007 (Volume 72, Number 235)]
[Rules and Regulations]
[Page 69287-69445]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr07de07-12]
[[Page 69287]]
-----------------------------------------------------------------------
Part II
Department of the Treasury
-----------------------------------------------------------------------
Office of the Comptroller of the Currency
12 CFR Part 3
-----------------------------------------------------------------------
Federal Reserve System
-----------------------------------------------------------------------
12 CFR Parts 208 and 225
-----------------------------------------------------------------------
Federal Deposit Insurance Corporation
-----------------------------------------------------------------------
12 CFR Part 325
-----------------------------------------------------------------------
Department of the Treasury
-----------------------------------------------------------------------
Office of Thrift Supervision
12 CFR Parts 559, 560, 563, and 567
-----------------------------------------------------------------------
Risk-Based Capital Standards: Advanced Capital Adequacy Framework--
Basel II; Final Rule
[[Page 69288]]
-----------------------------------------------------------------------
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.
-----------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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
barbara.bouchard@frb.gov) or Anna Lee Hewko, Senior Supervisory
Financial Analyst (202-530-6260 or anna.hewko@frb.gov), Division of
Banking Supervision and Regulation; or Mark E. Van Der Weide, Senior
Counsel (202-452-2263 or mark.vanderweide@frb.gov), 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
[[Page 69289]]
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.
---------------------------------------------------------------------------
\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
.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\4\ The agencies issued draft guidance on the advanced
approaches. See 72 FR 9084 (February 28, 2007).
---------------------------------------------------------------------------
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
[[Page 69290]]
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.
---------------------------------------------------------------------------
\5\ 71 FR 77445 (Dec. 26, 2006).
---------------------------------------------------------------------------
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
[[Page 69291]]
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
[[Page 69292]]
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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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:
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
\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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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