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BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Date:
October 26, 2007
To:
Board of Governors
From:
Governor Kroszner
Subject:
Implementation of Advanced Capital Adequacy Framework (Basel II Draft Final
Rule)
Attached are a memorandum to the Board, a draft Federal Register notice (draft final
rule), and a Technical Overview of the Final Rule that relate to the interagency implementation
of an advanced capital adequacy framework. The framework, which is based on the Basel
Committee on Banking Supervision's 2006 revised capital accord, will adopt advanced
measurement approaches for assessing risk-based capital for credit risk and operational risk. The
draft final rule would be published jointly by the four federal banking agencies in the Federal
Register after all of the agencies have completed their internal review and approval procedures.
The Committee on Supervisory and Regulatory Affairs has been briefed on the draft final
rule and I believe it is ready for the Board's consideration at an open Board meeting on
November 2, 2007.
Attachments
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Date:
To:
From:
Subject:
October 26, 2007
Board of Governors of the Federal Reserve System
Federal Reserve Staff 1
Implementation of Advanced Capital Adequacy Framework (Basel II Draft Final
Rule)
ACTION REQUESTED
Staff requests Board approval to issue a final rule implementing a new risk-based capital
framework based on the Basel Committee on Banking Supervision’s (Basel Committee) revised
capital accord entitled “International Convergence of Capital Measurement and Capital
Standards: A Revised Framework” (New Accord). Staff also requests Board approval to make
non-substantive edits to the final rule text prior to its publication to accommodate further
interagency discussion. A draft of the final rule is provided as Attachment 1.
Staff notes that the Federal Deposit Insurance Corporation is scheduled to hold a board
meeting on November 5, 2007, to consider the final rule. It is not certain at this time when the
other banking agencies (the Office of the Comptroller of the Currency and the Office of Thrift
Supervision) will complete their internal review and approval procedures. If approved by the
Board, the final rule would be published jointly by the agencies in the Federal Register after all
agencies have obtained final approval. In the event that substantive issues arise prior to
publication, staff would circulate a revised draft final rule to the Board for consideration by
notation vote.
1
Roger Cole, Steven Roberts, Deborah Bailey, Norah Barger, Robin Lumsdaine, Barbara Bouchard, Anna Lee
Hewko, and Constance Horsley (Division of Banking Supervision and Regulation); David Jones (Research
Division); Scott Alvarez, Mark Van Der Weide, Allison Breault, and April Snyder (Legal Division).
2
BACKGROUND
On September 25, 2006, the agencies issued a joint notice of proposed rulemaking
(proposal or proposed rule) implementing the Basel Committee’s New Accord. 2 The New
Accord was designed to modernize the Basel Committee’s first capital accord (Basel I) issued in
1988, which was developed in part to strengthen capital levels at banks and to foster international
consistency in capital measurement. The New Accord encompasses three pillars: minimum
regulatory capital requirements (pillar 1); supervisory review of capital adequacy (pillar 2); and
market discipline through enhanced public disclosure (pillar 3). Under pillar 1, a banking
organization calculates risk-based capital requirements for exposure to credit risk and operational
risk. Banking organizations with significant trading activities also factor in a measure for
exposure to market risk. The New Accord provides several methodologies for determining riskbased capital requirements for both credit risk and operational risk.
For credit risk, the New Accord includes a standardized approach, which modifies and
enhances the modestly risk-sensitive Basel I approach, and two internal ratings-based (IRB)
approaches, which use an institution’s internal estimates of key risk parameters in combination
with supervisory capital formulas to determine risk-based capital requirements. Under the
foundation IRB approach, some risk parameters are estimated by banking organizations and
others are set by supervisors. Under the advanced IRB approach, all of the key risk parameters
are determined by banking organizations.
The New Accord also provides three methodologies for operational risk. The basic
indicator approach and the standardized approach both link operational risk capital requirements
2
71 FR 55830. Also on September 25, 2006, the agencies issued a proposal to revise the market risk capital rules
(market risk proposal, 71 FR 55958) as well as two notices and requests for comment addressing proposed
regulatory reporting requirements related to the Basel II proposal and the market risk proposal (71 FR 55981 and 71
3
to fixed percentages of a banking organization’s gross income. The advanced measurement
approaches (AMA) rely on a banking organization’s internal operational risk measurement and
management processes.
The agencies’ proposal included only the advanced IRB approach for credit risk and the
AMA for operational risk (together, the advanced approaches). Under the proposal, banking
organizations with at least $250 billion of consolidated total assets or at least $10 billion of onbalance-sheet foreign exposures (core banking organizations) would be required to use the
advanced approaches, and other banking organizations that satisfied the substantial risk
measurement and management infrastructure requirements of the proposed rule would be able to
opt in to the advanced approaches.
The Federal Reserve Board received over 60 written comments, and staff and senior
officials participated in numerous meetings with industry representatives and other interested
parties to hear views on the proposal. Each of these written comments, and summaries of the
meetings, are included in the public record of the proposal. A summary of the comments will be
made available in the Office of the Secretary of the Board.
After reviewing all comments and considering issues and alternative approaches, agency
staffs have developed this draft final rule for the Board’s consideration. The remainder of this
memorandum (i) highlights several of the reasons staff supports moving to the advanced capital
adequacy framework, (ii) provides an overview of the draft final rule, and (iii) describes several
key issues commenters identified and how staff has responded to those issues in the draft final
rule. Attachment 2 provides a more complete overview of the mechanics of the final rule.
FR 55986). A draft final rule for market risk will be circulated later for Board consideration by notation vote. The
regulatory reporting templates for both the advanced approaches and market risk are expected to be finalized soon.
4
DISCUSSION
Reasons for Moving to the Advanced Capital Adequacy Framework
Staff believes that prudent and risk-sensitive regulatory capital requirements are integral
to ensuring that individual banks and the financial system in general have an adequate capital
cushion against losses. While the Basel I-based risk-based capital rules provided a major step
forward in capital risk sensitivity in the late 1980s, rapid and extensive evolution in the financial
marketplace has substantially reduced the effectiveness of those rules for the largest
internationally active banking organizations that offer evermore complex and sophisticated
products and services in a competitive global environment.
The simple risk-bucketing approach of Basel I creates some perverse incentives for risk
taking. For example, the Basel I-based rules require the same amount of regulatory capital
against all unsecured corporate loans and bonds regardless of actual risk, and treat almost all
first-lien residential mortgage exposures as equally risky. This provides an incentive for banking
organizations to shed lower-risk exposures and acquire or retain higher-risk exposures within
some asset categories. The Basel I-based rules also do not take into account important elements
of credit-risk mitigation – such as most forms of collateral, many guarantees and credit
derivatives, and the maturity and seniority of exposures – and, thus, may blunt incentives for
banks to reduce or otherwise manage risk. Moreover, the Basel I-based rules are particularly
inadequate for dealing with capital markets transactions, such as repurchase agreements,
securities borrowing and lending, margin loans, and over-the-counter (OTC) derivatives.
The advanced approaches of the New Accord are designed to reduce substantially the
perverse incentive effects and opportunities for regulatory capital arbitrage that exist under the
Basel I-based rules. Under the advanced approaches, risk-based capital requirements for
5
exposures will vary on the basis of a banking organization’s actual risk profile and experience.
A banking organization with higher risk will have higher regulatory capital requirements than a
banking organization with a lower risk profile. This enhanced risk sensitivity should ensure that
banking organizations have positive incentives for lending to creditworthy counterparties and for
lending on a collateralized basis. The advanced approaches also provide more sophisticated
methods to address capital market-related transactions.
In addition, the advanced approaches build on the economic capital and other riskmeasurement and management approaches of sophisticated banking organizations and are
designed to evolve over time as banking organizations refine and enhance their internal
approaches. As a result, the advanced approaches are better able than the current system to adapt
to innovations in banking and financial markets. The advanced approaches also should establish
a more coherent relationship between the risk-based regulatory measure of capital adequacy and
a banking organization’s day-to-day risk management. Under the draft final rule, the agencies
must approve a banking organization’s use of models under the advanced approaches.
Staff notes that banking organizations have made substantial progress in developing more
sophisticated risk measurement and management processes as a direct result of the advanced
approaches implementation process. As banking organizations are taking a more granular
approach to assessing risk drivers, they are making more informed decisions about extending
credit, mitigating risk, and determining overall capital needs. Staff believes that moving to the
advanced approaches will improve regulatory incentives for banking organizations and will serve
to promote safety and soundness for the banking sector and the financial system as a whole.
Before any banking organization will be permitted to use the advanced approaches without being
subject to transitional safeguards, staffs of the agencies have committed to assess the
6
functionality and the quantitative impact of the advanced approaches. Staff will recommend
modifications to the framework if material deficiencies are found.
Overview of the Draft Final Rule
The draft final rule maintains the existing risk-based capital rules’ (referred to as 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 draft
final rule are generally the same as in the general risk-based capital rules, although some
adjustments have been made for purposes of the advanced approaches. (See Attachment 1, draft
final rule preamble section IV.) Under the draft final rule, a banking organization must meet
specified infrastructure and risk measurement and management requirements before it may use
the advanced approaches to determine its risk-based capital requirements. (See Attachment 1,
draft final rule preamble sections III.A. and B.)
Under the advanced approaches, a banking organization calculates its risk-based capital
requirements by first identifying whether each of its on- and off-balance sheet exposures is a
wholesale, retail, securitization, or equity exposure. Wholesale exposures include most credit
exposures to companies, sovereigns, and other governmental entities. For each wholesale
exposure, a banking organization must assign four quantitative risk parameters: (i) probability of
default (PD, which is an estimate of the probability that the exposure’s obligor will default over a
one-year horizon); (ii) loss given default (LGD, which is an estimate of the economic loss rate on
the exposure if a default occurs during economic downturn conditions); (iii) exposure at default
(EAD, which is an estimate of the amount owed to the banking organization on the exposure at
the time of default); and (iv) maturity (M, which reflects the effective remaining maturity of the
exposure). Banking organizations may factor into their wholesale risk parameter estimates the
7
risk mitigating impact of collateral, and of credit derivatives and guarantees that meet certain
criteria. Banking organizations must input their risk parameter estimates for each wholesale
exposure into the appropriate wholesale IRB risk-based capital formula to determine the riskbased capital requirement for the exposure.
Retail exposures include most credit exposures to individuals and certain small credit
exposures to businesses. Under the draft final rule, a banking organization must sub-categorize
each retail exposure as a residential mortgage exposure, a qualifying revolving exposure (QRE),
or an other retail exposure. Within these subcategories, a banking organization must group
exposures into segments with similar risk characteristics and then assign the risk parameters PD,
LGD, and EAD to each retail segment. For retail exposures, a banking organization may take
into account the risk mitigating effects of collateral and guarantees in the segmentation process
and in the assignment of risk parameters. Similar to wholesale exposures, a banking
organization must input its risk parameter estimates for each retail segment into the IRB riskbased capital formula for the retail subcategory to determine the risk-based capital requirement
for the segment.
Securitization exposures include most tranched credit exposures to underlying financial
assets, such as most asset- and mortgage-backed securities. For securitization exposures, the
draft final rule has 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 a banking organization’s internal credit
assessments to risk weight exposures to asset-backed commercial paper programs; and the
Supervisory Formula Approach (SFA), which uses banking organization inputs and a
supervisory formula to risk weight exposures. Securitization exposures that do not qualify for
8
the RBA, the IAA, or the SFA, and certain other types of exposures such as gain-on-sale and
other credit-enhancing interest-only strips, are deducted from regulatory capital.
Equity exposures generally include ownership interests in the assets and income of a
company. Under the draft final rule, banking organizations may use an Internal Models
Approach (IMA) for determining risk-based capital requirements for equity exposures, subject to
certain qualifying criteria and risk weight floors. If a banking organization does not have a
qualifying internal model for equity exposures or chooses not to use such a model, it must use
the Simple Risk Weight Approach (SRWA). Under the SRWA, publicly traded equity exposures
generally are assigned a 300 percent risk weight and private equity exposures generally are
assigned a 400 percent risk weight. Certain equity exposures, such as Federal Reserve stock,
Federal Home Loan Bank stock, and community development equity investments, are subject to
a zero to 100 percent risk weight.
Operational risk is generally defined as the risk of loss resulting from inadequate or failed
internal processes, people, and systems or from external events (including legal risk but
excluding strategic and reputational risk). For operational risk, the draft final rule requires a
banking organization to develop qualifying AMA systems and to use its own methodology to
identify operational loss events, measure its exposure to operational risk, and assess a risk-based
capital requirement for that risk. A banking organization may take eligible operational risk
offsets and qualifying operational risk mitigants (such as insurance) into account when
determining its operational risk capital requirement.
The draft final rule also includes a pillar 2 requirement that a banking organization must
have a rigorous process for assessing its overall capital adequacy in relation to its overall risk
profile and a comprehensive strategy for maintaining an appropriate level of capital. In addition,
9
the draft final rule contains pillar 3 public disclosure requirements to provide information to
market participants on the capital structure, risk exposures, risk assessment processes and, thus,
the capital adequacy of a banking organization.
Key Issues Raised by Commenters
General considerations
Overall, commenters on the proposal supported the direction of the new framework and
the move to more risk-sensitive capital requirements. One overarching issue, however, was the
degree to which the proposal differed from the New Accord. Commenters said the differences
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 banking
organizations subject to the rule.
In addition, commenters generally disagreed with the agencies’ decision to propose only
the advanced approaches from the New Accord. Many commenters urged the agencies to permit
use of the standardized approach to credit risk and the basic indicator and standardized
approaches to operational risk. Commenters also objected to the agencies’ retention of the
leverage ratio and the transitional arrangements in the proposal, which included a one-year
delayed implementation date relative to the New Accord and a three-year transition period with
more gradual possible reductions in risk-based capital requirements compared to the New
Accord’s two-year transition period. Commenters also opposed the proposal’s identified
10 percent numerical benchmark for evaluating and responding to capital outcomes during the
transition period. Moreover, commenters raised numerous technical issues.
On July 20, 2007, representatives of the agencies issued a press release addressing
several of these concerns. The press release announced the agencies’ preliminary agreement to
10
eliminate language concerning a 10 percent benchmark regarding aggregate reductions in riskbased capital requirements. Further, the press release noted the agencies’ final rule should be
technically consistent in most respects with the international approaches in the New Accord;
however, the agencies continued to prefer to retain the transitional arrangements as proposed,
including a parallel run period and three transitional floor periods. (See Attachment 1, draft final
rule preamble sections I.E. and III.A.2.) Under the draft final rule, the first opportunity for a
banking organization to begin its parallel run is 2008 and the transitional floors generally
prohibit a banking organization’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 rules during the banking organizations’ first, second, and third transitional
floor periods, respectively. The press release noted the agencies would publish a study after the
end of the second transition period that evaluates the new framework to determine if there are
any material deficiencies.
The press release also stated that the agencies had agreed to proceed promptly to issue a
proposed rule that would provide all non-core banking organizations (that is, banking
organizations not required to adopt the advanced approaches) with the option to adopt a
standardized approach based on the New Accord. This new proposal will replace the agencies’
earlier Basel I-A proposal, issued in December 2006. 3 Interagency work is progressing on the
standardized proposal, and staff will submit that proposal to the Board for its consideration at a
later date. As described in the press release, the agencies intend to finalize the proposed
standardized option before core banking organizations begin the first transition year under the
advanced approaches. In addition, while not specifically mentioned in the press release, the
3
71 FR 77446 (Dec. 26, 2006).
11
agencies intend to retain the leverage ratio and the prompt corrective action regulations without
modification.
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 have reiterated a long-standing principle of conservatism in the final rule. In general,
under this principle, in limited situations a banking organization may choose not to apply a
provision of the final rule to one or more exposures if the banking organization can demonstrate
to the satisfaction of its primary Federal supervisor that not applying the provision would, in all
circumstances, generate a risk-based capital requirement for each exposure that is greater than
that which would otherwise be required under the final rule. (See Attachment 1, draft final rule
preamble section II.D.)
The draft final rule also includes modifications and technical amendments to address a
range of issues raised by commenters. A number of these revisions are intended to bring the
U.S. advanced approaches more in line with the New Accord. Other revisions are intended to
address issues related to regulatory burden, to provide more flexibility to both supervisors and
banking organizations, or to provide more certainty in areas where commenters believed the
proposal was not clear. Still other modifications address particular issues related to U.S.
markets. These modifications and technical amendments are discussed throughout Attachment 1
in the preamble to the draft final rule.
Scope of application of the final rule
The draft final rule includes without change the proposed criteria for identifying core
banking organizations and continues to permit other banking organizations (opt-in banks) to
adopt the advanced approaches if they meet the rule’s qualification requirements. As noted
12
above, core banking organizations are those with consolidated total assets (excluding assets held
by an insurance underwriting subsidiary) of $250 billion or more or with consolidated total onbalance sheet foreign exposure of $10 billion or more. A depository institution (DI) is a core
banking organization if it is a subsidiary of another DI or a bank holding company (BHC) that
uses the advanced approaches. Similarly, a BHC is a core banking organization if it has a
subsidiary DI that uses the advanced approaches.
While several commenters objected to these criteria, particularly as they might be applied
to foreign-owned banking organizations, staff believes the criteria appropriately identify those
banking organizations that, absent other relevant factors, should implement the advanced
approaches. Staff has clarified in the draft final rule that a core banking organization’s primary
Federal supervisor may determine that application of the final rule is not appropriate in light of
the banking organization’s asset size (including subsidiary DI asset size relative to total BHC
asset size), level of complexity, risk profile, or scope of operations. This determination may be
made for either a U.S.-owned or a foreign-owned banking organization. (See Attachment 1,
draft final rule preamble sections II.A. and B.)
The draft final rule does not give core banking organizations the option to use the simpler
approaches in the New Accord. Staff believes it would be appropriate to require large,
internationally active U.S. banking organizations to use the most advanced approaches of the
New Accord for several reasons. First and most important, the less advanced approaches of the
New Accord lack the risk sensitivity of the advanced approaches. As noted above, staff believes
that risk-sensitive regulatory capital requirements are integral to ensuring that large,
sophisticated banking organizations and the financial system more generally have adequate
capital to absorb financial losses. Second, the advanced approaches are designed to substantially
13
reduce the inappropriate incentive effects and opportunities for regulatory capital arbitrage
present in the existing Basel I-based risk-based capital rules and most easily exploitable by large,
complex banking organizations. The simpler approaches in the New Accord, which rely to a
greater extent on fixed risk weight buckets and supervisory-determined risk parameters, provide
significantly fewer impediments to arbitrage.
Third, the advanced approaches provide more substantial incentives for banking
organizations to improve their risk measurement and management practices than do the other
approaches. Staff also does not believe that competitive equity concerns support permitting
large, internationally active U.S. banking organizations to adopt the simpler approaches in the
New Accord. The Basel Committee did not design the New Accord’s simpler approaches for
large, complex banking organizations in the G-10 countries, and staff understands from the Fifth
Quantitative Impact Study (QIS5) 4 results that no large, complex banking organization in the G10 countries plans to use the New Accord’s standardized approach for credit risk.
Credit Risk Capital Requirements
Commenters raised several issues related to key definitions in, and mechanics of, the
proposal. For wholesale exposures, commenters objected to the wholesale definition of default,
to the requirement that each wholesale obligor have only one associated PD, and to the
proposal’s failure to include a separate risk-weight formula for exposures to small- to mediumsize enterprises (SMEs). For retail exposures, commenters disagreed with the proposal’s retail
definition of default and with the proposal’s definition of PD for segments of retail exposures
with material seasoning effects. For both wholesale and retail exposures, commenters opposed
the proposed requirement that banking organizations estimate an expected loss given default
4
Results of the Basel Committee’s QIS5 dated June 16, 2006, is available through the Bank for International
Settlements’ website at www.bis.org.
14
(ELGD) risk parameter in addition to the LGD risk parameter, and use a supervisory mapping
function to convert ELGD into LGD if they did not qualify to use their own internal estimates of
LGD. In addition, a number of commenters requested further clarity about the procedures
banking organizations should use to estimate risk parameters for portfolios characterized by a
lack of internal data or by little default experience.
In the securitization context, some commenters asserted that the definition of a
securitization exposure was too broad. With regard to equity exposures, commenters opposed
the proposal’s failure to include a grandfathering period. These issues are addressed below.
Wholesale exposures
Wholesale definition of default
Under the proposal, the agencies defined a wholesale obligor to be in default if, for any
wholesale exposure of the bank to the obligor, the bank had (i) placed the exposure on nonaccrual status; (ii) taken a full or partial charge-off or write-down on the exposure due to the
distressed financial condition of the obligor; or (iii) incurred a credit-related loss of 5 percent or
more of the exposure’s initial carrying value in connection with the sale of the exposure or the
transfer of the exposure to another reporting category.
This proposed definition was different from the definition in the New Accord, but was
designed to be responsive to commenter concerns expressed in response to the agencies’ earlier
proposed definition of wholesale default. 5 Commenters on the proposal strongly objected to the
proposed definition, noting that it was more prescriptive than the New Accord’s definition. They
asserted that the proposed definition would impose unjustifiable systems burden and expense on
banking organizations operating across multiple jurisdictions. They also asserted that many
5
The agencies issued an advance notice of proposed rulemaking related to the new risk-based capital framework
based on a 2003 Basel Committee consultative paper (68 FR 45900, August 4, 2003).
15
banking organizations’ existing data collection systems are based on the New Accord’s
definition, and therefore historical data relevant to the proposed definition are limited.
Moreover, some commenters expressed concern that the proposal’s U.S.-centric wholesale
definition of default would affect PD and LGD estimation and create competitive inequities
between U.S. banking organizations and non-U.S. banking organizations that use the New
Accord’s wholesale default definition. Finally, a number of commenters asserted that the
proposed 5 percent credit-related loss trigger inappropriately imported LGD and maturity-related
considerations into the definition of wholesale default, could hamper the use of loan sales as a
risk management practice, and could cause some performing obligors to be treated as defaulted.
Staff agrees with many of these commenter concerns and has revised the definition of
default for wholesale exposures to be consistent with the definition in the New Accord. (See
Attachment 1, draft final rule preamble section III.B.) Thus, under the draft final rule, a banking
organization’s obligor is in default if, for any wholesale exposure of the banking organization to
the obligor: (i) the banking organization considers that the obligor is unlikely to pay its credit
obligations to the banking organization in full, without recourse by the banking organization to
actions such as realizing collateral (if held); or (ii) the obligor is past due more than 90 days on
any material credit obligation to the banking organization. The draft final rule notes that the
following elements are indications of unlikeliness to pay:
(i)
The banking organization places the exposure on non-accrual status;
(ii)
The banking organization takes a full or partial charge-off or write-down on the
exposure due to the distressed financial condition of the obligor;
16
(iii)
The banking organization incurs a material credit-related loss in connection with
the sale of the exposure or the transfer of the exposure to the held-for-sale,
available-for-sale, trading, or other reporting category;
(iv)
The banking organization consents to a distressed restructuring of the exposure
that is likely to result in a diminished financial obligation caused by the material
forgiveness or postponement of principal, interest or (where relevant) fees;
(v)
The banking organization has filed as a creditor of the obligor for purposes of the
obligor’s bankruptcy under the U.S. Bankruptcy Code (or similar proceeding in a
foreign jurisdiction); or
(vi)
The obligor has sought or has been placed in bankruptcy or similar protection that
would avoid or delay repayment of the exposure to the banking organization.
Assignment of PD to wholesale obligors
Under the proposed rule, a banking organization would assign each legal entity wholesale
obligor to an internal rating grade and then associate a PD with each rating grade. Accordingly,
if a single wholesale exposure of the banking organization to an obligor triggered the proposed
rule’s definition of default, all of the banking organization’s wholesale exposures to that obligor
would receive the capital treatment for exposures to defaulted obligors. While a few
commenters expressly supported this approach, a substantial number of commenters expressed
reservations about this requirement. These commenters observed that in certain circumstances
an exposure’s transaction-specific characteristics affect its likelihood of default. In particular,
some commenters maintained that income-producing real estate lending should be exempt from
the one-rating-per-obligor requirement. They asserted that the probability that an obligor will
default on any one such facility depends primarily on the cash flows from the individual property
17
securing the facility, and not on the overall condition of the obligor. Several other commenters
asserted that exposures involving transfer risk and debtor-in-possession (DIP) financing
exposures also should be exempted from the one-rating-per-obligor requirement because the
likelihood of default for such exposures is affected by exposure-specific factors. 6
In general, staff believes that a two-dimensional rating system that strictly separates
obligor and exposure-level characteristics is a critical underpinning of the IRB approach.
However, staff agrees with commenters that in some circumstances a departure from this
principle may be reasonable. Accordingly, staff has modified the draft final rule to provide that
the following three types of exposures to the same legal entity or natural person may avoid the
one-rating-per-obligor requirement: exposures with transfer risk; certain income-producing real
estate exposures; and certain DIP financing exposures. (See Attachment 1, draft final rule
preamble section III.B.)
Risk weight formula for SMEs
The New Accord includes a separate risk-based capital formula for exposures to SMEs.
The SME formula in the New Accord results in a lower risk-based capital requirement for an
exposure to an SME than for an exposure to a larger firm that has the same risk parameter
estimates. A number of commenters urged the agencies to include in the final rule the SME riskbased capital formula from the New Accord, expressing concern about potential competitive
disparities in the market for SME lending between U.S. banking organizations and foreign
banking organizations subject to risk-based capital rules that include the New Accord’s SME
treatment.
6
DIP financing occurs when a borrower enters into bankruptcy and the banking organization extends additional
credit to the borrower under the auspices of the bankruptcy proceeding. DIP financing is different from other
exposure types in that it typically has priority over existing debt, equity, and other claims on the borrower.
18
While commenters raised important issues related to SME exposures, staff does not
believe that a distinct risk-weight formula for SME exposures is supported by sufficient
empirical evidence. Staff also has concerns about creating a domestic competitive disparity
between U.S. banking organizations subject to the advanced approaches and U.S. banking
organizations subject to other risk-based capital rules. As a result, the draft final rule does not
include a distinct risk-weight formula for SME exposures. Such exposures generally are
included in the treatment for wholesale exposures. (See Attachment 1, draft final rule preamble
section V.A.1.)
Retail Exposures
Retail definition of default
Under the proposal, qualifying revolving retail exposures and residential mortgage
exposures would be in default at 180 days past due; other retail exposures would be in default at
120 days past due. In addition, a retail exposure would be in default if the banking organization
has taken a full or partial charge-off or write-down of principal on the exposure for credit-related
reasons. The proposed days-past-due timeframes are consistent with those embodied in the
Federal Financial Institutions Examination Council’s Uniform Retail Credit Classification and
Account Management Policy, 7 and are consistent with national discretion provided in the New
Accord. While some commenters supported the proposed definition of retail default, other
commenters urged the agencies to adopt a 90-days-past-due trigger. Others requested that a nonaccrual trigger be added to the retail definition of default similar to the proposed wholesale
definition of default.
Staff has not incorporated a 90-days-past-due or non-accrual trigger into the draft final
rule. Retail non-accrual practices vary considerably among banking organizations, and staff
19
believes that adding a non-accrual trigger to the retail definition of default would result in
inconsistency among banking organizations in the treatment of retail exposures. Moreover, staff
believes that the 120- and 180-days-past-due thresholds, which are consistent with the New
Accord, reflect a point at which retail exposures in the United States are unlikely to return to
performing status. A banking organization that considers retail exposures to be defaulted at 90
days past due would likely have higher PD estimates and lower LGD estimates relative to a
banking organization using the proposed 120- and 180-day thresholds due to the established
tendency of a nontrivial proportion of U.S. retail exposures to “cure” or return to performing
status after becoming 90 days past due and before becoming 120 or 180 days past due.
Therefore, to prevent the incidence of a substantial number of “false” retail defaults, staff has
retained the proposed retail definition of default without substantive change in the draft final
rule.
As noted, the New Accord provides discretion for national supervisors to set retail default
triggers between 90 and 180 days past due for different products, as appropriate to local
conditions. Accordingly, banking organizations implementing the IRB approach in multiple
jurisdictions may be subject to different retail definitions of default in their home and host
jurisdictions. Staff believes that it could be costly and burdensome for a U.S. banking
organization to track retail default data and estimate risk parameters based on both the U.S. retail
definition of default and the definitions adopted in non-U.S. jurisdictions. Staff has therefore
incorporated some flexibility into the draft final rule. Specifically, for a retail exposure held by a
U.S. banking organization’s non-U.S. subsidiary subject to an IRB approach consistent with the
New Accord in a non-U.S. jurisdiction, the draft final rule allows the banking organization to use
7
65 FR 36903, June 12, 2000.
20
the definition of default in that non-U.S. jurisdiction, subject to prior approval by the banking
organization’s primary Federal supervisor.
Seasoning effects in the retail definition of PD
Some types of retail exposures typically display a seasoning pattern – the exposures have
relatively low default rates in their first year, rising default rates in the next few years, and
declining default rates for the remainder of their terms. Because the IRB framework typically
looks to a one-year horizon, the proposed rule defined PD for a segment of non-defaulted retail
exposures for which seasoning effects were material as the banking organization’s empirically
based best estimate of the annualized cumulative default rate over the expected remaining life of
exposures in the segment, capturing the average default experience for exposures in the segment
over a mix of economic conditions.
A number of commenters objected to this treatment of retail exposures with seasoning
effects. They asserted that requiring the use of an annualized cumulative default rate was too
prescriptive and would preclude other reasonable approaches. Staff believes that several
commenters presented reasonable alternative approaches to recognizing the effects of seasoning
in PD and, thus, staff has provided more flexibility for recognizing those effects in the draft final
rule. The draft final rule generally defines PD for a segment of non-defaulted retail exposures as
the banking organization’s empirically based best estimate of the long-run average one-year
default rate for the exposures in the segment, capturing the average default experience for
exposures in the segment over a mix of economic conditions and adjusted upward as appropriate
to reflect material seasoning effects. (See Attachment 1, draft final rule preamble section
III.B.2.)
21
Issues related to both wholesale and retail exposures
LGD and ELGD
Under the proposal, a banking organization generally would be required to estimate both
an ELGD and an LGD risk parameter for each wholesale exposure and for each segment of retail
exposures. The proposal defined ELGD as the banking organization’s empirically based best
estimate of the default-weighted average economic loss per dollar of EAD that the banking
organization expected to incur in the event that the exposure defaulted within a one-year horizon.
ELGD was required to incorporate a mix of economic conditions (including economic downturn
conditions). ELGD had four functions in the proposed rule: (i) as a component of the
calculation of expected credit loss (ECL) in the numerator of the risk-based capital ratios; (ii) in
the expected loss (EL) component of the IRB risk-based capital formulas; (iii) as a floor on the
value of the LGD risk parameter for each exposure; and (iv) as an input into a supervisory
mapping function (which enabled banking organizations that could not determine their own
estimates of LGD to convert ELGD estimates into LGD estimates).
Many commenters objected to the proposed rule’s requirement for banking organizations
to estimate ELGD, noting that ELGD is not required under the New Accord. Commenters
asserted that requiring ELGD estimation would create a competitive disadvantage by creating
additional systems, compliance, calculation, and reporting burden for those banking
organizations subject to the U.S. rule. They also maintained that inclusion of the ELGD risk
parameter would decrease the comparability of U.S. banking organization capital requirements
and public disclosures relative to those of foreign banking organizations applying the advanced
approaches.
22
Staff generally agrees with these concerns and has not included the ELGD risk parameter
in the draft final rule. Instead, consistent with the New Accord, a banking organization would
use LGD for the calculation of ECL in the risk-based capital numerator and the EL component of
the IRB risk-based capital formulas. Although staff has eliminated the ELGD risk parameter
from the draft final rule, consistent with the New Accord, the LGD of a wholesale exposure or
retail segment under the draft final rule must not be less than the banking organization’s
empirically based best estimate of the long-run default-weighted average economic loss, per
dollar of EAD, the banking organization would expect to incur if the obligor were to default
within a one-year horizon over a mix of economic conditions. (See Attachment 1, draft final rule
preamble section III.B.3.)
Supervisory mapping function
The proposed rule included two ways for a banking organization to generate LGD
estimates for wholesale exposures and retail segments. First, a banking organization could use
its own estimates of LGD for a subcategory of exposures if the banking organization had prior
written approval from its primary Federal supervisor to use its own estimates and the banking
organization could demonstrate that its estimates of LGD were reliable and sufficiently reflective
of economic downturn conditions. Second, the proposed rule contained a supervisory mapping
function for converting ELGD into LGD for risk-based capital purposes. A banking organization
that did not qualify to use its own estimates of LGD would instead compute LGD using the
linear supervisory mapping function LGD = 0.08 + 0.92 x ELGD. The agencies proposed the
supervisory mapping function because of concerns that banking organizations may find it
difficult to produce sufficiently robust internal estimates of LGD. The supervisory mapping
23
function provided a pragmatic methodology for banking organizations to use while refining their
LGD estimation techniques.
In general, commenters viewed the supervisory mapping function as a significant
departure from the New Accord that would add unwarranted prescriptiveness and regulatory
burden to the U.S. rule. Commenters expressed concern that U.S. supervisors would employ an
unreasonably high standard for allowing own estimates of LGD, thereby forcing banking
organizations to use the supervisory mapping function for an extended period of time. Some
commenters viewed the supervisory mapping function as crude and as overly punitive for
exposure types with very low loss severities, effectively imposing an 8 percent floor on LGD.
Commenters asserted that risk-based capital requirements would be increased at U.S. banking
organizations relative to their foreign competitors, particularly for high-quality assets, putting
U.S. banking organizations at a competitive disadvantage with respect to foreign banking
organizations.
Staff continues to believe that the supervisory mapping function is a reasonable aid for
dealing with difficulties in LGD estimation. However, staff also recognizes there may be several
valid methodologies for addressing LGD estimation challenges. Therefore, the draft final rule
does not require use of the supervisory mapping function. The preamble to the draft final rule
notes that a banking organization’s estimates of LGD must be reliable and sufficiently reflective
of economic downturn conditions and states that a banking organization should have rigorous
and well-documented policies and procedures for identifying economic downturn conditions for
each exposure subcategory; identifying adverse relationships between the relevant risk drivers of
default rates and loss rates given default; and incorporating identified relationships into LGD
estimates. (See Attachment 1, draft final rule preamble section III.B.3.)
24
Portfolios with limited data or low numbers of defaults
Many commenters requested further clarity about the procedures that banking
organizations should use to estimate risk parameters for portfolios characterized by a lack of
internal data or by very little default experience. Several commenters asked the agencies to
establish criteria for allowing banking organizations to apportion EL between LGD and PD for
certain low risk portfolios rather than estimating each risk parameter separately. Other
commenters suggested the agencies should consider allowing banking organizations to use the
New Accord’s standardized approach for credit risk for limited-data or low-default portfolios.
The draft final rule requires banking organizations to meet the qualification requirements
for all of their portfolios. The preamble to the draft final rule notes that banking organizations
that demonstrate appropriately rigorous processes and sufficient degrees of conservatism for
portfolios with limited data or low numbers of defaults will be able to meet the qualification
requirements. Specifically, under the final rule, a banking organization’s risk parameter
quantification process “must produce appropriately conservative risk parameter estimates where
the banking organization has limited relevant data.” Staff believes this requirement provides
sufficient flexibility and incentives for banking organizations to develop and document sound
practices for applying the IRB approach to portfolios with limited data. The preamble to the
draft final rule discusses the use of external data, scenario analysis, and other techniques to
support risk parameter estimation for limited-data or low-default portfolios. (See Attachment 1,
draft final rule preamble section III.B.3.)
Securitization exposures
The proposal defined a securitization exposure as an on-balance sheet or off-balance
sheet credit exposure that arises from a transaction in which (i) all or a portion of the credit risk
25
of one or more underlying exposures is transferred to one or more third parties; (ii) the credit risk
associated with the underlying exposures has been separated into at least two tranches reflecting
different levels of seniority; (iii) performance of the securitization exposure depends on the
performance of the underlying exposures; and (iv) all or substantially all of the underlying
exposures are financial exposures. Examples of financial exposures included loans,
commitments, receivables, asset-backed securities, mortgage-backed securities, other debt
securities, equity securities, or credit derivatives.
Commenters raised several objections to the proposed definition of securitization
exposure, but most consistently expressed concern that the definition was too broad because it
included all exposures involving the tranching of credit risk of underlying financial assets. In
particular, commenters asserted that the definition captured many exposures that were not
typically considered to be securitizations, including exposures to many hedge funds.
Commenters requested flexibility to apply the wholesale or equity framework (depending on the
exposure) rather than the securitization framework to these exposures.
Although the proposed definition of securitization exposure is generally consistent with
the New Accord, staff agrees with commenters that the proposed definition is quite broad in
some respects and would capture some exposures that would more appropriately be treated under
the wholesale or equity frameworks. To restrict the scope of the IRB securitization framework,
the draft final rule modifies the definition of a traditional securitization to make clear, for
example, that exposures to operating companies are not securitization exposures (even if all or
substantially all of the assets of the operating company are financial exposures). For this
purpose, the preamble to the draft final rule notes that operating companies generally are
companies that produce goods or services beyond the business of investing, reinvesting, holding,
26
or trading in financial assets. Examples of such financial operating companies include
depository institutions, bank holding companies, securities brokers and dealers, insurance
companies and non-bank mortgage lenders. Accordingly, under the draft final rule, an equity
investment in an operating company, such as a bank, generally would be an equity exposure and
a debt investment in such an operating company generally would be a wholesale exposure.
Investment firms, which generally engage exclusively in the business of investing,
reinvesting, holding, or trading in financial assets, would not be operating companies under the
draft final rule and would not qualify for this general exclusion from the definition of traditional
securitization. The draft final rule does provide, however, that the primary Federal supervisor of
a banking organization may exclude from the definition of traditional securitization an
investment firm that exercises substantially unfettered control over the size and composition of
its assets, liabilities, and off-balance sheet transactions. This provision allows a primary Federal
supervisor to distinguish structured finance vehicles, to which the IRB securitization framework
was designed to apply, from more flexible investment firms (such as certain hedge funds and
private equity funds), for which the IRB securitization framework was not directly intended. The
preamble to the draft final rule notes that managed collateralized debt obligation vehicles,
structured investment vehicles, and similar structures, which might allow considerable
management discretion regarding asset composition but are subject to substantial restrictions
regarding capital structure, would be treated as securitization exposures.
Staff remains concerned that the line between securitization exposures and nonsecuritization exposures may be difficult to draw in some circumstances. Thus, in addition to the
supervisory exclusion described above, the draft final rule contains a new component that
expressly permits a banking organization’s primary Federal supervisor to scope certain
27
transactions into the IRB securitization framework if justified by the economics of the
transaction. The draft final rule notes the agencies will consider a number of factors when
assessing the economic substance of a transaction, including, for example, the amount of equity
in the structure, overall leverage (whether on- or off-balance sheet), whether redemption rights
attach to the equity investor, and the ability of junior tranches to absorb losses without
interrupting contractual payments to more senior tranches. (See Attachment 1, draft final rule
preamble section V.A.3.)
Equity exposures
Under the New Accord, national supervisors have the option to provide a grandfathering
period for equity exposures – whereby for a maximum of ten years supervisors could permit
banking organizations to exempt from the IRB treatment equity investments held at the time of
publication of the New Accord. The proposal did not include such a grandfathering provision.
A number of commenters asserted that the proposal was inconsistent with the New Accord and
would subject U.S. banking organizations using the advanced approaches to significant
competitive inequity vis-à-vis foreign banks.
Staff continues to believe that it is not necessary to incorporate the optional
grandfathering period for equity exposures. The grandfathering concept would reduce the risk
sensitivity of the equity treatment. Moreover, the advanced approaches do not provide
grandfathering for other types of exposures. Finally, staff believes that overall the draft final rule
approach to equity exposures sufficiently mitigates potential competitive issues. Accordingly,
the draft final rule does not provide a grandfathering period for equity exposures.
As discussed earlier under the securitization section of this memorandum, the draft final
rule provides discretion to a banking organization’s primary Federal supervisor to exclude from
28
the IRB securitization framework equity investments in certain investment firms. The draft final
rule has been modified to generally apply a 600 percent risk weight under the SRWA to equity
exposures to such firms that have greater than immaterial leverage. (See Attachment 1, draft
final rule preamble section V.F.)
Operational risk
A number of commenters raised issues related to operational risk. The proposal
explicitly authorized banking organizations to take into account eligible operational risk offsets
but clarified that the only eligible operational risk offsets at the present time appeared to be those
relating to credit card fraud and securities processing. Several commenters noted that activities
besides securities processing and credit card fraud should be considered for operational risk
offsets. Staff believes that the proposed definition of 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 draft final rule.
Commenters also noted that the proposal appeared to place excessively strict limits on the
use of operational risk mitigants other than insurance. Staff has provided flexibility in this
regard and under the draft 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 Attachment 1, draft final rule preamble sections III.B. and III.V.)
Public disclosures
Many commenters expressed concern that the proposed public disclosures were excessive
and would hinder, rather than facilitate, market discipline by requiring banking organizations 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. Staff believes it is
29
important to retain the vast majority of the proposed disclosures, which are consistent with the
New Accord. These disclosures should enable market participants to gain key insights regarding
a banking organization’s capital structure, risk exposures, risk assessment processes, and
ultimately capital adequacy. Staff has modified the draft final rule to provide flexibility
regarding proprietary information.
RECOMMENDATION:
For the reasons set forth above, staff recommends that the Board approve the issuance of
the attached draft final rule.
Attachments
30
List of Acronyms
AMA
Advanced Measurement Approaches (for operational risk)
BHC
Bank Holding Company
DI
Depository Institution
DIP
Debtor-in-Possession
EAD
Exposure at Default
ECL
Expected Credit Loss
EL
Expected Loss
ELGD
Expected Loss Given Default
IAA
Internal Assessment Approach (for securitization exposures)
IMA
Internal Models Approach (for equity exposures)
IRB
Internal Ratings-Based
LGD
Loss Given Default
M
Maturity
OTC
Over-the-Counter
PD
Probability of Default
QIS5
Fifth Quantitative Impact Study
QRE
Qualifying Revolving Exposure
RBA
Ratings-Based Approach (for securitization exposures)
SFA
Supervisory Formula Approach (for securitization exposures)
SME
Small- to Medium-Size Enterprise
SWRA
Simple Risk Weight Approach (for equity exposures)
31
Attachment 1
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 3
[Docket No. 06-09]
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
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
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
31
DRAFT November 2, 2007
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.
DATES: This final rule is effective [INSERT DATE].
FOR FURTHER INFORMATION CONTACT:
OCC: Mark Ginsberg, Risk Expert, Capital Policy (202-927-4580) or Ron
Shimabukuro, Senior Counsel, Legislative and Regulatory Activities Division (202-8745090). 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) 8983548, 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,
“BHC” refer only to bank holding companies regulated by the Board and do not include savings and loan
holding companies regulated by the OTS.
32
DRAFT November 2, 2007
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
33
DRAFT November 2, 2007
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
Definition of default
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
34
DRAFT November 2, 2007
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
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
35
DRAFT November 2, 2007
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
36
DRAFT November 2, 2007
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
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’ website at www.bis.org.
37
DRAFT November 2, 2007
disclosures (Pillar 3). The New Accord includes several methodologies for determining a
bank’s risk-based capital requirements for credit, market, and operational risk.
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
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 risksensitive capital requirements. One overarching issue, however, was the areas where the
proposal differed from the New Accord. Commenters said the divergences generally
4
The agencies issued draft guidance on the advanced approaches. See 72 FR 9084 (February 28, 2007).
38
DRAFT November 2, 2007
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 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
39
DRAFT November 2, 2007
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.
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.).
5
71 FR 77445 (Dec. 26, 2006).
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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
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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 SMEspecific 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
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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 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
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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 riskbased 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
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with some time horizon (for example, one year). It could reflect, for example, credit
losses, operational losses, or other types of losses.
Figure 1 − Probability Distribution of Potential Losses
Mean
99.9th percentile
Expected Losses
Losses
Unexpected Losses
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
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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 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
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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
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 riskbased 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 riskbased capital requirement. 7
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 website at www.bis.org.
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
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As noted above, the supervisory model of credit risk underlying the IRB approach
embodies specific assumptions about the economic drivers of portfolio credit risk at
banks. As with any modeling approach, these assumptions represent simplifications of
very complex real-world phenomena and, at best, are only an approximation of the actual
credit risks at any bank. If these assumptions (described in greater detail below) are
incorrect or otherwise do not characterize a given bank precisely, the actual confidence
level implied by the IRB risk-based capital formulas may exceed or fall short of a true
99.9 percent confidence level.
In combination with other supervisory assumptions and parameters underlying the
IRB approach, the approach’s 99.9 percent nominal confidence level reflects a
judgmental pooling of available information, including supervisory experience. The
framework underlying this final rule reflects a desire on the part of the agencies to
achieve (i) risk-based capital requirements that are reflective of relative risk across
different assets and that are broadly consistent with maintaining at least an investmentgrade 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
hybrid instruments, such as subordinated debt. Thus, the 99.9 percent nominal confidence level embodied
in the IRB approach is not directly comparable to the nominal solvency standards underpinning banks’
economic capital models.
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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 riskbased 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
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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 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.
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
8
9
See BCBS Explanatory Note.
See BCBS Explanatory Note, section 5.3.
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residential mortgage exposures is based largely on supervisory experience with and
analysis of traditional long-term, fixed-rate mortgages.
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
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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
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.
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lease losses (ALLL) under the 1988 Accord, based on data obtained in the BCBS’s Third
Quantitative Impact Study (QIS-3). 11
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.
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.
11
12
BCBS, “QIS 3: Third Quantitative Impact Study,” May 2003.
BCBS press release, “Basel Committee maintains calibration of Basel II Framework,” May 24, 2006.
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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,
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 riskbased 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
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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 riskbased 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
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).
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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.
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 onbalance 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.
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.
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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 riskbased 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 creditenhancing 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
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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 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 riskweighted 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 riskweighted 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 riskweighted asset amounts for credit risk and operational risk, a bank must sum these
the underlying exposures that exceeds its pro rata claim on the underlying exposures, whether through
subordination provisions or other credit-enhancement techniques.
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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.
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
16
71 FR 55981 (September 25, 2006).
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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
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 riskbased 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-
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.
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counter (OTC) derivative contracts, repo-style transactions, and eligible margin loans. In
addition, this part describes the methodologies for reflecting credit risk mitigation in riskweighted 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.
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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 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 riskbased 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.
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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
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.
19
71 FR 55839-40 (September 25, 2006).
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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 thenexisting 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
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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:
•
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
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.
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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 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
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).
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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.
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
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
22
See 71 FR 77518 (Dec. 26, 2006).
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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
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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
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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 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
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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 crossborder 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 crossborder 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.
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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
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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
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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 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
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.
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Federal Reserve SR letter 01-0125 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.
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
25
SR 01-01, “Application of the Board’s Capital Adequacy Guidelines to Bank Holding Companies Owned
by Foreign Banking Organizations,” January 5, 2001.
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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,
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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
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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 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.
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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.
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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-
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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.
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,
26
The bank’s primary Federal supervisor may extend the bank’s first transitional floor period start date.
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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 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
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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
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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 riskbased 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
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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 floor period
First floor period
Transitional floor percentage
95 percent
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Second floor period
Third floor period
90 percent
85 percent
During the proposed transitional floor periods, a bank would calculate its riskweighted 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 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.
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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
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 riskbased 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
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 leverage ratio requirement is 4 percent.
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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.
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Under the final rule, as under the proposed rule, banks that meet the threshold
criteria in section 1(b)(1) (core banks) as of the effective date of this final rule, and banks
that opt in pursuant to section 1(b)(2) at the earliest possible date, must use the general
risk-based capital rules both during the parallel run and as a basis for the transitional floor
calculations. Should the agencies finalize a standardized risk-based capital rule, the
agencies expect that a bank that opts in after the earliest possible date or becomes a core
bank after the effective date of the final rule would use the risk-based capital regime (the
general risk-based capital rules or the standardized risk-based capital rules) used by the
bank immediately before the bank begins its parallel run both during the parallel run and
as a basis for the transitional floor calculations. Under the final rule, 2008 is the first
possible year for a bank to begin its parallel run and 2009 is the first possible year for a
bank to begin its first of three transitional floor periods.
B. Qualification Requirements
Because the advanced approaches use banks’ estimates of certain key risk
parameters to determine risk-based capital requirements, they introduce greater
complexity to the regulatory capital framework and require banks to possess a high level
of sophistication in risk measurement and risk management systems. As a result, the
final rule requires each core or opt-in bank to meet the qualification requirements
described in section 22 of the final rule to the satisfaction of its primary Federal
supervisor for a period of at least four consecutive calendar quarters before using the
advanced approaches to calculate its minimum risk-based capital requirements (subject to
the transitional floor provisions for at least an additional three years). The qualification
requirements are written broadly to accommodate the many ways a bank may design and
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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 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
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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.
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.
29
72 FR 9189.
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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-
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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
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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 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.
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Accordingly, the final rule does not require a bank to assign an internal risk rating to an
underlying obligor to whom the bank extends credit based solely on the financial strength
of a guarantor, provided that all of the bank’s exposures to that obligor are fully covered
by eligible guarantees and the bank applies the PD substitution approach to all of those
exposures. A bank in this situation is only required to assign an internal risk rating to the
guarantor. However, a bank must immediately assign an internal risk rating to the
obligor if a guarantee can no longer be recognized under this final rule.
In determining an obligor rating, a bank should consider key obligor attributes,
including both quantitative and qualitative factors that could affect the obligor’s default
risk. From a quantitative perspective, this could include an assessment of the obligor’s
historic and projected financial performance, trends in key financial performance ratios,
financial contingencies, industry risk, and the obligor’s position in the industry. On the
qualitative side, this could include an assessment of the quality of the obligor’s financial
reporting, non-financial contingencies (for example, labor problems and environmental
issues), and the quality of the obligor’s management based on an evaluation of
management’s ability to make realistic projections, management’s track record in
meeting projections, and management’s ability to effectively adapt to changes in the
economy and the competitive environment.
Under the proposed rule, a bank would assign each legal entity wholesale obligor
to a single rating grade. Accordingly, if a single wholesale exposure of the bank to an
obligor triggered the proposed rule’s definition of default, all of the bank’s wholesale
exposures to that obligor would be in default for risk-based capital purposes. In addition,
under the proposed rule, a bank would not be allowed to consider the value of collateral
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pledged to support a particular wholesale exposure (or any other exposure-specific
characteristics) when assigning a rating to the obligor of the exposure. A bank would,
however, consider all available financial information about the obligor – including, where
applicable, the total operating income or cash flows from all of the obligor’s projects or
businesses – when assigning an obligor rating.
While a few commenters expressly supported the proposal’s requirement for
banks to assign each legal entity wholesale obligor to a single rating grade, a substantial
number of commenters expressed reservations about this requirement. These
commenters observed that in certain circumstances an exposure’s transaction-specific
characteristics affect its likelihood of default. Commenters asserted that the agencies
should provide greater flexibility and allow banks to depart from the one-rating-perobligor requirement based on the economic substance of an exposure. In particular,
commenters maintained that income-producing real estate lending should be exempt from
the one-rating-per-obligor requirement. The commenters noted that the probability that
an obligor will default on any one such facility depends primarily on the cash flows from
the individual property securing the facility, not the overall condition of the obligor.
Similarly, several commenters asserted that exposures involving transfer risk and nonrecourse exposures should be exempted from the one-rating-per-obligor requirement.
In general, the agencies believe that a two-dimensional rating system that strictly
separates borrower and exposure-level characteristics is a critical underpinning of the
IRB approach. However, the agencies agree that exposures to the same borrower
denominated in different currencies may have different default probabilities. For
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example, a sovereign government may impose prohibitive exchange restrictions that
make it impossible for a borrower to transfer payments in one particular currency.
In addition, the agencies agree that certain income-producing real estate
exposures for which the bank, in economic substance, does not have recourse to the
borrower beyond the real estate serving as collateral for the exposure, have default
probabilities distinct from that of the borrower. Such situations would arise, for example,
where real estate collateral is located in a state where a bank, under applicable state law,
effectively does not have recourse to the borrower if the bank pursues the real estate
collateral in the event of default (for example, in a “one-action” state or a state with a
similar law). In one-action states such as Arizona, California, Idaho, Montana, Nevada,
and Utah, or in a state with a similar law, such as New York, the applicable foreclosure
laws materially limit a bank’s ability to collect against both the collateral and the
borrower.
A third instance in which exposures to the same borrower may have significantly
different default probabilities is when a borrower enters bankruptcy and the bank extends
additional credit to the borrower under the auspices of the bankruptcy proceedings. This
so-called debtor in possession (DIP) financing is unique from other exposure types
because it typically has priority over existing debt, equity, and other claims on the
borrower. The agencies believe that because of this unique priority status, if a bank has
an exposure to a borrower that declares bankruptcy and defaults on that exposure, and the
bank subsequently provides DIP financing to that obligor, it may not be appropriate to
require the bank to treat the DIP financing exposure at inception as an exposure to a
defaulted borrower.
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To address these circumstances and clarify the application of the one-rating-perobligor requirement, the agencies added a definition of obligor in the final rule. The final
rule defines an obligor as the legal entity or natural person contractually obligated on a
wholesale exposure except that a bank may treat three types of exposures to the same
legal entity or natural person as having separate obligors. First, exposures to the same
legal entity or natural person denominated in different currencies. Second, (i) incomeproducing real estate exposures for which all or substantially all of the repayment of the
exposure is reliant on cash flows of the real estate serving as collateral for the exposure;
the bank, in economic substance, does not have recourse to the borrower beyond the real
estate serving as collateral for the exposure; and no cross-default or cross-acceleration
clauses are in place other than clauses obtained solely in an abundance of caution; and (ii)
other credit exposures to the same legal entity or natural person. Third, (i) wholesale
exposures authorized under section 364 of the U.S. Bankruptcy Code (11 U.S.C. 364) to
a legal entity or natural person who is a debtor-in-possession for purposes of Chapter 11
of the Bankruptcy Code; and (ii) other credit exposures to the same legal entity or natural
person. All exposures to a single legal entity or natural person must be treated as
exposures to a single obligor unless they qualify for one of these three exceptions in the
final rule’s definition of obligor.
A bank’s obligor rating system must have at least seven discrete (nonoverlapping) obligor grades for non-defaulted obligors and at least one obligor grade for
defaulted obligors. The agencies believe that because the risk-based capital requirement
of a wholesale exposure is directly linked to its obligor rating grade, a bank must have at
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least seven non-overlapping obligor grades to differentiate sufficiently the
creditworthiness of non-defaulted wholesale obligors.
A bank must capture the estimated loss severity upon default for a wholesale
exposure either by directly assigning an LGD estimate to the exposure or by grouping the
exposure with other wholesale exposures into loss severity rating grades (reflecting the
bank’s estimate of the LGD of the exposure). LGD is described in more detail below.
Whether a bank chooses to assign LGD values directly or, alternatively, to assign
exposures to rating grades and then quantify the LGD for the rating grades, the key
requirement is that the bank must identify exposure characteristics that influence LGD.
Each of the loss severity rating grades must be associated with an empirically supported
LGD estimate. Banks employing loss severity grades must have a sufficiently granular
loss severity grading system to avoid grouping together exposures with widely ranging
LGDs.
Retail exposures
To implement the advanced approach for retail exposures, a bank must have an
internal system that segments its retail exposures to differentiate accurately and reliably
among degrees of credit risk. The most significant difference between the treatment of
wholesale and retail exposures is that the risk parameters for wholesale exposures are
assigned at the individual exposure level, whereas risk parameters for retail exposures are
assigned at the segment level. Banks typically manage retail exposures on a segment
basis, where each segment contains exposures with similar risk characteristics.
Therefore, a key characteristic of the final rule’s retail framework is that the risk
parameters for retail exposures are assigned to segments of exposures rather than to
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individual exposures. Under the retail framework, a bank groups its retail exposures into
segments with homogeneous risk characteristics and estimates PD and LGD for each
segment.
Some commenters stated that for internal risk management purposes they assign
risk parameters at the individual retail exposure level rather than at the segment level.
These commenters requested confirmation that this practice would be permissible for
risk-based capital purposes under the final rule. The agencies believe that a bank may
use its advanced systems, including exposure-level risk parameter estimates, to group
exposures into segments with homogeneous risk characteristics. Such exposure-level
estimates must be aggregated in order to assign segment-level risk parameters to each
segment of retail exposures.
A bank must group its retail exposures into three separate subcategories:
(i) residential mortgage exposures; (ii) QREs; and (iii) other retail exposures. The bank
must classify the retail exposures in each subcategory into segments to produce a
meaningful differentiation of risk. The final rule requires banks to segment separately
(i) defaulted retail exposures from non-defaulted retail exposures and (ii) retail eligible
margin loans for which the bank adjusts EAD rather than LGD to reflect the risk
mitigating effects of financial collateral from other retail eligible margin loans.
Otherwise, the agencies do not require that banks consider any particular risk drivers or
employ any minimum number of segments in any of the three retail subcategories.
In determining how to segment retail exposures within each subcategory for the
purpose of assigning risk parameters, a bank should use a segmentation approach that is
consistent with its approach for internal risk assessment purposes and that classifies
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exposures according to predominant risk characteristics or drivers. Examples of risk
drivers could include loan-to-value ratios, credit scores, loan terms and structure,
origination channel, geographical location of the borrower, collateral type, and bank
internal estimates of likelihood of default and loss severity given default. Regardless of
the risk drivers used, a bank must be able to demonstrate to its primary Federal supervisor
that its system assigns accurate and reliable PD and LGD estimates for each retail
segment on a consistent basis.
Definition of default
Wholesale default. In the ANPR, the agencies proposed to define default for a
wholesale exposure as either or both of the following events: (i) the bank determines that
the borrower is unlikely to pay its obligations to the bank in full, without recourse to
actions by the bank such as the realization of collateral; or (ii) the borrower is more than
90 days past due on principal or interest on any material obligation to the bank. The
ANPR’s definition of default was generally consistent with the New Accord.
A number of commenters on the ANPR encouraged the agencies to use a
wholesale definition of default that varied from the New Accord but conformed more
closely to that used by bank risk managers. Many of these commenters recommended
that the agencies define default for wholesale exposures as the entry into non-accrual or
charge-off status. In the proposed rule, the agencies amended the ANPR definition of
default to respond to these concerns. Under the proposed definition of default, a bank’s
wholesale obligor would be in default if, for any wholesale exposure of the bank to the
obligor, the bank had (i) placed the exposure on non-accrual status consistent with the
Consolidated Report of Condition and Income (Call Report) Instructions or the Thrift
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Financial Report (TFR) and the TFR Instruction Manual; (ii) taken a full or partial
charge-off or write-down on the exposure due to the distressed financial condition of the
obligor; or (iii) incurred a credit-related loss of 5 percent or more of the exposure’s initial
carrying value in connection with the sale of the exposure or the transfer of the exposure
to the held-for-sale, available-for-sale, trading account, or other reporting category.
The agencies received extensive comment on the proposed definition of default
for wholesale exposures. Commenters observed that the proposed definition of default
was different from and more prescriptive than the definition in the New Accord and
employed in other major jurisdictions. They asserted that the proposed definition would
impose unjustifiable systems burden and expense on banks operating across multiple
jurisdictions. Commenters also asserted that many banks’ data collection systems are
based on the New Accord’s definition of default, and therefore historical data relevant to
the proposed definition of default are limited. Moreover, commenters expressed concern
that risk parameters estimated using the proposed definition of default would differ
materially from those estimated using the New Accord’s definition of default, resulting in
different capital requirements for U.S. banks relative to their foreign peers.
The 5 percent credit-related loss trigger in the proposed definition of default for
wholesale obligors was the focus of significant commenter concern. Commenters
asserted that the trigger inappropriately imported LGD and maturity-related
considerations into the definition of default, could hamper the use of loan sales as a risk
management practice, and could cause obligors that are performing on their obligations to
be considered defaulted. These commenters also claimed that the 5 percent trigger would
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add significant implementation burden by, for example, requiring banks to distinguish
between credit-related and non-credit-related losses on sale.
Many commenters requested that the agencies conform the U.S. wholesale
definition of default to the New Accord. Other commenters requested that banks be
allowed the option to apply either the U.S. or the New Accord definition of default.
The agencies agree that the proposed definition of default for wholesale obligors
could have unintended consequences for implementation burden and international
consistency. Therefore, the final rule contains a definition of default for wholesale
obligors that is similar to the definition proposed in the ANPR and consistent with the
New Accord. Specifically, under the final rule, a bank’s wholesale obligor is in default
if, for any wholesale exposure of the bank to the obligor: (i) the bank considers that the
obligor is unlikely to pay its credit obligations to the bank in full, without recourse by the
bank to actions such as realizing collateral (if held); or (ii) the obligor is past due more
than 90 days on any material credit obligation to the bank. The final rule also clarifies,
consistent with the New Accord, that an overdraft is past due once the obligor has
breached an advised limit or has been advised of a limit smaller than the current
outstanding balance.
Consistent with the New Accord, the following elements may be indications of
unlikeliness to pay under this definition:
(i) The bank places the exposure on non-accrual status consistent with the Call
Report Instructions or the TFR and the TFR Instruction Manual;
(ii) The bank takes a full or partial charge-off or write-down on the exposure due
to the distressed financial condition of the obligor;
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(iii) The bank incurs a material credit-related loss in connection with the sale of
the exposure or the transfer of the exposure to the held-for-sale, available-for-sale,
trading account, or other reporting category;
(iv) The bank consents to a distressed restructuring of the exposure that is likely
to result in a diminished financial obligation caused by the material forgiveness or
postponement of principal, interest or (where relevant) fees;
(v) The bank has filed as a creditor of the obligor for purposes of the obligor’s
bankruptcy under the U.S. Bankruptcy Code (or a similar proceeding in a foreign
jurisdiction regarding the obligor’s credit obligation to the bank); or
(vi) The obligor has sought or has been placed in bankruptcy or similar protection
that would avoid or delay repayment of the exposure to the bank.
If a bank carries a wholesale exposure at fair value for accounting purposes, the
bank’s practices for determining unlikeliness to pay for purposes of the definition of
default should be consistent with the bank’s practices for determining credit-related
declines in the fair value of the exposure.
Like the proposed definition of default for wholesale obligors, the final rule states
that a wholesale exposure to an obligor remains in default until the bank has reasonable
assurance of repayment and performance for all contractual principal and interest
payments on all exposures of the bank to the obligor (other than exposures that have been
fully written-down or charged-off). The agencies expect a bank to employ standards for
determining whether it has a reasonable assurance of repayment and performance that are
similar to those for determining whether to restore a loan from non-accrual to accrual
status.
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Retail default. In response to comments on the ANPR, the agencies proposed to
define default for retail exposures according to the timeframes for loss classification that
banks generally use for internal purposes. These timeframes are embodied in the
FFIEC’s Uniform Retail Credit Classification and Account Management Policy. 30
Specifically, revolving retail exposures and residential mortgage exposures would be in
default at 180 days past due; other retail exposures would be in default at 120 days past
due. In addition, a retail exposure would be in default if the bank had taken a full or
partial charge-off or write-down of principal on the exposure for credit-related reasons.
Such an exposure would remain in default until the bank had reasonable assurance of
repayment and performance for all contractual principal and interest payments on the
exposure.
Although some commenters supported the proposed rule’s retail definition of
default, others urged the agencies to adopt a 90-days-past-due default trigger consistent
with the New Accord’s definition of default for retail exposures. Other commenters
requested that a non-accrual trigger be added to the retail definition of default similar to
that in the proposed wholesale definition of default. The commenters viewed this as a
practical way to allow a foreign banking organization to harmonize the U.S. retail
definition of default to a home country definition of default that has a 90-days-past-due
trigger.
The agencies believe that adding a non-accrual trigger to the retail definition of
default is not appropriate. Retail non-accrual practices vary considerably among banks,
and adding a non-accrual trigger to the retail definition of default would result in greater
30
FFIEC, “Uniform Retail Credit Classification and Account Management Policy,” 65 FR 36903, June 12,
2000.
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inconsistency among banks in the treatment of retail exposures. Moreover, a bank that
considers retail exposures to be defaulted at 90 days past due could have significantly
different risk parameter estimates than one that uses 120- and 180-days-past-due
thresholds. Such a bank would likely have higher PD estimates and lower LGD estimates
due to the established tendency of a nontrivial proportion of U.S. retail exposures to
“cure” or return to performing status after becoming 90 days past due and before
becoming 120 or 180 days past due. The agencies believe that the 120- and 180-dayspast-due thresholds, which are consistent with national discretion provided by the New
Accord, reflect a point at which retail exposures in the United States are unlikely to return
to performing status. Therefore, the agencies are incorporating the proposed retail
definition of default without substantive change in the final rule. (Parallel to the full or
partial charge-off or write-down trigger for retail exposures not held at fair value, the
agencies added a material negative fair value adjustment of principal for credit-related
reasons trigger for retail exposures held at fair value.)
The New Accord provides discretion for national supervisors to set the retail
default trigger at up to 180 days past due for different products, as appropriate to local
conditions. Accordingly, banks implementing the IRB approach in multiple jurisdictions
may be subject to different retail definitions of default in their home and host
jurisdictions. The agencies recognize that it could be costly and burdensome for a U.S.
bank to track default data and estimate risk parameters based on both the U.S. definition
of default and the definitions of default in non-U.S. jurisdictions where subsidiaries of the
U.S. bank implement the IRB approach. The agencies are therefore incorporating
flexibility into the retail definition of default. Specifically, for a retail exposure held by a
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U.S. bank’s non-U.S. subsidiary subject to an internal ratings-based approach to capital
adequacy consistent with the New Accord in a non-U.S. jurisdiction, the final rule allows
the bank to elect to use the definition of default of that jurisdiction, subject to prior
approval by the bank’s primary Federal supervisor. The primary Federal supervisor will
revoke approval for a bank to use this provision if the supervisor finds that the bank uses
the provision to arbitrage differences in national definitions of default.
The definition of default for retail exposures differs from the definition for the
wholesale portfolio in that the retail default definition applies on an exposure-byexposure basis rather than on an obligor-by-obligor basis. In other words, default on one
retail exposure does not require a bank to treat all other retail obligations of the same
borrower to the bank as defaulted. This difference reflects the fact that banks generally
manage retail credit risk based on segments of similar exposures rather than through the
assignment of ratings to particular borrowers. In addition, it is quite common for retail
borrowers that default on some of their obligations to continue payment on others.
Although the retail definition of default does not explicitly include credit-related
losses in connection with loan sales and the agencies have replaced the 5 percent creditrelated loss threshold for wholesale exposures with a less prescriptive treatment that is
consistent with the New Accord, the agencies expect banks to ensure that exposure sales
do not bias or otherwise distort the estimated risk parameters assigned by a bank to its
wholesale exposures and retail segments.
Rating philosophy
A bank’s internal risk rating policy for wholesale exposures must describe the
bank’s rating philosophy, which is how the bank’s wholesale obligor rating assignments
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are affected by the bank’s choice of the range of economic, business, and industry
conditions that are considered in the obligor rating process. The philosophical basis of a
bank’s rating system is important because, when combined with the credit quality of
individual obligors, it will determine the frequency of obligor rating changes in a
changing economic environment. Rating systems that rate obligors based on their ability
to perform over a wide range of economic, business, and industry conditions, sometimes
described as “through-the-cycle” systems, tend to have ratings that migrate more slowly
as conditions change. Banks that rate obligors based on a more narrow range of likely
expected conditions (primarily on recent conditions), sometimes called “point-in-time”
systems, tend to have ratings that migrate more frequently. Many banks will rate obligors
using an approach that considers a combination of the current conditions and a wider
range of other likely conditions. In any case, the bank must specify the rating philosophy
used and establish a policy for the migration of obligors from one rating grade to another
in response to economic cycles. A bank should understand the effects of ratings
migration on its risk-based capital requirements and ensure that sufficient capital is
maintained during all phases of the economic cycle.
Rating and segmentation reviews and updates
Each wholesale obligor rating and (if applicable) wholesale exposure loss severity
rating must reflect current information. A bank’s internal risk rating system for
wholesale exposures must provide for the review and update (as appropriate) of each
obligor rating and (if applicable) loss severity rating whenever the bank receives new
material information, but no less frequently than annually. Under the proposed rule, a
bank’s retail exposure segmentation system would provide for the review and update (as
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appropriate) of assignments of retail exposures to segments whenever the bank received
new material information. The proposed rule specified that the review would be required
no less frequently than quarterly.
One commenter noted that quarterly reviews may not be appropriate for highquality retail portfolios, such as retail exposures associated with a bank’s wealth
management or private banking businesses. The commenter suggested that banks should
have the flexibility to review and update segmentation assignments for such portfolios on
a less frequent basis appropriate to the credit quality of the portfolios.
The agencies agree that it may be appropriate for a bank to review and update
segmentation assignments for certain high-quality retail exposures on a less frequent
basis than quarterly, provided a bank is following sound risk management practices.
Therefore, the final rule generally requires a quarterly review and update, as appropriate,
of retail exposure segmentation assignments, allowing some flexibility to accommodate
sound internal risk management practices.
3. Quantification of risk parameters for wholesale and retail exposures
A bank must have a comprehensive risk parameter quantification process that
produces accurate, timely, and reliable estimates of the risk parameters – PD, LGD, EAD,
and (for wholesale exposures) M – for its wholesale obligors and exposures and retail
exposures. Statistical methods and models used to develop risk parameter estimates, as
well as any adjustments to the estimates or empirical data, should be transparent, well
supported, and documented. The following sections of the preamble discuss the rule’s
definitions of the risk parameters for wholesale exposures and retail segments.
Probability of default (PD)
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As noted above, under the final rule, a bank must assign each of its wholesale
obligors to an internal rating grade and then must associate a PD with each rating grade.
PD for a wholesale exposure to a non-defaulted obligor is the bank’s empirically based
best estimate of the long-run average one-year default rate for the rating grade assigned
by the bank to the obligor, capturing the average default experience for obligors in the
rating grade over a mix of economic conditions (including economic downturn
conditions) sufficient to provide a reasonable estimate of the average one-year default
rate over the economic cycle for the rating grade.
In addition, under the final rule, a bank must assign a PD to each segment of retail
exposures. Some types of retail exposures typically display a seasoning pattern – that is,
the exposures have relatively low default rates in their first year, rising default rates in the
next few years, and declining default rates for the remainder of their terms. Because of
the one-year IRB horizon, the proposed rule provided two different definitions of PD for
a segment of non-defaulted retail exposures based on the materiality of seasoning effects
for the segment or for the segment’s retail exposure subcategory. Under the proposed
rule, PD for a segment of non-defaulted retail exposures for which seasoning effects were
not material, or for a segment of non-defaulted retail exposures in a retail exposure
subcategory for which seasoning effects were not material, would be the bank’s
empirically based best estimate of the long-run average of one-year default rates for the
exposures in the segment, capturing the average default experience for exposures in the
segment over a mix of economic conditions (including economic downturn conditions)
sufficient to provide a reasonable estimate of the average one-year default rate over the
economic cycle for the segment. PD for a segment of non-defaulted retail exposures for
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which seasoning effects were material would be the bank’s empirically based best
estimate of the annualized cumulative default rate over the expected remaining life of
exposures in the segment, capturing the average default experience for exposures in the
segment over a mix of economic conditions (including economic downturn conditions) to
provide a reasonable estimate of the average performance over the economic cycle for the
segment.
Commenters objected to this treatment of retail exposures with material seasoning
effects. They asserted that requiring banks to use an annualized cumulative default rate
to recognize seasoning effects was too prescriptive and would preclude other reasonable
approaches. The agencies believe that commenters have presented reasonable alternative
approaches to recognizing the effects of seasoning in PD and are, therefore, providing
additional flexibility for recognizing those effects in the final rule.
Based on comments and additional consideration, the agencies also are clarifying
that a segment of retail exposures has material seasoning effects if there is a material
relationship between the time since origination of exposures within the segment and the
bank’s best estimate of the long-run average one-year default rate for the exposures in the
segment. Moreover, because the agencies believe that the IRB approach must, at a
minimum, require banks to hold appropriate amounts of risk-based capital to address
credit risks over a one-year horizon, the final rule’s incorporation of seasoning effects is
explicitly one-directional. Specifically, a bank must increase PDs above the best estimate
of the long-run average one-year default rate for segments of unseasoned retail
exposures, but may not decrease PD below the best estimate of the long-run average one-
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year default rate for a segment of retail exposures that the bank estimates will have lower
PDs in future years due to seasoning.
The final rule defines PD for a segment of non-defaulted retail exposures as the
bank’s empirically based best estimate of the long-run average one-year default rate for
the exposures in the segment, capturing the average default experience for exposures in
the segment over a mix of economic conditions (including economic downturn
conditions) sufficient to provide a reasonable estimate of the average one-year default
rate over the economic cycle for the segment and adjusted upward as appropriate for
segments for which seasoning effects are material. If a bank does not adjust PD to reflect
seasoning effects for a segment of exposures, it should be able to demonstrate to its
primary Federal supervisor, using empirical analysis, why seasoning effects are not
material or why adjustment is not relevant for the segment.
For wholesale exposures to defaulted obligors and for segments of defaulted retail
exposures, PD is 100 percent.
Loss given default (LGD)
Under the proposed rule, a bank would directly estimate an ELGD and LGD risk
parameter for each wholesale exposure or would assign each wholesale exposure to an
expected loss severity grade and a downturn loss severity grade, estimate an ELGD risk
parameter for each expected loss severity grade, and estimate an LGD risk parameter for
each downturn loss severity grade. In addition, a bank would estimate an ELGD and
LGD risk parameter for each segment of retail exposures.
Expected loss given default (ELGD)
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The proposed rule defined the ELGD of a wholesale exposure as the bank’s
empirically based best estimate of the default-weighted average economic loss per dollar
of EAD the bank expected to incur in the event that the obligor of the exposure (or a
typical obligor in the loss severity grade assigned by the bank to the exposure) defaulted
within a one-year horizon. 31 The proposed rule defined ELGD for a segment of retail
exposures as the bank’s empirically based best estimate of the default-weighted average
economic loss per dollar of EAD the bank expected to incur on exposures in the segment
that default within a one-year horizon. ELGD estimates would incorporate a mix of
economic conditions (including economic downturn conditions). ELGD had four
functions in the proposed rule—as a component of the calculation of ECL in the
numerator of the risk-based capital ratios; in the EL component of the IRB risk-based
capital formulas; as a floor on the value of the LGD risk parameter; and as an input into
the supervisory mapping function.
Many commenters objected to the proposed rule’s requirement for banks to
estimate ELGD for each wholesale exposure and retail segment, noting that ELGD
estimation is not required under the New Accord. Commenters asserted that requiring
ELGD estimation would create a competitive disadvantage by creating additional
systems, compliance, calculation, and reporting burden for those banks subject to the
U.S. rule, many of which have already substantially developed their systems based on the
New Accord. They also maintained that it would decrease the comparability of U.S.
banks’ capital requirements and public disclosures relative to those of foreign banking
organizations applying the advanced approaches. Several commenters also contended
that defining ECL in terms of ELGD instead of LGD raised tier 1 risk-based capital
31
Under the proposal, ELGD was not the statistical expected value of LGD.
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requirements for U.S. banks compared to foreign banks using the New Accord’s LGDbased ECL definition.
The agencies have concluded that the regulatory burden and potential competitive
inequities identified by commenters outweigh the supervisory benefits of the proposed
ELGD risk parameter, and are, therefore, not including it in the final rule. Instead,
consistent with the New Accord, a bank must use LGD for the calculation of ECL and the
EL component of the IRB risk-based capital formulas. Because the proposed ELGD risk
parameter was equal to or less than LGD, this change generally will have the effect of
decreasing both the numerator and denominator of the risk-based capital ratios.
Consistent with the New Accord, under the final rule, the LGD of a wholesale
exposure or retail segment must not be less than the bank’s empirically based best
estimate of the long-run default-weighted average economic loss, per dollar of EAD, the
bank would expect to incur if the obligor (or a typical obligor in the loss severity grade
assigned by the bank to the exposure or segment) were to default within a one-year
horizon over a mix of economic conditions, including economic downturn conditions.
The final rule also specifies that LGD may not be less than zero. The implications of
eliminating the ELGD risk parameter for the supervisory mapping function are discussed
below.
Economic loss and post-default extensions of credit
Commenters requested additional clarity regarding the treatment of post-default
extensions of credit. LGD is an estimate of the economic loss that would be incurred on
an exposure, relative to the exposure’s EAD, if the obligor were to default within a oneyear horizon during economic downturn conditions. The estimated economic loss
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amount must capture all material credit-related losses on the exposure (including accrued
but unpaid interest or fees, losses on the sale of repossessed collateral, direct workout
costs, and an appropriate allocation of indirect workout costs). Where positive or
negative cash flows on a wholesale exposure to a defaulted obligor or on a defaulted
retail exposure (including proceeds from the sale of collateral, workout costs, and drawdowns of unused credit lines) are expected to occur after the date of default, the estimated
economic loss amount must reflect the net present value of cash flows as of the default
date using a discount rate appropriate to the risk of the exposure. The possibility of postdefault extensions of credit made to facilitate collection of an exposure would be treated
as negative cash flows and reflected in LGD.
For example, assume a loan to a retailer goes into default. The bank determines
that the recovery would be enhanced by some additional expenditure to ensure an orderly
workout process. One option would be for the bank to hire a third-party to facilitate the
collection of the loan. Another option would be for the bank to extend additional credit
directly to the defaulted obligor to allow the obligor to make an orderly liquidation of
inventory. Both options represent negative cash flows on the original exposure, which
must be discounted at a rate that is appropriate to the risk of the exposure.
Economic downturn conditions
The expected loss severities of some exposures may be substantially higher
during economic downturn conditions than during other periods, while for other types of
exposures they may not. Accordingly, the proposed rule required banks to use an LGD
estimate that reflected economic downturn conditions for purposes of calculating the riskbased capital requirements for wholesale exposures and retail segments.
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Several commenters objected to the requirement that LGD estimates must reflect
economic downturn conditions. Some of these commenters stated that empirical
evidence of correlation between economic downturn and LGD is inconclusive, except in
certain cases. A few noted that estimates of expected LGD include conservative inputs,
such as a conservative estimate of potential loss in the event of default or a conservative
discount rate or collateral assumptions. One commenter suggested that if a bank can
demonstrate it has been prudent in its LGD estimation and it has no evidence of the
cyclicality of LGDs, it should not be required to calculate downturn LGDs. Other
commenters remarked that the requirement to incorporate downturn conditions into LGD
estimates should not be used as a surrogate for proper modeling of PD/LGD correlations.
Finally, a number of commenters supported a pillar 2 approach for addressing LGD
estimation.
Consistent with the New Accord, the final rule maintains the requirement for a
bank to use an LGD estimate that reflects economic downturn conditions for purposes of
calculating the risk-based capital requirements for wholesale exposures and retail
segments. More specifically, banks must produce for each wholesale exposure (or loss
severity rating grade) and retail segment an estimate of the economic loss per dollar of
EAD that the bank would expect to incur if default were to occur within a one-year
horizon during economic downturn conditions.
For the purpose of defining economic downturn conditions, the proposed rule
identified two wholesale exposure subcategories – high-volatility commercial real estate
(HVCRE) wholesale exposures and non-HVCRE wholesale exposures (that is, all
wholesale exposures that are not HVCRE exposures) – and three retail exposure
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subcategories – residential mortgage exposures, QREs, and other retail exposures. The
proposed rule defined economic downturn conditions with respect to an exposure as those
conditions in which the aggregate default rates for the exposure’s entire wholesale or
retail subcategory held by the bank (or subdivision of such subcategory selected by the
bank) in the exposure’s national jurisdiction (or subdivision of such jurisdiction selected
by the bank) were significantly higher than average.
The agencies specifically sought comment on whether to require banks to
determine economic downturn conditions at a more granular level than an entire
wholesale or retail exposure subcategory in a national jurisdiction. Some commenters
stated that the proposed requirement is at a sufficiently granular level. Others asserted
that the requirement should be eliminated or made less granular. Those commenters
favoring less granularity stated that aggregate default rates for different product
subcategories in different countries are unlikely to peak at the same time and that
requiring economic downturn analysis at the product subcategory and national
jurisdiction level does not recognize potential diversification effects across products and
national jurisdictions and is thus overly conservative. Commenters also maintained that
the proposed granularity requirement adds complexity and implementation burden
relative to the New Accord.
The agencies believe that the proposed definition of economic downturn
conditions incorporates an appropriate level of granularity and are incorporating it
unchanged in the final rule. The agencies understand that downturns in particular
geographical subdivisions of national jurisdictions or in particular industrial sectors may
result in significantly increased loss rates in material subdivisions of a bank’s exposures.
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The agencies also recognize that diversification across those subdivisions may mitigate
risk for the overall organization. However, the agencies believe that the required
minimum level of granularity at the subcategory and national jurisdiction level provides a
suitable balance between allowing for the benefits of diversification and appropriate
conservatism for risk-based capital requirements.
Under the final rule, a bank must consider economic downturn conditions that
appropriately reflect its actual exposure profile. For example, a bank with a geographical
or industry sector concentration in a subcategory of exposures may find that information
relating to a downturn in that geographical region or industry sector may be more
relevant for the bank than a general downturn affecting many regions or industries. The
final rule (like the proposed rule) allows banks to subdivide exposure subcategories or
national jurisdictions as they deem appropriate given the exposures held by the bank.
Moreover, the agencies note that the exposure subcategory/national jurisdiction
granularity requirement is only a minimum granularity requirement.
Supervisory mapping function
The proposed rule provided banks two methods of generating LGD estimates for
wholesale exposures and retail segments. First, a bank could use its own estimates of
LGD for a subcategory of exposures if the bank had prior written approval from its
primary Federal supervisor to use internal estimates for that subcategory of exposures. In
approving a bank’s use of internal estimates of LGD, a bank’s primary Federal supervisor
would consider whether the bank’s internal estimates of LGD were reliable and
sufficiently reflective of economic downturn conditions. The supervisor would also
consider whether the bank has rigorous and well-documented policies and procedures for
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identifying economic downturn conditions for the exposure subcategory, identifying
material adverse correlations between the relevant drivers of default rates and loss rates
given default, and incorporating identified correlations into internal LGD estimates. If a
bank had supervisory approval to use its own estimates of LGD for an exposure
subcategory, it would use its own estimates of LGD for all exposures within that
subcategory.
As an alternative to internal estimates of LGD, the proposed rule provided a
supervisory mapping function for converting ELGD into LGD for risk-based capital
purposes. A bank that did not qualify to use its own estimates of LGD for a subcategory
of exposures would instead compute LGD using the linear supervisory mapping function:
LGD = 0.08 + 0.92 x ELGD. A bank would not have to apply the supervisory mapping
function to repo-style transactions, eligible margin loans, and OTC derivative contracts
(defined below in section V.C. of this preamble). The agencies proposed the supervisory
mapping function because of concerns that banks may find it difficult to produce internal
estimates of LGD that are sufficient for risk-based capital purposes because LGD data for
important portfolios may be sparse, and there is limited industry experience with
incorporating downturn conditions into LGD estimates. The supervisory mapping
function provided a pragmatic methodology for banks to use while refining their LGD
estimation techniques.
In general, commenters viewed the supervisory mapping function as a significant
deviation from the New Accord that would add unwarranted prescriptiveness and
regulatory burden to the U.S. rule. Commenters requested more flexibility to address
problems with LGD estimation, including the ability to apply appropriate margins of
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conservatism as contemplated in the New Accord. Commenters expressed concern that
U.S. supervisors would employ an unreasonably high standard for allowing own
estimates of LGD, forcing banks to use the supervisory mapping function for an extended
period of time. Commenters also expressed concern that supervisors would view the
output of the supervisory mapping function as a floor on internal estimates of LGD.
Commenters asserted that in both cases risk-based capital requirements would be
increased at U.S. banks relative to their foreign competitors, particularly for high-quality
assets, putting U.S. banks at a competitive disadvantage to foreign banks.
In particular, many commenters viewed the supervisory mapping function as
overly punitive for exposure categories with relatively low loss severities, effectively
imposing an 8 percent floor on LGD. Commenters also objected to the proposed
requirement that a bank use the supervisory mapping function for an entire subcategory
of exposures even if it had difficulty estimating LGD only for a small subset of those
exposures.
The agencies continue to believe that the supervisory mapping function is a
reasonable aid for dealing with problems in LGD estimation. The agencies recognize,
however, that there may be several valid methodologies for addressing such problems.
For example, a relative scarcity of historical loss data for a particular obligor or exposure
type may be addressed by increased reliance on alternative data sources and dataenhancing tools for quantification and alternative techniques for validation. In addition, a
bank should reflect in its estimates of risk parameters a margin of conservatism that is
related to the likely range of uncertainty. These concepts are discussed below in the
quantification principles section of the preamble.
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Therefore, the agencies are not including the supervisory mapping function in the
final rule. However, the agencies continue to believe that the function (and associated
estimation of the long-run default-weighted average economic loss rate given default
within a one-year horizon) is one way a bank could address difficulties in estimating
LGD. However it chooses to estimate LGD, a bank’s estimates of LGD must be reliable
and sufficiently reflective of economic downturn conditions, and the bank should have
rigorous and well-documented policies and procedures for identifying economic
downturn conditions for each exposure subcategory, identifying changes in material
adverse relationships between the relevant drivers of default rates and loss rates given
default, and incorporating identified relationships into LGD estimates.
Pre-default reductions in exposure
The proposed rule incorporated comments on the ANPR suggesting a need to
better accommodate certain credit products, most prominently asset-based lending
programs, whose structures typically result in a bank recovering substantial amounts of
the exposure prior to the default date – for example, through paydowns of outstanding
principal. The agencies believe that actions taken prior to default to mitigate losses are
an important component of a bank’s overall credit risk management, and that such actions
should be reflected in LGD when banks can quantify their effectiveness in a reliable
manner. In the proposed rule, this was achieved by measuring LGD relative to the
exposure’s EAD (defined in the next section) as opposed to the amount actually owed at
default. 32
32
To illustrate, suppose that for a particular asset-based lending exposure the EAD equaled $100 and that
for every $1 owed by the obligor at the time of default the bank’s recovery would be $0.40. Furthermore,
suppose that in the event of default within a one-year horizon, pre-default paydowns of $20 would reduce
the exposure amount to $80 at the time of default. In this case, the bank’s economic loss rate measured
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Commenters agreed that the IRB approach should allow banks to recognize in
their risk parameters the benefits of expected pre-default recoveries and other expected
reductions in exposure prior to default. Some commenters suggested, however, that it is
more appropriate to reflect pre-default recoveries in EAD rather than LGD. Other
commenters supported the proposed rule’s approach or asserted that banks should have
the option of incorporating pre-default recoveries in either LGD or EAD. Commenters
discouraged the agencies from restricting the types of pre-default reductions in exposure
that could be recognized, and generally contended that the reductions should be
recognized for all exposures for which a pattern of pre-default reductions can be
estimated reliably and accurately by the bank.
Consistent with the New Accord, the agencies have decided to maintain the
proposed treatment of pre-default reductions in exposure in the final rule. The final rule
does not limit the exposure types to which a bank may apply this treatment. However,
the agencies have clarified their requirement for quantification of LGD in section
22(c)(4) of the final rule. This section states that where the bank’s quantification of LGD
directly or indirectly incorporates estimates of the effectiveness of its credit risk
management practices in reducing its exposure to troubled obligors prior to default, the
bank must support such estimates with empirical analysis showing that the estimates are
consistent with its historical experience in dealing with such exposures during economic
downturn conditions.
relative to the amount owed at default (60 percent) would exceed the economic loss rate measured relative
to EAD (48 percent = .60 x ($100 -$20)/$100), because the former does not reflect fully the impact of the
pre-default paydowns.
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A bank’s methods for reflecting changes in exposure during the period prior to
default must be consistent with other aspects of the final rule. For example, a bank must
use a default horizon no longer than one year, consistent with the one-year default
horizon incorporated in other aspects of the final rule, such as the quantification of PD.
In addition, a pre-default reduction in the outstanding amount on one exposure that does
not reflect a reduction in the bank's total exposure to the obligor, such as a refinancing,
should not be reflected as a pre-default recovery for LGD quantification purposes.
The following simplified example illustrates how a bank could approach
incorporating pre-default reductions in exposure in LGD. Assume a bank has a portfolio
of asset-based loans fully collateralized by receivables. The bank maintains a database of
such loans that have defaulted, which records the exposure at the time of default and the
losses incurred at and after the date of default. After careful analysis of its historical data,
the bank finds that for every $100 of exposure on a typical asset-based loan at the time of
default, properly discounted average losses are $80 under economic downturn conditions.
Thus, the bank may assign an LGD estimate of 80 percent that is based on such evidence.
However, assume that the bank division responsible for collections reports that
the bank’s loan workout practices generally result in exposures on the asset-based loans
being significantly reduced between the time the loan is identified internally as a problem
exposure and the time when the obligor is in default for risk-based capital purposes. The
bank studies the pre-default paydown behavior of obligors that default within the next
one-year horizon and during economic downturn conditions. In particular, the bank uses
its internal historical data to map exposure amounts for asset-based loans at the time of
default to exposure amounts for the same loans at various points in time prior to default
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and confirms that the pattern of pre-default paydowns corresponds to reductions in the
bank’s overall exposures to the obligors, as opposed to refinancings.
Robust empirical analysis further indicates that pre-default paydowns for assetbased loans to obligors that default within the next one-year horizon during economic
downturn conditions depend on the length of time the loan has been subject to workout.
Specifically, the bank finds that the prospects for further pre-default paydowns diminish
markedly the longer the bank has managed the loan as a problem credit exposure. For
loans that are not in workout or that the bank has placed in workout for fewer than 90
days, the bank’s analysis indicates that pre-default paydowns on loans to obligors
defaulting within the next year during economic downturn conditions were, on average,
50 percent of the current amount owed by the obligor. In contrast, for asset-based loans
that have been in workout for at least 90 days, the bank’s analysis indicates that any
further pre-default recoveries tend to be immaterial. Thus, provided this analysis is
suitable for estimating LGDs according to section 22(c) of the final rule, the bank may
appropriately assign an LGD estimate of 40 percent to asset-based loans that are not in
workout or that have been in workout for fewer than 90 days. For asset-based loans that
have been in workout for at least 90 days, the bank should assign an LGD of 80 percent.
Exposure at default (EAD)
Under the proposed rule, EAD for the on-balance sheet component of a wholesale
or retail exposure generally was (i) the bank’s carrying value for the exposure (including
net accrued but unpaid interest and fees) 33 less any allocated transfer risk reserve for the
exposure, if the exposure was classified as held-to-maturity or for trading; or (ii) the
33
“Net accrued but unpaid interest and fees” are accrued but unpaid interest and fees net of any amount
expensed by the bank as uncollectable.
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bank’s carrying value for the exposure (including net accrued but unpaid interest and
fees) less any allocated transfer risk reserve for the exposure and any unrealized gains on
the exposure plus any unrealized losses on the exposure, if the exposure was classified as
available-for-sale.
One commenter asserted that banks should not be required to include net accrued
but unpaid interest and fees in EAD. Rather, this commenter requested the flexibility to
incorporate such interest and fees in either EAD or LGD. The agencies believe that net
accrued but unpaid interest and fees represent credit exposure to an obligor, similar to the
unpaid principal of a loan extended to the obligor, and thus are most appropriately
included in EAD. Moreover, requiring all banks to include such interest and fees in EAD
rather than LGD promotes consistency and comparability across banks for regulatory
reporting and public disclosure purposes.
The agencies are therefore maintaining the substance of the proposed rule’s
definition of EAD for on-balance sheet exposures in the final rule. The final rule clarifies
that, for purposes of EAD, all exposures other than securities classified as available-for
sale receive the treatment specified for exposures classified as held-to-maturity or for
trading under the proposal. Some exposures held at fair value, such as partially funded
loan commitments, may have both on-balance sheet and off-balance sheet components.
In such cases, a bank must compute EAD for both the positive on- and off-balance sheet
components of the exposure.
For the off-balance sheet component of a wholesale or retail exposure (other than
an OTC derivative contract, repo-style transaction, or eligible margin loan) in the form of
a loan commitment or line of credit, EAD under the proposed rule was the bank’s best
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estimate of net additions to the outstanding amount owed the bank, including estimated
future additional draws of principal and accrued but unpaid interest and fees, that were
likely to occur over the remaining life of the exposure assuming the exposure were to go
into default. This estimate of net additions would reflect what would be expected during
a period of economic downturn conditions. This treatment is retained in the final rule.
Also, consistent with the New Accord, the final rule extends this “own estimates”
treatment to trade-related letters of credit and for transaction-related contingencies.
Trade-related letters of credit are short-term self-liquidating instruments used to finance
the movement of goods and are collateralized by the underlying goods. A transactionrelated contingency includes such items as a performance bond or performance-based
standby letter of credit.
For the off-balance sheet component of a wholesale or retail exposure other than
an OTC derivative contract, repo-style transaction, eligible margin loan, loan
commitment, or line of credit issued by a bank, EAD was the notional amount of the
exposure. This treatment is retained in the final rule.
One commenter asked the agencies to permit banks to employ the New Accord’s
flexibility to reflect additional draws on lines of credit in either LGD or EAD. For the
same reasons that the agencies are requiring banks to include net accrued but unpaid
interest and fees in EAD, the agencies have decided to continue the requirement in the
final rule for banks to reflect estimates of additional draws in EAD, consistent with the
proposed rule.
Another commenter noted that the “remaining life of the exposure” concept in the
proposed definition of EAD for off-balance sheet exposures is ambiguous and
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inconsistent with defining PD over a one-year horizon. To address this commenter’s
concern, the agencies have modified the definition of EAD. The final rule requires a
bank to estimate net additions to the outstanding amount owed the bank in the event of
default over a one-year horizon.
Other commenters noted that banks may reduce their exposure to certain sectors
in periods of economic downturn, and inquired as to the extent to which such practices
may be reflected in EAD estimates. The agencies believe that such practices may be
reflected in EAD estimates for loan commitments, lines of credit, trade-related letters of
credit, and transaction-related contingencies to the extent that those practices are reflected
in the bank’s data on defaulted exposures. They may be reflected in EAD estimates for
on-balance sheet exposures only at the time the on-balance sheet exposure is actually
reduced.
To illustrate the EAD concept, assume a bank has a $100 unsecured, fully drawn,
two-year term loan with $10 of interest payable at the end of the first year and a balloon
payment of $110 at the end of the term. Suppose it has been six months since the loan’s
origination, and accrued interest equals $5. The EAD of this loan would be equal to the
outstanding principal amount plus accrued interest, or $105.
Next, consider the case of an open-end revolving credit line of $100, on which the
borrower had drawn $70 (the unused portion of the line is $30). Current accrued but
unpaid interest and fees are zero. The bank can document that, on average, during
economic downturn conditions, 20 percent of the remaining undrawn amounts are drawn
in the year preceding a firm’s default. Therefore, the bank’s estimate of future draws is
$6 (20% x $30). Additionally, the bank’s analysis indicates that, on average, during
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economic downturn conditions, such a facility can be expected to have accrued at the
time of default unpaid interest and commitment fees equal to three months of interest
against the drawn amount and 0.5 percent against the undrawn amount, which in this
example is assumed to equal $0.25. Thus, the EAD for estimated future accrued but
unpaid interest and fees equals $0.25. In sum, the EAD should be the drawn amount plus
estimated future accrued but unpaid fees plus the estimated amount of future draws =
$76.25 ($70 + $0.25 + $6).
Under the proposed rule, EAD for a segment of retail exposures was the sum of
the EADs for each individual exposure in the segment. The agencies have changed this
provision in the final rule, recognizing that banks typically estimate EAD for a segment
of retail exposures rather than on an individual exposure basis.
Under the final and proposed rules, for wholesale or retail exposures in which
only the drawn balance has been securitized, the bank must reflect its share of the
exposures’ undrawn balances in EAD. The undrawn balances of revolving exposures for
which the drawn balances have been securitized must be allocated between the seller’s
and investors’ interests on a pro rata basis, based on the proportions of the seller’s and
investors’ shares of the securitized drawn balances. For example, if the EAD of a group
of securitized exposures’ undrawn balances is $100, and the bank’s share (seller’s
interest) in the securitized exposures is 25 percent, the bank must reflect $25 in EAD for
the undrawn balances.
The final rule (like the proposed rule) contains a separate treatment of EAD for
OTC derivative contracts, which is in section 32 of the rule and discussed in more detail
in section V.C. of the preamble. The final rule also clarifies that a bank may use the
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treatment of EAD in section 32 of the rule for repo-style transactions and eligible margin
loans, or the bank may use the general definition of EAD described in this section for
such exposures.
General quantification principles
The final rule, like the proposed rule, requires data used by a bank to estimate risk
parameters to be relevant to the bank’s actual wholesale and retail exposures and of
sufficient quality to support the determination of risk-based capital requirements for the
exposures. For wholesale exposures, estimation of the risk parameters must be based on
a minimum of five years of default data to estimate PD, seven years of loss severity data
to estimate LGD, and seven years of exposure amount data to estimate EAD. For
segments of retail exposures, estimation of risk parameters must be based on a minimum
of five years of default data to estimate PD, five years of loss severity data to estimate
LGD, and five years of exposure amount data to estimate EAD. Default, loss severity,
and exposure amount data must include periods of economic downturn conditions or the
bank must adjust its estimates of risk parameters to compensate for the lack of data from
such periods. Banks must base their estimates of PD, LGD, and EAD on the final rule’s
definition of default, and must review at least annually and update (as appropriate) their
risk parameters and risk parameter quantification process.
In all cases, banks are expected to use the best available data for quantifying the
risk parameters. A bank could meet the minimum data requirement by using internal
data, external data, or pooled data combining internal data with external data. Internal
data refers to any data on exposures held in a bank’s existing or historical portfolios,
including data elements or information provided by third parties regarding such
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exposures. External data refers to information on exposures held outside of the bank’s
portfolio or aggregate information across an industry. For new lines of business, where a
bank lacks sufficient internal data, a bank likely will need to use external data to
supplement its internal data.
The agencies recognize that the minimum sample period for reference data
provided in the final rule may not provide the best available results. A longer sample
period usually captures varying economic conditions better than a shorter sample period.
In addition, a longer sample period will include more default observations for LGD and
EAD estimation. Banks should consider using a longer-than-minimum sample period
when possible. However, the potential increase in precision afforded by a larger sample
size should be weighed against the potential for diminished comparability of older data to
the existing portfolio.
Portfolios with limited data or limited defaults
Many commenters requested further clarity about the procedures that banks
should use to estimate risk parameters for portfolios characterized by a lack of internal
data or with very little default experience. In particular, the GAO report recommended
that the agencies provide additional clarity on this issue. Several commenters indicated
that the agencies should establish criteria for identifying homogeneous portfolios of lowrisk exposures and allow banks to apportion expected loss between LGD and PD for
those portfolios rather than estimating each risk parameter separately. Other commenters
suggested that the agencies consider whether banks should be permitted to use the New
Accord’s standardized approach for credit risk for such portfolios.
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The final rule requires banks to meet the qualification requirements in section 22
for all portfolios of exposures. The agencies expect that banks demonstrating
appropriately rigorous processes and sufficient degrees of conservatism for portfolios
with limited data or limited defaults will be able to meet the qualification requirements.
Section 22(c)(3) of the final rule specifically states that a bank’s risk parameter
quantification process “must produce appropriately conservative risk parameter estimates
where the bank has limited relevant data.” The agencies believe that this section provides
sufficient flexibility and incentives for banks to develop and document sound practices
for applying the IRB approach to portfolios lacking sufficient data.
The section of the preamble below expands upon potential approaches to
portfolios with limited data. The BCBS publication “Validation of low-default portfolios
in the Basel II Framework” 34 also provides a resource for banks facing this issue. The
agencies will work with banks through the supervisory and examination processes to
address particular situations.
Portfolios with limited data. The final rule, like the proposal, permits the use of
external data in quantification of risk parameters. External data should be informative of,
and appropriate to, a bank’s existing exposures. In some cases, a bank may be able to
acquire and use external data from a third party to estimate risk parameters until the
bank’s internal database meets the requirements of the rule. Alternatively, a bank may be
able to identify a set of data-rich internal exposures that could be used to inform the
estimation of risk parameters for the portfolio for which it has insufficient data. The key
considerations for a bank in determining whether to use alternative data sources will be
34
BCBS, Basel Committee Newsletter No. 6, “Validation of low-default portfolios in the Basel II
Framework,” September 2005.
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whether such data are sufficiently accurate, complete, representative and informative of
the bank’s existing exposures and whether the bank’s quantification of risk parameters is
rigorously conducted and well documented.
For instance, consider a bank that has recently extended its credit card operations
to include a new market segment for credit card loans and, therefore, has limited internal
data on the performance of the exposures in this new market segment. The bank could
acquire external data from various vendors that would provide a broad, market-wide
picture of default and loss experience in the new market segment. This external data
could then be supplemented by the bank’s internal data and experience with its existing
credit card operations. By comparing the bank’s experience with its existing customers
to the market data, the bank can refine the risk parameters estimated from the external
data on the new market segment and make those parameters more accurate for the bank’s
new market segment of exposures. Using the combination of these data sources, the bank
may be able to estimate appropriately conservative estimates of risk parameters for its
new market segment of exposures. If the bank is not able to do so, it must include the
new market segment of exposures in its set of aggregate immaterial exposures and apply
a 100 percent risk weight.
Portfolios with limited defaults. Commenters indicated that they had experienced
very few defaults for some portfolios, most notably margin loans and exposures to some
sovereign issuers, which made it difficult to separately estimate PD and LGD. The
agencies recognize that some portfolios have experienced very few defaults and have
very low loss experiences. The absence of defaults or losses in historical data does not,
however, preclude the potential for defaults or large losses to arise in future
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circumstances. Moreover, as discussed previously, the ability to separate EL into PD and
LGD is a key component of the IRB approach.
As with the cases described above in which internal data are limited in all
dimensions, external data from some related portfolios or for similar obligors may be
used to estimate risk parameters that are then mapped to the low default portfolio or
obligor. For example, banks could consider instances of near default or credit
deterioration short of default in these low default portfolios to inform estimates of what
might happen if a default were to occur. Similarly, scenario analysis that evaluates the
hypothetical impact of severe market disruptions may help inform the bank’s parameter
estimates for margin loans. For very low-risk wholesale obligors that have publicly
traded financial instruments, banks may be able to glean information about the relative
values of PD and LGD from different changes in credit spreads on instruments of
different maturity or from different moves in credit spreads and equity prices. In all
cases, risk parameter estimates should incorporate a degree of conservatism that is
appropriate for the overall rigor of the quantification process.
Other quantification process considerations. Both internal and external reference
data should not differ systematically from a bank’s existing portfolio in ways that seem
likely to be related to default risk, loss severity, or exposure at default. Otherwise, the
derived PD, LGD, or EAD estimates may not be applicable to the bank’s existing
portfolio. Accordingly, the bank must conduct a comprehensive review and analysis of
reference data at least annually to determine the relevance of reference data to the bank’s
exposures, the quality of reference data to support PD, LGD, and EAD estimates, and the
consistency of reference data to the definition of default in the final rule. Furthermore, a
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bank must have adequate internal or external data to estimate the risk parameters PD,
LGD, and EAD (each of which incorporates a one-year time horizon) for all wholesale
exposure and retail segments, including those originated for sale or that are in the
securitization pipeline.
As noted above, periods of economic downturn conditions must be included in the
data sample (or adjustments to risk parameters must be made). If the reference data
include data from beyond the minimum number of years (to capture a period of economic
downturn conditions or for other valid reasons), the reference data need not cover all of
the intervening years. However, a bank should justify the exclusion of available data
and, in particular, any temporal discontinuities in data used. Including periods of
economic downturn conditions increases the size and potentially the breadth of the
reference data set. According to some empirical studies, the average loss rate is higher
during periods of economic downturn conditions, such that exclusion of such periods
would bias LGD or EAD estimates downward and unjustifiably lower risk-based capital
requirements.
Risk parameter estimates should take into account the robustness of the
quantification process. The assumptions and adjustments embedded in the quantification
process should reflect the degree of uncertainty or potential error inherent in the process.
In practice, a reasonable estimation approach likely would result in a range of defensible
risk parameter estimates. The choices of the particular assumptions and adjustments that
determine the final estimate, within the defensible range, should reflect the uncertainty in
the quantification process. More uncertainty in the process should be reflected in the
assignment of final risk parameter estimates that result in higher risk-based capital
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requirements relative to a quantification process with less uncertainty. The degree of
conservatism applied to adjust for uncertainty should be related to factors such as the
relevance of the reference data to a bank’s existing exposures, the robustness of the
models, the precision of the statistical estimates, and the amount of judgment used
throughout the process. A bank is not required to add a margin of conservatism at each
step if doing so would produce an excessively conservative result. Instead, the overall
margin of conservatism should adequately account for all uncertainties and weaknesses in
the quantification process. Improvements in the quantification process (including use of
more complete data and better estimation techniques) may reduce the appropriate degree
of conservatism over time.
Judgment will inevitably play a role in the quantification process and may
materially affect the estimates of risk parameters. Judgmental adjustments to estimates
are often necessary because of limitations on available reference data or because of
inherent differences between the reference data and the bank’s existing exposures. The
bank’s risk parameter quantification process must produce appropriately conservative
risk parameter estimates when the bank has limited relevant data, and any adjustments
that are part of the quantification process must not result in a pattern of bias toward lower
risk parameter estimates. This does not prohibit individual adjustments that result in
lower estimates of risk parameters, as both upward and downward adjustments are
expected. Individual adjustments are less important than broad patterns; consistent signs
of judgmental decisions that materially lower risk parameter estimates may be evidence
of systematic bias, which is not permitted.
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In estimating relevant risk parameters, banks should not rely on the possibility of
U.S. government financial assistance, except for the financial assistance that the U.S.
government has a legally binding commitment to provide.
4. Optional approaches that require prior supervisory approval
A bank that intends to apply the internal models methodology to counterparty
credit risk, the double default treatment for credit risk mitigation, the IAA for
securitization exposures to ABCP programs, or the IMA to equity exposures must receive
prior written approval from its primary Federal supervisor. The criteria on which
approval will be based are described in the respective sections below.
5. Operational risk
A bank must have operational risk management processes, data and assessment
systems, and quantification systems that meet the qualification requirements in
section 22(h) of the final rule. A bank must have an operational risk management
function that is independent of business line management. The operational risk
management function is responsible for the design, implementation, and oversight of the
bank’s operational risk data and assessment systems, operational risk quantification
systems, and related processes. The roles and responsibilities of the operational risk
management function may vary between banks, but should be clearly documented. The
operational risk management function should have an organizational stature
commensurate with the bank’s operational risk profile. At a minimum, the bank’s
operational risk management function should ensure the development of policies and
procedures for the explicit management of operational risk as a distinct risk to the bank’s
safety and soundness.
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A bank also must establish and document a process to identify, measure, monitor,
and control operational risk in bank products, activities, processes, and systems. This
process should provide for the consistent and comprehensive collection of the data
needed to estimate the bank’s exposure to operational risk. This process must capture
business environment and internal control factors affecting the bank’s operational risk
profile. The process must also ensure reporting of operational risk exposures, operational
loss events, and other relevant operational risk information to business unit management,
senior management, and to the board of directors (or a designated committee of the
board).
The final rule defines an operational loss event as an event that results in loss and
is associated with any of the seven operational loss event type categories. Under the final
rule, the agencies have included definitions of the seven operational loss event type
categories, consistent with the descriptions outlined in the New Accord. The seven
operational loss event type categories are: (i) internal fraud, which is the operational loss
event type category that comprises operational losses resulting from an act involving at
least one internal party of a type intended to defraud, misappropriate property or
circumvent regulations, the law or company policy, excluding diversity and
discrimination-type events; (ii) external fraud, which is the operational loss event type
category that comprises operational losses resulting from an act by a third party of a type
intended to defraud, misappropriate property or circumvent the law; 35 (iii) employment
practices and workplace safety, which is the operational loss event type category that
comprises operational losses resulting from an act inconsistent with employment, health,
35
Retail credit card losses arising from non-contractual, third-party initiated fraud (for example, identity
theft) are external fraud operational losses. All other third-party initiated credit losses are to be treated as
credit risk losses.
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or safety laws or agreements, payment of personal injury claims, or payment arising from
diversity or discrimination events; (iv) clients, products, and business practices, which is
the operational loss event type category that comprises operational losses resulting from
the nature or design of a product or from an unintentional or negligent failure to meet a
professional obligation to specific clients (including fiduciary and suitability
requirements); (v) damage to physical assets, which is the operational loss event type
category that comprises operational losses resulting from the loss of or damage to
physical assets from natural disaster or other events; (vi) business disruption and system
failures, which is the operational loss event type category that comprises operational
losses resulting from disruption of business or system failures; and (vii) execution,
delivery, and process management, which is the operational loss event type category that
comprises operational losses resulting from failed transaction processing or process
management or losses arising from relations with trade counterparties and vendors.
The final rule does not require a bank to capture internal operational loss event
data according to these categories. However, unlike the proposed rule, the final rule
requires that a bank must be able to map such data into the seven operational loss event
type categories. The agencies believe such mapping will promote reporting consistency
and comparability across banks and is consistent with expectations in the New Accord. 36
A bank’s operational risk management processes should reflect the scope and
complexity of its business lines, as well as its corporate organizational structure. Each
bank’s operational risk profile is unique and should have a tailored risk management
approach appropriate for the scale and materiality of the operational risks present in the
bank.
36
New Accord, ¶673.
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Operational risk data and assessment system
A bank must have an operational risk data and assessment system that
incorporates on an ongoing basis the following four elements: internal operational loss
event data, external operational loss event data, results of scenario analysis, and
assessments of the bank’s business environment and internal controls. These four
operational risk elements should aid the bank in identifying the level and trend of
operational risk, determining the effectiveness of operational risk management and
control efforts, highlighting opportunities to better mitigate operational risk, and
assessing operational risk on a forward-looking basis. A bank’s operational risk data and
assessment system must be structured in a manner consistent with the bank’s current
business activities, risk profile, technological processes, and risk management processes.
The proposed rule defined operational loss as a loss (excluding insurance or tax
effects) resulting from an operational loss event. Operational losses included all
expenses associated with an operational loss event except for opportunity costs, forgone
revenue, and costs related to risk management and control enhancements implemented to
prevent future operational losses. The definition of operational loss is an important issue,
as it is a critical building block in a bank’s calculation of its operational risk capital
requirement under the AMA. More specifically, the bank’s estimate of operational risk
exposure – the basis for determining a bank’s risk-weighted asset amount for operational
risk – is an estimate of aggregate operational losses generated by the bank’s AMA
process.
Many commenters supported the agencies’ proposed definition of operational loss
and viewed it as appropriate and consistent with general use within the banking industry.
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Some commenters, however, opposed the inclusion of a specific definition of operational
loss and asserted that the proposed treatment of operational loss is too prescriptive. In
addition, some commenters maintained that including a definition of operational loss is
inconsistent with the New Accord, which does not explicitly define operational loss. In
response to a specific question in the proposal, many commenters asserted that the
definition of operational loss should relate to its impact on regulatory capital rather than
economic capital concepts. One commenter, however, recommended using the
replacement cost of any fixed asset affected by an operational loss event to reflect the
actual financial impact of the event.
Because operational losses are the building blocks in a bank’s calculation of its
operational risk capital requirement under the AMA, the agencies continue to believe that
it is necessary to define what is meant by operational loss to achieve comparability and
foster consistency both across banks and across business lines within a bank.
Additionally, the agencies agree with those commenters who asserted that the definition
of operational loss should relate to its impact on regulatory capital. Therefore, the
agencies have adopted the proposed definition of operational loss unchanged.
In the preamble to the proposed rule, the agencies recognized that there was a
potential to double-count all or a portion of the risk-based capital requirement associated
with fixed assets. Under the proposed rule, the credit-risk-weighted asset amount for a
bank’s premises would equal the carrying value of the premises on the financial
statements of the bank, determined in accordance with GAAP. A bank’s operational risk
exposure estimate addressing bank premises generally would be different than, and in
addition to, the risk-based capital requirement generated under the proposed rule and
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could, at least in part, address the same risk exposure. The majority of commenters on
this issue recommended removing the credit risk capital requirement for premises and
other fixed assets and preserving only the operational risk capital requirement.
The agencies are maintaining the proposed rule’s treatment of fixed assets in the
final rule. The New Accord generally provides a risk weight of 100 percent for assets for
which an IRB treatment is not specified. 37 Consistent with the New Accord, the final
rule provides that the risk-weighted asset amount for any on-balance sheet asset that does
not meet the definition of a wholesale, retail, securitization, or equity exposure is equal to
the carrying value of the asset. Also consistent with the New Accord, the final rule
continues to include damage to physical assets among the operational loss event types
incorporated into a bank’s operational risk exposure estimate. 38 The agencies believe
that requiring a bank to calculate both a credit risk and operational risk capital
requirement for premises and fixed assets is justified in light of the fact that the credit risk
capital requirement covers a broader set of risks, whereas the operational risk capital
requirement covers potential physical damage to the asset. The agencies view this
treatment of premises and other fixed assets as consistent with the New Accord and have
confirmed that the approach is consistent with the approaches used by other jurisdictions
implementing the New Accord.
A bank must have a systematic process for capturing and using internal
operational loss event data in its operational risk data and assessment systems. The final
rule defines a bank’s internal operational loss event data as its gross operational loss
amounts, dates, recoveries, and relevant causal information for operational loss events
37
38
New Accord, ¶214.
New Accord, Annex 9.
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occurring at the bank. Under the proposed rule, a bank’s operational risk data and
assessment system would include a minimum historical observation period of five years
of internal operational losses. With approval of its primary Federal supervisor, however,
a bank could use a shorter historical observation period to address transitional situations
such as integrating a new business line. A bank also could refrain from collecting
internal operational loss event data for individual operational losses below established
dollar threshold amounts if the bank could demonstrate to the satisfaction of its primary
Federal supervisor that the thresholds were reasonable, did not exclude important internal
operational loss event data, and permitted the bank to capture substantially all the dollar
value of the bank’s operational losses.
Several commenters expressed concern over the proposal’s five-year minimum
historical observation period requirement for internal operational loss event data. These
commenters recommended that the agencies align this provision with the New Accord,
which allows for a three-year historical observation period upon initial AMA
implementation.
While the proposed rule required a bank to include in its operational risk data and
assessment systems a historical observation period of at least five years for internal
operational loss event data, it also provided for a shorter observation period subject to
agency approval to address transitional situations, such as integrating a new business line.
The agencies believe that these proposed provisions provide sufficient flexibility to
consider other situations, on a case-by-case basis, in which a shorter observation period
may be appropriate, such as a bank’s initial implementation of an AMA. Therefore, the
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final rule retains the five-year historical observation period requirements and the
transitional flexibility for internal operational loss event data, as proposed.
In relation to the provision that permits a bank to refrain from collecting internal
operational loss event data below established thresholds, a few commenters sought
clarification of the proposed requirement that the thresholds must permit the bank to
capture “substantially all” of the dollar value of a bank’s operational losses. In particular,
they questioned whether a bank must collect all or a very high percentage of operational
losses or whether smaller losses could be modeled.
To demonstrate the appropriateness of its threshold for internal operational loss
event data collection, a bank might choose to collect all internal operational loss event
data, at least for a time, to support a meaningful analysis around the appropriateness of its
chosen data collection threshold. Alternatively, a bank might be able to obtain data from
systems outside of its operational risk data and assessment system (for example, the
bank’s general ledger system) to demonstrate the impact of choosing different thresholds
on its operational risk exposure estimates.
With respect to the commenters’ question regarding modeling smaller losses, the
agencies would consider permitting such an approach based on whether the approach
meets the overall qualification requirements outlined in the final rule. In particular, the
agencies would consider whether the bank satisfies those requirements pertaining to a
bank’s operational risk quantification system as well as its control, oversight, and
validation mechanisms. Such modeling considerations, however, would not eliminate the
requirement for a bank to demonstrate the appropriateness of any established internal
operational loss event data collection thresholds.
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A bank also must establish a systematic process to determine its methodologies
for incorporating external operational loss event data into its operational risk data and
assessment systems. The proposed and final rules define external operational loss event
data for a bank as gross operational loss amounts, dates, recoveries, and relevant causal
information for operational loss events occurring at organizations other than the bank.
External operational loss event data may serve a number of different purposes in a bank’s
operational risk data and assessment systems. For example, external operational loss
event data may be a particularly useful input in determining a bank’s level of exposure to
operational risk when internal operational loss event data are limited. In addition,
external operational loss event data provide a means for the bank to understand industry
experience and, in turn, provide a means for the bank to assess the adequacy of its
internal operational loss event data.
While internal and external operational loss event data provide a historical
perspective on operational risk, it is also important that a bank incorporate forwardlooking elements into its operational risk data and assessment systems. Accordingly,
under the final rule, as under the proposed rule, a bank must incorporate business
environment and internal control factors into its operational risk data and assessment
systems to assess fully its exposure to operational risk. In principle, a bank with strong
internal controls in a stable business environment would have less exposure to
operational risk than a bank with internal control weaknesses that is growing rapidly or
introducing new products. In this regard, a bank should identify and assess the level and
trends in operational risk and related control structures at the bank. These assessments
should be current and comprehensive across the bank, and they should identify the
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operational risks facing the bank. The framework established by a bank to maintain these
risk assessments should be sufficiently flexible to accommodate increasing complexity,
new activities, changes in internal control systems, and an increasing volume of
information. A bank must also periodically compare the results of its prior business
environment and internal control factor assessments against the bank’s actual operational
losses incurred in the intervening period.
A few commenters sought clarification on the agencies’ expectations regarding a
bank’s periodic comparisons of its prior business environment and internal control factor
assessments against its actual operational losses. One commenter expressed concern over
the difficulty of conducting an empirically robust analysis to fulfill the requirement.
Under the final rule, a bank has flexibility in the approach it uses to conduct its
business environment and internal control factor assessments. As such, the methods for
conducting comparisons of these assessments against actual operational loss experience
may also vary and precise modeling calibration may not be practical. The agencies
maintain, however, that it is important for a bank to perform such comparisons to ensure
that its assessments are current, reasonable, and appropriately factored into the bank’s
AMA framework. In addition, the comparisons could highlight the need for potential
adjustments to the bank’s operational risk management processes.
A bank also must have a systematic process for determining its methodologies for
incorporating scenario analysis into its operational risk data and assessment systems. As
an input to a bank’s operational risk data and assessment systems, scenario analysis is
especially relevant for business lines or operational loss event types where internal data,
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external data, and assessments of the business environment and internal control factors do
not provide a sufficiently robust estimate of the bank’s exposure to operational risk.
Similar to business environment and internal control factor assessments, the
results of scenario analysis provide a means for a bank to incorporate a forward-looking
element into its operational risk data and assessment systems. Under the proposed rule,
scenario analysis was defined as a systematic process of obtaining expert opinions from
business managers and risk management experts to derive reasoned assessments of the
likelihood and loss impact of plausible high-severity operational losses. The agencies
have clarified this definition in the final rule to recognize that there are various methods
and inputs a bank may use to conduct its scenario analysis. For this reason, the modified
definition indicates that scenario analysis may include the well-reasoned evaluation and
use of external operational loss event data, adjusted as appropriate to ensure relevance to
a bank’s operational risk profile and control structure.
A bank’s operational risk data and assessment systems must include credible,
transparent, systematic, and verifiable processes that incorporate all four operational risk
elements (that is, internal operational loss event data, external operational loss event data,
scenario analysis, and business environment and internal control factors). The bank
should have clear standards for the collection and modification of all elements. The bank
should combine these four elements in a manner that most effectively enables it to
quantify its exposure to operational risk.
Operational risk quantification system
A bank must have an operational risk quantification system that generates
estimates of its operational risk exposure using its operational risk data and assessment
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systems. The final rule defines operational risk exposure as the 99.9th percentile of the
distribution of potential aggregate operational losses, as generated by the bank’s
operational risk quantification system over a one-year horizon (and not incorporating
eligible operational risk offsets or qualifying operational risk mitigants). The mean of
such a total loss distribution is the bank’s EOL. The final rule defines EOL as the
expected value of the distribution of potential aggregate operational losses, as generated
by the bank’s operational risk quantification system using a one-year horizon. The
bank’s UOL is the difference between the bank’s operational risk exposure and the
bank’s EOL.
A few commenters sought clarification on whether the agencies would impose
specific requirements around the use and weighting of the four elements of a bank’s
operational risk data and assessment system, and whether there were any limitations on
how external data or scenario analysis could be used as modeling inputs. Another
commenter expressed concern that for some U.S.-chartered DIs that were subsidiaries of
foreign banking organizations, it might be difficult to ever have enough internal
operational loss event data to generate statistically significant operational risk exposure
estimates.
The agencies recognize that banks will have different inputs and methodologies
for estimating their operational risk exposure given the inherent flexibility of the AMA.
It follows that the weights assigned in combining the four required elements of a bank’s
operational risk data and assessment system (internal operational loss event data, external
operational loss event data, scenario analysis, and assessments of the bank’s business
environment and internal control factors) will also vary across banks. Factors affecting
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the weighting include a bank’s operational risk profile, operational loss experience,
internal control environment, and relative quality and content of the four elements. These
factors will influence the emphasis placed on certain elements relative to others. As such,
the agencies are not prescribing specific requirements around the weighting of each
element, nor are they placing any specific limitations on the use of the elements. In view
of this flexibility, however, under the final rule a bank’s operational risk quantification
systems must include a credible, transparent, systematic, and verifiable approach for
weighting the use of the four elements.
As part of its operational risk exposure estimate, a bank must use a unit of
measure that is appropriate for the bank’s range of business activities and the variety of
operational loss events to which it is exposed. The proposed rule defined a unit of
measure as the level (for example, organizational unit or operational loss event type) at
which the bank’s operational risk quantification system generated a separate distribution
of potential operational losses. Under the proposed rule, a bank could not combine
business activities or operational loss events with different risk profiles within the same
loss distribution.
Many commenters expressed concern that the prohibition against combining
business activities or operational loss events with different risk profiles within the same
loss distribution was an impractical standard because some level of combination was
unavoidable. Additionally, commenters noted that data limitations made it difficult to
quantify risk profiles at a granular level. Commenters also expressed concern that the
proposed rule appeared to preclude the use of “top-down” approaches, given that under a
firm-wide approach business activities or operational loss events with different risk
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profiles would necessarily be combined within the same loss distribution. One
commenter suggested that, because of data limitations and the potential for wide
variations in risk profiles within individual business lines and/or types of operational loss
events, banks be afforded some latitude in moving from a “top-down” approach to a
“bottom-up” approach.
The agencies have retained the proposed definition of unit of measure in the final
rule. The agencies recognize, however, that there is a need for flexibility in assessing
whether a bank’s chosen unit of measure is appropriate for the bank’s range of business
activities and the variety of operational loss events to which it is exposed. In some
instances, data limitations may indeed prevent a bank’s operational risk quantification
systems from generating a separate distribution of potential operational losses for certain
business lines or operational loss event types. Therefore, the agencies have modified the
final rule to provide a bank more flexibility in devising an appropriate unit of measure.
Specifically, a bank must employ a unit of measure that is appropriate for its range of
business activities and the variety of operational loss events to which it is exposed, and
that does not combine business activities or operational loss events with demonstrably
different risk profiles within the same loss distribution.
The agencies recognize that operational losses across operational loss event types
and business lines may be related. Under the final rule, as under the proposed rule, a
bank may use its internal estimates of dependence among operational losses within and
across business lines and operational loss event types if the bank can demonstrate to the
satisfaction of its primary Federal supervisor that its process for estimating dependence is
sound, robust to a variety of scenarios, implemented with integrity, and allows for the
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uncertainty surrounding the estimates. The agencies expect that a bank’s assumptions
regarding dependence will be conservative given the uncertainties surrounding
dependence modeling for operational risk. If a bank does not satisfy the requirements
surrounding dependence, the bank must sum operational risk exposure estimates across
units of measure to calculate its total operational risk exposure.
Under the proposed rule, dependence was defined as “a measure of the
association among operational losses across and within business lines and operational
loss event types.” One commenter recommended that the agencies revise the definition
of dependence to “a measure of the association among operational losses across and
within units of measure.” The agencies recognize that examples of units of measure
include, but are not limited to, business lines and operational loss event types, and that a
bank’s operational risk quantification system could generate distributions of potential
operational losses that are separate from its business lines and operational loss event
types. Units of measure can also encompass correlations over time. Therefore, the
agencies have amended the final rule to define dependence as a measure of the
association among operational losses across and within units of measure.
As noted above, under the proposed rule, a bank that did not satisfy the
requirements surrounding dependence would sum operational risk exposure estimates
across units of measure to calculate its total operational risk exposure. Several
commenters asserted that the New Accord does not require a bank to sum its operational
risk exposure estimates across units of measure if the bank cannot demonstrate adequate
support of its dependence assumptions. One commenter asked the agencies to remove
this requirement from the final rule. Several commenters suggested that if a bank cannot
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provide sufficient support for its dependence estimates, a conservative assumption of
positive dependence is warranted, but not an assumption of perfect positive dependence
as implied by the summation requirement. Another commenter suggested that the
dependence assumption should be based upon a conservative statistical analysis of
industry data.
The New Accord states that, absent a satisfactory demonstration of a bank’s
“systems for determining correlations” to its national supervisor, “risk measures for
different operational risk estimates must be added for purposes of calculating the
regulatory minimum capital requirement.” 39 The agencies continue to believe that this
treatment of operational risk exposure estimates across units of measure is prudent until
the relationships among operational losses are better understood. Therefore, the final rule
retains the proposed rule’s requirement regarding the summation of operational risk
exposure estimates.
Several commenters believed that a bank should be permitted to demonstrate the
nature of the relationship between the causes of different operational losses based on any
available informative empirical evidence. These commenters suggested that such
evidence could be statistical or anecdotal, and could be based on information ranging
from established statistical techniques to more general mathematical approaches to clear
logical arguments about the degree to which risks and losses are related, or the similarity
of circumstance between the bank and a peer group for which acceptable estimates of
dependency are available.
The agencies recognize that there may be different ways to estimate the
relationship among operational losses across and within units of measure. Therefore,
39
New Accord, ¶669.
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under the final rule, a bank has flexibility to use different methodologies to demonstrate
dependence across units of measure. However, the bank must demonstrate to the
satisfaction of its primary Federal supervisor that its process for estimating dependence is
sound, robust to a variety of scenarios, implemented with integrity, and allows for the
uncertainty surrounding the estimates.
A bank’s chosen unit of measure affects how it should account for dependence.
Explicit assumptions regarding dependence across units of measure are always necessary
to estimate operational risk exposure at the bank level. However, explicit assumptions
regarding dependence within units of measure are not necessary, and under many
circumstances models assume statistical independence within each unit of measure. The
use of only a few units of measure increases the need to ensure that dependence within
units of measure is suitably reflected in the operational risk exposure estimate.
In addition, the bank’s process for estimating dependence should provide for
ongoing monitoring, recognizing that dependence estimates can change. The agencies
expect that a bank’s approach for developing explicit and objective dependence
determinations will improve over time. As such, the bank should develop a process for
assessing incremental improvements to the approach (for example, through out-of-sample
testing).
Under the final rule, as under the proposed rule, a bank must review and update
(as appropriate) its operational risk quantification system whenever the bank becomes
aware of information that may have a material effect on the bank’s estimate of
operational risk exposure, but no less frequently than annually.
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The agencies recognize that, in limited circumstances, there may not be sufficient
data available for a bank to generate a credible estimate of its own operational risk
exposure at the 99.9 percent confidence level. In these limited circumstances, under the
proposed rule, a bank could use an alternative operational risk quantification system,
subject to prior approval by the bank’s primary Federal supervisor. The alternative
approach was not available at the BHC level.
One commenter asserted that, in line with the New Accord’s continuum of
operational risk measurement approaches, all banks, including BHCs, should be
permitted to adopt an alternative operational risk quantification system, such as the New
Accord’s standardized approach or allocation approach. The commenter further noted
that a bank’s use of an allocation approach should not be subject to more stringent terms
and conditions than those set forth in the New Accord.
The agencies are maintaining the alternative approach provision in the final rule.
The agencies are not prescribing specific estimation methodologies under this approach
and expect use of an alternative approach to occur on a very limited basis. A bank
proposing to use an alternative operational risk quantification system must submit a
proposal to its primary Federal supervisor. In evaluating a bank’s proposal, the primary
Federal supervisor will review the bank’s justification for requesting use of an alternative
approach in light of the bank’s size, complexity, and risk profile. The bank’s primary
Federal supervisor will also consider whether the estimate of operational risk under the
alternative approach is appropriate (for example, whether the estimate results in capital
levels that are commensurate with the bank’s operational risk profile and is sensitive to
changes in the bank’s risk profile) and can be supported empirically. Furthermore, the
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agencies expect a bank using an alternative operational risk quantification system to
adhere to the rule’s qualification requirements, including establishment and use of
operational risk management processes and data and assessment systems. As under the
proposed rule, the alternative approach is not available at the BHC level.
A bank proposing an alternative approach to operational risk based on an
allocation methodology should be aware of certain limitations associated with the use of
such an approach. Specifically, the agencies will not permit a DI to accept an allocation
of operational risk capital requirements that includes non-DIs. Unlike the crossguarantee provision of the Federal Deposit Insurance Act, which provides that a DI is
liable for any losses incurred by the FDIC in connection with the failure of a commonlycontrolled DI, there are no statutory provisions requiring cross-guarantees between a DI
and its non-DI affiliates. 40 Furthermore, depositors and creditors of a DI generally have
no legal recourse to capital funds that are not held by the DI or its affiliate DIs.
6. Data management and maintenance
A bank must have data management and maintenance systems that adequately
support all aspects of the bank’s advanced IRB systems, operational risk management
processes, operational risk data and assessment systems, operational risk quantification
systems, and, to the extent the bank uses the following systems, the internal models
methodology, the double default excessive correlation detection process, the IMA for
equity exposures, and the IAA for securitization exposures to ABCP programs
(collectively, advanced systems).
The bank’s data management and maintenance systems must adequately support
the timely and accurate reporting of risk-based capital requirements. Specifically, a bank
40
12 U.S.C. 1815(e).
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must retain sufficient data elements related to key risk drivers to permit monitoring,
validation, and refinement of the bank’s advanced systems. A bank’s data management
and maintenance systems should generally support the rule’s qualification requirements
relating to quantification, validation, and control and oversight mechanisms, as well as
the bank’s broader risk management and reporting needs. The precise data elements to
be collected are dictated by the features and methodologies of the risk measurement and
management systems employed by the bank. To meet the significant data management
challenges presented by the quantification, validation, and control and oversight
requirements of the advanced approaches, a bank must retain data in an electronic format
that allows timely retrieval for analysis, reporting, and disclosure purposes. The agencies
did not receive any material comments on these data management requirements.
7. Control and oversight mechanisms
The consequences of an inaccurate or unreliable advanced system can be
significant, particularly regarding the calculation of risk-based capital requirements.
Accordingly, bank senior management is responsible for ensuring that all advanced
systems function effectively and comply with the qualification requirements.
Under the proposed rule, a bank’s board of directors (or a designated committee
of the board) would at least annually evaluate the effectiveness of, and approve, the
bank’s advanced systems. Multiple commenters objected to this requirement.
Commenters suggested that a bank’s board of directors should have more narrowly
defined responsibilities, and that evaluation of a bank’s advanced systems would be more
effectively and appropriately accomplished by senior management.
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The agencies believe that a bank’s board of directors has ultimate accountability
for the effectiveness of the bank’s advanced systems. However, the agencies agree that it
is not necessarily the responsibility of a bank’s board of directors to conduct an
evaluation of the effectiveness of a bank’s advanced systems. Evaluation may include
transaction testing, validation, and audit activities more appropriately the responsibility of
senior management. Accordingly, the final rule requires a bank’s board of directors to
review the effectiveness of, and approve, the bank’s advanced systems at least annually.
To support senior management’s and the board of directors’ oversight
responsibilities, a bank must have an effective system of controls and oversight that
ensures ongoing compliance with the qualification requirements; maintains the integrity,
reliability, and accuracy of the bank’s advanced systems; and includes adequate corporate
governance and project management processes. Banks have flexibility to determine how
to achieve integrity in their risk management systems. Banks are, however, expected to
follow standard control principles in their systems such as checks and balances,
separation of duties, appropriateness of incentives, and data integrity assurance, including
that of information purchased from third parties. Moreover, the oversight process should
be sufficiently independent of the advanced systems’ development, implementation, and
operation to ensure the integrity of the component systems. The objective of risk
management system oversight is to ensure that the various systems used in determining
risk-based capital requirements are operating as intended. The oversight process should
draw conclusions on the soundness of the components of the risk management system,
identify errors and flaws, and recommend corrective action as appropriate.
Validation
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A bank must validate its advanced systems on an ongoing basis. Validation is the
set of activities designed to give the greatest possible assurances of accuracy of the
advanced systems. Validation includes three broad components: (i) evaluation of the
conceptual soundness of the advanced systems; (ii) ongoing monitoring that includes
process verification and comparison of the bank’s internal estimates with relevant
internal and external data sources or results from other estimation techniques
(benchmarking); and (iii) outcomes analysis that includes back-testing.
Each of these three components of validation must be applied to the bank’s risk
rating and segmentation systems, risk parameter quantification processes, and internal
models that are part of the bank’s advanced systems. A sound validation process should
take business cycles into account, and any adjustments for stages of the economic cycle
should be clearly specified in advance and fully documented as part of the validation
policy. Senior management of the bank should be notified of the validation results and
should take corrective action where appropriate.
A bank’s validation process must be independent of the advanced systems’
development, implementation, and operation, or be subject to independent assessment of
its adequacy and effectiveness. A bank should ensure that individuals who perform the
review are not biased in their assessment due to their involvement in the development,
implementation, or operation of the processes or products. For example, reviews of the
internal risk rating and segmentation systems should be performed by individuals who
were not part of the development, implementation, or maintenance of those systems. In
addition, individuals performing the reviews should possess the requisite technical skills
and expertise to fulfill their mandate.
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The first component of validation is evaluating conceptual soundness, which
involves assessing the quality of the design and construction of a risk measurement or
management system. This evaluation of conceptual soundness should include
documentation and empirical evidence supporting the methods used and the variables
selected in the design and quantification of the bank’s advanced systems. The
documentation should also evidence an understanding of the systems’ limitations. The
development of internal risk rating and segmentation systems and their quantification
processes requires banks to exercise judgment. Validation should ensure that these
judgments are well informed and considered, and generally include a body of expert
opinion. A bank should review developmental evidence whenever the bank makes
material changes in its advanced systems.
The second component of the validation process for a bank’s advanced systems is
ongoing monitoring to confirm that the systems were implemented appropriately and
continue to perform as intended. Such monitoring involves process verification and
benchmarking. Process verification includes verifying that internal and external data are
accurate and complete, as well as ensuring that: internal risk rating and segmentation
systems are being used, monitored, and updated as designed; ratings are assigned to
wholesale obligors and exposures as intended; and appropriate remediation is undertaken
if deficiencies exist.
Benchmarking means the comparison of a bank’s internal estimates with relevant
internal and external data or with estimates based on other estimation techniques. Banks
are required to use alternative data sources or risk assessment approaches to draw
inferences about the validity of their internal risk ratings, segmentations, risk parameter
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estimates, and model outputs on an ongoing basis. For credit risk ratings, examples of
alternative data sources include independent internal raters (such as loan review), external
rating agencies, wholesale and retail credit risk models developed independently, or retail
credit bureau models. Because it may take considerable time before outcomes with
which to conduct sufficiently robust backtesting are available, benchmarking will be a
very important validation device. Benchmarking applies to all quantification processes
and internal risk rating and segmentation activities.
Benchmarking allows a bank to compare its estimates with those of other
estimation techniques and data sources. Results of benchmarking exercises can be a
valuable diagnostic tool in identifying potential weaknesses in a bank’s risk
quantification system. While benchmarking activities allow for inferences about the
appropriateness of the quantification processes and internal risk rating and segmentation
systems, they are not the same as backtesting. Differences observed between the bank’s
risk estimates and the benchmark do not necessarily indicate that the internal risk ratings,
segmentation decisions, or risk parameter estimates are in error. The benchmark itself is
an alternative prediction, and the difference may be due to different data or methods. As
part of the benchmarking exercise, the bank should investigate the source of the
differences and whether the extent of the differences is appropriate.
The third component of the validation process is outcomes analysis, which is the
comparison of the bank’s forecasts of risk parameters and other model outputs with
actual outcomes. A bank’s outcomes analysis must include backtesting, which is the
comparison of the bank’s forecasts generated by its internal models with actual outcomes
during a sample period not used in model development. In this context, backtesting is
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one form of out-of-sample testing. The agencies note that in other contexts backtesting
may refer to in-sample fit, but in-sample fit analysis is not what the rule requires a bank
to do as part of the advanced approaches validation process.
Actual outcomes should be compared with expected ranges around the estimated
values of the risk parameters and model results. Randomness and many other variables
will make discrepancies between realized outcomes and the estimated risk parameters
inevitable. Therefore the expected ranges should take into account relevant elements of a
bank’s internal risk rating or segmentation processes. For example, depending on the
bank’s rating philosophy, year-by-year realized default rates may be expected to differ
significantly from the long-run one-year average. Also, changes in economic conditions
between the historical data and current period can lead to differences between actual
outcomes and estimates.
One commenter asserted that requiring a bank to perform a statistically robust
form of backtesting would be an impractically high standard for AMA qualification given
the nature of operational risk. The commenter further claimed that validating an
operational risk model must rely on the robustness of the logical structure of the model
and the appropriateness of the resultant operational risk exposure when benchmarked
against other established reference points.
The agencies recognize that it may take considerable time before actual outcomes
outside of the sample period used in model development are available that would allow a
bank to backtest its operational risk models by comparing its internal estimates with these
outcomes. The agencies also acknowledge that a bank may be unable to backtest an
operational risk model with the same degree of statistical precision that it is able to
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backtest an internal market risk model. When a bank’s backtesting process is not
sufficiently robust, a bank may need to rely more heavily on benchmarking and other
alternative validation devices. The agencies maintain, however, that backtesting provides
important feedback on the accuracy of model outputs and that a bank should be able to
assess how actual losses compare with estimates previously generated by its model.
Internal audit
A bank must have an internal audit function independent of business-line
management that at least annually assesses the effectiveness of the controls supporting
the bank’s advanced systems. Internal audit should review the validation process,
including validation procedures, responsibilities, results, timeliness, and responsiveness
to findings. Further, internal audit should evaluate the depth, scope, and quality of the
risk management system review process and conduct appropriate testing to ensure that
the conclusions of these reviews are well founded. Internal audit must report its findings
at least annually to the bank’s board of directors (or a committee thereof).
Stress testing
A bank must periodically stress test its advanced systems. Stress testing analysis
is a means of understanding how economic cycles, especially downturns as described by
stress scenarios, affect risk-based capital requirements, including migration across rating
grades or segments and the credit risk mitigation benefits of double default treatment.
Stress testing analysis consists of identifying stress scenarios and then assessing the
effects of the scenarios on key performance measures, including risk-based capital
requirements. Under the rule, changes in borrower credit quality will lead to changes in
risk-based capital requirements. Because credit quality changes typically reflect
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changing economic conditions, risk-based capital requirements may also vary with the
economic cycle. During an economic downturn, risk-based capital requirements will
increase if wholesale obligors or retail exposures migrate toward lower credit quality
rating grades or segments.
Supervisors expect banks to manage their regulatory capital position so that they
remain at least adequately capitalized during all phases of the economic cycle. A bank
that credibly estimates regulatory capital levels during a downturn can be more confident
of appropriately managing regulatory capital.
Banks should use a range of plausible but severe scenarios and methods when
stress testing to manage regulatory capital. Scenarios may be historical, hypothetical, or
model-based. Key variables specified in a scenario may include, for example, interest
rates, transition matrices (ratings and score-band segments), asset values, credit spreads,
market liquidity, economic growth rates, inflation rates, exchange rates, or
unemployment rates. A bank may choose to have scenarios apply to an entire portfolio,
or it may identify scenarios specific to various sub-portfolios. The severity of the stress
scenarios should be consistent with the periodic economic downturns experienced in the
bank’s market areas. Such scenarios may be less severe than those used for other
purposes, such as testing a bank’s solvency.
The scope of stress testing analysis should be broad and include all material
portfolios. The time horizon of the analysis should be consistent with the specifics of the
scenario and should be long enough to measure the material effects of the scenario on key
performance measures. For example, if a scenario such as a historical recession has
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material income and segment or ratings migration effects over two years, the appropriate
time horizon is at least two years.
8. Documentation
A bank must adequately document all material aspects of its advanced systems,
including but not limited to the internal risk rating and segmentation systems, risk
parameter quantification processes, model design, assumptions, and validation results.
The guiding principle governing documentation is that it should support the requirements
for the quantification, validation, and control and oversight mechanisms as well as the
bank’s broader risk management and reporting needs. Documentation is also critical to
the supervisory oversight process.
The bank should document the rationale for all material assumptions
underpinning its chosen analytical frameworks, including the choice of inputs,
distributional assumptions, and weighting of quantitative and qualitative elements. The
bank also should document and justify any subsequent changes to these assumptions.
C. Ongoing Qualification
A bank using the advanced approaches must meet the qualification requirements
on an ongoing basis. Banks are expected to improve their advanced systems as they
improve data gathering capabilities and as industry practice evolves. To facilitate the
supervisory oversight of systems changes, a bank must notify its primary Federal
supervisor when it makes a change to its advanced systems that results in a material
change in the bank’s risk-weighted asset amount for an exposure type, or when the bank
makes any significant change to its modeling assumptions.
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If an agency determines that a bank that uses the advanced approaches to
calculate its risk-based capital requirements has fallen out of compliance with one or
more of the qualification requirements, the agency will notify the bank of its failure to
comply. After receiving such notice, a bank must establish and submit a plan satisfactory
to its primary Federal supervisor to return to compliance. If the bank’s primary Federal
supervisor determines that the bank’s risk-based capital requirements are not
commensurate with the bank’s credit, market, operational, or other risks, it may require
the bank to calculate its risk-based capital requirements using the general risk-based
capital rules or a modified form of the advanced approaches (for example, with fixed
supervisory risk parameters).
Under the proposed rule, a bank that fell out of compliance with the qualification
requirements would also be required to disclose publicly its noncompliance with the
qualification requirements promptly after receiving notice of noncompliance from its
primary Federal supervisor. Commenters objected to this requirement, noting that it is
not one of the public disclosure requirements of the New Accord. The agencies have
determined that the public disclosure of noncompliance is not always necessary, because
the disclosure may not reflect the degree of noncompliance. Therefore, the agencies are
not including a general noncompliance disclosure requirement in the final rule. However,
the agencies acknowledge that a bank’s significant noncompliance with the qualification
requirements is an important factor in market participants’ assessments of the bank’s risk
profile and, thus, a primary Federal supervisor may require public disclosure of
noncompliance with the qualification requirements if such noncompliance is significant.
D. Merger and Acquisition Transition Provisions
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Due to the advanced approaches’ rigorous systems requirements, a bank that
merges with or acquires another company might not be able to quickly integrate the
merged or acquired company’s exposures into its risk-based capital calculations. The
proposed rule provided transition provisions that would allow the acquiring bank time to
integrate the merged or acquired company into its advanced approaches, subject to an
implementation plan submitted to the bank’s primary Federal supervisor. As proposed,
the transition provisions applied only to banks that had already qualified to use the
advanced approaches. The agencies recognize, however, that a bank in the process of
qualifying to use the advanced approaches may merge with or acquire a company and
need time to integrate the company into its advanced approaches on an implementation
schedule distinct from its original implementation plan. In the final rule, the agencies are
therefore allowing banks to take advantage of the proposed rule’s transition provisions
for mergers and acquisitions both before and after they qualify to use the advanced
approaches.
Under the proposed rule, a bank could use the transition provisions for the merged
or acquired company’s exposures for up to 24 months following the calendar quarter
during which the merger or acquisition consummates. A bank’s primary Federal
supervisor could extend the transition period for up to an additional 12 months.
Commenters generally supported this timeframe and associated supervisory flexibility.
Therefore, the final rule adopts the proposed rule’s merger and acquisition transition
timeframe without change.
To take advantage of the merger and acquisition transition provisions, the
acquiring bank must submit to its primary Federal supervisor an implementation plan for
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using the advanced approaches for the merged or acquired company. The proposed rule
required a bank to submit such a plan within 30 days of consummating the merger or
acquisition. Many commenters asserted that the 30-day timeframe for submission of an
implementation plan may be too short, particularly given the many integration activities
that must take place immediately following the consummation of a merger or acquisition.
These commenters generally suggested that banks instead be given 90 or 180 days to
submit the implementation plan. The agencies agree with these commenters that the
proposed timeframe for submitting an implementation plan may be too short.
Accordingly, the final rule requires a bank to submit an implementation plan within 90
days of the consummation of a merger or acquisition.
Under the final rule, if a bank that uses the advanced approaches to calculate riskbased capital requirements merges with or acquires a company that does not calculate
risk-based capital requirements using the advanced approaches, the acquiring bank may
use the general risk-based capital rules to compute the risk-weighted assets and
associated capital for the merged or acquired company’s exposures during the merger and
acquisition transition timeframe. Any ALLL (net of allocated transfer risk reserves)
associated with the acquired company’s exposures may be included in the acquiring
bank’s tier 2 capital up to 1.25 percent of the acquired company’s risk-weighted assets. 41
Such ALLL is excluded from the acquiring bank’s eligible credit reserves. The riskweighted assets of the acquired company are not included in the acquiring bank’s creditrisk-weighted assets but are included in the acquiring bank’s total risk-weighted assets. If
the acquiring bank uses the general risk-based capital rules for acquired exposures, it
41
Any amount of the acquired company’s ALLL that was eliminated in accounting for the acquisition is
not included in the acquiring bank’s regulatory capital.
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must disclose publicly the amounts of risk-weighted assets and qualifying capital
calculated under the general risk-based capital rules with respect to the acquired company
and under this rule for the acquiring bank. The primary Federal supervisor of the bank
will monitor the merger or acquisition to determine whether the acquiring bank’s
application of the general risk-based capital rules for the acquired company produces
appropriate risk-based capital requirements for the assets of the acquired company in
light of the overall risk profile of the acquiring bank.
Similarly, a core or opt-in bank that merges with or acquires another core or optin bank might not be able to apply its systems for the advanced approaches immediately
to the acquired bank’s exposures. Accordingly, the final rule permits a core or opt-in
bank that merges with or acquires another core or opt-in bank to use the acquired bank’s
advanced approaches to determine the risk-weighted asset amounts for, and deductions
from capital associated with, the acquired bank’s exposures during the merger and
acquisition transition timeframe.
A third potential merger or acquisition scenario is a bank subject to the general
risk-based capital rules that merges with or acquires a bank that uses the advanced
approaches. If, after the merger or acquisition, the acquiring bank is not a core bank, it
could choose to opt in to the advanced approaches or to apply the general risk-based
capital rules to the consolidated bank. If the acquiring bank chooses to remain on the
general risk-based capital rules, the bank must immediately apply the general risk-based
capital rules to all its exposures, including those of the acquired bank.
If the acquiring bank chooses or is required to move to the advanced approaches,
however, it could apply the advanced approaches to the acquired exposures (provided
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that it continues to meet all of the qualification requirements for those exposures) for up
to 24 months (with a potential 12-month extension) while it completes the process of
qualifying to use the advanced approaches for the entire bank. If the acquiring bank has
not begun implementing the advanced approaches at the time of the merger or
acquisition, it may instead use the transition timeframes described in section III.A. of the
preamble and section 21 of the final rule. In the latter case, the bank must consult with its
primary Federal supervisor regarding the appropriate risk-based capital treatment of the
acquired exposures. In no case may a bank permanently apply the advanced approaches
only to an acquired bank’s exposures and not to the consolidated bank.
Because eligible credit reserves and the ALLL are treated differently under the
general risk-based capital rules and the advanced approaches, the final rule specifies how
the acquiring bank must treat the general allowances associated with the merged or
acquired company’s exposures during the period when the general risk-based capital
rules apply to the acquiring bank. Specifically, ALLL associated with the exposures of
the merged or acquired company may not be directly included in the acquiring bank’s tier
2 capital. Rather, any excess eligible credit reserves (that is, eligible credit reserves
minus total expected credit losses) associated with the merged or acquired company’s
exposures may be included in the acquiring bank’s tier 2 capital up to 0.6 percent of the
credit-risk-weighted assets associated with those exposures.
IV. Calculation of Tier 1 Capital and Total Qualifying Capital
The final rule maintains the minimum risk-based capital ratio requirements of 4.0
percent tier 1 capital to total risk-weighted assets and 8.0 percent total qualifying capital
to total risk-weighted assets. A bank’s total qualifying capital is the sum of its tier 1
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(core) capital elements and tier 2 (supplemental) capital elements, subject to various
limits and restrictions, minus certain deductions (adjustments). The agencies are not
restating the elements of tier 1 and tier 2 capital in the final rule. Those capital elements
generally remain as they are currently in the general risk-based capital rules. 42 Consistent
with the proposed rule, the final rule includes regulatory text for certain adjustments to
the capital elements for purposes of the advanced approaches.
Under the final rule, consistent with the proposal, after identifying the elements of
tier 1 and tier 2 capital, a bank must make certain adjustments to determine its tier 1
capital and total qualifying capital (the numerator of the total risk-based capital ratio).
Some of these adjustments are made only to the tier 1 portion of the capital base. Other
adjustments are made 50 percent from tier 1 capital and 50 percent from tier 2 capital. 43
A bank must still have at least 50 percent of its total qualifying capital in the form of tier
1 capital. 44
Under the final rule, as under the proposal, a bank must deduct from tier 1 capital
goodwill, other intangible assets, and deferred tax assets to the same extent that those
assets are deducted from tier 1 capital under the general risk-based capital rules. Thus,
all goodwill is deducted from tier 1 capital. Certain intangible assets – including
mortgage servicing assets, non-mortgage servicing assets, and purchased credit card
relationships – that meet the conditions and limits in the general risk-based capital rules
do not have to be deducted from tier 1 capital. Likewise, deferred tax assets that are
42
See 12 CFR part 3, Appendix A, § 2 (national banks); 12 CFR part 208, Appendix A, § II (state member
banks); 12 CFR part 225, Appendix A, § II (bank holding companies); 12 CFR part 325, Appendix A, § I
(state nonmember banks); and 12 CFR 567.5 (savings associations).
43
If the amount deductible from tier 2 capital exceeds the bank’s actual tier 2 capital, however, the bank
must deduct the shortfall amount from tier 1 capital.
44
Any assets deducted from capital in computing the numerator of the risk-based capital ratios are also not
included in risk-weighted assets in the denominator of the ratio.
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dependent upon future taxable income and that meet the valuation requirements and
limits in the general risk-based capital rules do not have to be deducted from tier 1
capital. 45
Under the general risk-based capital rules, a bank also must deduct from its tier 1
capital certain percentages of the adjusted carrying value of its nonfinancial equity
investments. An advanced approaches bank is not required to make these deductions.
Instead, the bank’s equity exposures generally are subject to the equity treatment in part
VI of the final rule and described in section V.F. of this preamble. 46
A number of commenters urged the agencies to revisit the existing definitions of
tier 1 and tier 2 capital, including some of the deductions. Some offered specific
suggestions, such as removing the requirement to deduct goodwill from tier 1 capital or
revising the limitations on certain capital instruments that may be included in regulatory
capital. Other commenters noted that the definition of regulatory capital and related
deductions should be thoroughly debated internationally before changes are made in any
one national jurisdiction. The agencies believe that the definition of regulatory capital
should be as consistent as possible across national jurisdictions. The BCBS has formed a
45
See 12 CFR part 3, Appendix A, § 2 (national banks); 12 CFR part 208, Appendix A, § II (state member
banks); 12 CFR part 225, Appendix A, § II (bank holding companies); 12 CFR part 325, Appendix A, § I
(state nonmember banks). OTS existing rules are formulated differently, but include similar deductions.
Under OTS rules, for example, goodwill is included within the definition of “intangible assets” and is
deducted from tier 1 (core) capital along with other intangible assets. See 12 CFR 567.1 and 567.5(a)(2)(i).
Similarly, purchased credit card relationships and mortgage and non-mortgage servicing assets are included
in capital to the same extent as the other agencies’ rules. See 12 CFR 567.5(a)(2)(ii) and 567.12. The
deduction of deferred tax assets is discussed in Thrift Bulletin 56.
46
By contrast, OTS rules require the deduction of equity investments from total capital. 12 CFR
567.5(c)(2)(ii). “Equity investments” are defined to include (i) investments in equity securities (other than
investments in subsidiaries, equity investments that are permissible for national banks, indirect ownership
interests in certain pools of assets (for example, mutual funds), Federal Home Loan Bank stock and Federal
Reserve Bank stock); and (ii) investments in certain real property. 12 CFR 567.1. Savings associations
applying the final rule are not required to deduct investments in equity securities. Instead, such
investments are subject to the equity treatment in part VI of the final rule. Equity investments in real estate
continue to be deducted to the same extent as under the general risk-based capital rules.
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working group that is currently looking at issues related to the definition of regulatory
capital. Accordingly, the agencies have not modified the existing definition of regulatory
capital and related deductions at this time, other than with respect to implementation of
the advanced approaches.
Under the general risk-based capital rules, a bank is allowed to include in tier 2
capital its ALLL up to 1.25 percent of risk-weighted assets (net of certain deductions).
Amounts of ALLL in excess of this limit are deducted from the gross amount of riskweighted assets.
Under the proposed rule, the ALLL was treated differently. The proposed rule
included a methodology for adjusting risk-based capital requirements based on a
comparison of the bank’s eligible credit reserves to its ECL. The proposed rule defined
eligible credit reserves as all general allowances, including the ALLL, established
through a charge against earnings to absorb credit losses associated with on- or offbalance sheet wholesale and retail exposures. As proposed, eligible credit reserves did
not include allocated transfer risk reserves established pursuant to 12 U.S.C. 3904 47 and
other specific reserves created against recognized losses. The final rule maintains the
proposed definition of eligible credit reserves.
The proposed rule defined a bank’s total ECL as the sum of ECL for all wholesale
and retail exposures other than exposures to which the bank applied the double default
treatment (described below). The bank’s ECL for a wholesale exposure to a nondefaulted obligor or a non-defaulted retail segment was equal to the product of PD,
ELGD, and EAD for the exposure or segment. The ECL for non-defaulted exposures
47
12 U.S.C. 3904 does not apply to savings associations regulated by the OTS. As a result, the OTS final
rule does not refer to allocated transfer risk reserves.
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thus reflected expected economic losses, including the cost of carry and direct and
indirect workout expenses. The bank’s ECL for a wholesale exposure to a defaulted
obligor or a defaulted retail segment was equal to the bank’s impairment estimate for
allowance purposes for the exposure or segment. The ECL for defaulted exposures thus
was based on accounting measures of credit loss incorporated into a bank’s charge-off
and reserving practices.
In the proposal, the agencies solicited comment on a possible alternative treatment
for determining ECL for a defaulted exposure that would be more consistent with the
proposed treatment of ECL for non-defaulted exposures. That alternative approach
calculated ECL as the bank’s current carrying value of the exposure multiplied by the
bank’s best estimate of the expected economic loss rate associated with the exposure
(measured relative to the current carrying value). Commenters on this issue generally
supported the proposed treatment and expressed some concern about the added
complexity of the alternative treatment.
The agencies believe that, for defaulted exposures, any difference between a
bank’s best estimate of economic losses and its impairment estimate for ALLL purposes
is likely to be small. The agencies also believe that the proposed ALLL impairment
approach is less burdensome for banks than the “best estimate of economic loss”
approach. As a result, the agencies are retaining this aspect of the proposed definition of
ECL for defaulted exposures. The agencies recognize that this treatment requires a bank
to specify how much of its ALLL is attributable to defaulted exposures, and emphasize
that a bank must capture all material economic losses on defaulted exposures when
building its databases for estimating LGDs for non-defaulted exposures.
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The agencies also sought comment on the appropriate measure of ECL for assets
held at fair value with gains and losses flowing through earnings. Commenters expressed
the view that there should be no ECL for such assets because expected losses on such
assets already have been removed from regulatory capital. The agencies agree with this
position and, therefore, under the final rule, a bank may assign an ECL of zero to assets
held at fair value with gains and losses flowing through earnings. The agencies are
otherwise maintaining the proposed definition of ECL in the final rule, with the
substitution of LGD for ELGD noted above.
Under the final rule, consistent with the proposal, a bank must compare the total
dollar amount of its ECL to its eligible credit reserves. If there is a shortfall of eligible
credit reserves compared to total ECL, the bank must deduct 50 percent of the shortfall
from tier 1 capital and 50 percent from tier 2 capital. If eligible credit reserves exceed
total ECL, the excess portion of eligible credit reserves may be included in tier 2 capital
up to 0.6 percent of credit-risk-weighted assets.
A number of commenters objected to the 0.6 percent limit on inclusion of excess
reserves in tier 2 capital and suggested that there should be a higher or no limit on the
amount of excess reserves that may be included in regulatory capital. While the 0.6
percent limit is part of the New Accord, some commenters asserted that this limitation
would put U.S. banks at a competitive disadvantage because U.S. accounting practices
(as compared to accounting practices in many other countries) lead to higher reserves that
are more likely to exceed the limitation. Another commenter asserted that the proposed
limitation on excess reserves is more restrictive than the current cap on ALLL in the
general risk-based capital rules. Finally, several commenters suggested that because
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ALLL is the first buffer against credit losses, it should be included without limit in tier 1
capital.
The agencies believe that the proposed 0.6 percent limit on inclusion of excess
reserves in tier 2 capital is roughly equivalent to the 1.25 percent cap in the general riskbased capital rules and serves to maintain general consistency in the treatment of reserves
domestically and internationally. Accordingly, the agencies have included the 0.6
percent cap in the final rule.
Under the proposed rule, a bank would deduct from tier 1 capital any after-tax
gain-on-sale. Gain-on-sale was defined as an increase in a bank’s equity capital that
resulted from a securitization, other than an increase in equity capital that resulted from
the bank’s receipt of cash in connection with the securitization. The agencies designed
this deduction to offset accounting treatments that produce an increase in a bank’s equity
capital and tier 1 capital at the inception of a securitization – for example, a gain
attributable to a CEIO that results from Financial Accounting Standard (FAS) 140
accounting treatment for the sale of underlying exposures to a securitization special
purpose entity (SPE). Over time, as the bank, from an accounting perspective, realizes
the increase in equity capital and tier 1 capital booked at the inception of the
securitization through actual receipt of cash flows, the amount of the required deduction
would shrink accordingly.
Under the general risk-based capital rules,48 a bank must deduct CEIOs, whether
purchased or retained, from tier 1 capital to the extent that the CEIOs exceed 25 percent
48
See 12 CFR part 3, Appendix A, § 2(c)(4) (national banks); 12 CFR part 208, Appendix A, § I.B.1.c.
(state member banks); 12 CFR part 225, Appendix A, § I.B.1.c. (bank holding companies); 12 CFR part
325, Appendix A, § I.B.5. (state nonmember banks); 12 CFR 567.5(a)(2)(iii) and 567.12(d)(2) (savings
associations).
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of the bank’s tier 1 capital. Under the proposed rule, a bank would deduct CEIOs from
tier 1 capital to the extent they represent gain-on-sale, and would deduct any remaining
CEIOs 50 percent from tier 1 capital and 50 percent from tier 2 capital.
Under the proposed rule, certain other securitization exposures also would be
deducted from tier 1 and tier 2 capital. These exposures included, for example,
securitization exposures with an applicable external rating (defined below) that is more
than one category below investment grade (for example, below BB-) and most
subordinated unrated securitization exposures. When a bank deducted a securitization
exposure (other than gain-on-sale) from regulatory capital, the bank would take the
deduction 50 percent from tier 1 capital and 50 percent from tier 2 capital. Moreover,
under the proposal, a bank could calculate any deductions from tier 1 and tier 2 capital
with respect to a securitization exposure (including after-tax gain-on-sale) net of any
deferred tax liabilities associated with the exposure.
The agencies received a number of comments on the proposed securitizationlinked deductions. In particular, some commenters urged the agencies to retain the
general risk-based capital rule for deducting only CEIOs that exceed 25 percent of tier 1
capital. Some of these commenters noted that the “harsher” securitization-linked
deductions under the advanced approaches could have a significant tier 1 capital impact
and, accordingly, could have an unwarranted effect on a bank’s tier 1 leverage ratio
calculation. A few commenters encouraged the agencies to permit a bank to replace the
deduction approach for certain securitization exposures with a 1,250 percent risk weight
approach, in part to mitigate potential tier 1 leverage ratio effects.
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The agencies are retaining the securitization-related deductions as proposed. The
proposed deductions are part of the New Accord’s securitization framework. The
agencies believe that they should be retained to foster consistency among participants in
the international securitization markets.
The proposed rule also required a bank to deduct the bank’s exposure on certain
unsettled and failed capital markets transactions 50 percent from tier 1 capital and
50 percent from tier 2 capital. The agencies are retaining this deduction as proposed.
The agencies are also retaining, as proposed, the deductions in the general riskbased capital rules for investments in unconsolidated banking and finance subsidiaries
and reciprocal holdings of bank capital instruments. Further, the agencies are retaining
the current treatment for national and state banks that control or hold an interest in a
financial subsidiary. As required by the Gramm-Leach-Bliley Act, assets and liabilities
of the financial subsidiary are not consolidated with those of the bank for risk-based
capital purposes and the bank must deduct its equity investment (including retained
earnings) in the financial subsidiary from regulatory capital – 50 percent from tier 1
capital and 50 percent from tier 2 capital. 49 A BHC generally does not deconsolidate the
assets and liabilities of the financial subsidiaries of the BHC’s subsidiary banks and does
not deduct from its regulatory capital the equity investments of its subsidiary banks in
49
See Public Law 106-102 (November 12, 1999), codified, among other places, at 12 USC 24a. See also
12 CFR 5.39(h)(1) (national banks); 12 CFR 208.73(a) (state member banks); 12 CFR part 325, Appendix
A, § I.B.2. (state nonmember banks). Again, OTS rules are formulated differently. For example, OTS
rules do not use the terms “unconsolidated banking and finance subsidiary” or “financial subsidiary.”
Rather, as required by section 5(t)(5) of the Home Owners’ Loan Act (HOLA), equity and debt investments
in non-includable subsidiaries (generally subsidiaries that are engaged in activities that are not permissible
for a national bank) are deducted from assets and tier 1 (core) capital. 12 CFR 567.5(a)(2)(iv) and (v). As
required by HOLA, OTS will continue to deduct non-includable subsidiaries. Reciprocal holdings of bank
capital instruments are deducted from a savings association’s total capital under 12 CFR 567.5(c)(2).
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financial subsidiaries. Rather, a BHC generally fully consolidates the financial
subsidiaries of its subsidiary banks. These treatments continue under the final rule.
For BHCs with consolidated insurance underwriting subsidiaries that are
functionally regulated by a State insurance regulator (or subject to comparable
supervision and regulatory capital requirements in a non-U.S. jurisdiction), the proposed
rule set forth the following treatment. The assets and liabilities of the subsidiary would
be consolidated for purposes of determining the BHC’s risk-weighted assets. However,
the BHC would deduct from tier 1 capital an amount equal to the insurance underwriting
subsidiary’s minimum regulatory capital requirement as determined by its functional (or
equivalent) regulator. For U.S. regulated insurance underwriting subsidiaries, this
amount generally would be 200 percent of the subsidiary’s Authorized Control Level as
established by the appropriate state insurance regulator.
The proposal noted that its approach with respect to functionally regulated
consolidated insurance underwriting subsidiaries was different from the New Accord,
which broadly endorses a deconsolidation and deduction approach for insurance
subsidiaries. The proposal acknowledged the Board’s concern that a full deconsolidation
and deduction approach does not capture the credit risk in insurance underwriting
subsidiaries at the consolidated BHC level.
Several commenters objected to the proposed deduction from tier 1 capital and
instead supported a deduction 50 percent from tier 1 capital and 50 percent from tier 2
capital. Others supported the full deduction and deconsolidation approach endorsed by
the New Accord and maintained that, by contrast, the proposed approach was overly
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conservative and resulted in a double-count of capital requirements for insurance
regulation and banking regulation.
The Board continues to believe that a consolidated BHC risk-based capital
measure should incorporate all credit, market, and operational risks to which the BHC is
exposed, regardless of the legal entity subsidiary where a risk exposure resides. The
Board also believes that a fully consolidated approach minimizes the potential for
regulatory capital arbitrage; it eliminates incentives to book individual exposures at a
subsidiary that is deducted from the consolidated entity for capital purposes where a
different, potentially more favorable, capital requirement is applied at the subsidiary.
Moreover, the Board does not agree that the proposed approach results in a double-count
of capital requirements. Rather, the capital requirements imposed by a functional
regulator or other supervisory authority at the subsidiary level reflect the capital needs at
the particular subsidiary. The consolidated measure of minimum capital requirements
should reflect the consolidated organization.
Thus, the Board is retaining the proposed requirement that assets and liabilities of
insurance underwriting subsidiaries are consolidated for determining risk-weighted
assets. The Board has modified the final rule for BHCs, however, to allow the associated
capital deduction to be made 50 percent from tier 1 capital and 50 percent from tier 2
capital.
V. Calculation of Risk-Weighted Assets
Under the final rule, a bank’s total risk-weighted assets is the sum of its credit
risk-weighted assets and risk-weighted assets for operational risk, minus the sum of its
excess eligible credit reserves (eligible credit reserves in excess of its total ECL) not
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included in tier 2 capital. Unlike under the proposal, allocated transfer risk reserves are
not subtracted from total risk-weighted assets under the final rule. Because the EAD of
wholesale exposures and retail segments is calculated net of any allocated transfer risk
reserves, a second subtraction of the reserves from risk-weighted assets is not
appropriate.
A. Categorization of Exposures
To calculate credit risk-weighted assets, a bank must determine risk-weighted
asset amounts for exposures that have been grouped into four general categories:
wholesale, retail, securitization, and equity. It must also identify and determine riskweighted asset amounts for assets not included in an exposure category and any nonmaterial portfolios of exposures to which the bank elects not to apply the IRB approach.
To exclude a portfolio from the IRB approach, a bank must demonstrate to the
satisfaction of its primary Federal supervisor that the portfolio (when combined with all
other portfolios of exposures that the bank seeks to exclude from the IRB approach) is
not material to the bank. As described above, credit-risk-weighted assets is defined as
1.06 multiplied by the sum of total wholesale and retail risk-weighted assets, riskweighted assets for securitization exposures, and risk-weighted assets for equity
exposures.
1. Wholesale exposures
Consistent with the proposed rule, the final rule defines a wholesale exposure as a
credit exposure to a company, individual, sovereign entity, or other governmental entity
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(other than a securitization exposure, retail exposure, or equity exposure). 50 The term
“company” is broadly defined to mean a corporation, partnership, limited liability
company, depository institution, business trust, SPE, association, or similar organization.
Examples of a wholesale exposure include: (i) a non-tranched guarantee issued by a bank
on behalf of a company; 51 (ii) a repo-style transaction entered into by a bank with a
company and any other transaction in which a bank posts collateral to a company and
faces counterparty credit risk; (iii) an exposure that a bank treats as a covered position
under the market risk rule for which there is a counterparty credit risk capital
requirement; (iv) a sale of corporate loans by a bank to a third party in which the bank
retains full recourse; (v) an OTC derivative contract entered into by a bank with a
company; (vi) an exposure to an individual that is not managed by the bank as part of a
segment of exposures with homogeneous risk characteristics; and (vii) a commercial
lease.
The agencies proposed two subcategories of wholesale exposures – HVCRE
exposures and non-HVCRE exposures. Under the proposed rule, HVCRE exposures
would be subject to a separate IRB risk-based capital formula that would produce a
higher risk-based capital requirement for a given set of risk parameters than the IRB riskbased capital formula for non-HVCRE wholesale exposures. Further, the agencies
50
The proposed rule excluded from the definition of a wholesale exposure certain pre-sold one-to-four
family residential construction loans and certain multifamily residential loans. The treatment of such loans
under the final rule is discussed below in section V.B.5. of the preamble.
51
As described below, tranched guarantees (like most transactions that involve a tranching of credit risk)
generally are securitization exposures under the final rule. The final rule defines a guarantee broadly to
include almost any transaction (other than a credit derivative) that involves the transfer of the credit risk of
an exposure from one party to another party. This definition of guarantee generally includes, for example,
a credit spread option under which a bank has agreed to make payments to its counterparty in the event of
an increase in the credit spread associated with a particular reference obligation issued by a company.
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proposed that once an exposure was determined to be an HVCRE exposure, it would
remain an HVCRE exposure until paid in full, sold, or converted to permanent financing.
The proposed rule defined an HVCRE exposure as a credit facility that finances
or has financed the acquisition, development, or construction of real property, excluding
facilities that finance (i) one- to four-family residential properties or (ii) commercial real
estate projects that meet the following conditions: (A) the exposure’s loan-to-value
(LTV) ratio is less than or equal to the applicable maximum supervisory LTV ratio in the
real estate lending standards of the agencies; 52 (B) the borrower has contributed capital to
the project in the form of cash or unencumbered readily marketable assets (or has paid
development expenses out-of-pocket) of at least 15 percent of the real estate’s appraised
“as completed” value; and (C) the borrower contributed the amount of capital required
before the bank advances funds under the credit facility, and the capital contributed by
the borrower or internally generated by the project is contractually required to remain in
the project throughout the life of the project.
Several commenters raised issues related to the requirement that banks must
separate HVCRE exposures from other wholesale exposures. One commenter asserted
that a separate risk-weight function for HVCRE exposures is unnecessary because the
higher risk associated with such exposures would be reflected in higher PDs and LGDs.
Other commenters stated that tracking the exception requirements for acquisition,
development, or construction loans would be burdensome and expressed concern that all
multifamily loans could be subject to the HVCRE treatment. Yet other commenters
requested that the agencies exclude from the definition of HVCRE all multifamily
52
12 CFR part 34, Subpart D (OCC); 12 CFR part 208, Appendix C (Board); 12 CFR part 365, Appendix
A (FDIC); and 12 CFR 560.100-560.101 (OTS).
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acquisition, development, or construction loans; additional commercial real estate
exposures; and other exposures with significant project equity and/or pre-sale
commitments. A few commenters supported the proposed approach to HVCRE
exposures.
The agencies have determined that the proposed definition of HVCRE exposures
strikes an appropriate balance between risk-sensitivity and simplicity. Thus, the final rule
retains the definition as proposed. If a bank does not want to track compliance with the
definition for burden-related reasons, the bank may choose to apply the HVCRE riskweight function to all credit facilities that finance the acquisition, construction, or
development of multifamily and commercial real property. The agencies believe that this
treatment would be an appropriate application of the principle of conservatism discussed
in section II.D. of the preamble and set forth in section 1(d) of the final rule.
The New Accord identifies five sub-classes of specialized lending for which the
primary source of repayment of the obligation is the income generated by the financed
asset(s) rather than the independent capacity of a broader commercial enterprise. The
sub-classes are project finance, object finance, commodities finance, income-producing
real estate, and HVCRE. The New Accord provides a methodology to accommodate
banks that cannot meet the requirements for the estimation of PD for these exposure
types. The proposed rule did not include a separate treatment for specialized lending
beyond the separate IRB risk-based capital formula for HVCRE exposures specified in
the New Accord. The agencies noted in the proposal that sophisticated banks that would
be applying the advanced approaches in the United States should be able to estimate risk
parameters for specialized lending. The agencies continue to believe that banks using the
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advanced approaches in the United States should be able to estimate risk parameters for
specialized lending and, therefore, have not adopted a separate treatment for specialized
lending in the final rule.
In contrast to the New Accord, the agencies did not propose a separate risk-based
capital function for exposures to small- and medium-size enterprises (SMEs). The SME
function in the New Accord generates a lower risk-based capital requirement for an
exposure to an SME than for an exposure to a larger firm that has the same risk parameter
values. The agencies were not aware of compelling evidence that smaller firms are
subject to less systematic risk than is already reflected in the wholesale exposure riskbased capital formula, which specifies lower AVCs as PDs increase.
A number of commenters objected to this aspect of the proposal and urged the
agencies to include in the final rule the SME risk-based capital function from the New
Accord. Several commenters expressed concern about potential competitive disparities
in the market for SME lending between U.S. banks and foreign banks subject to rules that
include the New Accord’s treatment of SME exposures. Others asserted that lower
AVCs and risk-based capital requirements were appropriate for SME exposures because
the asset values of exposures to smaller firms are more idiosyncratic than those of
exposures to larger firms.
While commenters raised important issues related to SME exposures, the agencies
have decided not to add a distinct risk-weight function for such exposures to the final
rule. The agencies continue to believe that a distinct risk-weight function with a lower
AVC for SME exposures is not substantiated by sufficient empirical evidence and may
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give rise to a domestic competitive inequity between banks subject to the advanced
approaches and banks subject to the general risk-based capital rules.
2. Retail exposures
Under the final rule, as under the proposed rule, retail exposures generally include
exposures (other than securitization exposures or equity exposures) to an individual and
small exposures to businesses that are managed as part of a segment of similar exposures,
not on an individual-exposure basis. There are three subcategories of retail exposure: (i)
residential mortgage exposures; (ii) QREs; and (iii) other retail exposures. The final rule
retains the proposed definitions of the retail exposure subcategories and, thus, defines
residential mortgage exposure as an exposure that is primarily secured by a first or
subsequent lien on one- to four-family residential property. 53 This includes both term
loans and HELOCs. An exposure primarily secured by a first or subsequent lien on
residential property that is not one to four family also is included as a residential
mortgage exposure as long as the exposure has both an original and current outstanding
amount of no more than $1 million. There is no upper limit on the size of an exposure
that is secured by one- to four-family residential properties. To be a residential mortgage
exposure, the bank must manage the exposure as part of a segment of exposures with
homogeneous risk characteristics. Residential mortgage loans that are managed on an
individual basis, rather than managed as part of a segment, are categorized as wholesale
exposures.
QREs are defined as exposures to individuals that are (i) revolving, unsecured,
and unconditionally cancelable by the bank to the fullest extent permitted by Federal law;
53
The proposed rule excluded from the definition of a residential mortgage exposure certain pre-sold oneto-four family residential construction loans and certain multifamily residential loans. The treatment of
such loans under the final rule is discussed below in section V.B.5. of the preamble.
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(ii) have a maximum exposure amount (drawn plus undrawn) of up to $100,000; and
(iii) are managed as part of a segment of exposures with homogeneous risk
characteristics. In practice, QREs typically include exposures where customers'
outstanding borrowings are permitted to fluctuate based on their decisions to borrow and
repay, up to a limit established by the bank. Most credit card exposures to individuals
and overdraft lines on individual checking accounts are QREs.
The category of other retail exposures includes two types of exposures. First, all
exposures to individuals for non-business purposes (other than residential mortgage
exposures and QREs) that are managed as part of a segment of similar exposures are
other retail exposures. Such exposures may include personal term loans, margin loans,
auto loans and leases, credit card accounts with credit lines above $100,000, and student
loans. There is no upper limit on the size of these types of retail exposures to individuals.
Second, exposures to individuals or companies for business purposes (other than
residential mortgage exposures and QREs), up to a single-borrower exposure threshold of
$1 million, that are managed as part of a segment of similar exposures are other retail
exposures. For the purpose of assessing exposure to a single borrower, the bank must
aggregate all business exposures to a particular legal entity and its affiliates that are
consolidated under GAAP. If that borrower is a natural person, any consumer loans (for
example, personal credit card loans or mortgage loans) to that borrower would not be part
of the aggregate. A bank could distinguish a consumer loan from a business loan by the
loan department through which the loan is made. Exposures to a borrower for business
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purposes primarily secured by residential property count toward the $1 million singleborrower other retail business exposure threshold. 54
The residual value portion of a retail lease exposure is excluded from the
definition of an other retail exposure. Consistent with the New Accord, a bank must
assign the residual value portion of a retail lease exposure a risk-weighted asset amount
equal to its residual value as described in section 31 of the final rule.
3. Securitization exposures
The proposed rule defined a securitization exposure as an on-balance sheet or
off-balance sheet credit exposure that arises from a traditional or synthetic securitization
(including credit-enhancing representations and warranties). A traditional securitization
was defined as a transaction in which (i) all or a portion of the credit risk of one or more
underlying exposures is transferred to one or more third parties other than through the use
of credit derivatives or guarantees; (ii) the credit risk associated with the underlying
exposures has been separated into at least two tranches reflecting different levels of
seniority; (iii) performance of the securitization exposures depends on the performance of
the underlying exposures; and (iv) all or substantially all of the underlying exposures are
financial exposures. Examples of financial exposures are loans, commitments,
receivables, asset-backed securities, mortgage-backed securities, other debt securities,
equity securities, or credit derivatives. The proposed rule also defined mortgage-backed
pass-through securities guaranteed by Fannie Mae or Freddie Mac (whether or not issued
out of a structure that tranches credit risk) as securitization exposures.
54
The proposed rule excluded from the definition of an other retail exposure certain pre-sold one-to-four
family residential construction loans and certain multifamily residential loans. The treatment of such loans
under the final rule is discussed below in section V.B.5. of the preamble.
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A synthetic securitization was defined as a transaction in which (i) all or a portion
of the credit risk of one or more underlying exposures is transferred to one or more third
parties through the use of one or more credit derivatives or guarantees (other than a
guarantee that transfers only the credit risk of an individual retail exposure); (ii) the credit
risk associated with the underlying exposures has been separated into at least two
tranches reflecting different levels of seniority; (iii) performance of the securitization
exposures depends on the performance of the underlying exposures; and (iv) all or
substantially all of the underlying exposures are financial exposures. Accordingly, the
proposed definition of a securitization exposure included tranched cover or guarantee
arrangements – that is, arrangements in which an entity transfers a portion of the credit
risk of an underlying exposure to one or more guarantors or credit derivative providers
but also retains a portion of the credit risk, where the risk transferred and the risk retained
are of different seniority levels.
The preamble to the proposal noted that, provided there is a tranching of credit
risk, securitization exposures could include, among other things, asset-backed and
mortgage-backed securities; loans, lines of credit, liquidity facilities, and financial
standby letters of credit; credit derivatives and guarantees; loan servicing assets; servicer
cash advance facilities; reserve accounts; credit-enhancing representations and
warranties; and CEIOs. Securitization exposures also could include assets sold with
retained tranched recourse.
As explained in the proposal, if a bank purchases an asset-backed security issued
by a securitization SPE and purchases a credit derivative to protect itself from credit
losses associated with the asset-backed security, the purchase of the credit derivative by
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the investing bank does not turn the traditional securitization into a synthetic
securitization. Instead, the investing bank would be viewed as having purchased a
traditional securitization exposure and would reflect the CRM benefits of the credit
derivative through the securitization CRM rules described later in the preamble and in
section 46 of the rule. Moreover, if a bank provides a guarantee or a credit derivative on
a securitization exposure, that guarantee or credit derivative would also be a
securitization exposure.
Commenters raised several objections to the proposed definitions of traditional
and synthetic securitizations. First, several commenters objected to the requirement that
all or substantially all of the underlying exposures must be financial exposures. These
commenters noted that the securitization market rapidly evolves and expands to cover
new asset classes – such as intellectual property rights, project finance revenues, and
entertainment royalties – that may or may not be financial assets. Commenters expressed
particular concern that the proposed definitions may exclude from the securitization
framework leases that include a material lease residual component.
The agencies believe that requiring all or substantially all of the underlying
exposures for a securitization to be financial exposures creates an important boundary
between the wholesale and retail frameworks, on the one hand, and the securitization
framework, on the other hand. Accordingly, the agencies are maintaining this
requirement in the final rule. The securitization framework was designed to address the
tranching of the credit risk of financial exposures and was not designed, for example, to
apply to tranched credit exposures to commercial or industrial companies or nonfinancial
assets. Accordingly, under the final rule, a specialized loan to finance the construction or
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acquisition of large-scale projects (for example, airports and power plants), objects (for
example, ships, aircraft, or satellites), or commodities (for example, reserves, inventories,
precious metals, oil, or natural gas) generally is not a securitization exposure because the
assets backing the loan typically are nonfinancial assets (the facility, object, or
commodity being financed). In addition, although some structured transactions involving
income-producing real estate or HVCRE can resemble securitizations, these transactions
generally would not be securitizations because the underlying exposure would be real
estate. Consequently, exposures resulting from the tranching of the risks of nonfinancial
assets are not subject to the final rule’s securitization framework, but generally are
subject to the rules for wholesale exposures.
Based on their cash flow characteristics, for purposes of the final rule, the
agencies would consider many of the asset classes identified by commenters — including
lease residuals and entertainment royalties — to be financial assets. Both the designation
of exposures as securitization exposures and the calculation of risk-based capital
requirements for securitization exposures will be guided by the economic substance of a
transaction rather than its legal form. 55
Some commenters asserted that the proposal generally to define as securitization
exposures all exposures involving credit risk tranching of underlying financial assets was
too broad. The proposed definition captured many exposures these commenters did not
consider to be securitization exposures, including tranched exposures to a single
underlying financial exposure and exposures to many hedge funds and private equity
55
Several commenters asked the agencies to confirm that the typical syndicated credit facility would not be
a securitization exposure. The agencies confirm that a syndicated credit facility is not a securitization
exposure so long as less than substantially all of the borrower’s assets are financial exposures.
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funds. Commenters requested flexibility to apply the wholesale or equity framework
(depending on the exposure) rather than the securitization framework to these exposures.
The agencies believe that a single, unified approach to dealing with the tranching
of credit risk is important to create a level playing field across the securitization, credit
derivative, and other financial markets, and therefore have decided to maintain the
proposed treatment of tranched exposures to a single underlying financial asset in the
final rule. The agencies believe that basing the applicability of the securitization
framework on the presence of some minimum number of underlying exposures would
complicate the rule and would create a divergence from the New Accord, without any
material improvement in risk sensitivity. The securitization framework is designed
specifically to deal with tranched exposures to credit risk. Moreover, the principal riskbased capital approaches of the securitization framework take into account the effective
number of underlying exposures.
The agencies agree with commenters that the proposed definition for
securitization exposures was quite broad and captured some exposures that would more
appropriately be treated under the wholesale or equity frameworks. To limit the scope of
the IRB securitization framework, the agencies have modified the definition of traditional
securitization in the final rule to make clear that operating companies are not traditional
securitizations (even if all or substantially all of their assets are financial exposures). For
purposes of the final rule’s definition of traditional securitization, operating companies
generally are companies that produce goods or provide services beyond the business of
investing, reinvesting, holding, or trading in financial assets. Examples of operating
companies are depository institutions, bank holding companies, securities brokers and
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dealers, insurance companies, and non-bank mortgage lenders. Accordingly, an equity
investment in an operating company, such as a bank, generally would be an equity
exposure under the final rule; a debt investment in an operating company, such as a bank,
generally would be a wholesale exposure under the final rule.
Investment firms, which generally do not produce goods or provide services
beyond the business of investing, reinvesting, holding, or trading in financial assets, are
not operating companies for purposes of the final rule and would not qualify for this
general exclusion from the definition of traditional securitization. Examples of
investment firms would include companies that are exempted from the definition of an
investment company under section 3(a) of the Investment Company Act of 1940 (15
U.S.C. 80a-3(a)) by either section 3(c)(1) (15 U.S.C. 80a-3(c)(1)) or section 3(c)(7) (15
U.S.C. 80a-3(c)(7)) of the Act.
The final definition of a traditional securitization also provides the primary
Federal supervisor of a bank with discretion to exclude from the definition of traditional
securitization investment firms that exercise substantially unfettered control over the size
and composition of their assets, liabilities, and off-balance sheet transactions. The
agencies will consider a number of factors in the exercise of this discretion, including an
assessment of the investment firm’s leverage, risk profile, and economic substance. This
supervisory exclusion is intended to provide discretion to a bank’s primary Federal
supervisor to distinguish structured finance transactions, to which the securitization
framework was designed to apply, from more flexible investment firms such as many
hedge funds and private equity funds. Only investment firms that can easily change the
size and composition of their capital structure, as well as the size and composition of their
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assets and off-balance sheet exposures, would be eligible for this exclusion from the
definition of traditional securitization under this new provision. The agencies do not
consider managed collateralized debt obligation vehicles, structured investment vehicles,
and similar structures, which allow considerable management discretion regarding asset
composition but are subject to substantial restrictions regarding capital structure, to have
substantially unfettered control. Thus, such transactions meet the final rule’s definition
of traditional securitization.
The agencies also have added two additional exclusions to the definition of
traditional securitization for small business investment companies (SBICs) and
community development investment vehicles. As a result, a bank’s equity investments in
SBICs and community development equity investments generally are treated as equity
exposures under the final rule.
The agencies remain concerned that the line between securitization exposures and
non-securitization exposures may be difficult to draw in some circumstances. In addition
to the supervisory exclusion from the definition of traditional securitization described
above, the agencies have added a new component to the definition of traditional
securitization to specifically permit a primary Federal supervisor to scope certain
transactions into the securitization framework if justified by the economics of the
transaction. Similar to the analysis for excluding an investment firm from treatment as a
traditional securitization, the agencies will consider the economic substance, leverage,
and risk profile of transactions to ensure that the appropriate IRB classification is made.
The agencies will consider a number of factors when assessing the economic substance of
a transaction including, for example, the amount of equity in the structure, overall
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leverage (whether on- or off-balance sheet), whether redemption rights attach to the
equity investor, and the ability of the junior tranches to absorb losses without interrupting
contractual payments to more senior tranches.
One commenter asked whether a bank could ignore the credit protection provided
by a tranched guarantee for risk-based capital purposes and instead calculate the riskbased capital requirement for the guaranteed exposure as if the guarantee did not exist.
The agencies believe that this treatment would be an appropriate application of the
principle of conservatism discussed in section II.D. of this preamble and set forth in
section 1(d) of the final rule.
As noted above, the proposed rule defined mortgage-backed pass-through
securities guaranteed by Fannie Mae or Freddie Mac (whether or not issued out of a
structure that tranches credit risk) as securitization exposures. The agencies have
reconsidered this proposal and have concluded that a special treatment for these securities
is inconsistent with the New Accord and would violate the fundamental credit-tranchingbased nature of the definition of securitization exposures. The final rule therefore does
not define all mortgage-backed pass-through securities guaranteed by Fannie Mae or
Freddie Mac to be securitization exposures. As a result, those mortgage-backed
securities that involve tranching of credit risk will be securitization exposures; those
mortgage-backed securities that do not involve tranching of credit risk will not be
securitization exposures. 56
56
Several commenters asked the agencies to clarify whether a special purpose entity that issues multiple
classes of securities that have equal priority in the capital structure of the issuer but different maturities
would be considered a securitization SPE. The agencies do not believe that maturity differentials alone
constitute credit risk tranching for purposes of the definitions of traditional securitization and synthetic
securitization.
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A few commenters asserted that OTC derivatives with a securitization SPE as the
counterparty should be excluded from the definition of securitization exposure and
treated as wholesale exposures. The agencies believe that the securitization framework is
the most appropriate way to assess the counterparty credit risk of such exposures because
this risk is a tranched exposure to the credit risk of the underlying financial assets of the
securitization SPE. The agencies are addressing specific commenter concerns about the
burden of applying the securitization framework to these exposures in preamble section
V.E. below and section 42(a)(5) of the final rule.
4. Equity exposures
The proposed rule defined an equity exposure to mean:
(i) A security or instrument whether voting or non-voting that represents a direct
or indirect ownership interest in, and a residual claim on, the assets and income of a
company, unless: (A) the issuing company is consolidated with the bank under GAAP;
(B) the bank is required to deduct the ownership interest from tier 1 or tier 2 capital; (C)
the ownership interest is redeemable; (D) the ownership interest incorporates a payment
or other similar obligation on the part of the issuing company (such as an obligation to
pay periodic interest); or (E) the ownership interest is a securitization exposure.
(ii) A security or instrument that is mandatorily convertible into a security or
instrument described in (i).
(iii) An option or warrant that is exercisable for a security or instrument described
in (i).
(iv) Any other security or instrument (other than a securitization exposure) to the
extent the return on the security or instrument is based on the performance of a security
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or instrument described in (i). For example, a short position in an equity security or a
total return equity swap would be characterized as an equity exposure.
The proposal noted that nonconvertible term or perpetual preferred stock
generally would be considered wholesale exposures rather than equity exposures.
Financial instruments that are convertible into an equity exposure only at the option of
the holder or issuer also generally would be considered wholesale exposures rather than
equity exposures provided that the conversion terms do not expose the bank to the risk of
losses arising from price movements in that equity exposure. Upon conversion, the
instrument would be treated as an equity exposure. In addition, the agencies note that
unfunded equity commitments, which are commitments to make equity investments at a
future date, meet the definition of an equity exposure.
Many commenters expressed support for the proposed definition of equity
exposure, except for the proposed exclusion of equity investments in hedge funds and
other leveraged investment vehicles, as discussed above. The agencies are adopting the
proposed definition for equity exposures with one exception. They have eliminated in the
final rule the exclusion of a redeemable ownership interest from the definition of equity
exposure. The agencies believe that redeemable ownership interests, such as those in
mutual funds and private equity funds, are most appropriately treated as equity exposures.
The agencies anticipate that, as a general matter, each of a bank’s exposures will
fit in one and only one exposure category. One exception to this principle is that equity
derivatives generally will meet the definition of an equity exposure (because of the
bank’s exposure to the underlying equity security) and the definition of a wholesale
exposure (because of the bank’s credit risk exposure to the counterparty). In such cases,
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as discussed in more detail below, the bank’s risk-based capital requirement for the
equity derivative generally is the sum of its risk-based capital requirement for the
derivative counterparty credit risk and for the underlying exposure.
5. Boundary between operational risk and other risks
With the introduction of an explicit risk-based capital requirement for operational
risk, issues arise about the proper treatment of operational losses that also could be
attributed to either credit risk or market risk. The agencies recognize that these boundary
issues are important and have significant implications for how banks must compile loss
data sets and compute risk-based capital requirements under the final rule. Consistent
with the treatment in the New Accord and the proposed rule, banks must treat operational
losses that are related to market risk as operational losses for purposes of calculating riskbased capital requirements under this final rule. For example, losses incurred from a
failure of bank personnel to properly execute a stop loss order, from trading fraud, or
from a bank selling a security when a purchase was intended, must be treated as
operational losses.
Under the proposed rule, banks would treat losses that are related to both
operational risk and credit risk as credit losses for purposes of calculating risk-based
capital requirements. For example, where a loan defaults (credit risk) and the bank
discovers that the collateral for the loan was not properly secured (operational risk), the
bank’s resulting loss would be attributed to credit risk (not operational risk). This general
separation between credit and operational risk is supported by current U.S. accounting
standards for the treatment of credit risk.
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To be consistent with prevailing practice in the credit card industry, the proposed
rule included an exception to this standard for retail credit card fraud losses. Specifically,
retail credit card losses arising from non-contractual, third party-initiated fraud (for
example, identity theft) would be treated as external fraud operational losses under the
proposed rule. All other third party-initiated losses would be treated as credit losses.
Generally, commenters urged the agencies not to be prescriptive on risk boundary
issues and to give banks discretion to categorize risk as they deem appropriate, subject to
supervisory review. Other commenters noted that boundary issues are so significant that
the agencies should not contemplate any additional exceptions to treating losses related to
both credit and operational risk as credit losses unless the exceptions are agreed to by the
BCBS. Several commenters objected to specific aspects of the agencies’ proposal and
suggested that additional types of losses related to credit risk and operational risk,
including losses related to check fraud, overdraft fraud, and small business loan fraud,
should be treated as operational losses for purposes of calculating risk-based capital
requirements. One commenter expressly noted its support for the agencies’ proposal,
which effectively requires banks to treat losses on HELOCs related to both credit risk and
operational risk as credit losses for purposes of calculating risk-based capital
requirements.
Because of the substantial potential impact boundary issues have on risk-based
capital requirements under the advanced approaches, there should be consistency across
U.S. banks in how they categorize losses that relate to both credit risk and operational
risk. Moreover, the agencies believe that international consistency on this issue is an
important objective. Therefore, the final rule maintains the proposed boundaries for
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losses that relate to both credit risk and operational risk and does not incorporate any
additional exemptions beyond that in the proposal.
6. Boundary between the final rule and the market risk rule
For banks subject to the market risk rule, the existing market risk rule applies to
all positions classified as trading positions in regulatory reports. The New Accord
establishes additional criteria for positions to be eligible for application of the market risk
rule. The agencies are incorporating these additional criteria into the market risk rule
through a separate rulemaking that is expected to be finalized soon and published in the
Federal Register. Under this final rule, as under the proposal, core and opt-in banks
subject to the market risk rule must use the market risk rule for exposures that are
covered positions under the market risk rule. Core and opt-in banks not subject to the
market risk rule must use this final rule for all of their exposures.
B. Risk-Weighted Assets for General Credit Risk (Wholesale Exposures, Retail
Exposures, On-Balance Sheet Assets that Are Not Defined by Exposure Category,
and Immaterial Credit Portfolios)
Under the proposed rule, the wholesale and retail risk-weighted assets calculation
consisted of four phases: (1) categorization of exposures; (2) assignment of wholesale
exposures to rating grades and segmentation of retail exposures; (3) assignment of risk
parameters to wholesale obligors and exposures and segments of retail exposures; and
(4) calculation of risk-weighted asset amounts. The agencies did not receive any negative
comments on the four phases for calculating wholesale and retail risk-weighted assets
and, thus, are adopting the four-phase concept as proposed. Where applicable, the
agencies have clarified particular issues within the four-phase process.
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1. Phase 1 − Categorization of exposures
In phase 1, a bank must determine which of its exposures fall into each of the four
principal IRB exposure categories – wholesale exposures, retail exposures, securitization
exposures, and equity exposures. In addition, a bank must identify within the wholesale
exposure category certain exposures that receive a special treatment under the wholesale
framework. These exposures include HVCRE exposures, sovereign exposures, eligible
purchased wholesale exposures, eligible margin loans, repo-style transactions, OTC
derivative contracts, unsettled transactions, and eligible guarantees and eligible credit
derivatives that are used as credit risk mitigants.
The treatment of HVCRE exposures and eligible purchased wholesale receivables
is discussed below in this section. The treatment of eligible margin loans, repo-style
transactions, OTC derivative contracts, and eligible guarantees and eligible credit
derivatives that are credit risk mitigants is discussed in section V.C. of the preamble. In
addition, sovereign exposures and exposures to or directly and unconditionally
guaranteed by the Bank for International Settlements, the International Monetary Fund,
the European Commission, the European Central Bank, and multilateral development
banks are exempt from the 0.03 percent floor on PD discussed in the next section.
The proposed rule recognized as multilateral development banks only those
multilateral lending institutions or regional development banks in which the U.S.
government is a shareholder or contributing member. The final rule adopts a slightly
expanded definition of multilateral development bank. Specifically, under the final rule,
multilateral development bank is defined to include the International Bank for
Reconstruction and Development, the International Finance Corporation, the Inter-
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American Development Bank, the Asian Development Bank, the African Development
Bank, the European Bank for Reconstruction and Development, the European Investment
Bank, the European Investment Fund, the Nordic Investment Bank, the Caribbean
Development Bank, the Islamic Development Bank, the Council of Europe Development
Bank; any multilateral lending institution or regional development bank in which the U.S.
government is a shareholder or contributing member; and any multilateral lending
institution that a bank’s primary Federal supervisor determines poses comparable credit
risk.
In phase 1, a bank also must subcategorize its retail exposures as residential
mortgage exposures, QREs, or other retail exposures. In addition, a bank must identify
any on-balance sheet asset that does not meet the definition of a wholesale, retail,
securitization, or equity exposure, as well as any non-material portfolio of exposures to
which it chooses, subject to supervisory review, not to apply the IRB risk-based capital
formulas.
2. Phase 2 − Assignment of wholesale obligors and exposures to rating grades and retail
exposures to segments
In phase 2, a bank must assign each wholesale obligor to a single rating grade (for
purposes of assigning an estimated PD) and may assign each wholesale exposure to loss
severity rating grades (for purposes of assigning an estimated LGD). A bank that elects
not to use a loss severity rating grade system for a wholesale exposure must directly
assign an estimated LGD to the wholesale exposure in phase 3. As a part of the process
of assigning wholesale obligors to rating grades, a bank must identify which of its
wholesale obligors are in default. In addition, a bank must group its retail exposures
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within each retail subcategory into segments that have homogeneous risk
characteristics. 57
Segmentation is the grouping of exposures within each subcategory according to
the predominant risk characteristics of the borrower (for example, credit score, debt-toincome ratio, and delinquency) and the exposure (for example, product type and LTV
ratio). In general, retail segments should not cross national jurisdictions. A bank has
substantial flexibility to use the retail portfolio segmentation it believes is most
appropriate for its activities, subject to the following broad principles:
•
Differentiation of risk – Segmentation should provide meaningful differentiation
of risk. Accordingly, in developing its risk segmentation system, a bank should consider
the chosen risk drivers’ ability to separate risk consistently over time and the overall
robustness of the bank’s approach to segmentation.
•
Reliable risk characteristics – Segmentation should use borrower-related risk
characteristics and exposure-related risk characteristics that reliably and consistently over
time differentiate a segment’s risk from that of other segments.
•
Consistency – Risk drivers for segmentation should be consistent with the
predominant risk characteristics used by the bank for internal credit risk measurement
and management.
•
Accuracy – The segmentation system should generate segments that separate
exposures by realized performance and should be designed so that actual long-run
outcomes closely approximate the retail risk parameters estimated by the bank.
57
If the bank determines the EAD for eligible margin loans using the approach in section 32(b) of the rule,
it must segment retail eligible margin loans for which the bank uses this approach separately from other
retail exposures.
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A bank might choose to segment exposures by common risk drivers that are
relevant and material in determining the loss characteristics of a particular retail product.
For example, a bank may segment mortgage loans by LTV band, age from origination,
geography, origination channel, and credit score. Statistical modeling, expert judgment,
or some combination of the two may determine the most relevant risk drivers.
Alternatively, a bank might segment by grouping exposures with similar loss
characteristics, such as loss rates or default rates, as determined by historical performance
of segments with similar risk characteristics.
A bank must segment defaulted retail exposures separately from non-defaulted
retail exposures and should base the segmentation of defaulted retail exposures on
characteristics that are most predictive of current loss and recovery rates. This
segmentation should provide meaningful differentiation so that individual exposures
within each defaulted segment do not have material differences in their expected loss
severity.
Banks commonly obtain tranched credit protection, for example first-loss or
second-loss guarantees, on certain retail exposures such as residential mortgages. The
proposal recognized that the securitization framework, which applies to tranched
wholesale exposures, is not appropriate for individual retail exposures. Therefore, the
agencies proposed to exclude tranched guarantees that apply only to an individual retail
exposure from the securitization framework. The preamble to the proposal noted that an
important result of this exclusion is that, in contrast to the treatment of wholesale
exposures, a bank may recognize recoveries from both a borrower and a guarantor for
purposes of estimating LGD for certain retail exposures.
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Most commenters who addressed the agencies’ proposed treatment for tranched
retail guarantees supported the proposed approach. One commenter urged the agencies to
extend the treatment of tranched guarantees of retail exposures to wholesale exposures.
Another commenter asserted that the proposed treatment was inconsistent with the New
Accord.
The agencies have determined that while the securitization framework is the most
appropriate risk-based capital treatment for most tranched guarantees, the regulatory
burden associated with applying it to tranched guarantees of individual retail exposures
exceeds the supervisory benefit. The agencies are therefore adopting the proposed
treatment in the final rule and excluding tranched guarantees of individual retail
exposures from the securitization framework.
Some banks expressed concern about the treatment of eligible margin loans under
the New Accord. Due to the highly collateralized nature and low loss frequency of
margin loans, banks typically collect little customer-specific information that they could
use to differentiate margin loans into segments. The agencies believe that a bank could
appropriately segment its margin loan portfolio using only product-specific risk drivers,
such as product type and origination channel. A bank could then use the definition of
default to associate a PD and LGD with each segment. As described in section 32 of the
rule, a bank may adjust the EAD of eligible margin loans to reflect the risk-mitigating
effect of financial collateral. If a bank elects this option to adjust the EAD of eligible
margin loans, it must associate an LGD with the segment that does not reflect the
presence of collateral.
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Under the proposal, if a bank was not able to estimate PD and LGD for an eligible
margin loan, the bank could apply a 300 percent risk weight to the EAD of the loan.
Commenters generally objected to this approach. As discussed in section III.B.3. of the
preamble, several commenters asserted that the agencies should permit banks to treat
margin loans and other portfolios that exhibit low loss frequency or for which a bank has
limited data on a portfolio basis, by apportioning EL between PD and LGD for portfolios
rather than estimating each risk parameter separately. Other commenters suggested that
banks should be expected to develop sound practices for applying the IRB approach to
such exposures and adopt an appropriate degree of conservatism to address the level of
uncertainty in the estimation process. Several commenters added that if a bank simply is
unable to estimate PD and LGD for eligible margin loans, they would support the
agencies’ proposal to apply a flat risk weight to the EAD of eligible margin loans.
However, they asserted that the risk weight should not exceed 100 percent given the low
levels of loss associated with these types of exposures.
As discussed in section III.B.3. of the preamble, the final rule provides flexibility
and incentives for banks to develop and document sound practices for applying the IRB
approach to portfolios with limited data or default history, which may include eligible
margin loans. However, the agencies believe that for banks facing particular challenges
with respect to estimating PD and LGD for eligible margin loans, the proposed
application of a 300 percent risk weight to the EAD of an eligible margin loan is a
reasonable alternative. The option balances pragmatism with the provision of appropriate
incentives for banks to develop processes to apply the IRB approach to such exposures.
Accordingly, the final rule continues to provide banks with the option of applying a 300
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percent risk weight to the EAD of an eligible margin loan for which it cannot estimate PD
and LGD.
Purchased wholesale exposures
A bank may also elect to use a top-down approach, similar to the treatment of
retail exposures, for eligible purchased wholesale exposures. Under the final rule, as
under the proposal, this approach may be used for exposures purchased directly by the
bank. In addition, the final rule clarifies that this approach also may be used for
exposures purchased by a securitization SPE in which the bank has invested and for
which the bank calculates the capital requirement on the underlying exposures (KIRB) for
purposes of the SFA (as defined in section V.E.4. of the preamble). Under this approach,
in phase 2, a bank would group its eligible purchased wholesale exposures into segments
that have homogeneous risk characteristics. To be an eligible purchased wholesale
exposure, several criteria must be met:
•
The purchased wholesale exposure must be purchased from an unaffiliated seller
and must not have been directly or indirectly originated by the purchasing bank or
securitization SPE;
•
The purchased wholesale exposure must be generated on an arm’s-length basis
between the seller and the obligor (intercompany accounts receivable and receivables
subject to contra-accounts between firms that buy and sell to each other would not satisfy
this criterion);
•
The purchasing bank must have a claim on all proceeds from the exposure or a
pro rata interest in the proceeds;
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DRAFT November 2, 2007
•
The purchased wholesale exposure must have an effective remaining maturity of
less than one year; and
•
The purchased wholesale exposure must, when consolidated by obligor, not
represent a concentrated exposure relative to the portfolio of purchased wholesale
exposures.
Wholesale lease residuals
The agencies proposed a treatment for wholesale lease residuals that differs from
the New Accord. A wholesale lease residual typically exposes a bank to the risk of a
decline in value of the leased asset and to the credit risk of the lessee. Although the New
Accord provides for a flat 100 percent risk weight for wholesale lease residuals, the
preamble to the proposal noted that the agencies believed this treatment was excessively
punitive for leases to highly creditworthy lessees. Accordingly, the proposed rule
required a bank to treat its net investment in a wholesale lease as a single exposure to the
lessee. As proposed, there would not be a separate capital calculation for the wholesale
lease residual. Commenters on this issue broadly supported the agencies’ proposed
approach. The agencies believe the proposed approach appropriately reflects current
bank risk management practice and are adopting the proposed approach in the final rule.
Commenters also requested this treatment for retail lease residuals. However, the
agencies have determined that the proposal to apply a flat 100 percent risk weight for
retail lease residuals, consistent with the New Accord, appropriately balances risk
sensitivity and complexity and are maintaining this treatment in the final rule.
3. Phase 3 − Assignment of risk parameters to wholesale obligors and exposures and
retail segments
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In phase 3, a bank associates a PD with each wholesale obligor rating grade;
associates an LGD with each wholesale loss severity rating grade or assigns an LGD to
each wholesale exposure; assigns an EAD and M to each wholesale exposure; and
assigns a PD, LGD, and EAD to each segment of retail exposures. In some cases it may
be reasonable to assign the same PD, LGD, or EAD to multiple segments of retail
exposures. The quantification phase for PD, LGD, and EAD can generally be divided
into four steps—obtaining historical reference data, estimating the risk parameters for the
reference data, mapping the historical reference data to the bank’s current exposures, and
determining the risk parameters for the bank’s current exposures. As discussed in more
detail below, quantification of M is accomplished through direct computation based on
the contractual characteristics of the exposure.
A bank should base its estimation of the values assigned to PD, LGD, and EAD 58
on historical reference data that are a reasonable proxy for the bank’s current exposures
and that provide meaningful predictions of the performance of such exposures. A
“reference data set” consists of a set of exposures to defaulted wholesale obligors and
defaulted retail exposures (in the case of LGD and EAD estimation) or to both defaulted
and non-defaulted wholesale obligors and retail exposures (in the case of PD estimation).
The reference data set should be described using a set of observed characteristics.
Relevant characteristics might include debt ratings, financial measures, geographic
regions, the economic environment and industry/sector trends during the time period of
the reference data, borrower and loan characteristics related to the risk parameters (such
as loan terms, LTV ratio, credit score, income, debt-to-income ratio, or performance
58
EAD for repo-style transactions and eligible margin loans may be calculated as described in section 32
of the final rule. EAD for OTC derivatives must be calculated as described in section 32 of the final rule.
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history), or other factors that are related in some way to the risk parameters. Banks may
use more than one reference data set to improve the robustness or accuracy of the
parameter estimates.
A bank should then apply statistical techniques to the reference data to determine
a relationship between risk characteristics and the estimated risk parameter. The result of
this step is a model that ties descriptive characteristics to the risk parameter estimates. In
this context, the term ‘model’ is used in the most general sense; a model may use simple
concepts, such as the calculation of averages, or more complex ones, such as an approach
based on rigorous regression techniques. This step may include adjustments for
differences between this final rule’s definition of default and the default definition in the
reference data set, or adjustments for data limitations. This step includes adjustments for
seasoning effects related to retail exposures, if material.
A bank may use more than one estimation technique to generate estimates of the
risk parameters, especially if there are multiple sets of reference data or multiple sample
periods. If multiple estimates are generated, the bank should have a clear and consistent
policy on reconciling and combining the different estimates.
Once a bank estimates PD, LGD, and EAD for its reference data sets, it should
create a link between its portfolio data and the reference data based on corresponding
characteristics. Variables or characteristics that are available for the existing portfolio
should be mapped or linked to the variables used in the default, loss-severity, or exposure
amount model. In order to effectively map the data, reference data characteristics need to
allow for the construction of rating and segmentation criteria that are consistent with
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those used on the bank’s portfolio. An important element of mapping is making
adjustments for differences between reference data sets and the bank’s exposures.
Finally, a bank must apply the risk parameters estimated for the reference data to
the bank’s actual portfolio data. As noted above, the bank must attribute a PD to each
wholesale obligor risk grade, an LGD to each wholesale loss severity grade or wholesale
exposure, an EAD and M to each wholesale exposure, and a PD, LGD, and EAD to each
segment of retail exposures. If multiple data sets or estimation methods are used, the
bank must adopt a means of combining the various estimates at this stage.
The final rule, as noted above, permits a bank to elect to segment its eligible
purchased wholesale exposures like retail exposures. A bank that chooses to apply this
treatment must directly assign a PD, LGD, EAD, and M to each such segment. If a bank
can estimate ECL (but not PD or LGD) for a segment of eligible purchased wholesale
exposures, the bank must assume that the LGD of the segment equals 100 percent and
that the PD of the segment equals ECL divided by EAD. The bank must estimate ECL
for the eligible purchased wholesale exposures without regard to any assumption of
recourse or guarantees from the seller or other parties. The bank must then use the
wholesale exposure formula in section 31(e) of the final rule to determine the risk-based
capital requirement for each segment of eligible purchased wholesale exposures.
A bank may recognize the credit risk mitigation benefits of collateral that secures
a wholesale exposure by adjusting its estimate of the LGD of the exposure and may
recognize the credit risk mitigation benefits of collateral that secures retail exposures by
adjusting its estimate of the PD and LGD of the segment of retail exposures. In certain
cases, however, a bank may take financial collateral into account in estimating the EAD
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of repo-style transactions, eligible margin loans, and OTC derivative contracts (as
provided in section 32 of the final rule).
Consistent with the proposed rule, the final rule also provides that a bank may use
an EAD of zero for (i) derivative contracts that are publicly traded on an exchange that
requires the daily receipt and payment of cash-variation margin; (ii) derivative contracts
and repo-style transactions that are outstanding with a qualifying central counterparty
(defined below), but not for those transactions that the qualifying central counterparty has
rejected; and (iii) credit risk exposures to a qualifying central counterparty that arise from
derivative contracts and repo-style transactions in the form of clearing deposits and
posted collateral. The final rule, like the proposed rule, defines a qualifying central
counterparty as a counterparty (for example, a clearing house) that: (i) facilitates trades
between counterparties in one or more financial markets by either guaranteeing trades or
novating contracts; (ii) requires all participants in its arrangements to be fully
collateralized on a daily basis; and (iii) the bank demonstrates to the satisfaction of its
primary Federal supervisor is in sound financial condition and is subject to effective
oversight by a national supervisory authority.
Some repo-style transactions and OTC derivative contracts giving rise to
counterparty credit risk may result, from an accounting point of view, in both on- and offbalance sheet exposures. A bank that uses an EAD approach to measure the exposure
amount of such transactions is not required to apply separately a risk-based capital
requirement to an on-balance sheet receivable from the counterparty recorded in
connection with that transaction. Because any exposure arising from the on-balance
sheet receivable is captured in the risk-based capital requirement determined under the
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EAD approach, a separate capital requirement would double count the exposure for
regulatory capital purposes.
A bank may take into account the risk reducing effects of eligible guarantees and
eligible credit derivatives in support of a wholesale exposure by applying the PD
substitution approach or the LGD adjustment approach to the exposure as provided in
section 33 of the final rule or, if applicable, applying the double default treatment to the
exposure as provided in section 34 of the final rule. A bank may decide separately for
each wholesale exposure that qualifies for the double default treatment whether to apply
the PD substitution approach, the LGD adjustment approach, or the double default
treatment. A bank may take into account the risk-reducing effects of guarantees and
credit derivatives in support of retail exposures in a segment when quantifying the PD
and LGD of the segment.
The proposed rule imposed several supervisory limitations on risk parameters
assigned to wholesale obligors and exposures and segments of retail exposures. First, the
PD for each wholesale obligor or segment of retail exposures could not be less than 0.03
percent, except for exposures to or directly and unconditionally guaranteed by a
sovereign entity, the Bank for International Settlements, the International Monetary Fund,
the European Commission, the European Central Bank, or a multilateral development
bank, to which the bank assigns a rating grade associated with a PD of less than 0.03
percent.
Second, the LGD of a segment of residential mortgage exposures (other than
segments of residential mortgage exposures for which all or substantially all of the
principal of the exposures is directly and unconditionally guaranteed by the full faith and
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credit of a sovereign entity) could not be less than 10 percent. These supervisory floors
on PD and LGD applied regardless of whether the bank recognized an eligible guarantee
or eligible credit derivative as provided in sections 33 and 34 of the proposed rule.
Commenters did not object to the floor on PD, and the agencies are including it in
the final rule. A number of commenters, however, objected to the 10 percent floor on
LGD for segments of residential mortgage exposures. These commenters asserted that
the floor would penalize low-risk mortgage lending and would provide a disincentive for
obtaining high-quality collateral. The agencies continue to believe that the LGD floor is
appropriate at least until banks and the agencies gain more experience with the advanced
approaches. Accordingly, the agencies are maintaining the floor in the final rule. As the
agencies gain more experience with the advanced approaches they will reconsider the
need for the floor together with other calibration issues identified during the parallel run
and transitional floor periods. The agencies also intend to address this issue and other
calibration issues with the BCBS and other supervisory and regulatory authorities, as
appropriate.
The 10 percent LGD floor for residential mortgage exposures applies at the
segment level. The agencies will not allow a bank to artificially group exposures into
segments to avoid the LGD floor for mortgage products. A bank should use consistent
risk drivers to determine its retail exposure segmentations and not artificially segment
low LGD loans with higher LGD loans to avoid the floor.
A bank also must calculate M for each wholesale exposure. Under the proposed
rule, for wholesale exposures other than repo-style transactions, eligible margin loans,
and OTC derivative contracts subject to a qualifying master netting agreement (defined in
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section V.C.2. of this preamble), M was defined as the weighted-average remaining
maturity (measured in whole or fractional years) of the expected contractual cash flows
from the exposure, using the undiscounted amounts of the cash flows as weights. A bank
could use its best estimate of future interest rates to compute expected contractual interest
payments on a floating-rate exposure, but it could not consider expected but
noncontractually required returns of principal, when estimating M. A bank could, at its
option, use the nominal remaining maturity (measured in whole or fractional years) of the
exposure. The M for repo-style transactions, eligible margin loans, and OTC derivative
contracts subject to a qualifying master netting agreement was the weighted-average
remaining maturity (measured in whole or fractional years) of the individual transactions
subject to the qualifying master netting agreement, with the weight of each individual
transaction set equal to the notional amount of the transaction. The M for netting sets for
which the bank used the internal models methodology was calculated as described in
section 32(c) of the proposed rule.
Many commenters requested more flexibility in the definition of M, including the
ability to estimate noncontractually required prepayments and the ability to use either
discounted or undiscounted cash flows. However, the agencies believe that the proposed
definition of M, which is consistent with the New Accord, is appropriately conservative
and provides for a consistent definition of M across internationally active banks. The
final rule therefore maintains the proposed definition of M.
Under the final rule, as under the proposal, for most exposures M may be no
greater than five years and no less than one year. For exposures that have an original
maturity of less than one year and are not part of a bank’s ongoing financing of the
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obligor, however, a bank may set M as low as one day, consistent with the New Accord.
An exposure is not part of a bank’s ongoing financing of the obligor if the bank (i) has a
legal and practical ability not to renew or roll over the exposure in the event of credit
deterioration of the obligor; (ii) makes an independent credit decision at the inception of
the exposure and at every renewal or rollover; and (iii) has no substantial commercial
incentive to continue its credit relationship with the obligor in the event of credit
deterioration of the obligor. Examples of transactions that may qualify for the exemption
from the one-year maturity floor include amounts due from other banks, including
deposits in other banks; bankers’ acceptances; sovereign exposures; short-term selfliquidating trade finance exposures; repo-style transactions; eligible margin loans;
unsettled trades and other exposures resulting from payment and settlement processes;
and collateralized OTC derivative contracts subject to daily remargining.
4. Phase 4 − Calculation of risk-weighted assets
After a bank assigns risk parameters to each of its wholesale obligors and
exposures and retail segments, the bank must calculate the dollar risk-based capital
requirement for each wholesale exposure to a non-defaulted obligor and each segment of
non-defaulted retail exposures (except eligible guarantees and eligible credit derivatives
that hedge another wholesale exposure). Other than for exposures to which the bank
applies the double default treatment in section 34 of the final rule, a bank makes this
calculation by inserting the risk parameters for the wholesale obligor and exposure or
retail segment into the appropriate IRB risk-based capital formula specified in Table B,
and multiplying the output of the formula (K) by the EAD of the exposure or segment. 59
59
Alternatively, as noted above, a bank may apply a 300 percent risk weight to the EAD of an eligible
margin loan if the bank is not able to assign a rating grade to the obligor of the loan.
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Section 34 contains a separate double default risk-based capital requirement formula.
Eligible guarantees and eligible credit derivatives that are hedges of a wholesale exposure
are reflected in the risk-weighted assets amount of the hedged exposure (i) through
adjustments made to the risk parameters of the hedged exposure under the PD
substitution or LGD adjustment approach in section 33 of the final rule or (ii) through a
separate double default risk-based capital requirement formula in section 34 of the final
rule.
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Retail
Table B – IRB Risk-Based Capital Formulas for Wholesale Exposures to Non-Defaulted Obligors
and Segments of Non-Defaulted Retail Exposures1
Capital
Requirement
(K)
NonDefaulted
Exposures
⎡
⎤
⎛ N −1 ( PD ) + R × N −1 ( 0 .999 ) ⎞
⎟ − (LGD × PD )⎥
K = ⎢ LGD × N ⎜
⎟
⎜
1− R
⎢⎣
⎥⎦
⎠
⎝
For residential mortgage exposures: R = 0.15
Correlation
Factor (R)
For qualifying revolving exposures: R = 0.04
For other retail exposures: R = 0.03 + 0.13 × e −35×PD
Wholesale
Capital
⎡
⎤
⎛ N −1 ( PD ) + R × N −1 ( 0 . 999 ) ⎞
⎟ − (LGD × PD )⎥ × ⎛⎜ 1 + ( M − 2 .5 ) × b ⎞⎟
⎜
K
LGD
N
=
×
⎢
Requirement
⎟
⎜
1 − 1 .5 × b
1− R
⎠
⎠
⎝
⎣⎢
⎦⎥ ⎝
(K)
NonDefaulted
Exposures
For HVCRE exposures:
Correlation
Factor (R)
R = 0.12 + 0.18 × e −50× PD
For wholesale exposures other than HVCRE exposures:
R = 0.12 + 0.12 × e −50×PD
2
Maturity
b = (0.11852− 0.05478× ln(PD))
Adjustment
(b)
1
N(.) means the cumulative distribution function for a standard normal random variable.
N-1(.) means the inverse cumulative distribution function for a standard normal random
variable. The symbol e refers to the base of the natural logarithms, and the function ln(.)
refers to the natural logarithm of the expression within parentheses. The formulas apply
when PD is greater than zero. If the PD equals zero, the capital requirement K is equal to
zero.
The sum of the dollar risk-based capital requirements for wholesale exposures to
non-defaulted obligors (including exposures subject to the double default treatment
described below) and segments of non-defaulted retail exposures equals the total dollar
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risk-based capital requirement for those exposures and segments. The total dollar riskbased capital requirement multiplied by 12.5 equals the risk-weighted asset amount.
Under the proposed rule, to compute the risk-weighted asset amount for a
wholesale exposure to a defaulted obligor, a bank would first have to compare two
amounts: (i) the sum of 0.08 multiplied by the EAD of the wholesale exposure plus the
amount of any charge-offs or write-downs on the exposure; and (ii) K for the wholesale
exposure (as determined in Table B immediately before the obligor became defaulted),
multiplied by the EAD of the exposure immediately before the exposure became
defaulted. If the amount calculated in (i) were equal to or greater than the amount
calculated in (ii), the dollar risk-based capital requirement for the exposure would be 0.08
multiplied by the EAD of the exposure. If the amount calculated in (i) were less than the
amount calculated in (ii), the dollar risk-based capital requirement for the exposure would
be K for the exposure (as determined in Table B immediately before the obligor became
defaulted), multiplied by the EAD of the exposure. The reason for this comparison was
to ensure that a bank did not receive a regulatory capital benefit as a result of the
exposure moving from non-defaulted to defaulted status.
The proposed rule provided a simpler approach for segments of defaulted retail
exposures. The dollar risk-based capital requirement for a segment of defaulted retail
exposures was 0.08 multiplied by the EAD of the segment.
Some commenters objected to the proposed risk-based capital treatment of
defaulted wholesale exposures, which differs from the approach in the New Accord.
These commenters contended that it would be burdensome to track the pre-default riskbased capital requirements for purposes of the proposed comparison. These commenters
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also claimed that the cost and burden of the proposed treatment of defaulted wholesale
exposures would subject banks to a competitive disadvantage relative to international
counterparts subject to an approach similar to that in the New Accord.
In view of commenters’ concerns about cost and regulatory burden, the final rule
treats defaulted wholesale exposures the same as defaulted retail exposures. The dollar
risk-based capital requirement of a wholesale exposure to a defaulted obligor equals 0.08
multiplied by the EAD of the exposure. The agencies will review banks’ practices to
ensure that banks are not moving exposures from non-defaulted to defaulted status for the
primary purpose of obtaining a reduction in risk-based capital requirements.
To convert the dollar risk-based capital requirements for defaulted exposures into
a risk-weighted asset amount, the bank must sum the dollar risk-based capital
requirements for all wholesale exposures to defaulted obligors and segments of defaulted
retail exposures and multiply the sum by 12.5.
A bank may assign a risk-weighted asset amount of zero to cash owned and held
in all offices of the bank or in transit, and for gold bullion held in the bank’s own vaults
or held in another bank’s vaults on an allocated basis, to the extent the gold bullion assets
are offset by gold bullion liabilities. The risk-weighted asset amount for an on-balance
sheet asset that does not meet the definition of a wholesale, retail, securitization, or equity
exposure – for example, property, plant, and equipment and mortgage servicing rights –
is its carrying value. The risk-weighted asset amount for a portfolio of exposures that the
bank has demonstrated to its primary Federal supervisor’s satisfaction is, when combined
with all other portfolios of exposures that the bank seeks to treat as immaterial for riskbased capital purposes, not material to the bank generally is its carrying value (for on-
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balance sheet exposures) or notional amount (for off-balance sheet exposures). For this
purpose, the notional amount of an OTC derivative contract that is not a credit derivative
is the EAD of the derivative as calculated in section 32 of the final rule. If an OTC
derivative contract is a credit derivative, the notional amount is the notional amount of
the credit derivative.
Total wholesale and retail risk-weighted assets are defined as the sum of riskweighted assets for wholesale exposures to non-defaulted obligors and segments of nondefaulted retail exposures, wholesale exposures to defaulted obligors and segments of
defaulted retail exposures, assets not included in an exposure category, non-material
portfolios of exposures (as calculated under section 31 of the final rule), and unsettled
transactions (as calculated under section 35 of the final rule and described in section V.D.
of the preamble) minus the amounts deducted from capital pursuant to the general riskbased capital rules (excluding those deductions reversed in section 12 of the final rule).
5. Statutory provisions on the regulatory capital treatment of certain mortgage loans
The general risk-based capital rules assign 50 percent and 100 percent risk
weights to certain one- to four-family residential pre-sold construction loans and
multifamily residential loans. 60 The agencies adopted these provisions as a result of the
Resolution Trust Corporation Refinancing, Restructuring, and Improvement Act of 1991
(RTCRRI Act). 61 The RTCRRI Act mandates that each agency provide in its capital
60
See 12 CFR part 3, Appendix A, section 3(a)(3)(iii) (national banks); 12 CFR part 208, Appendix A,
section III.C.3. (state member banks); 12 CFR part 225, Appendix A, section III.C.3. (bank holding
companies); 12 CFR part 325, Appendix A, section II.C. (state nonmember banks); 12 CFR 567.6(a)(1)(iii)
and (iv) (savings associations).
61
See §§ 618(a) and (b) of the RTCRRI Act, Pub. L. 102-233. The first class includes loans for the
construction of a residence consisting of 1-to-4 family dwelling units that have been pre-sold under firm
contracts to purchasers who have obtained firm commitments for permanent qualifying mortgages and have
made substantial earnest money deposits. The second class includes loans that are secured by a first lien on
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regulations (i) a 50 percent risk weight for certain one- to four-family residential pre-sold
construction loans and multifamily residential loans that meet specific statutory criteria in
the RTCRRI Act and any other underwriting criteria imposed by the agencies; and (ii) a
100 percent risk weight for one- to four-family residential pre-sold construction loans for
residences for which the purchase contract is cancelled. 62
When Congress enacted the RTCRRI Act in 1991, the agencies’ risk-based capital
rules reflected the Basel I framework. Consequently, the risk weight treatment for certain
categories of mortgage loans in the RTCRRI Act assumes a risk weight bucketing
approach, instead of the more risk-sensitive IRB approach in the advanced approaches.
In the proposed rule, the agencies identified three types of residential mortgage
loans addressed by the RTCRRI Act that would continue to receive the risk weights
provided in the Act. Consistent with the general risk-based capital rules, the proposed
rule would apply the following risk weights (instead of the risk weights that would
otherwise be produced under the IRB risk-based capital formulas): (i) a 50 percent risk
weight for one- to four-family residential construction loans if the residences have been
pre-sold under firm contracts to purchasers who have obtained firm commitments for
permanent qualifying mortgages and have made substantial earnest money deposits, and
the loans meet the other underwriting characteristics established by the agencies in the
general risk-based capital rules; 63 (ii) a 50 percent risk weight for multifamily residential
loans that meet certain statutory loan-to-value, debt-to-income, amortization, and
performance requirements, and meet the other underwriting characteristics established by
a residence consisting of more than 4 dwelling units if the loan meets certain criteria outlined in the
RTCRRI Act.
62
See §§ 618(a) and (b) of the RTCRRI Act.
63
See § 618(a)(1)((B) of the RTCRRI Act.
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the agencies in the general risk-based capital rules; 64 and (iii) a 100 percent risk weight
for one- to four-family residential pre-sold construction loans for a residence for which
the purchase contract is cancelled. 65 Under the proposal, mortgage loans that did not
meet the relevant criteria would not qualify for the statutory risk weights and would be
risk-weighted according to the IRB risk-based capital formulas.
Commenters generally opposed the proposed assignment of a 50 percent risk
weight to multifamily and pre-sold single family residential construction exposures.
Commenters maintained that the RTCRRI Act capital requirements do not align with
risk, are contrary to the intent of the New Accord and to its implementation in other
jurisdictions, and would impose additional compliance burdens on banks without any
associated benefit.
The agencies agree with these concerns and have decided to adopt in the final rule
an alternative described in the preamble to the proposed rule. The proposed rule’s
preamble noted the tension between the statutory risk weights provided by the RTCRRI
Act and the more risk-sensitive IRB approaches to risk-based capital requirements. The
preamble observed that the RTCRRI Act permits the agencies to prescribe additional
underwriting characteristics for identifying loans that are subject to the 50 percent
statutory risk weights, provided these underwriting characteristics are “consistent with
the purposes of the minimum acceptable capital requirements to maintain the safety and
soundness of financial institutions.” The agencies asked whether they should impose the
following additional underwriting criteria as additional requirements for a core or opt-in
bank to qualify for the statutory 50 percent risk weight for a particular mortgage loan: (i)
64
65
See § 618(b)(1)(B) of the RTCRRI Act.
See § 618(a)(2) of the RTCRRI Act.
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that the bank has an IRB risk measurement and management system in place that assesses
the PD and LGD of prospective residential mortgage exposures; and (ii) that the bank’s
IRB system generates a 50 percent risk weight for the loan under the IRB risk-based
capital formula. If the bank’s IRB system does not generate a 50 percent risk weight for
a particular loan, the loan would not qualify for the statutory risk weight and would
receive the risk weight generated by the IRB system.
A few commenters opposed this alternative approach and indicated that the
additional underwriting criteria would increase operational burden. Other commenters,
however, observed that compliance with the additional underwriting criteria would not be
burdensome.
After careful consideration of the comments and further analysis of the text, spirit
and legislative history of the RTCRRI Act, the agencies have concluded that they should
impose the additional underwriting criteria described in the preamble to the proposed rule
as minimum requirements for a core or opt-in bank to use the statutory 50 percent risk
weight for particular loans. The agencies believe that the imposition of these criteria is
consistent with the plain language of the RTCRRI Act, which allows a bank to use the 50
percent risk weight only if it meets the additional underwriting characteristics established
by the agencies. The agencies have concluded that the additional underwriting
characteristics imposed in the final rule are “consistent with the purposes of the minimum
acceptable capital requirements to maintain the safety and soundness of financial
institution,” because the criteria will make the risk-based capital requirement for these
loans a function of each bank’s historical loss experience for the loans and will therefore
more accurately reflect the performance and risk of loss for these loans. The additional
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underwriting characteristics are also consistent with the purposes and legislative history
of RTCRRI Act, which was designed to reflect the true level of risk associated with these
types of mortgage loans and to do so in accordance with the Basel Accord. 66
A capital-related provision of the Federal Deposit Insurance Corporation
Improvement Act of 1991 (“FDICIA”), enacted by Congress just four days after its
adoption of the RTCRRI Act, also supports the addition of the new underwriting
characteristics. Section 305(b)(1)(B) of FDICIA 67 directs each agency to revise its riskbased capital standards for insured depository institutions to ensure that those standards
“reflect the actual performance and expected risk of loss of multifamily mortgages.”
Although this addresses only multifamily mortgage loans (and not one- to four-family
residential pre-sold construction loans), it provides the agencies with a Congressional
mandate – equal in force and power to section 618 of the RTCRRI Act – to enhance the
risk sensitivity of the regulatory capital treatment of multifamily mortgage loans.
Crucially, the IRB approach required of core and opt-in banks will produce capital
requirements that more accurately reflect both performance and risk of loss for
multifamily mortgage loans than either the Basel I risk weight or the RTCRRI Act risk
weight.
As noted above, section 618(a)(2) of the RTCRRI Act mandates that each agency
amend its capital regulations to provide a 100 percent risk weight to any single-family
residential construction loan for which the purchase contract is cancelled. Because the
statute does not authorize the agencies to establish additional underwriting characteristics
for this small category of loans, the final rule, like the proposed rule, provides a
66
See, e.g., Floor debate for the Resolution Trust Corporation Refinancing, Restructuring, and
Improvement Act of 1991, p. H11853, House of Representatives, Nov. 26, 1991 (Rep. Wylie)
67
12 U.S.C. § 1828.
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100 percent risk weight for single-family residential construction loans for which the
purchase contract is cancelled.
C. Credit Risk Mitigation (CRM) Techniques
Banks use a number of techniques to mitigate credit risk. This section of the
preamble describes how the final rule recognizes the risk-mitigating effects of both
financial collateral (defined below) and nonfinancial collateral, as well as guarantees and
credit derivatives, for risk-based capital purposes. To recognize credit risk mitigants for
risk-based capital purposes, a bank should have in place operational procedures and risk
management processes that ensure that all documentation used in collateralizing or
guaranteeing a transaction is legal, valid, binding, and enforceable under applicable law
in the relevant jurisdictions. The bank should have conducted sufficient legal review to
reach a well-founded conclusion that the documentation meets this standard and should
reconduct such a review as necessary to ensure continuing enforceability.
Although the use of CRM techniques may reduce or transfer credit risk, it
simultaneously may increase other risks, including operational, liquidity, and market
risks. Accordingly, it is imperative that banks employ robust procedures and processes to
control risks, including roll-off risk and concentration of risks, arising from the bank’s
use of CRM techniques and to monitor the implications of using CRM techniques for the
bank’s overall credit risk profile.
1. Collateral
Under the final rule, a bank generally recognizes collateral that secures a
wholesale exposure as part of the LGD estimation process and generally recognizes
collateral that secures a retail exposure as part of the PD and LGD estimation process, as
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described above in section V.B.3. of the preamble. However, in certain limited
circumstances described in the next section, a bank may adjust EAD to reflect the risk
mitigating effect of financial collateral.
Although the final rule does not contain specific regulatory requirements about
how a bank incorporates collateral into PD or LGD estimates, a bank should, when
reflecting the credit risk mitigation benefits of collateral in its estimation of the risk
parameters of a wholesale or retail exposure:
(i) Conduct sufficient legal review to ensure, at inception and on an ongoing
basis, that all documentation used in the collateralized transaction is binding on all parties
and legally enforceable in all relevant jurisdictions;
(ii) Consider the correlation between obligor risk and collateral risk in the
transaction;
(iii) Consider any currency and/or maturity mismatch between the hedged
exposure and the collateral;
(iv) Ground its risk parameter estimates for the transaction in historical data,
using historical recovery rates where available; and
(v) Fully take into account the time and cost needed to realize the liquidation
proceeds and the potential for a decline in collateral value over this time period.
The bank also should ensure that:
(i) The legal mechanism under which the collateral is pledged or transferred
ensures that the bank has the right to liquidate or take legal possession of the collateral in
a timely manner in the event of the default, insolvency, or bankruptcy (or other defined
credit event) of the obligor and, where applicable, the custodian holding the collateral;
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(ii) The bank has taken all steps necessary to fulfill legal requirements to secure
its interest in the collateral so that it has and maintains an enforceable security interest;
(iii) The bank has clear and robust procedures to ensure observation of any legal
conditions required for declaring the default of the borrower and prompt liquidation of
the collateral in the event of default;
(iv) The bank has established procedures and practices for (A) conservatively
estimating, on a regular ongoing basis, the market value of the collateral, taking into
account factors that could affect that value (for example, the liquidity of the market for
the collateral and obsolescence or deterioration of the collateral), and (B) where
applicable, periodically verifying the collateral (for example, through physical inspection
of collateral such as inventory and equipment); and
(v) The bank has in place systems for promptly requesting and receiving
additional collateral for transactions whose terms require maintenance of collateral values
at specified thresholds.
2. Counterparty credit risk of repo-style transactions, eligible margin loans, and OTC
derivative contracts
This section describes two EAD-based methodologies — a collateral haircut
approach and an internal models methodology — that a bank may use instead of an LGD
estimation methodology to recognize the benefits of financial collateral in mitigating the
counterparty credit risk associated with repo-style transactions, eligible margin loans,
collateralized OTC derivative contracts, and single product groups of such transactions
with a single counterparty subject to a qualifying master netting agreement (netting
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sets). 68 A third methodology, the simple VaR methodology, is also available to recognize
financial collateral mitigating the counterparty credit risk of single product netting sets of
repo-style transactions and eligible margin loans. These methodologies are substantially
the same as those in the proposal, except for a few differences identified below.
One difference from the proposal is that, consistent with the New Accord, under
the final rule these three methodologies may also be used to recognize the benefits of any
collateral (not only financial collateral) mitigating the counterparty credit risk of repostyle transactions that are included in a bank’s VaR-based measure under the market risk
rule. In response to comments requesting broader application of the EAD-based
methodologies for recognizing the risk-mitigating effect of collateral, the agencies added
this flexibility to the final rule to enhance international consistency and reduce regulatory
burden.
A bank may use any combination of the three methodologies for collateral
recognition; however, it must use the same methodology for similar exposures. This
means that, as a general matter, the agencies expect a bank to use one of the three
methodologies for all its repo-style transactions, one of the three methodologies for all its
eligible margin loans, and one of the three methodologies for all its OTC derivative
contracts. A bank may, however, apply a different methodology to subsets of repo-style
transactions, eligible margin loans, or OTC derivatives by product type or geographical
location if its application of different methodologies is designed to separate transactions
that do not have similar risk profiles and is not designed to arbitrage the rule. For
example, a bank may choose to use one methodology for agency securities lending
68
For purposes of the internal models methodology in section 32(d) of the rule, discussed below in section
V.C.4. of this preamble, netting set also means a group of transactions with a single counterparty that are
subject to a qualifying cross-product master netting agreement.
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transactions – that is, repo-style transactions in which the bank, acting as agent for a
customer, lends the customer’s securities and indemnifies the customer against loss – and
another methodology for all other repo-style transactions.
This section also describes the methodology for calculating EAD for an OTC
derivative contract or set of OTC derivative contracts subject to a qualifying master
netting agreement. Table C illustrates which EAD estimation methodologies may be
applied to particular types of exposure.
Table C
OTC derivative
Recognition of collateral
for OTC derivatives
Repo-style transaction
Eligible margin loan
Cross-product netting set
Current
Collateral
exposure
haircut
methodology approach
X
X 70
X
X
Models approach
Simple
Internal
69
VaR
models
methodology methodology
X
X
X
X
X
X
X
Qualifying master netting agreement
Under the final rule, consistent with the proposal, a qualifying master netting
agreement is defined to mean any written, legally enforceable bilateral agreement,
provided that:
(i) The agreement creates a single legal obligation for all individual transactions
covered by the agreement upon an event of default, including bankruptcy, insolvency, or
similar proceeding, of the counterparty;
69
Only repo-style transactions and eligible margin loans subject to a single-product qualifying master
netting agreement are eligible for the simple VaR methodology.
70
In conjunction with the current exposure methodology.
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(ii) The agreement provides the bank the right to accelerate, terminate, and closeout on a net basis all transactions under the agreement and to liquidate or set off collateral
promptly upon an event of default, including upon an event of bankruptcy, insolvency, or
similar proceeding, of the counterparty, provided that, in any such case, any exercise of
rights under the agreement will not be stayed or avoided under applicable law in the
relevant jurisdictions;
(iii) The bank has conducted sufficient legal review to conclude with a wellfounded basis (and has maintained sufficient written documentation of that legal review)
that the agreement meets the requirements of paragraph (ii) of this definition and that in
the event of a legal challenge (including one resulting from default or from bankruptcy,
insolvency, or similar proceeding) the relevant court and administrative authorities would
find the agreement to be legal, valid, binding, and enforceable under the law of the
relevant jurisdictions;
(iv) The bank establishes and maintains procedures to monitor possible changes in
relevant law and to ensure that the agreement continues to satisfy the requirements of this
definition; and
(v) The agreement does not contain a walkaway clause (that is, a provision that
permits a non-defaulting counterparty to make lower payments than it would make
otherwise under the agreement, or no payment at all, to a defaulter or the estate of a
defaulter, even if the defaulter or the estate of the defaulter is a net creditor under the
agreement).
The agencies consider the following jurisdictions to be relevant for a qualifying
master netting agreement: the jurisdiction in which each counterparty is chartered or the
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equivalent location in the case of non-corporate entities, and if a branch of a counterparty
is involved, then also the jurisdiction in which the branch is located; the jurisdiction that
governs the individual transactions covered by the agreement; and the jurisdiction that
governs the agreement.
EAD for repo-style transactions and eligible margin loans
Under the final rule, a bank may recognize the risk-mitigating effect of financial
collateral that secures a repo-style transaction, eligible margin loan, or single-product
netting set of such transactions and the risk-mitigating effect of any collateral that secures
a repo-style transaction that is included in a bank’s VaR-based measure under the market
risk rule through an adjustment to EAD rather than LGD. The bank may use a collateral
haircut approach or one of two models approaches: a simple VaR methodology (for
single-product netting sets of repo-style transactions or eligible margin loans) or an
internal models methodology. Figure 2 illustrates the methodologies available for
calculating EAD and LGD for eligible margin loans and repo-style transactions.
Figure 2 – EAD and LGD for Eligible Margin Loans and Repo-Style Transactions
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Eligible Margin Loans &
Repo-Style Transactions
Notional Exposure
with Adjusted LGD
Adjusted Exposure at
Default Approach
Plug PD, Adjusted LGD,
and Notional EAD into
wholesale function
Models
Approach
Haircut
Approach
Is there a Master
Netting Agreement?
No
Internal
Models
Methodology
Standardized
Repo-Style
Transaction?
Yes
Simple VaR
Methodology
Own Estimates
Yes
5 day
Holding Period
No
10 day
Holding Period
Plug PD, Unsecured
LGD, and Adjusted
EAD into wholesale
function
The proposed rule defined a repo-style transaction as a repurchase or reverse
repurchase transaction, or a securities borrowing or securities lending transaction
(including a transaction in which the bank acts as agent for a customer and indemnifies
the customer against loss), provided that:
(i) The transaction is based solely on liquid and readily marketable securities or
cash;
(ii) The transaction is marked to market daily and subject to daily margin
maintenance requirements;
(iii) The transaction is executed under an agreement that provides the bank the
right to accelerate, terminate, and close-out the transaction on a net basis and to liquidate
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or set off collateral promptly upon an event of default (including upon an event of
bankruptcy, insolvency, or similar proceeding) of the counterparty, provided that, in any
such case, any exercise of rights under the agreement will not be stayed or avoided under
applicable law in the relevant jurisdictions; 71 and
(iv) The bank has conducted and documented sufficient legal review to conclude
with a well-founded basis that the agreement meets the requirements of paragraph (iii) of
this definition and is legal, valid, binding, and enforceable under applicable law in the
relevant jurisdictions.
In the proposal, the agencies recognized that criterion (iii) above may pose
challenges for certain transactions that would not be eligible for certain exemptions from
bankruptcy or receivership laws because the counterparty – for example, a sovereign
entity or a pension fund – is not subject to such laws. The agencies sought comment on
ways this criterion could be crafted to accommodate such transactions when justified on
prudential grounds, while ensuring that the requirements in criterion (iii) are met for
transactions that are eligible for those exemptions.
Several commenters responded to this question by urging the agencies to modify
the third component of the repo-style transaction definition in accordance with the 2006
interagency securities borrowing rule. 72 Under the securities borrowing rule, the
agencies accorded preferential risk-based capital treatment for cash-collateralized
securities borrowing transactions that either met a bankruptcy standard such as the
71
This requirement is met where all transactions under the agreement are (i) executed under U.S. law and
(ii) constitute “securities contracts” or “repurchase agreements” under section 555 or 559, respectively, of
the Bankruptcy Code (11 U.S.C. 555 or 559), qualified financial contracts under section 11(e)(8) of the
Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or netting contracts between or among financial
institutions under sections 401-407 of the Federal Deposit Insurance Corporation Improvement Act of 1991
(12 U.S.C. 4401-4407) or the Federal Reserve Board’s Regulation EE (12 CFR part 231).
72
71 FR 8932, February 22, 2006.
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standard in criterion (iii) above or were overnight or unconditionally cancelable at any
time by the bank. Commenters maintained that banks are able to terminate promptly a
repo-style transaction with a counterparty whose financial condition is deteriorating so
long as the transaction is done on an overnight basis or is unconditionally cancelable by
the bank. As a result, these commenters contended that events of default and losses on
such transactions are very rare.
The agencies have decided to modify the definition of repo-style transaction
consistent with this suggestion by commenters and consistent with the 2006 securities
borrowing rule. The agencies believe that this modification will resolve, in a manner that
preserves safety and soundness, technical difficulties that banks would have had in
meeting the proposed rule’s definition for a material proportion of their repo-style
transactions. Consistent with the 2006 securities borrowing rule, a reasonably short
notice period, typically no more than the standard settlement period associated with the
securities underlying the repo-style transaction, would not detract from the
unconditionality of the bank’s termination rights. With regard to overnight transactions,
the counterparty generally should have no expectation, either explicit or implicit, that the
bank will automatically roll over the transaction. The agencies are maintaining in
substance all the other components of the proposed definition of repo-style transaction.
The proposed rule defined an eligible margin loan as an extension of credit where:
(i) The credit extension is collateralized exclusively by debt or equity securities
that are liquid and readily marketable;
(ii) The collateral is marked to market daily and the transaction is subject to daily
margin maintenance requirements;
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(iii) The extension of credit is conducted under an agreement that provides the
bank the right to accelerate and terminate the extension of credit and to liquidate or set
off collateral promptly upon an event of default (including upon an event of bankruptcy,
insolvency, or similar proceeding) of the counterparty, provided that, in any such case,
any exercise of rights under the agreement will not be stayed or avoided under applicable
law in the relevant jurisdictions; 73 and
(iv) The bank has conducted and documented sufficient legal review to conclude
with a well-founded basis that the agreement meets the requirements of paragraph (iii) of
this definition and is legal, valid, binding, and enforceable under applicable law in the
relevant jurisdictions.
Commenters generally supported this definition, but some objected to the
prescriptiveness of criterion (iii). Criterion (iii) is necessary to ensure that a bank is
quickly able to realize the value of its collateral in the event of obligor default. Collateral
stayed by bankruptcy and not liquidated until a date far in the future is more
appropriately reflected as a discounted positive cash flow in LGD estimation. Criterion
(iii) is satisfied when the bank has conducted sufficient legal review to conclude with a
well-founded basis (and has maintained sufficient written documentation of that legal
review) that a margin loan would be exempt from the bankruptcy auto-stay. The
agencies are therefore maintaining substantially the same definition of eligible margin
loan in the final rule.
73
This requirement is met under the circumstances described in footnote 73. Under the U.S. Bankruptcy
Code, “margin loans” are a type of securities contract, but the term “margin loan” does not encompass all
loans that happen to be secured by securities collateral. Rather, Congress intended the term “margin loan”
to include only those loans commonly known in the industry as margin loans, such as credit permitted in an
account under the Board’s Regulation T or where a financial intermediary extends credit for the purchase,
sale, carrying, or trading of securities. See H.R. Rep. No. 109-131, at 119, 130 (2005).
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With the exception of repo-style transactions that are included in a bank’s VaRbased measure under the market risk rule (as discussed above), for purposes of
determining EAD for repo-style transactions, eligible margin loans, and OTC derivatives,
and recognizing collateral mitigating the counterparty credit risk of such exposures, the
final rule (consistent with the proposed rule) allows banks to take into account only
financial collateral. The proposed rule defined financial collateral as collateral in the
form of any of the following instruments in which the bank has a perfected, first priority
security interest or the legal equivalent thereof: (i) cash on deposit with the bank
(including cash held for the bank by a third-party custodian or trustee); (ii) gold bullion;
(iii) long-term debt securities that have an applicable external rating of one category
below investment grade or higher (for example, at least BB-); (iv) short-term debt
instruments that have an applicable external rating of at least investment grade (for
example, at least A-3); (v) equity securities that are publicly traded; (vi) convertible
bonds that are publicly traded; and (vii) mutual fund shares and money market mutual
fund shares if a price for the shares is publicly quoted daily.
In connection with this definition, the agencies asked for comment on the
appropriateness of requiring that a bank have a perfected, first priority security interest,
or the legal equivalent thereof, in the definition of financial collateral. A couple of
commenters supported this requirement, but several other commenters objected. The
objecting commenters acknowledged that the requirement would generally be consistent
with current U.S. collateral practices for repo-style transactions, eligible margin loans,
and OTC derivatives, but they criticized the requirement on the grounds that:
(i) obtaining a perfected, first priority security interest may not be the current market
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practice outside the United States; (ii) U.S. practices may evolve in such a fashion as to
not meet this requirement; and (iii) the requirement is not explicit in the New Accord.
Other commenters asked the agencies to clarify that the requirement would be met for all
or certain forms of collateral if the bank had possession and control of the collateral and a
reasonable basis to believe it could promptly liquidate the collateral.
The agencies believe that in order to use the EAD adjustment approaches for
exposures within the United States, a bank must have a perfected, first priority security
interest in collateral, with the exception of cash on deposit with the bank and certain
custodial arrangements. The agencies have modified the proposed requirement to address
a concern raised by several commenters that a bank could fail to satisfy the first priority
security interest requirement because of the senior security interest of a third-party
custodian involved as an intermediary in the transaction. Under the final rule, a bank
meets the security interest requirement so long as the bank has a perfected, first priority
security interest in the collateral notwithstanding the prior security interest of any
custodial agent. Outside of the United States, the definition of financial collateral can be
satisfied as long as the bank has the legal equivalent of a perfected, first priority security
interest. For example, cash on deposit with the bank is an example of the legal equivalent
of a perfected, first priority security interest. The agencies intend to apply this “legal
equivalent” standard flexibly to deal with non-U.S. collateral access regimes.
The agencies also invited comment on the extent to which assets that do not meet
the definition of financial collateral are the basis of repo-style transactions engaged in by
banks or are taken by banks as collateral for eligible margin loans or OTC derivatives.
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The agencies also inquired as to whether the definition of financial collateral should be
expanded to reflect any other asset types.
A substantial number of commenters asked the agencies to add asset types to the
list of financial collateral. The principal recommended additions included: (i) noninvestment-grade externally rated bonds; (ii) bonds that are not externally rated; (iii) all
financial instruments; (iv) letters of credit; (v) mortgages loans; and (vi) certificates of
deposit. Some commenters that advocated inclusion of a wider range of bonds admitted
that it may be reasonable to impose some sort of liquidity requirement on the additional
bonds and to impose a 25-50 percent standard supervisory haircut for such additional
bonds. Some of the commenters that advocated inclusion of a broader range of bonds
and mortgages asserted that such inclusion would be warranted by the exemption from
bankruptcy auto-stay accorded to repo-style transactions involving such assets by the
U.S. Bankruptcy Code. 74
As described above, to enhance international consistency and conform the final
rule more closely to the New Accord, the agencies have decided to permit a bank to use
the EAD approach for all repo-style transactions that are included in a bank’s VaR-based
measure under the market risk rule, regardless of the underlying collateral type. The
agencies are satisfied that such repo-style transactions would be based on collateral that is
sufficiently liquid to justify applying the EAD approach.
The agencies have included conforming residential mortgages in the definition of
financial collateral and as acceptable underlying instruments in the definitions of repostyle transaction and eligible margin loan based on the liquidity of such mortgages and
their widespread use as collateral in repo-style transactions. However, because this
74
11 U.S.C. 559.
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DRAFT November 2, 2007
inclusion goes beyond the New Accord’s recognition of financial collateral, the agencies
decided to take a conservative approach and require banks to use the standard supervisory
haircut approach, with a 25 percent haircut and minimum ten-business-day holding
period, in order to recognize conforming residential mortgage collateral in EAD (other
than for repo-style transactions that are included in a bank’s VaR-based measure under
the market risk rule). Use of the standard supervisory haircut approach for repo-style
transactions, eligible margin loans, and OTC derivatives collateralized by conforming
mortgages does not preclude a bank’s use of the other EAD adjustment approaches for
exposures collateralized by other types of financial collateral. Due to concerns about
both competitive equity and the liquidity and price availability of other types of
collateral, the agencies are not otherwise expanding the proposed definition of financial
collateral in the final rule.
Collateral haircut approach
Under the collateral haircut approach of the final rule, similar to the proposed
rule, a bank must set EAD equal to the sum of three quantities: (i) the value of the
exposure less the value of the collateral; (ii) the absolute value of the net position in a
given instrument or in gold (where the net position in a given instrument or in gold equals
the sum of the current market values of the instrument or gold the bank has lent, sold
subject to repurchase, or posted as collateral to the counterparty minus the sum of the
current market values of that same instrument or gold the bank has borrowed, purchased
subject to resale, or taken as collateral from the counterparty) multiplied by the market
price volatility haircut appropriate to that security; and (iii) the sum of the absolute values
of the net position of any cash, instruments, or gold in each currency that is different from
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the settlement currency multiplied by the haircut appropriate to each currency mismatch.
To determine the appropriate haircuts, a bank may choose to use standard supervisory
haircuts or, with prior written approval from its primary Federal supervisor, its own
estimates of haircuts.
In the preamble to the proposed rule, for purposes of the collateral haircut
approach, the agencies clarified that a given security would include, for example, all
securities with a single Committee on Uniform Securities Identification Procedures
(CUSIP) number and would not include securities with different CUSIP numbers, even if
issued by the same issuer with the same maturity date. The agencies sought comment on
alternative approaches for determining a given security for purposes of the collateral
haircut approach. A few commenters expressed support for the proposed CUSIP
approach to defining a given security, but one commenter asked the agencies to permit
each bank the flexibility to define given security. The collateral haircut approach in the
final rule is based on a bank’s net position in a “given instrument or gold” rather than in a
“given security” to more precisely capture the positions to which a bank must apply the
haircuts. To enhance safety and soundness and comparability across banks, the agencies
believe that it is important to preserve the relatively clear CUSIP approach to defining a
given instrument for purposes of the collateral haircut approach. Accordingly, the
agencies are maintaining the CUSIP approach as appropriate for determining a given
instrument for instruments that are securities.
Standard supervisory haircuts. Under the final rule, as under the proposed rule, if
a bank chooses to use standard supervisory haircuts, it must use an 8 percent haircut for
each currency mismatch and the haircut appropriate to each security in Table D below.
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These haircuts are based on the ten-business-day holding period for eligible margin loans
and must be multiplied by the square root of ½ to convert the standard supervisory
haircuts to the five-business-day minimum holding period for repo-style transactions. A
bank must adjust the standard supervisory haircuts upward on the basis of a holding
period longer than ten business days for eligible margin loans or five business days for
repo-style transactions where and as appropriate to take into account the illiquidity of an
instrument.
Table D – Standard Supervisory Market Price Volatility Haircuts
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Applicable external
Residual maturity for debt
rating grade category
securities
for debt securities
Two highest
≤ 1 year
investment-grade
>1 year, ≤ 5 years
rating categories for
long-term
> 5 years
ratings/highest
investment-grade
rating category for
short-term ratings
Two lowest
≤ 1 year
investment-grade
>1 year, ≤ 5 years
rating categories for
> 5 years
both short- and longterm ratings
One rating category
All
below investment
grade
Main index equities 75 (including convertible bonds) and
gold
Other publicly traded equities (including convertible
bonds), conforming residential mortgages, and
nonfinancial collateral
Mutual funds
Cash on deposit with the bank (including a certificate of
deposit issued by the bank)
Issuers exempt
from the 3 b.p.
floor
.005
Other issuers
.01
.02
.04
.04
.08
.01
.03
.06
.02
.06
.12
.15
.25
.15
.25
Highest haircut applicable to any
security in which the fund can
invest
0
As an example, assume a bank that uses standard supervisory haircuts has
extended an eligible margin loan of $100 that is collateralized by five-year U.S. Treasury
notes with a market value of $100. The value of the exposure less the value of the
collateral would be zero, and the net position in the security ($100) times the supervisory
haircut (.02) would be $2. There is no currency mismatch. Therefore, the EAD of the
exposure would be $0 + $2 = $2.
75
The proposed and final rules define a “main index” as the S&P 500 Index, the FTSE All-World Index,
and any other index for which the bank demonstrates to the satisfaction of its primary Federal supervisor
that the equities represented in the index have comparable liquidity, depth of market, and size of bid-ask
spreads as equities in the S&P 500 Index and the FTSE All-World Index.
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DRAFT November 2, 2007
Own estimates of haircuts. Under the final rule, as under the proposal, with the
prior written approval of the bank’s primary Federal supervisor, a bank may calculate
security type and currency mismatch haircuts using its own internal estimates of market
price volatility and foreign exchange volatility. The bank’s primary Federal supervisor
would base approval to use internally estimated haircuts on the satisfaction of certain
minimum qualitative and quantitative standards. These standards include: (i) the bank
must use a 99th percentile one-tailed confidence interval and a minimum five-businessday holding period for repo-style transactions and a minimum ten-business-day holding
period for all other transactions; (ii) the bank must adjust holding periods upward where
and as appropriate to take into account the illiquidity of an instrument; (iii) the bank must
select a historical observation period for calculating haircuts of at least one year; and
(iv) the bank must update its data sets and recompute haircuts no less frequently than
quarterly and reassess data sets and haircuts whenever market prices change materially.
A bank must estimate individually the volatilities of the exposure, the collateral, and
foreign exchange rates, and may not take into account the correlations between them.
Under the final rule, as under the proposal, a bank that uses internally estimated
haircuts must adhere to the following rules. The bank may calculate internally estimated
haircuts for categories of debt securities that have an applicable external rating of at least
investment grade. The haircut for a category of securities must be representative of the
internal volatility estimates for securities in that category that the bank has lent, sold
subject to repurchase, posted as collateral, borrowed, purchased subject to resale, or taken
as collateral. In determining relevant categories, the bank must at a minimum take into
account (i) the type of issuer of the security; (ii) the applicable external rating of the
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security; (iii) the maturity of the security; and (iv) the interest rate sensitivity of the
security. A bank must calculate a separate internally estimated haircut for each
individual debt security that has an applicable external rating below investment grade and
for each individual equity security. In addition, a bank must internally estimate a
separate currency mismatch haircut for each individual mismatch between each net
position in a currency that is different from the settlement currency.
One commenter recommended that the agencies permit banks to use categorybased internal estimate haircuts for non-investment-grade bonds and equity securities.
The agencies have decided to adopt the proposed rule’s provisions on category-based
haircuts because they are consistent with the New Accord and because the volatilities of
non-investment-grade bonds and of equity securities are more dependent on
idiosyncratic, issuer-specific events than the volatility of investment-grade bonds.
Under the final rule, as under the proposal, when a bank calculates an internally
estimated haircut on a TN-day holding period, which is different from the minimum
holding period for the transaction type, the bank must calculate the applicable haircut
(HM) using the following square root of time formula:
HM = HN
TM
,
TN
where
(i) TM = five for repo-style transactions and ten for eligible margin loans;
(ii) TN = holding period used by the bank to derive HN; and
(iii) HN = haircut based on the holding period TN.
Simple VaR methodology
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DRAFT November 2, 2007
As noted above, under the final rule, as under the proposal, a bank may use one of
two internal models approaches to recognize the risk mitigating effects of financial
collateral that secures a repo-style transaction or eligible margin loan. This section of the
preamble describes the simple VaR methodology; a later section of the preamble
describes the internal models methodology (which also may be used to determine the
EAD for OTC derivative contracts). The agencies received no material comments on the
simple VaR methodology and are adopting the methodology without change from the
proposal.
With the prior written approval of its primary Federal supervisor, a bank may
estimate EAD for repo-style transactions and eligible margin loans subject to a single
product qualifying master netting agreement using a VaR model. Under the simple VaR
methodology, a bank’s EAD for the transactions subject to such a netting agreement is
equal to the value of the exposures minus the value of the collateral plus a VaR-based
estimate of potential future exposure (PFE). The value of the exposures is the sum of the
current market values of all securities and cash the bank has lent, sold subject to
repurchase, or posted as collateral to a counterparty under the netting set. The value of
the collateral is the sum of the current market values of all securities and cash the bank
has borrowed, purchased subject to resale, or taken as collateral from a counterparty
under the netting set. The VaR-based estimate of PFE is an estimate of the bank’s
maximum exposure on the netting set over a fixed time horizon with a high level of
confidence.
Specifically, the VaR model must estimate the bank’s 99th percentile, one-tailed
confidence interval for an increase in the value of the exposures minus the value of the
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collateral (∑E - ∑C) over a five-business-day holding period for repo-style transactions
or over a ten-business-day holding period for eligible margin loans using a minimum
one-year historical observation period of price data representing the instruments that the
bank has lent, sold subject to repurchase, posted as collateral, borrowed, purchased
subject to resale, or taken as collateral.
The qualification requirements for the use of a VaR model are less stringent than
the qualification requirements for the internal models methodology described below. The
main ongoing qualification requirement for using a VaR model is that the bank must
validate its VaR model by establishing and maintaining a rigorous and regular
backtesting regime.
3. EAD for OTC derivative contracts
Under the final rule, as under the proposed rule, a bank may use either the current
exposure methodology or the internal models methodology to determine the EAD for
OTC derivative contracts. An OTC derivative contract is defined as a derivative contract
that is not traded on an exchange that requires the daily receipt and payment of cashvariation margin. A derivative contract is defined to include interest rate derivative
contracts, exchange rate derivative contracts, equity derivative contracts, commodity
derivative contracts, credit derivatives, and any other instrument that poses similar
counterparty credit risks. The rule also defines derivative contracts to include unsettled
securities, commodities, and foreign exchange trades with a contractual settlement or
delivery lag that is longer than the normal settlement period (which the rule defines as the
lesser of the market standard for the particular instrument or five business days). This
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includes, for example, agency mortgage-backed securities transactions conducted in the
To-Be-Announced market.
Figure 3 illustrates the treatment of OTC derivative contracts.
Figure 3—EAD and LGD for OTC Derivative Contracts
EAD for
OTC
Derivatives
Current
Exposure
Methodology
Internal Models
Methodology
Master
Netting
Agreement
Yes
Collateral
Considered in
Internal Models
Methodology
No
Net Replacement Cost
+ Adjusted Potential
Future Exposure
Transaction Replacement
Cost + Potential Future
Exposure
Is Collateral Posted?
Yes
Adjust LGD
Plug PD, Adjusted LGD,
and EAD into Wholesale
Function
No
Haircut Collateral
to Adjust EAD
Standardized
Haircuts
Own
Estimates
Plug PD, Unsecured
LGD, and EAD into
Wholesale Function
Plug PD, Unsecured
LGD, and Adjusted
EAD into Wholesale
Function
Current exposure methodology
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DRAFT November 2, 2007
The final rule’s current exposure methodology for determining EAD for single
OTC derivative contracts is similar to the methodology in the general risk-based capital
rules and is the same as the current exposure methodology in the proposal. Under the
current exposure methodology, the EAD for an OTC derivative contract is equal to the
sum of the bank’s current credit exposure and PFE on the derivative contract. The
current credit exposure for a single OTC derivative contract is the greater of the mark-tomarket value of the derivative contract or zero.
The final rule’s current exposure methodology for OTC derivative contracts
subject to qualifying master netting agreements is also similar to the treatment in the
agencies’ general risk-based capital rules and, with one exception discussed below, is the
same as the treatment in the proposal. Under the general risk-based capital rules and
under the proposed rule, a bank could not recognize netting agreements for OTC
derivative contracts for risk-based capital purposes unless it obtained a written and
reasoned legal opinion representing that, in the event of a legal challenge, the bank’s
exposure would be found to be the net amount in the relevant jurisdictions. 76 The
agencies asked for comment on methods banks would use to ensure enforceability of
single product OTC derivative netting agreements in the absence of an explicit written
legal opinion requirement.
Although one commenter supported the proposed rule’s written legal opinion
requirement, many other commenters asked the agencies to remove this requirement.
These commenters maintained that, provided a transaction is conducted in a jurisdiction
and with a counterparty type that is covered by a commissioned legal opinion, use of
industry-developed standardized contracts for certain OTC derivative products and
76
This requirement was found in footnote 8 of the proposed rule text (in section 32(b)(2)).
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DRAFT November 2, 2007
reliance on commissioned legal opinions as to the enforceability of these contracts should
be a sufficient guarantor of enforceability. These commenters added that reliance on
such commissioned legal opinions is standard market practice.
The agencies continue to believe that the legal enforceability of netting
agreements is a necessary condition for a bank to recognize netting effects in its capital
calculation. However, the agencies have conducted additional analysis and agree that a
unique, written legal opinion is not necessary in all cases to ensure the enforceability of
an OTC derivative netting agreement. Accordingly, the agencies have removed the
requirement that a bank obtain a written and well reasoned legal opinion for each of its
qualifying master netting agreements that cover OTC derivatives. As a result, under the
final rule, to obtain netting treatment for multiple OTC derivative contracts subject to a
qualifying master netting agreement, a bank must conduct sufficient legal review to
conclude with a well-founded basis (and maintain sufficient written documentation of
that legal review) that the agreement would provide termination netting benefits and is
legal, valid, binding, and enforceable. In some cases, this requirement could be met by
reasoned reliance on a commissioned legal opinion or an in-house counsel analysis. In
other cases, however – for example, involving certain new derivative transactions or
derivative counterparties in unusual jurisdictions – the bank would need to obtain an
explicit written legal opinion from external or internal legal counsel addressing the
particular situation.
The proposed rule’s conversion factor (CF) matrix used to compute PFE was
based on the matrices in the general risk-based capital rules, with two exceptions. First,
under the proposed rule, the CF for credit derivatives that are not used to hedge the credit
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risk of exposures subject to an IRB credit risk capital requirement was specified to be 5.0
percent for contracts with investment-grade reference obligors and 10.0 percent for
contracts with non-investment-grade reference obligors. 77 The CF for a credit derivative
contract did not depend on the remaining maturity of the contract. The second change
was that floating/floating basis swaps were no longer exempted from the CF for interest
rate derivative contracts. The exemption was put into place when such swaps were very
simple, and the agencies believed it was no longer appropriate given the evolution of the
product. The computation of the PFE of multiple OTC derivative contracts subject to a
qualifying master netting agreement did not change from the general risk-based capital
rules. The agencies received no material comment on these provisions of the proposed
rule and have adopted them as proposed.
Under the final rule, as under the proposed rule, if an OTC derivative contract is
collateralized by financial collateral and a bank uses the current exposure methodology to
determine EAD for the exposure, the bank must first determine an unsecured EAD as
described above and in section 32(c) of the rule. To take into account the risk-reducing
effects of the financial collateral, the bank may either adjust the LGD of the contract or, if
the transaction is subject to daily marking-to-market and remargining, adjust the EAD of
the contract using the collateral haircut approach for repo-style transactions and eligible
margin loans described above and in section 32(b) of the rule.
Under part VI of the final rule, and of the proposed rule, a bank must treat an
equity derivative contract as an equity exposure and compute a risk-weighted asset
amount for that exposure. If the bank is using the internal models approach for its equity
77
The counterparty credit risk of a credit derivative that is used to hedge the credit risk of an exposure
subject to an IRB credit risk capital requirement is captured in the IRB treatment of the hedged exposure, as
detailed in sections 33 and 34 of the proposed rule.
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exposures, it also must compute a risk-weighted asset amount for its counterparty credit
risk exposure on the equity derivative contract. However, if the bank is using the simple
risk weight approach for its equity exposures, it may choose not to hold risk-based capital
against the counterparty credit risk of the equity derivative contract. Likewise, a bank
that purchases a credit derivative that is recognized under section 33 or 34 of the rule as a
credit risk mitigant for an exposure that is not a covered position under the market risk
rule does not have to compute a separate counterparty credit risk capital requirement for
the credit derivative. 78 If a bank chooses not to hold risk-based capital against the
counterparty credit risk of such equity or credit derivative contracts, it must do so
consistently for all such equity derivative contracts or for all such credit derivative
contracts. Further, where the contracts are subject to a qualifying master netting
agreement, the bank must either include them all or exclude them all from any measure
used to determine counterparty credit risk exposure to all relevant counterparties for riskbased capital purposes.
In addition, where a bank provides protection through a credit derivative that is
not treated as a covered position under the market risk rule, it must treat the credit
derivative as a wholesale exposure to the reference obligor and compute a risk-weighted
asset amount for the credit derivative under section 31 of the rule. The bank need not
compute a counterparty credit risk capital requirement for the credit derivative, so long as
it does so consistently for all such credit derivatives and either includes all or excludes all
78
The agencies recognize that there are reasons why a bank’s credit portfolio might contain purchased
credit protection on a reference name in a notional principal amount that exceeds the bank’s currently
measured EAD to that obligor. If the protection amount of the credit derivative is materially greater than
the EAD of the exposure being hedged, however, the bank generally must treat the credit derivative as two
separate exposures and calculate a counterparty credit risk capital requirement for the exposure that is not
providing credit protection to the hedged exposure.
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DRAFT November 2, 2007
such credit derivatives that are subject to a qualifying master netting agreement from any
measure used to determine counterparty credit risk exposure to all relevant counterparties
for risk-based capital purposes. Where the bank provides protection through a credit
derivative treated as a covered position under the market risk rule, it must compute a
counterparty credit risk capital requirement for the credit derivative under section 31 of
the rule.
4. Internal models methodology
The final rule, like the proposed rule, includes an internal models methodology
for the calculation of EAD for the counterparty credit exposure of OTC derivatives,
eligible margin loans, and repo-style transactions. The internal models methodology
requires a risk model that estimates EAD at the level of a netting set. A transaction not
subject to a qualifying master netting agreement is considered to be its own netting set
and a bank must calculate EAD for each such transaction individually.
A bank may use the internal models methodology for OTC derivatives
(collateralized or uncollateralized) and single-product netting sets thereof, for eligible
margin loans and single-product netting sets thereof, or for repo-style transactions and
single-product netting sets thereof. A bank that uses the internal models methodology for
a particular transaction type (that is, OTC derivative contracts, eligible margin loans, or
repo-style transactions) must use the internal models methodology for all transactions of
that transaction type. However, a bank may choose whether or not to use the internal
models methodology for each transaction type.
A bank also may use the internal models methodology for OTC derivatives,
eligible margin loans, and repo-style transactions subject to a qualifying cross-product
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master netting agreement if (i) the bank effectively integrates the risk mitigating effects
of cross-product netting into its risk management and other information technology
systems; and (ii) the bank obtains the prior written approval of its primary Federal
supervisor.
The final rule tracks the proposed rule by defining a qualifying cross-product
master netting agreement as a qualifying master netting agreement that provides for
termination and close-out netting across multiple types of financial transactions or
qualifying master netting agreements in the event of a counterparty’s default, provided
that:
(i) The underlying financial transactions are OTC derivative contracts, eligible
margin loans, or repo-style transactions; and
(ii) The bank obtains a written legal opinion verifying the validity and
enforceability of the netting agreement under applicable law of the relevant jurisdictions
if the counterparty fails to perform upon an event of default, including upon an event of
bankruptcy, insolvency, or similar proceeding.
As discussed in the proposal, banks use several measures to manage their
exposure to the counterparty credit risk of repo-style transactions, eligible margin loans,
and OTC derivatives, including PFE, expected exposure (EE), and expected positive
exposure (EPE). PFE is the maximum exposure estimated to occur over a future horizon
at a high level of statistical confidence. Banks often use PFE when measuring
counterparty credit risk exposure against counterparty credit limits. EE is the expected
value of the probability distribution of non-negative credit risk exposures to a
counterparty at any specified future date, whereas EPE is the time-weighted average of
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individual expected exposures estimated for a given forecasting horizon (one year in the
proposed rule). The final rule clarifies that, when estimating EE, a bank must set any
negative market values in the probability distribution of market values to a counterparty
at a specified future date to zero to convert the probability distribution of market values
to the probability distribution of credit risk exposures. Banks typically compute EPE,
EE, and PFE using a common stochastic model.
A paper published by the BCBS in July 2005 titled “The Application of Basel II
to Trading Activities and the Treatment of Double Default Effects” notes that EPE is an
appropriate EAD measure for determining risk-based capital requirements for
counterparty credit risk because transactions with counterparty credit risk “are given the
same standing as loans with the goal of reducing the capital treatment’s influence on a
firm’s decision to extend an on-balance sheet loan rather than engage in an economically
equivalent transaction that involves exposure to counterparty credit risk.” 79 An
adjustment to EPE, called “effective EPE” and described below, is used in the calculation
of EAD under the internal models methodology. EAD is calculated as a multiple of
effective EPE.
To address the concern that EE and EPE may not capture risk arising from the
replacement of existing short-term positions over the one-year horizon used for capital
requirements (rollover risk) or may underestimate the exposures of eligible margin loans,
repo-style transactions, and OTC derivatives with short maturities, the final rule, like the
proposed rule, uses a netting set’s effective EPE as the basis for calculating EAD for
counterparty credit risk. Consistent with the use of a one-year PD horizon, effective EPE
79
BCBS, “The Application of Basel II to Trading Activities and the Treatment of Double Default Effects,”
July 2005, ¶ 15.
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is the time-weighted average of effective EE over one year where the weights are the
proportion that an individual effective EE represents in a one-year time interval. If all
contracts in a netting set mature before one year, effective EPE is the average of effective
EE until all contracts in the netting set mature. For example, if the longest maturity
contract in the netting set matures in six months, effective EPE would be the average of
effective EE over six months.
Effective EE is defined as:
Effective EEtk = max(Effective EEtk-1, EEtk)
where exposure is measured at future dates t1, t2, t3,. . . and effective EEt0 equals
current exposure. Alternatively, a bank may use a measure that is more conservative than
effective EPE for every counterparty (that is, a measure based on peak exposure) with
prior approval of its primary Federal supervisor.
The final rule clarifies that if a bank hedges some or all of the counterparty credit
risk associated with a netting set using an eligible credit derivative, the bank may take the
reduction in exposure to the counterparty into account when estimating EE. If the bank
recognizes this reduction in exposure to the counterparty in its estimate of EE, it must
also use its internal model to estimate a separate EAD for the bank’s exposure to the
protection provider of the credit derivative.
The EAD for instruments with counterparty credit risk must be determined
assuming economic downturn conditions. To accomplish this determination in a prudent
manner, the internal models methodology sets EAD equal to EPE multiplied by a scaling
factor termed “alpha.” Alpha is set at 1.4; a bank’s primary Federal supervisor has the
flexibility to raise this value based on the bank’s specific characteristics of counterparty
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credit risk. In addition, with supervisory approval, a bank may use its own estimate of
alpha, subject to a floor of 1.2.
In the proposal, the agencies requested comment on all aspects of the effective
EPE approach to counterparty credit risk and, in particular, on the appropriateness of the
monotonically increasing effective EE function, the alpha constant of 1.4, and the floor
on internal estimates of alpha of 1.2. Commenters expressed a number of objections to
the proposed rule’s internal models methodology.
Several commenters contended that banks that use the internal models
methodology should be permitted to calculate effective EPE at the counterparty level and
should not be required to calculate effective EPE at the netting set level. These
commenters indicated that while the New Accord mandates calculation at the netting set
level, those banks that currently use an EPE-style approach to measuring counterparty
credit risk for internal risk management purposes typically use a counterparty-bycounterparty EPE approach. They asserted that forcing banks to use a netting-set-bynetting-set approach would be burdensome for banks and would provide the agencies no
material regulatory benefits, as netting effects are taken into account in the calculation of
EE.
The agencies have retained the netting set focus of the calculation of effective
EPE to preserve international consistency. The agencies will continue to review the
implications, particularly with respect to the appropriate recognition of netting benefits,
of allowing banks to calculate effective EPE at the counterparty level.
One commenter objected to the proposed rule’s requirement that a bank use
effective EE (as opposed to EE). This commenter contended that effective EE is an
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excessively conservative and imprecise mechanism to address rollover risk in a portfolio
of short-term transactions. The commenter represented that rollover risk should be
addressed under Pillar 2 rather than Pillar 1. The agencies continue to believe that
rollover risk is a core credit risk that should be covered by explicit risk-based capital
requirements. The agencies also remain concerned that EE and EPE (as opposed to
effective EE and effective EPE) would not adequately incorporate rollover risk and do
not believe that bank internal estimates of rollover risk are sufficiently reliable at this
time to use for risk-based capital purposes. To ensure consistency with the New Accord
and in light of the lack of alternative prudent mechanisms to incorporate rollover risk, the
agencies continue to include effective EE and effective EPE in the final rule.
Several commenters criticized the default alpha of 1.4 and the 1.2 floor on
internal estimates of alpha. These commenters contended that these supervisory alphas
were too conservative for many dealer banks with large, diverse, and granular portfolios
of repo-style transactions, eligible margin loans, and OTC derivatives. Although the
agencies acknowledge the possibility that certain banks with certain types of portfolios at
certain times could warrant an alpha of less than 1.2, the agencies believe it is important
to have a supervisory floor on alpha. This floor will ensure consistency with the New
Accord, comparability among the various banks that use the internal models
methodology, and sufficient capital through the economic cycle for securities financing
transactions and OTC derivatives. Therefore, the agencies are retaining the alpha floor as
proposed.
Similar to the proposal, under the final rule a bank’s primary Federal supervisor
must determine that the bank meets certain qualifying criteria before the bank may use
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the internal models methodology. These criteria consist of the following operational
requirements, modeling standards, and model validation requirements.
First, the bank must have the systems capability to estimate EE on a daily basis.
While this requirement does not require the bank to report EE daily, or even estimate EE
daily, the bank must demonstrate that it is capable of performing the estimation daily.
Second, the bank must estimate EE at enough future time points to accurately
reflect all future cash flows of contracts in the netting set. To accurately reflect the
exposure arising from a transaction, the model should incorporate those contractual
provisions, such as reset dates, that can materially affect the timing, probability, or
amount of any payment. The requirement reflects the need for an accurate estimate of
EPE. However, in order to balance the ability to calculate exposures with the need for
information on timely basis, the number of time points is not specified.
Third, the bank must have been using an internal model that broadly meets the
minimum standards to calculate the distributions of exposures upon which the EAD
calculation is based for a period of at least one year prior to approval. This requirement
is to ensure that the bank has integrated the modeling into its counterparty credit risk
management process.
Fourth, the bank’s model must account for the non-normality of exposure
distribution where appropriate. Non-normality of exposure distribution means high loss
events occur more frequently than would be expected on the basis of a normal
distribution, the statistical term for which is leptokurtosis. In many instances, there may
not be a need to account for this. Expected exposures are much less likely to be affected
by leptokurtosis than peak exposures or high percentile losses. However, the bank must
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demonstrate that its EAD measure is not affected by leptokurtosis or must account for it
within the model.
Fifth, the bank must measure, monitor, and control the exposure to a counterparty
over the whole life of all contracts in the netting set, in addition to accurately measuring
and actively monitoring the current exposure to counterparties. The bank should exercise
active management of both existing exposure and exposure that could change in the
future due to market moves.
Sixth, the bank must be able to measure and manage current exposures gross and
net of collateral held, where appropriate. The bank must estimate expected exposures for
OTC derivative contracts both with and without the effect of collateral agreements. By
contrast, under the proposed rule, a bank would have to measure and manage current
exposure gross and net of collateral held. Some commenters criticized this requirement
as inconsistent with the New Accord and bank internal risk management practices. The
agencies agree and have revised the rule to only require a bank to “be able to” measure
and manage current exposures gross and net of collateral.
Seventh, the bank must have procedures to identify, monitor, and control specific
wrong-way risk throughout the life of an exposure. In this context, wrong-way risk is the
risk that future exposure to a counterparty will be high when the counterparty’s
probability of default is also high. Wrong-way risk generally arises from events specific
to the counterparty, rather than broad market downturns.
Eighth, the data used by the bank should be adequate for the measurement and
modeling of the exposures. In particular, the model must use current market data to
compute current exposures. When a bank uses historical data to estimate model
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parameters, the bank must use at least three years of data that cover a wide range of
economic conditions. This requirement reflects the longer horizon for counterparty credit
risk exposures compared to market risk exposures. The data must be updated at least
quarterly or more frequently if market conditions warrant. Banks should consider using
model parameters based on forward looking measures, where appropriate.
Ninth, the bank must subject its models used in the calculation of EAD to an
initial validation and annual model review process. The model review should consider
whether the inputs and risk factors, as well as the model outputs, are appropriate. The
review of outputs should include a rigorous program of backtesting model outputs against
realized exposures.
Maturity under the internal models methodology
Like corporate loan exposures, counterparty exposure on netting sets is
susceptible to changes in economic value that stem from deterioration in the
counterparty’s creditworthiness short of default. The effective maturity parameter (M)
reflects the impact of these changes on capital. The formula used to compute M for
netting sets with maturities greater than one year must be different than that generally
applied to wholesale exposures in order to reflect how counterparty credit exposures
change over time. The final rule’s definition of M under the internal models
methodology is identical to that of the proposed rule and is based on a weighted average
of expected exposures over the life of the transactions relative to their one year
exposures. Consistent with the New Accord, the final rule expands upon the proposal by
providing that a bank that uses an internal model to calculate a one-sided credit valuation
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adjustment may use the effective credit duration estimated by the model as M(EPE) in
place of the formula in the paragraph below.
If the remaining maturity of the exposure or the longest-dated contract contained
in a netting set is greater than one year, the bank must set M for the exposure or netting
set equal to the lower of 5 years or M(EPE), where:
maturity
(i) M ( EPE ) = 1 +
∑ EE
k
× Δt k × df k
tk >1 year
tk ≤1 year
∑ effectiveEE
k =1
k
× Δt k × df k
and (ii) dfk is the risk-free discount factor for future time period tk. The cap of five years
on M is consistent with the treatment of wholesale exposures under section 31 of the rule.
If the remaining maturity of the exposure or the longest-dated contract in the
netting set is one year or less, the bank must set M for the exposure or netting set equal to
one year except as provided in section 31(d)(7) of the rule. In this case, repo-style
transactions, eligible margin loans, and collateralized OTC derivative transactions subject
to daily remargining agreements may use the effective maturity of the longest maturity
transaction in the netting set as M.
Collateral agreements under the internal models methodology
The provisions of the final rule on collateral agreements under the internal models
methodology are the same as those of the proposed rule. Under the final rule, if a bank
has prior written approval from its primary Federal supervisor, it may capture within its
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internal model the effect on EAD of a collateral agreement that requires receipt of
collateral when exposure to the counterparty increases. In no circumstances, however,
may a bank take into account in EAD collateral agreements triggered by deterioration of
counterparty credit quality. Several commenters asked the agencies to permit banks to
incorporate in EAD collateral agreements that are dependent on a decline in the external
rating of the counterparty. The agencies do not believe that banks are able to model the
necessary correlations with sufficient reliability to accept these types of collateral
agreements under the internal models methodology at this time.
In the context of the internal models methodology, the rule defines a collateral
agreement as a legal contract that: (i) specifies the time when, and circumstances under
which, the counterparty is required to exchange collateral with the bank for a single
financial contract or for all financial contracts covered under a qualifying master netting
agreement; and (ii) confers upon the bank a perfected, first priority security interest
(notwithstanding the prior security interest of any custodial agent), or the legal equivalent
thereof, in the collateral posted by the counterparty under the agreement. This security
interest must provide the bank with a right to close out the financial positions and the
collateral upon an event of default of or failure to perform by the counterparty under the
collateral agreement. A contract would not satisfy this requirement if the bank’s exercise
of rights under the agreement may be stayed or avoided under applicable law in the
relevant jurisdictions.
If a bank’s internal model does not capture the effects of collateral agreements,
the final rule provides a “shortcut” method to provide the bank with some benefit, in the
form of a smaller EAD, for collateralized counterparties. Under the shortcut method,
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effective EPE is the lesser of a threshold amount (linked to the exposure amount at which
a counterparty must post collateral) plus an add-on and effective EPE without a collateral
agreement. Although any bank may use this “shortcut” method under the internal models
methodology, the agencies expect banks that make extensive use of collateral agreements
to develop the modeling capacity to measure the impact of such agreements on EAD.
The shortcut method provided in the final rule is identical to the shortcut method
provided in the proposed rule.
Alternative methods
Under the final rule, consistent with the proposed rule, a bank using the internal
models methodology may use an alternative method to determine EAD for certain
transactions, provided that the bank can demonstrate to its primary Federal supervisor
that the method’s output is more conservative than an alpha of 1.4 (or higher) times
effective EPE.
Use of an alternative method may be appropriate where a new product or business
line is being developed, where a recent acquisition has occurred, or where the bank
believes that other more conservative methods to measure counterparty credit risk for a
category of transactions are prudent. The alternative method should be applied to all
similar transactions. When an alternative method is used, the bank should either treat the
particular transactions concerned as a separate netting set with the counterparty or apply
the alternative model to the entire original netting set.
The agencies recognize that for new OTC derivative products a bank may need a
transition period during which to incorporate a new product into its internal models
methodology or to demonstrate that an alternative method is more conservative than an
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alpha of 1.4 (or higher) times effective EPE. The final rule therefore provides that for
material portfolios of new OTC derivative products, a bank may assume that the current
exposure methodology in section 32(c) of the rule meets the conservatism requirement
for a period not longer than 180 days. As a general matter, the agencies expect that the
current exposure methodology in section 32(c) of the rule would be an acceptable, more
conservative method for immaterial portfolios of OTC derivatives.
5. Guarantees and credit derivatives that cover wholesale exposures
The New Accord specifies that a bank may adjust either the PD or the LGD of a
wholesale exposure to reflect the risk mitigating effects of a guarantee or credit
derivative. Similarly, under the final rule, as under the proposed rule, a bank may choose
either a PD substitution or an LGD adjustment approach to recognize the risk mitigating
effects of an eligible guarantee or eligible credit derivative on a wholesale exposure (or in
certain circumstances may choose to use a double default treatment, as discussed below).
In all cases a bank must use the same risk parameters for calculating ECL for a wholesale
exposure as it uses for calculating the risk-based capital requirement for the exposure.
Moreover, in all cases, a bank’s ultimate PD and LGD for the hedged wholesale exposure
may not be lower than the PD and LGD floors discussed above and described in
section 31(d) of the rule.
Eligible guarantees and eligible credit derivatives
Under the proposed rule, guarantees and credit derivatives had to meet specific
eligibility requirements to be recognized as CRM for a wholesale exposure. The
proposed rule defined an eligible guarantee as a guarantee that:
(i) Is written and unconditional;
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(ii) Covers all or a pro rata portion of all contractual payments of the obligor on
the reference exposure;
(iii) Gives the beneficiary a direct claim against the protection provider;
(iv) Is non-cancelable by the protection provider for reasons other than the breach
of the contract by the beneficiary;
(v) Is legally enforceable against the protection provider in a jurisdiction where
the protection provider has sufficient assets against which a judgment may be attached
and enforced; and
(vi) Requires the protection provider to make payment to the beneficiary on the
occurrence of a default (as defined in the guarantee) of the obligor on the reference
exposure without first requiring the beneficiary to demand payment from the obligor.
Commenters suggested a number of improvements to the proposed definition of
eligible guarantee. One commenter asked the agencies to clarify that the unconditionality
requirement in criterion (i) of the definition would be interpreted consistently with the
New Accord’s requirement that “there should be no clause in the protection contract
outside the direct control of the bank that could prevent the protection provider from
being obliged to pay out in a timely manner in the event that the original counterparty
fails to make the payment(s) due.” 80 The agencies are not providing the requested
clarification. The agencies have acquired considerable experience in the intricate issue of
the conditionality of guarantees under the general risk-based capital rules and intend to
address the meaning of “unconditional” in the context of eligible guarantees under this
final rule on a case-by-case basis going forward.
80
New Accord, ¶189.
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This same commenter also asked the agencies to revise the second criterion of the
definition from coverage of “all or a pro rata portion of all contractual payments of the
obligor on the reference exposure” to coverage of “all or a pro rata portion of all principal
or due and payable amounts on the reference exposure.” The agencies have decided to
preserve the second criterion of the eligible guarantee definition without change to ensure
that a bank only obtains CRM benefits from credit risk mitigants that cover all sources of
credit exposure to the obligor. Although it is appropriate to provide partial CRM benefits
under the wholesale framework for partial but pro rata guarantees of all contractual
payments, the agencies are less comfortable with providing partial CRM benefits under
the wholesale framework where the extent of the loss coverage of the credit exposure is
not so easily quantifiable. Accordingly, for example, if a bank obtains a principal-only or
interest-only guarantee of a corporate bond, the guarantee will not qualify as an eligible
guarantee and the bank will not be able to obtain any CRM benefits from the guarantee.
Some commenters asked the agencies to modify the fourth criterion of the eligible
guarantee definition to clarify, consistent with the New Accord, that a guarantee that is
terminable by the bank and the protection provider by mutual consent may qualify as an
eligible guarantee. This is an appropriate clarification of the definition and, therefore, the
agencies have amended the fourth criterion of the definition to require that the guarantee
be non-cancelable by the protection provider unilaterally.
One commenter asked the agencies to modify the fifth criterion of the eligible
guarantee definition, which requires the guarantee to be legally enforceable in a
jurisdiction where the protection provider has sufficient assets, by deleting the word
“sufficient.” The agencies have preserved the fifth criterion of the proposed definition
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intact. The agencies do not think that it would be consistent with safety and soundness to
permit a bank to obtain CRM benefits under the rule if the guarantee were not legally
enforceable against the protection provider in a jurisdiction where the protection provider
has sufficient available assets.
Finally, some commenters objected to the sixth and final criterion of the eligible
guarantee definition, which requires the protection provider to make payments to the
beneficiary upon default of the obligor without first requiring the beneficiary to demand
payment from the obligor. The agencies have decided to modify this criterion to make it
more consistent with the New Accord and actual market practice. The final rule’s sixth
criterion requires only that the guarantee permit the bank to obtain payment from the
protection provider in the event of an obligor default in a timely manner and without first
having to take legal actions to pursue the obligor for payment.
The agencies also have performed additional analysis and review of the definition
of eligible guarantee and have decided to add two additional criteria to the definition.
The first additional criterion prevents guarantees from certain affiliated companies from
being eligible guarantees. Under the final rule, a guarantee will not be an eligible
guarantee if the protection provider is an affiliate of the bank (other than an affiliated
depository institution, bank, securities broker or dealer, or insurance company that does
not control the bank and that is subject to consolidated supervision and regulation
comparable to that imposed on U.S. depository institutions, securities broker-dealers, or
insurance companies). For purposes of the definition, an affiliate of a bank is defined as
a company that controls, is controlled by, or is under common control with, the bank.
Control of a company is defined as (i) ownership, control, or holding with power to vote
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25 percent or more of a class of voting securities of the company; or (ii) consolidation of
the company for financial reporting purposes.
The strong correlations among the financial conditions of affiliated parties would
typically render guarantees from affiliates of the bank of little value precisely when the
bank would need them most – when the bank itself is in financial distress. 81 For
example, a guarantee that a bank might receive from its parent shell bank holding
company would provide little credit risk mitigation to the bank as the bank approached
insolvency because the financial condition of the holding company would depend
critically on the financial health of the subsidiary bank. Moreover, the holding company
typically would experience no increase in its regulatory capital requirement for issuing
the guarantee because the guarantee would be on behalf of a consolidated subsidiary and
would be eliminated in the consolidation of the holding company’s financial statements. 82
The agencies have decided, however, that a bank should be able to recognize
CRM benefits by obtaining a guarantee from an affiliated insured depository institution,
bank, securities broker or dealer, or insurance company that does not control the bank and
that is subject to consolidated supervision and regulation comparable to that imposed on
U.S. depository institutions, securities broker-dealers, or insurance companies (as the
case may be). A depository institution for this purpose includes all subsidiaries of the
depository institution except financial subsidiaries. The final rule recognizes guarantees
from these types of affiliates because they are financial institutions subject to prudential
81
This concern of the agencies is the same concern that led the agencies to exclude from the definition of
tier 1 capital any instrument that has credit-sensitive features – such as an interest rate or dividend rate that
increases as the credit quality of the bank issuer declines or an investor put right that is triggered by a
decline in issuer credit quality. See, e.g., 12 CFR part 208, appendix A, section II.A.1.b.
82
Although the Board’s Regulation W places strict quantitative and qualitative limits on guarantees issued
by a bank on behalf of an affiliate, it does not restrict all guarantees issued by an affiliate on behalf of a
bank. See, e.g., 12 CFR 223.3(e).
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regulation by national or state supervisory authorities. The agencies expect that the
prudential regulation of the affiliate would help prevent the affiliate from exposing itself
excessively to the credit exposures of the bank. Similarly, these affiliates would be
subject to regulatory capital requirements of their own and should experience an increase
in their regulatory capital requirements for issuing the guarantee.
The second additional criterion precludes a guarantee from eligible guarantee
status if the guarantee increases the beneficiary’s cost of credit protection in response to
deterioration in the credit quality of the reference exposure. This additional criterion is
consistent with the New Accord’s treatment of guarantees and with the proposed rule’s
operational requirements for synthetic securitizations.
The proposed rule defined an eligible credit derivative as a credit derivative in the
form of a credit default swap, nth-to-default swap, or total return swap provided that:
(i) The contract meets the requirements of an eligible guarantee and has been
confirmed by the protection purchaser and the protection provider;
(ii) Any assignment of the contract has been confirmed by all relevant parties;
(iii) If the credit derivative is a credit default swap or nth-to-default swap, the
contract includes the following credit events:
(A) Failure to pay any amount due under the terms of the reference exposure
(with a grace period that is closely in line with the grace period of the reference
exposure); and
(B) Bankruptcy, insolvency, or inability of the obligor on the reference exposure
to pay its debts, or its failure or admission in writing of its inability generally to pay its
debts as they become due, and similar events;
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(iv) The terms and conditions dictating the manner in which the contract is to be
settled are incorporated into the contract;
(v) If the contract allows for cash settlement, the contract incorporates a robust
valuation process to estimate loss reliably and specifies a reasonable period for obtaining
post-credit event valuations of the reference exposure;
(vi) If the contract requires the protection purchaser to transfer an exposure to the
protection provider at settlement, the terms of the exposure provide that any required
consent to transfer may not be unreasonably withheld;
(vii) If the credit derivative is a credit default swap or nth-to-default swap, the
contract clearly identifies the parties responsible for determining whether a credit event
has occurred, specifies that this determination is not the sole responsibility of the
protection provider, and gives the protection purchaser the right to notify the protection
provider of the occurrence of a credit event; and
(viii) If the credit derivative is a total return swap and the bank records net
payments received on the swap as net income, the bank records offsetting deterioration in
the value of the hedged exposure (either through reductions in fair value or by an addition
to reserves).
Commenters generally supported the proposed rule’s definition of eligible credit
derivative, but two commenters asked for a series of changes. These commenters asked
that the final rule specifically reference contingent credit default swaps (CCDSs) in the
list of eligible forms of credit derivatives. CCDS are a relatively new type of credit
derivative, and the agencies are still considering their appropriate role within the riskbased capital rules. However, to enable the rule to adapt to future market innovations, the
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agencies have revised the definition of eligible credit derivative to add to the list of
eligible credit derivative forms “any other form of credit derivative approved by” the
bank’s primary Federal supervisor. 83
One commenter asked that the agencies amend the third criterion of the eligible
credit derivative definition, which applies to credit default swaps and nth-to-default
swaps. The commenter indicated that standard practice in the credit derivatives market is
for a credit default swap to contain provisions that exempt the protection provider from
making default payments to the protection purchaser if the reference obligor’s failure to
pay is in an amount below a de minimis threshold. The agencies do not believe that
safety and soundness would be materially impaired by conforming this criterion of the
eligible credit derivative definition to the current standard market practice. Under the
final rule, therefore, a credit derivative will satisfy the definition of an eligible credit
derivative if the protection provider’s obligation to make default payments to the
protection purchaser is triggered only if the reference obligor’s failure to pay exceeds any
applicable minimal payment threshold that is consistent with standard market practice.
Finally, a commenter asked for clarification of the meaning of the sixth criterion
of the definition of eligible credit derivative, which states that if the contract requires the
protection purchaser to transfer an exposure to the protection provider at settlement, the
terms of the exposure provide that any required consent to transfer may not be
unreasonably withheld. To address any potential ambiguity about which exposure’s
transferability must be analyzed, the agencies have amended the sixth component to read:
83
One commenter also asked the agencies to clarify that a bank should translate the phrase “beneficiary” in
the definition of eligible guarantee to “protection purchaser” when confirming that a credit derivative meets
all the requirements of the definition of eligible guarantee. The agencies have not amended the rule to
address this point, but do confirm that such translation is appropriate.
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“If the contract requires the protection purchaser to transfer an exposure to the protection
provider at settlement, the terms of at least one of the exposures that is permitted to be
transferred under the contract must provide that any required consent to transfer may not
be unreasonably withheld.”
The proposed rule also provided that a bank may recognize an eligible credit
derivative that hedges an exposure that is different from the credit derivative’s reference
exposure used for determining the derivative’s cash settlement value, deliverable
obligation, or occurrence of a credit event only if:
(i) The reference exposure ranks pari passu (that is, equal) or junior to the hedged
exposure; and
(ii) The reference exposure and the hedged exposure are exposures to the same
legal entity, and legally enforceable cross-default or cross-acceleration clauses are in
place.
One commenter acknowledged that the proposal’s pari passu ceiling is consistent
with the New Accord but asked for clarification that the provision only requires reference
exposure equality or subordination with respect to priority of payments. Although the
agencies have concluded that it is not necessary to amend the rule to provide this
clarification, the agencies agree that the pari passu ceiling relates to priority of payments
only.
Two commenters also asked the agencies to provide an exception to the crossdefault/cross-acceleration requirement where the hedged exposure is an OTC derivative
contract or a qualifying master netting agreement that covers OTC derivative contracts.
Although some parts of the debt markets have incorporated obligations from OTC
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derivative contracts in cross-default/cross-acceleration clauses, the commenter asserted
that the practice is not prevalent in many parts of the market. In addition, the commenter
maintained that, unlike a failure to pay on a loan or a bond, failure to pay on an OTC
derivative contract generally would not trigger a credit event with respect to the reference
exposure of the credit default swap. The agencies have not made this change. The
proposed cross-default/cross-acceleration requirement is consistent with the New Accord.
In addition, the agencies are reluctant to permit a bank to obtain CRM benefits for an
exposure hedged by a credit derivative whose reference exposure is different than the
hedged exposure unless the hedged and reference exposures would default
simultaneously. If the hedged exposure could default prior to the default of the reference
exposure, the bank may suffer losses on the hedged exposure and not be able to collect
default payments on the credit derivative. The final rule clarifies that, in order to
recognize the credit risk mitigation benefits of an eligible credit derivative, crossdefault/cross-acceleration provisions must assure payments under the credit derivative are
triggered if the obligor fails to pay under the terms of the hedged exposure.
PD substitution approach
Under the PD substitution approach of the final rule, as under the proposal, if the
protection amount (as defined below) of the eligible guarantee or eligible credit
derivative is greater than or equal to the EAD of the hedged exposure, a bank may
substitute for the PD of the hedged exposure the PD associated with the rating grade of
the protection provider. If the bank determines that full substitution leads to an
inappropriate degree of risk mitigation, the bank may substitute a higher PD for that of
the protection provider.
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If the guarantee or credit derivative provides the bank with the option to receive
immediate payout on triggering the protection, then the bank must use the lower of the
LGD of the hedged exposure (not adjusted to reflect the guarantee or credit derivative)
and the LGD of the guarantee or credit derivative. If the guarantee or credit derivative
does not provide the bank with the option to receive immediate payout on triggering the
protection (and instead provides for the guarantor to assume the payment obligations of
the obligor over the remaining life of the hedged exposure), the bank must use the LGD
of the guarantee or credit derivative.
If the protection amount of the eligible guarantee or eligible credit derivative is
less than the EAD of the hedged exposure, however, the bank must treat the hedged
exposure as two separate exposures (protected and unprotected) to recognize the credit
risk mitigation benefit of the guarantee or credit derivative. The bank must calculate its
risk-based capital requirement for the protected exposure under section 31 of the rule
(using a PD equal to the protection provider’s PD, an LGD determined as described
above, and an EAD equal to the protection amount of the guarantee or credit derivative).
If the bank determines that full substitution leads to an inappropriate degree of risk
mitigation, the bank may use a higher PD than that of the protection provider. The bank
must calculate its risk-based capital requirement for the unprotected exposure under
section 31 of the rule (using a PD equal to the obligor’s PD, an LGD equal to the hedged
exposure’s LGD not adjusted to reflect the guarantee or credit derivative, and an EAD
equal to the EAD of the original hedged exposure minus the protection amount of the
guarantee or credit derivative).
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The protection amount of an eligible guarantee or eligible credit derivative is
defined as the effective notional amount of the guarantee or credit derivative reduced by
any applicable haircuts for maturity mismatch, lack of restructuring, and currency
mismatch (each described below). The effective notional amount of a guarantee or credit
derivative is the lesser of the contractual notional amount of the credit risk mitigant and
the EAD of the hedged exposure, multiplied by the percentage coverage of the credit risk
mitigant. For example, the effective notional amount of a guarantee that covers, on a pro
rata basis, 40 percent of any losses on a $100 bond would be $40.
The agencies received no material comments on the above-described structure of
the PD substitution approach, and the final rule’s PD substitution approach is
substantially the same as that of the proposed rule.
LGD adjustment approach
Under the LGD adjustment approach of the final rule, as under the proposal, if the
protection amount of the eligible guarantee or eligible credit derivative is greater than or
equal to the EAD of the hedged exposure, the bank’s risk-based capital requirement for
the hedged exposure is the greater of (i) the risk-based capital requirement for the
exposure as calculated under section 31 of the rule (with the LGD of the exposure
adjusted to reflect the guarantee or credit derivative); or (ii) the risk-based capital
requirement for a direct exposure to the protection provider as calculated under
section 31 of the rule (using the bank’s PD for the protection provider, the bank’s LGD
for the guarantee or credit derivative, and an EAD equal to the EAD of the hedged
exposure).
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If the protection amount of the eligible guarantee or eligible credit derivative is
less than the EAD of the hedged exposure, however, the bank must treat the hedged
exposure as two separate exposures (protected and unprotected) in order to recognize the
credit risk mitigation benefit of the guarantee or credit derivative. The bank’s risk-based
capital requirement for the protected exposure would be the greater of (i) the risk-based
capital requirement for the protected exposure as calculated under section 31 of the rule
(with the LGD of the exposure adjusted to reflect the guarantee or credit derivative and
EAD set equal to the protection amount of the guarantee or credit derivative); or (ii) the
risk-based capital requirement for a direct exposure to the protection provider as
calculated under section 31 of the rule (using the bank’s PD for the protection provider,
the bank’s LGD for the guarantee or credit derivative, and an EAD set equal to the
protection amount of the guarantee or credit derivative). The bank must calculate its riskbased capital requirement for the unprotected exposure under section 31 of the rule using
a PD set equal to the obligor’s PD, an LGD set equal to the hedged exposure’s LGD (not
adjusted to reflect the guarantee or credit derivative), and an EAD set equal to the EAD
of the original hedged exposure minus the protection amount of the guarantee or credit
derivative.
The agencies received no material comments on the above-described structure of
the LGD adjustment approach, and the final rule’s LGD adjustment approach is
substantially the same as that of the proposed rule.
The PD substitution approach allows a bank to effectively assess risk-based
capital against a hedged exposure as if it were a direct exposure to the protection
provider, and the LGD adjustment approach produces a risk-based capital requirement for
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a hedged exposure that is never lower than that of a direct exposure to the protection
provider. Accordingly, these approaches do not fully reflect the risk mitigation benefits
certain types of guarantees and credit derivatives may provide because the resulting riskbased capital requirement does not consider the joint probability of default of the obligor
of the hedged exposure and the protection provider, sometimes referred to as the “double
default” benefit. The agencies have decided, consistent with the New Accord and the
proposed rule, to recognize double default benefits in the wholesale framework only for
certain hedged exposures covered by certain guarantees and credit derivatives. A later
section of the preamble describes which hedged exposures are eligible for the double
default treatment and describes the double default treatment that is available to those
exposures.
Maturity mismatch haircut
Under the final rule, a bank that seeks to reduce the risk-based capital requirement
on a wholesale exposure by recognizing an eligible guarantee or eligible credit derivative
must adjust the effective notional amount of the credit risk mitigant downward to reflect
any maturity mismatch between the hedged exposure and the credit risk mitigant. A
maturity mismatch occurs when the residual maturity of a credit risk mitigant is less than
that of the hedged exposure(s).
The proposed rule provided, consistent with the New Accord, that when the
hedged exposures have different residual maturities, the longest residual maturity of any
of the hedged exposures would be used as the residual maturity of all hedged exposures.
One commenter criticized this provision as excessively conservative. The agencies agree
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and have decided to restrict the application of this provision to securitization CRM. 84
Accordingly, under the final rule, to calculate the risk-based capital requirement for a
group of hedged wholesale exposures that are covered by a single eligible guarantee
under which the protection provider has agreed to backstop all contractual payments
associated with each hedged exposure, a bank should treat each hedged exposure as if it
were fully covered by a separate eligible guarantee. To determine whether any of the
hedged wholesale exposures has a maturity mismatch with the eligible guarantee, the
bank must assess whether the residual maturity of the eligible guarantee is less than that
of the hedged exposure.
The residual maturity of a hedged exposure is the longest possible remaining time
before the obligor is scheduled to fulfil its obligation on the exposure. When determining
the residual maturity of the guarantee or credit derivative, embedded options that may
reduce the term of the credit risk mitigant must be taken into account so that the shortest
possible residual maturity for the credit risk mitigant is used to determine the potential
maturity mismatch. Where a call is at the discretion of the protection provider, the
residual maturity of the guarantee or credit derivative is the first call date. If the call is at
the discretion of the bank purchasing the protection, but the terms of the arrangement at
inception of the guarantee or credit derivative contain a positive incentive for the bank to
call the transaction before contractual maturity, the remaining time to the first call date is
the residual maturity of the credit risk mitigant. For example, where there is a step-up in
the cost of credit protection in conjunction with a call feature or where the effective cost
84
Under the final rule, if an eligible guarantee provides tranched credit protection to a group of hedged
exposures – for example, the guarantee covers the first 2 percent of aggregate losses for the group – the
bank must determine the risk-based capital requirements for the hedged exposures under the securitization
framework.
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of protection increases over time even if credit quality remains the same or improves, the
residual maturity of the credit risk mitigant is the remaining time to the first call.
Eligible guarantees and eligible credit derivatives with maturity mismatches may
only be recognized if their original maturities are equal to or greater than one year. As a
result, a guarantee or credit derivative is not recognized for a hedged exposure with an
original maturity of less than one year unless the credit risk mitigant has an original
maturity of equal to or greater than one year or an effective residual maturity equal to or
greater than that of the hedged exposure. In all cases, credit risk mitigants with maturity
mismatches may not be recognized when they have an effective residual maturity of three
months or less.
When a maturity mismatch exists, a bank must apply the following maturity
mismatch adjustment to determine the effective notional amount of the guarantee or
credit derivative adjusted for maturity mismatch: Pm = E x (t-0.25)/(T-0.25), where:
(i) Pm = effective notional amount of the credit risk mitigant adjusted for maturity
mismatch;
(ii) E = effective notional amount of the credit risk mitigant;
(iii) t = lesser of T or effective residual maturity of the credit risk mitigant,
expressed in years; and
(iv) T = lesser of 5 or effective residual maturity of the hedged exposure,
expressed in years.
Other than as discussed above with respect to pools of hedged exposures with
different residual maturities, the final rule’s provisions on maturity mismatch do not
differ from those of the proposed rule.
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Restructuring haircut
Under the final rule, as under the proposed rule, a bank that seeks to recognize an
eligible credit derivative that does not include a distressed restructuring as a credit event
that triggers payment under the derivative must reduce the recognition of the credit
derivative by 40 percent. A distressed restructuring is a restructuring of the hedged
exposure involving forgiveness or postponement of principal, interest, or fees that results
in a charge-off, specific provision, or other similar debit to the profit and loss account.
In other words, the effective notional amount of the credit derivative adjusted for
lack of restructuring credit event (and maturity mismatch, if applicable) is: Pr = Pm x
0.60, where:
(i) Pr = effective notional amount of the credit risk mitigant, adjusted for lack of
restructuring credit event (and maturity mismatch, if applicable); and
(ii) Pm = effective notional amount of the credit risk mitigant adjusted for
maturity mismatch (if applicable).
Two commenters opposed the 40 percent restructuring haircut. One commenter
contended that the 40 percent haircut is too punitive. The other commenter contended
that the 40 percent haircut should not apply when the hedged exposure is an OTC
derivative contract or a qualifying master netting agreement that covers OTC derivative
contracts. The 40 percent haircut is a rough estimate of the reduced CRM benefits that
accrue to a bank that purchases a credit derivative without restructuring coverage.
Nonetheless, the agencies recognize that restructuring events could result in substantial
economic losses to a bank. Moreover, the 40 percent haircut is consistent with the New
Accord and is a reasonably prudent mechanism for ensuring that banks do not receive
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excessive CRM benefits for purchasing credit protection that does not cover all material
sources of economic loss to the bank on the hedged exposure.
The final rule’s provisions on lack of restructuring as a credit event do not differ
from those of the proposed rule.
Currency mismatch haircut
Under the final rule, as under the proposed rule, where the eligible guarantee or
eligible credit derivative is denominated in a currency different from that in which any
hedged exposure is denominated, the effective notional amount of the guarantee or credit
derivative must be adjusted for currency mismatch (and maturity mismatch and lack of
restructuring credit event, if applicable). The adjusted effective notional amount is
calculated as: Pc = Pr x (1-Hfx), where:
(i) Pc = effective notional amount of the credit risk mitigant, adjusted for currency
mismatch (and maturity mismatch and lack of restructuring credit event, if applicable);
(ii) Pr = effective notional amount of the credit risk mitigant (adjusted for
maturity mismatch and lack of restructuring credit event, if applicable); and
(iii) Hfx = haircut appropriate for the currency mismatch between the credit risk
mitigant and the hedged exposure.
A bank may use a standard supervisory haircut of 8 percent for Hfx (based on a
ten-business-day holding period and daily marking-to-market and remargining).
Alternatively, a bank may use internally estimated haircuts for Hfx based on a tenbusiness-day holding period and daily marking-to-market and remargining if the bank
qualifies to use the own-estimates haircuts in paragraph (b)(2)(iii) of section 32, the
simple VaR methodology in paragraph (b)(3) of section 32, or the internal models
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methodology in paragraph (d) of section 32 of the rule. The bank must scale these
haircuts up using a square root of time formula if the bank revalues the guarantee or
credit derivative less frequently than once every ten business days.
The agencies received no comments on the currency mismatch provisions
discussed above, and the final rule’s provisions on currency mismatch do not differ from
those of the proposed rule.
Example
Assume that a bank holds a five-year $100 corporate exposure, purchases a $100
credit derivative to mitigate its credit risk on the exposure, and chooses to use the PD
substitution approach. The unsecured LGD of the corporate exposure is 30 percent; the
LGD of the credit derivative is 80 percent. The credit derivative is an eligible credit
derivative, has the bank’s exposure as its reference exposure, has a three-year maturity,
no restructuring provision, no currency mismatch with the bank’s hedged exposure, and
the protection provider assumes the payment obligations of the obligor upon default. The
effective notional amount and initial protection amount of the credit derivative would be
$100. The maturity mismatch would reduce the protection amount to $100 x (3-.25)/(5.25) or $57.89. The haircut for lack of restructuring would reduce the protection amount
to $57.89 x 0.6 or $34.74. So the bank would treat the $100 corporate exposure as two
exposures: (i) an exposure of $34.74 with the PD of the protection provider, an LGD of
80 percent, and an M of five; and (ii) an exposure of $65.26 with the PD of the obligor,
an LGD of 30 percent, and an M of five.
Multiple credit risk mitigants
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The New Accord provides that if multiple credit risk mitigants (for example, two
eligible guarantees) cover a single exposure, a bank must disaggregate the exposure into
portions covered by each credit risk mitigant (for example, the portion covered by each
guarantee) and must calculate separately the risk-based capital requirement of each
portion. 85 The New Accord also indicates that when credit risk mitigants provided by a
single protection provider have differing maturities, they should be subdivided into
separate layers of protection. 86 In the proposal, the agencies invited comment on whether
and how the agencies should address these and other similar situations in which multiple
credit risk mitigants cover a single exposure.
Commenters generally agreed that the agencies should provide additional
guidance about how to address situations where multiple credit risk mitigants cover a
single exposure. Although one commenter recommended that the agencies permit banks
effectively to recognize triple default benefits in situations where two credit risk
mitigants cover a single exposure, commenters did not provide material specific
suggestions as to their preferred approach to addressing these situations. Thus, the
agencies have decided to adopt the New Accord’s principles for dealing with multiple
credit risk mitigant situations. The agencies have added several additional provisions to
section 33(a) of the final rule to provide clarity in this area.
Double default treatment
As noted above, the final rule, like the proposed rule, contains a separate riskbased capital methodology for hedged exposures eligible for double default treatment.
The final rule’s double default provisions are identical to those of the proposed rule, with
85
86
New Accord, ¶206.
Id.
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the exception of some limited changes to the definition of an eligible double default
guarantor discussed below.
To be eligible for double default treatment, a hedged exposure must be fully
covered or covered on a pro rata basis (that is, there must be no tranching of credit risk)
by an uncollateralized single-reference-obligor credit derivative or guarantee (or certain
nth-to-default credit derivatives) provided by an eligible double default guarantor (as
defined below). Moreover, the hedged exposure must be a wholesale exposure other than
a sovereign exposure. 87 In addition, the obligor of the hedged exposure must not be an
eligible double default guarantor, an affiliate of an eligible double default guarantor, or
an affiliate of the guarantor.
The proposed rule defined eligible double default guarantor to include a
depository institution (as defined in section 3 of the Federal Deposit Insurance Act
(12 U.S.C. 1813)); a bank holding company (as defined in section 2 of the Bank Holding
Company Act (12 U.S.C. 1841)); a savings and loan holding company (as defined in
12 U.S.C. 1467a) provided all or substantially all of the holding company’s activities are
permissible for a financial holding company under 12 U.S.C. 1843(k)); a securities
broker or dealer registered (under the Securities Exchange Act of 1934) with the
Securities and Exchange Commission (SEC); an insurance company in the business of
providing credit protection (such as a monoline bond insurer or re-insurer) that is subject
to supervision by a state insurance regulator; a foreign bank (as defined in section 211.2
of the Federal Reserve Board’s Regulation K (12 CFR 211.2)); a non-U.S. securities
firm; or a non-U.S. based insurance company in the business of providing credit
87
The New Accord permits certain retail small business exposures to be eligible for double default
treatment. Under the final rule, however, a bank must effectively desegment a retail small business
exposure (thus rendering it a wholesale exposure) to make it eligible for double default treatment.
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protection. The proposal required an eligible double default guarantor to (i) have a bankassigned PD that, at the time the guarantor issued the guarantee or credit derivative, was
equal to or lower than the PD associated with a long-term external rating of at least the
third highest investment-grade rating category; and (ii) have a current bank-assigned PD
that is equal to or lower than the PD associated with a long-term external rating of at least
investment grade. In addition, the proposal permitted a non-U.S. based bank, securities
firm, or insurance company to qualify as an eligible double default guarantor only if the
firm were subject to consolidated supervision and regulation comparable to that imposed
on U.S. depository institutions, securities firms, or insurance companies (as the case may
be) or had issued and outstanding an unsecured long-term debt security without credit
enhancement that had a long-term applicable external rating in one of the three highest
investment-grade rating categories.
Commenters expressed two principal criticisms of the proposed definition of an
eligible double default guarantor. First, commenters asked the agencies to conform the
definition to the New Accord by permitting a foreign financial firm to qualify so long as
it had an outstanding long-term debt security with an external rating of investment grade
or higher (for example, BBB- or higher) instead of in one of the three highest investmentgrade rating categories (for example, A- or higher). In light of the other eligibility
criteria, the agencies have concluded that it would be appropriate to conform this
provision of the definition to the New Accord.
Commenters also requested that the agencies conform the definition of eligible
double default guarantor to the New Accord by permitting a financial firm to qualify so
long as it had a bank-assigned PD, at the time the guarantor issued the guarantee or credit
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derivative or at any time thereafter, that was equal to or lower than the PD associated
with a long-term external rating of at least the third highest investment-grade rating
category. In light of the other eligibility criteria, the agencies have concluded that it
would be appropriate to conform this provision of the definition to the New Accord.
Effectively, under the final rule, the scope of an eligible double default guarantor
is limited to financial firms whose normal business includes the provision of credit
protection, as well as the management of a diversified portfolio of credit risk. This
restriction arises from the agencies’ concern to limit double default recognition to
financial institutions that have a high level of credit risk management expertise and that
provide sufficient market disclosure. The restriction is also designed to limit the risk of
excessive correlation between the creditworthiness of the guarantor and the obligor of the
hedged exposure due to their performance depending on common economic factors
beyond the systematic risk factor. As a result, hedged exposures to potential credit
protection providers or affiliates of credit protection providers are not eligible for the
double default treatment. In addition, the agencies have excluded hedged exposures to
sovereign entities from eligibility for double default treatment because of the potential
high correlation between the creditworthiness of a sovereign and that of a guarantor.
One commenter urged the agencies to delete the requirement that the obligor of a
hedged exposure that qualifies for double default treatment not be an eligible double
default guarantor or an affiliate of such an entity. This commenter represented that this
requirement significantly constrained the scope of application of double default treatment
and assumed inappropriately that there is an excessive amount of correlation among all
financial firms. The agencies acknowledge that this requirement is a crude mechanism to
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prevent excessive wrong-way risk, but the agencies have decided to retain the
requirement in light of its consistency with the New Accord and the limited ability of
banks to measure accurately correlations among obligors.
In addition to limiting the types of guarantees, credit derivatives, guarantors, and
hedged exposures eligible for double default treatment, the rule limits wrong-way risk
further by requiring a bank to implement a process to detect excessive correlation
between the creditworthiness of the obligor of the hedged exposure and the protection
provider. The bank must receive prior written approval from its primary Federal
supervisor for this process in order to recognize double default benefits for risk-based
capital purposes. To apply double default treatment to a particular hedged exposure, the
bank must determine that there is not excessive correlation between the creditworthiness
of the obligor of the hedged exposure and the protection provider. For example, the
creditworthiness of an obligor and a protection provider would be excessively correlated
if the obligor derives a high proportion of its income or revenue from transactions with
the protection provider. If excessive correlation is present, the bank may not use the
double default treatment for the hedged exposure.
The risk-based capital requirement for a hedged exposure subject to double
default treatment is calculated by multiplying a risk-based capital requirement for the
hedged exposure (as if it were unhedged) by an adjustment factor that considers the PD
of the protection provider (see section 34 of the rule). Thus, the PDs of both the obligor
of the hedged exposure and the protection provider are factored into the hedged
exposure’s risk-based capital requirement. In addition, as under the PD substitution
treatment in section 33 of the rule, the bank is allowed to set LGD equal to the lower of
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the LGD of the hedged exposure (not adjusted to reflect the guarantee or credit
derivative) or the LGD of the guarantee or credit derivative if the guarantee or credit
derivative provides the bank with the option to receive immediate payout on the
occurrence of a credit event. Otherwise, the bank must set LGD equal to the LGD of the
guarantee or credit derivative. Accordingly, in order to apply the double default
treatment, the bank must estimate a PD for the protection provider and an LGD for the
guarantee or credit derivative. Finally, a bank using the double default treatment must
make applicable adjustments to the protection amount of the guarantee or credit
derivative to reflect maturity mismatches, currency mismatches, and lack of restructuring
coverage (as under the PD substitution and LGD adjustment approaches in section 33 of
the rule).
One commenter objected that the calibration of the double default formula under
the proposed rule was too conservative because it assumed an excessive amount of
correlation between the obligor of the hedged exposure and the protection provider. The
agencies have decided to leave the calibration unaltered in light of its consistency with
the New Accord. The agencies will evaluate this decision over time and will raise this
issue with the BCBS if appropriate.
6. Guarantees and credit derivatives that cover retail exposures
Like the proposal, the final rule provides a different treatment for guarantees and
credit derivatives that cover retail exposures than for those that cover wholesale
exposures. The approach set forth above for guarantees and credit derivatives that cover
wholesale exposures is an exposure-by-exposure approach consistent with the overall
exposure-by-exposure approach the rule takes to wholesale exposures. The agencies
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believe that a different treatment for guarantees that cover retail exposures is necessary
and appropriate because of the rule’s segmentation approach to retail exposures. The
approaches to retail guarantees described in this section generally apply only to
guarantees of individual retail exposures. Guarantees of multiple retail exposures (such
as pool private mortgage insurance (PMI)) are typically tranched (that is, they cover less
than the full amount of the hedged exposures) and, therefore, are securitization exposures
under the final rule.
The rule does not specify the ways in which guarantees and credit derivatives may
be taken into account in the segmentation of retail exposures. Likewise, the rule does not
explicitly limit the extent to which a bank may take into account the credit risk mitigation
benefits of guarantees and credit derivatives in its estimation of the PD and LGD of retail
segments, except by the application of overall floors on certain PD and LGD
assignments. This approach has the principal advantage of being relatively easy for
banks to implement – the approach generally would not disrupt the existing retail
segmentation practices of banks and would not interfere with banks’ quantification of PD
and LGD for retail segments.
In the proposal, the agencies expressed some concern, however, that this approach
would provide banks with substantial discretion to incorporate double default and double
recovery effects. To address these concerns, the preamble to the proposed rule described
two possible alternative treatments for guarantees of retail exposures. The first
alternative distinguished between eligible retail guarantees and all other (non-eligible)
guarantees of retail exposures. Under this alternative, an eligible retail guarantee would
be an eligible guarantee that applies to a single retail exposure and is (i) PMI issued by a
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highly creditworthy insurance company; or (ii) issued by a sovereign entity or a political
subdivision of a sovereign entity.
Under this alternative, a bank would be able to recognize the credit risk mitigation
benefits of eligible retail guarantees that cover retail exposures in a segment by adjusting
its estimates of LGD for the segment to reflect recoveries from the guarantor. However,
the bank would have to estimate the PD of a segment without reflecting the benefit of
guarantees. Specifically, a segment’s PD would be an estimate of the stand-alone
probability of default for the retail exposures in the segment, before taking account of any
guarantees. Accordingly, for this limited set of traditional guarantees of retail exposures
by high credit quality guarantors, a bank would be allowed to recognize the benefit of the
guarantee when estimating LGD but not when estimating PD.
This alternative approach would provide a different treatment for non-eligible
retail guarantees. In short, within the retail framework, a bank would not be able to
recognize non-eligible retail guarantees when estimating PD and LGD for any segment of
retail exposures. A bank would be required to estimate PD and LGD for segments
containing retail exposures with non-eligible guarantees as if the exposures were not
guaranteed. However, a bank would be permitted to recognize non-eligible retail
guarantees provided by a wholesale guarantor by treating the hedged retail exposure as a
direct exposure to the guarantor and applying the appropriate wholesale IRB risk-based
capital formula. In other words, for retail exposures covered by non-eligible retail
guarantees, a bank would be permitted to reflect the guarantee by “desegmenting” the
retail exposures (which effectively would convert the retail exposures into wholesale
exposures) and then applying the rules set forth above for guarantees that cover
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wholesale exposures. Thus, under this approach, a bank would not be allowed to
recognize either double default or double recovery effects for non-eligible retail
guarantees.
A second alternative that the agencies described in the preamble to the proposed
rule would permit a bank to recognize the credit risk mitigation benefits of all eligible
guarantees (whether eligible retail guarantees or not) that cover retail exposures by
adjusting its estimates of LGD for the relevant segments, but would subject a bank’s riskbased capital requirement for a segment of retail exposures that are covered by one or
more non-eligible retail guarantees to a floor. Under this second alternative, the agencies
could impose a floor on risk-based capital requirements of between 2 percent and
6 percent on such a segment of retail exposures.
A substantial number of commenters supported the flexible approach in the text of
the proposed rule. A few commenters also supported the first alternative approach in the
preamble of the proposed rule. Commenters uniformly urged the agencies not to adopt
the second alternative approach. The agencies have decided to adopt the approach to
retail guarantees in the text of the proposed rule and not to adopt either alternative
approach described in the proposed rule preamble. Although the first alternative
approach addresses prudential concerns, the agencies have concluded that it is
excessively conservative and prescriptive and would not harmonize with banks’ internal
risk measurement and management practices. The agencies also have determined that the
second alternative approach is insufficiently risk sensitive and is not consistent with the
New Accord. In light of the final rule’s flexible approach to retail guarantees, the
agencies expect banks to limit their use of guarantees in the retail segmentation process
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and retail risk parameter estimation process to situations where the bank has particularly
reliable data about the CRM benefits of such guarantees.
D. Unsettled Securities, Foreign Exchange, and Commodity Transactions
Section 35 of the final rule describes the risk-based capital requirements for
unsettled and failed securities, foreign exchange, and commodities transactions. The
agencies did not receive any material comments on this aspect of the proposed rule and
are adopting it as proposed.
Under the final rule, certain transaction types are excluded from the scope of
section 35, including:
(i) Transactions accepted by a qualifying central counterparty that are subject to
daily marking-to-market and daily receipt and payment of variation margin (which do not
have a risk-based capital requirement); 88
(ii) Repo-style transactions (the risk-based capital requirements of which are
determined under sections 31 and 32 of the final rule);
(iii) One-way cash payments on OTC derivative contracts (the risk-based capital
requirements of which are determined under sections 31 and 32 of the final rule); and
(iv) Transactions with a contractual settlement period that is longer than the
normal settlement period (defined below), which transactions are treated as OTC
derivative contracts and assessed a risk-based capital requirement under sections 31 and
32 of the final rule. The final rule also provides that, in the case of a system-wide failure
of a settlement or clearing system, the bank’s primary Federal supervisor may waive risk-
88
The agencies consider a qualifying central counterparty to be the functional equivalent of an exchange,
and have long exempted exchange-traded contracts from risk-based capital requirements.
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based capital requirements for unsettled and failed transactions until the situation is
rectified.
The final rule contains separate treatments for delivery-versus-payment (DvP) and
payment-versus-payment (PvP) transactions with a normal settlement period, on the one
hand, and non-DvP/non-PvP transactions with a normal settlement period, on the other
hand. The final rule provides the following definitions of a DvP transaction, a PvP
transaction, and a normal settlement period. A DvP transaction is a securities or
commodities transaction in which the buyer is obligated to make payment only if the
seller has made delivery of the securities or commodities and the seller is obligated to
deliver the securities or commodities only if the buyer has made payment. A PvP
transaction is a foreign exchange transaction in which each counterparty is obligated to
make a final transfer of one or more currencies only if the other counterparty has made a
final transfer of one or more currencies. A transaction has a normal settlement period if
the contractual settlement period for the transaction is equal to or less than the market
standard for the instrument underlying the transaction and equal to or less than five
business days.
A bank must hold risk-based capital against a DvP or PvP transaction with a
normal settlement period if the bank’s counterparty has not made delivery or payment
within five business days after the settlement date. The bank must determine its riskweighted asset amount for such a transaction by multiplying the positive current exposure
of the transaction for the bank by the appropriate risk weight in Table E. The positive
current exposure of a transaction of a bank is the difference between the transaction value
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at the agreed settlement price and the current market price of the transaction, if the
difference results in a credit exposure of the bank to the counterparty.
Table E − Risk Weights for Unsettled DvP and PvP Transactions
Number of business days
after contractual
settlement date
From 5 to 15
From 16 to 30
From 31 to 45
46 or more
Risk weight to be
applied to positive
current exposure
100%
625%
937.5%
1,250%
A bank must hold risk-based capital against any non-DvP/non-PvP transaction
with a normal settlement period if the bank has delivered cash, securities, commodities,
or currencies to its counterparty but has not received its corresponding deliverables by the
end of the same business day. The bank must continue to hold risk-based capital against
the transaction until the bank has received its corresponding deliverables. From the
business day after the bank has made its delivery until five business days after the
counterparty delivery is due, the bank must calculate its risk-based capital requirement
for the transaction by treating the current market value of the deliverables owed to the
bank as a wholesale exposure.
For purposes of computing a bank’s risk-based capital requirement for unsettled
non-DvP/non-PvP transactions, a bank may assign an internal obligor rating to a
counterparty for which it is not otherwise required under the final rule to assign an
obligor rating on the basis of the applicable external rating of any outstanding unsecured
long-term debt security without credit enhancement issued by the counterparty. A bank
may estimate a loss severity rating or LGD for the exposure, or may use a 45 percent
LGD for the exposure provided the bank uses the 45 percent LGD for all such exposures
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(that is, for all non-DvP/non-PvP transactions subject to a risk-based capital requirement
other than deduction under section 35 of the final rule). Alternatively, a bank may use a
100 percent risk weight for all non-DvP/non-PvP transactions subject to a risk-based
capital requirement other than deduction under section 35 of the final rule.
If, in a non-DvP/non-PvP transaction with a normal settlement period, the bank
has not received its deliverables by the fifth business day after counterparty delivery was
due, the bank must deduct the current market value of the deliverables owed to the bank
50 percent from tier 1 capital and 50 percent from tier 2 capital.
The total risk-weighted asset amount for unsettled transactions equals the sum of
the risk-weighted asset amount for each DvP and PvP transaction with a normal
settlement period and the risk-weighted asset amount for each non-DvP/non-PvP
transaction with a normal settlement period.
E. Securitization Exposures
This section describes the framework for calculating risk-based capital
requirements for securitization exposures (the securitization framework). In contrast to
the framework for wholesale and retail exposures, the securitization framework does not
permit a bank to rely on its internal assessments of the risk parameters of a securitization
exposure. 89 For securitization exposures, which typically are tranched exposures to a
pool of underlying exposures, such assessments would require implicit or explicit
estimates of correlations among the losses on the underlying exposures and estimates of
the credit risk-transfering consequences of tranching. Such correlation and tranching
89
Although the IAA described below does allow a bank to use an internal-ratings-based approach to
determine its risk-based capital requirement for an exposure to an ABCP program, banks are required to
follow NRSRO rating criteria and therefore are required implicitly to use the NRSRO’s determination of
the correlation of the underlying exposures in the ABCP program.
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effects are difficult to estimate and validate in an objective manner and on a goingforward basis. Instead, the securitization framework relies principally on two sources of
information, where available, to determine risk-based capital requirements: (i) an
assessment of the securitization exposure’s credit risk made by a nationally recognized
statistical rating organization (NRSRO); or (ii) the risk-based capital requirement for the
underlying exposures as if the exposures had not been securitized (along with certain
other objective information about the securitization exposure, such as the size and
relative seniority of the exposure).
1. Hierarchy of approaches
The securitization framework contains three general approaches for determining
the risk-based capital requirement for a securitization exposure: a ratings-based approach
(RBA), an internal assessment approach (IAA), and a supervisory formula approach
(SFA). Consistent with the New Accord and the proposal, under the final rule a bank
generally must apply the following hierarchy of approaches to determine the risk-based
capital requirement for a securitization exposure.
Gains-on-sale and CEIOs.
Under the proposed rule, a bank would deduct from tier 1 capital any after-tax
gain-on-sale resulting from a securitization and would deduct from total capital any
portion of a CEIO that does not constitute a gain-on-sale, as described in section 42(a)(1)
and (c) of the proposed rule. Thus, if the after-tax gain-on-sale associated with a
securitization equaled $100 while the amount of CEIOs associated with that same
securitization equaled $120, the bank would deduct $100 from tier 1 capital and $20 from
total capital ($10 from tier 1 capital and $10 from tier 2 capital).
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Several commenters asserted that the proposed deductions of gains-on-sale and
CEIOs were excessively conservative, because such deductions are not reflected in an
originating bank’s maximum risk-based capital requirement associated with a single
securitization transaction (described below). Commenters noted that while securitization
does not increase an originating bank’s overall risk exposure to the securitized assets, in
some circumstances the proposal would result in a securitization transaction increasing an
originating bank’s risk-based capital requirement. To address this concern, some
commenters suggested deducting CEIOs from total capital only when the CEIOs
constitute a gain-on-sale. Others urged adopting the treatment of CEIOs in the general
risk-based capital rules. Under this treatment, the entire amount of CEIOs beyond a
concentration threshold is deducted from total capital and there is no separate gain-onsale deduction.
The final rule retains the proposed deduction of gains-on-sale and CEIOs. These
deductions are consistent with the New Accord, and the agencies believe they are
warranted given historical supervisory concerns with the subjectivity involved in
valuations of gains-on-sale and CEIOs. Furthermore, although the treatments of gainson-sale and CEIOs can increase an originating bank’s risk-based capital requirement
following a securitization, the agencies believe that such anomalies will be rare where a
securitization transfers significant credit risk from the originating bank to third parties.
Ratings-based approach (RBA).
If a securitization exposure is not a gain-on-sale or CEIO, a bank must apply the
RBA to a securitization exposure if the exposure qualifies for the RBA. As a general
matter, an exposure qualifies for the RBA if the exposure has an external rating from an
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NRSRO or has an inferred rating (that is, the exposure is senior to another securitization
exposure in the transaction that has an external rating from an NRSRO). 90 For example,
a bank generally must use the RBA approach to determine the risk-based capital
requirement for an asset-backed security that has an applicable external rating of AA+
from an NRSRO and for another tranche of the same securitization that is unrated but
senior in all respects to the asset-backed security that was rated. In this example, the
senior unrated tranche would be treated as if it were rated AA+.
Internal assessment approach (IAA).
If a securitization exposure does not qualify for the RBA but the exposure is to an
ABCP program – such as a credit enhancement or liquidity facility – the bank may apply
the IAA (if the bank, the exposure, and the ABCP program qualify for the IAA) or the
SFA (if the bank and the exposure qualify for the SFA) to the exposure. As a general
matter, a bank will qualify to use the IAA if the bank establishes and maintains an
internal risk rating system for exposures to ABCP programs that has been approved by
the bank’s primary Federal supervisor. Alternatively, a bank may use the SFA if the
bank is able to calculate a set of risk factors relating to the securitization, including the
risk-based capital requirement for the underlying exposures as if they were held directly
by the bank. A bank that qualifies for and chooses to use the IAA must use the IAA for
all exposures that qualify for the IAA.
A number of commenters asserted that a bank should be permitted to use the IAA
for a securitization exposure to an ABCP conduit even when the exposure has an inferred
rating, provided all other IAA eligibility criteria were met. The commenters maintained
90
A securitization exposure held by an originating bank must have two or more external ratings or inferred
ratings to qualify for the RBA.
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that the RBA would produce an excessive risk-based capital requirement for an unrated
securitization exposure, such as a liquidity facility, when the inferred rating is based on a
rated security that is very junior to the unrated exposure. Commenters suggested that
allowing a bank to use the IAA instead of the RBA in such circumstances would lead to a
risk-based capital requirement that was better aligned with the unrated exposure’s actual
risk.
Like the New Accord, the final rule does not allow a bank to use the IAA for
securitization exposures that qualify for the RBA based on an inferred rating. While in
some cases the IAA might produce a more risk-sensitive capital treatment relative to an
inferred rating under the RBA, the agencies – as well as the majority of commenters –
believe that it is important to retain as much consistency as possible with the New Accord
to provide a level international playing field for financial services providers in a
competitive line of business. The commenters’ concerns relating to inferred ratings apply
only to a small proportion of outstanding ABCP liquidity facilities. In many cases, a
bank may mitigate such concerns by having the ABCP program issue an additional,
intermediate layer of externally rated securities, which would provide a more accurate
reference for inferring a rating on the unrated liquidity facility. The agencies intend to
monitor developments in this area and, as appropriate, will coordinate any reassessment
of the hierarchy of securitization approaches with the BCBS and other supervisory and
regulatory authorities.
Supervisory formula approach (SFA).
If a securitization exposure is not a gain-on-sale or a CEIO, does not qualify for
the RBA, and is not an exposure to an ABCP program for which the bank is applying the
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IAA, the bank may apply the SFA to the exposure if the bank is able to calculate the SFA
risk parameters for the securitization. In many cases, an originating bank would use the
SFA to determine its risk-based capital requirements for retained securitization
exposures.
Deduction.
If a securitization exposure is not a gain-on-sale or a CEIO and does not qualify
for the RBA, the IAA, or the SFA, the bank must deduct the exposure from total capital.
Numerous commenters requested an alternative to deducting the securitization
exposure from capital. Some of these commenters noted that if a bank does not service
the underlying assets, the bank may not be able to produce highly accurate estimates of a
key SFA risk parameter, KIRB, which is the risk-based capital requirement as if the
underlying assets were held directly by the bank. Commenters expressed concern that,
under the proposal, a bank would be required to deduct from capital some structured
lending products that have long histories of low credit losses. Commenters maintained
that a bank should be allowed to calculate the securitization exposure’s risk-based capital
requirement using the rules for wholesale exposures or using an IAA-like approach under
which the bank’s internal risk rating for the exposure would be mapped into an NRSRO’s
rating category.
Like the proposal, the final rule contains only those securitization approaches in
the New Accord. As already noted, the agencies -- and most commenters -- believe that
it is important to minimize substantive differences between the final rule and the New
Accord to foster international consistency. Furthermore, the agencies believe that the
hierarchy of securitization approaches is sufficiently comprehensive to accommodate
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demonstrably low-risk structured lending arrangements in a risk-sensitive manner. As
described in greater detail below, for securitization exposures that are not eligible for the
RBA or the IAA, a bank has flexibility under the SFA to tailor its procedures for
estimating KIRB to the data that are available. The agencies recognize that, in light of data
shortcomings, a bank may have to use approaches to estimating KIRB that are less
sophisticated than what the bank might use for similar assets that it originates, services,
and holds directly. Supervisors generally will review the reasonableness of KIRB
estimates in the context of available data, and will expect estimates of KIRB to incorporate
appropriate conservatism to address any data shortcomings.
Total risk-weighted assets for securitization exposures equals the sum of riskweighted assets calculated under the RBA, IAA, and SFA, plus any risk-weighted asset
amounts calculated under the early amortization provisions in section 47 of the final rule.
Exceptions to the general hierarchy of approaches
Consistent with the New Accord and the proposed rule, the final rule includes a
mechanism that generally prevents a bank’s effective risk-based capital requirement from
increasing as a result of the bank securitizing its assets. Specifically, the rule limits a
bank’s effective risk-based capital requirement for all of its securitization exposures to a
single securitization to the applicable risk-based capital requirement if the underlying
exposures were held directly by the bank. Under the rule, unless one or more of the
underlying exposures does not meet the definition of a wholesale, retail, securitization, or
equity exposure, the total risk-based capital requirement for all securitization exposures
held by a single bank associated with a single securitization (including any regulatory
capital requirement that relates to an early amortization provision, but excluding any
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capital requirements that relate to the bank’s gain-on-sale or CEIOs associated with the
securitization) cannot exceed the sum of (i) the bank’s total risk-based capital
requirement for the underlying exposures as if the bank directly held the underlying
exposures; and (ii) the bank’s total ECL for the underlying exposures.
One commenter urged the agencies to delete the reference to ECL in the capital
calculation. However, the agencies believe it is appropriate to include the ECL of the
underlying exposures in this calculation because ECL is included in the New Accord’s
limit, and because the bank would have had to estimate the ECL of the exposures and
hold reserves or capital against the ECL if the bank held the underlying exposures on its
balance sheet.
This maximum risk-based capital requirement is different from the general riskbased capital rules. Under the general risk-based capital rules, banks generally are
required to hold a dollar in capital for every dollar in residual interest, regardless of the
effective risk-based capital requirement on the underlying exposures. The agencies
adopted this dollar-for-dollar capital treatment for a residual interest to recognize that in
many instances the relative size of the residual interest retained by the originating bank
reveals market information about the quality of the underlying exposures and transaction
structure that may not have been captured under the general risk-based capital rules.
Given the significantly heightened risk sensitivity of the IRB approach, the agencies
believe that the maximum risk-based capital requirement in the final rule is appropriate.
The securitization framework also includes provisions to limit the double
counting of risks in situations involving overlapping securitization exposures. While the
proposal addressed only those overlapping exposures arising in the context of exposures
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to ABCP programs and mortgage loan swaps with recourse, the final rule addresses
overlapping exposures for securitizations more generally. If a bank has multiple
securitization exposures that provide duplicative coverage of the underlying exposures of
a securitization (such as when a bank provides a program-wide credit enhancement and
multiple pool-specific liquidity facilities to an ABCP program), the bank is not required
to hold duplicative risk-based capital against the overlapping position. Instead, the bank
would apply to the overlapping position the applicable risk-based capital treatment under
the securitization framework that results in the highest capital requirement. If different
banks have overlapping exposures to a securitization, however, each bank must hold
capital against the entire maximum amount of its exposure. Although duplication of
capital requirements will not occur for individual banks, some systemic duplication may
occur where multiple banks have overlapping exposures to the same securitization.
The proposed rule also addressed the risk-based capital treatment of a
securitization of non-IRB assets. Claims to future music concert and film receivables are
examples of financial assets that are not wholesale, retail, securitization, or equity
exposures. In these cases, the SFA cannot be used because of the absence of a risksensitive measure of the credit risk of the underlying exposures. Specifically, under the
proposed rule, if a bank had a securitization exposure and any underlying exposure of the
securitization was not a wholesale, retail, securitization or equity exposure, the bank
would (i) apply the RBA if the securitization exposure qualifies for the RBA and is not
gain-on-sale or a CEIO; or (ii) otherwise, deduct the exposure from total capital.
Numerous commenters asserted that a bank should be allowed to use the IAA in
these situations since, unlike the SFA, the IAA is tied to NRSRO rating methodologies
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rather than to the risk-based capital requirement for the underlying exposures. The
agencies believe that this is a reasonable approach for exposures to ABCP conduits. The
final rule permits a bank to use the IAA for a securitization exposure for which any
underlying exposure of the securitization is not a wholesale, retail, securitization or
equity exposure, provided the securitization exposure is not gain-on-sale, not a CEIO,
and not eligible for the RBA, and all of the IAA qualification criteria are met.
As described in section V.A.3. of this preamble, a few commenters asserted that
OTC derivatives with a securitization SPE as the counterparty should be excluded from
the definition of securitization exposure. These commenters objected to the burden of
using the securitization framework to calculate a capital requirement for counterparty
credit risk for OTC derivatives with a securitization SPE. The agencies continue to
believe that the securitization framework is the most appropriate way to assess the
counterparty credit risk of such exposures, and that in many cases the relatively simple
RBA will apply to such exposures. In response to commenter concerns about burden, the
agencies have decided to add an optional simple risk weight approach for certain OTC
derivatives. Under the final rule, if a securitization exposure is an OTC derivative
contract (other than a credit derivative) that has a first priority claim on the cash flows
from the underlying exposures (notwithstanding amounts due under interest rate or
currency derivative contracts, fees due, or other similar payments), a bank may choose to
apply an effective 100 percent risk weight to the exposure rather than the general
securitization hierarchy of approaches. This treatment is subject to supervisory approval.
Like the proposed rule, the final rule contains three additional exceptions to the
general hierarchy. Each exception parallels the general risk-based capital rules. First, an
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interest-only mortgage-backed security must be assigned a risk weight that is no less than
100 percent. Although a number of commenters objected to this risk weight floor on the
grounds that it was not risk sensitive, the agencies believe that a minimum risk weight of
100 percent is prudent in light of the uncertainty implied by the substantial price volatility
of these securities. Second, a sponsoring bank that qualifies as a primary beneficiary and
must consolidate an ABCP program as a variable interest entity under GAAP generally
may exclude the consolidated ABCP program assets from risk-weighted assets. 91 In
such cases, the bank must hold risk-based capital against any securitization exposures of
the bank to the ABCP program. Third, as required by Federal statute, a special set of
rules applies to transfers of small business loans and leases with recourse by wellcapitalized depository institutions. 92
Servicer cash advances
A traditional securitization typically employs a servicing bank that – on a day-today basis – collects principal, interest, and other payments from the underlying exposures
of the securitization and forwards such payments to the securitization SPE or to investors
in the securitization. Such servicing banks often provide to the securitization a credit
facility under which the servicing bank may advance cash to ensure an uninterrupted flow
of payments to investors in the securitization (including advances made to cover
foreclosure costs or other expenses to facilitate the timely collection of the underlying
exposures). These servicer cash advance facilities are securitization exposures.
91
See Financial Accounting Standards Board, Interpretation No. 46: Consolidation of Variable Interest
Entities (January 2003).
92
See 12 U.S.C. 1835, which places a cap on the risk-based capital requirement applicable to a wellcapitalized DI that transfers small business loans with recourse. The final rule does not expressly state that
the agencies may permit adequately capitalized banks to use the small business recourse rule on a case-bycase basis because the agencies may do this under the general reservation of authority contained in
section 1 of the rule.
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Under the final rule, as under the proposed rule, a servicing bank must determine
its risk-based capital requirement for any advances under such a facility using the
hierarchy of securitization approaches described above. The treatment of the undrawn
portion of the facility depends on whether the facility is an “eligible” servicer cash
advance facility. An eligible servicer cash advance facility is a servicer cash advance
facility in which (i) the servicer is entitled to full reimbursement of advances (except that
a servicer may be obligated to make non-reimburseable advances for a particular
underlying exposure if any such advance is limited to an insignificant amount of the
outstanding principal balance of that exposure); (ii) the servicer’s right to reimbursement
is senior in right of payment to all other claims on the cash flows from the underlying
exposures of the securitization; and (iii) the servicer has no legal obligation to, and does
not, make advances to the securitization if the servicer concludes the advances are
unlikely to be repaid. Consistent with the general risk-based capital rules with respect to
residential mortgage servicer cash advances, a servicing bank is not required to hold riskbased capital against the undrawn portion of an eligible servicer cash advance facility. A
bank that provides a non-eligible servicer cash advance facility must determine its riskbased capital requirement for the undrawn portion of the facility in the same manner as
the bank would determine its risk-based capital requirement for any other undrawn
securitization exposure.
Amount of a securitization exposure
Under the proposed rule, the amount of an on-balance sheet securitization
exposure was the bank’s carrying value, if the exposure was held-to-maturity or for
trading, or the bank’s carrying value minus any unrealized gains and plus any unrealized
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losses on the exposure, if the exposure was available-for-sale. In general, the amount of
an off-balance sheet securitization exposure was the notional amount of the exposure.
For an OTC derivative contract that was not a credit derivative, the notional amount was
the EAD of the derivative contract (as calculated in section 32).
In the final rule the agencies are maintaining the substance of the proposed
provision on the amount of a securitization exposure with one exception. The final rule
provides that the amount of a securitization exposure that is a repo-style transaction,
eligible margin loan, or OTC derivative (other than a credit derivative) is the EAD of the
exposure as calculated in section 32 of the final rule. The agencies believe this change is
consistent with the way banks manage these exposures, more appropriately reflects the
collateral that directly supports these exposures, and recognizes the credit risk mitigation
benefits of netting where these exposures are part of a cross-product netting set. Because
the collateral associated with a repo-style transaction or eligible margin loan is reflected
in the determination of exposure amount under section 32 of the rule, these transactions
are not eligible for the general securitization collateral approach in section 46(b) of the
final rule. Similarly, if a bank chooses to reflect collateral associated with an OTC
derivative contract in its determination of exposure amount under section 32 of the rule, it
may not also apply the general securitization collateral approach in section 46(b) of the
final rule. Similar to the definition of EAD for on-balance sheet exposures, the agencies
are clarifying that the amount of an on-balance sheet securitization exposure is based on
whether or not the exposure is classified as an available for sale security.
Under the proposal, when a securitization exposure to an ABCP program takes
the form of a commitment, such as a liquidity facility, the notional amount could be
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reduced to the maximum potential amount that the bank currently would be required to
fund under the arrangement’s documentation (the maximum potential amount that could
be drawn given the assets currently held by the program). Within some ABCP programs,
however, certain commitments, such as liquidity facilities, may be dynamic in that the
maximum amount that can be drawn at any moment depends on the current credit quality
of the program’s underlying assets. That is, if the underlying assets were to remain fixed,
but their credit quality deteriorated, the maximum amount that could be drawn against the
liquidity facility could increase.
The final rule clarifies that in such circumstances the notional amount of an offbalance sheet securitization exposure to an ABCP program may be reduced to the
maximum potential amount that the bank could be required to fund given the program’s
current assets (calculated without regard to the current credit quality of these assets).
Thus, if $100 is the maximum amount that could be drawn given the current volume and
current credit quality of the program’s assets, but the maximum potential draw against
these same assets could increase to as much as $200 if their credit quality were to
deteriorate, then the exposure amount is $200.
Some commenters recommended capping the securitization amount for an ABCP
liquidity facility at the amount of the outstanding commercial paper covered by that
facility. The agencies believe, however, that this would be inappropriate if the liquidity
provider could be required to advance a larger amount. The agencies note that when
calculating the exposure amount of a liquidity facility, a bank may take into account any
limits on advances – including limits based on the amount of commercial paper
outstanding – that are contained in the program’s documentation.
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Implicit support
Like the proposed rule, the final rule sets forth the regulatory capital
consequences if a bank provides support to a securitization in excess of the bank’s
predetermined contractual obligation to provide credit support to the securitization. First,
consistent with the general risk-based capital rules, 93 a bank that provides such implicit
support must hold regulatory capital against all of the underlying exposures associated
with the securitization as if the exposures had not been securitized, and must deduct from
tier 1 capital any after-tax gain-on-sale resulting from the securitization. Second, the
bank must disclose publicly (i) that it has provided implicit support to the securitization,
and (ii) the regulatory capital impact to the bank of providing the implicit support. The
bank’s primary Federal supervisor also may require the bank to hold regulatory capital
against all the underlying exposures associated with some or all the bank’s other
securitizations as if the exposures had not been securitized, and to deduct from tier 1
capital any after-tax gain-on-sale resulting from such securitizations.
Operational requirements for traditional securitizations
In a traditional securitization, an originating bank typically transfers a portion of
the credit risk of exposures to third parties by selling them to a securitization SPE. Under
the final rule, consistent with the proposed rule, banks engaging in a traditional
securitization may exclude the underlying exposures from the calculation of riskweighted assets only if each of the following conditions is met: (i) the transfer is a sale
under GAAP; (ii) the originating bank transfers to third parties credit risk associated with
the underlying exposures; and (iii) any clean-up calls relating to the securitization are
eligible clean-up calls (as discussed below). Originating banks that meet these conditions
93
Interagency Guidance on Implicit Recourse in Asset Securitizations, May 23, 2002.
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must hold regulatory capital against any securitization exposures they retain in
connection with the securitization. Originating banks that fail to meet these conditions
must hold regulatory capital against the transferred exposures as if they had not been
securitized and must deduct from tier 1 capital any gain-on-sale resulting from the
transaction. The operational requirements for synthetic securitization are described in
preamble section V.E.7., below.
Consistent with the general risk-based capital rules, the above operational
requirements refer specifically to GAAP for the purpose of determining whether a
securitization transaction should be treated as an asset sale or a financing. In contrast, the
New Accord stipulates guiding principles for use in determining whether sale treatment is
warranted. One commenter requested that the agencies conform the proposed operational
requirements for traditional securitizations to those in the New Accord. The agencies
believe that the current conditions to qualify for sale treatment under GAAP are broadly
consistent with the guiding principles enumerated in the New Accord. However, if
GAAP in this area were to change materially in the future, the agencies would reassess,
and possibly revise, the operational standards.
Clean-up calls
To satisfy the operational requirements for securitizations and enable an
originating bank to exclude the underlying exposures from the calculation of its riskbased capital requirements, any clean-up call associated with a securitization must be an
eligible clean-up call. The proposal defined a clean-up call as a contractual provision that
permits a servicer to call securitization exposures (for example, asset-backed securities)
before the stated (or contractual) maturity or call date. The preamble to the proposed rule
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explained that, in the case of a traditional securitization, a clean-up call is generally
accomplished by repurchasing the remaining securitization exposures once the amount of
underlying exposures or outstanding securitization exposures falls below a specified
level. In the case of a synthetic securitization, the clean-up call may take the form of a
clause that extinguishes the credit protection once the amount of underlying exposures
has fallen below a specified level.
Under the proposed rule, an eligible clean-up call would be a clean-up call that:
(i) Is exercisable solely at the discretion of the servicer;
(ii) Is not structured to avoid allocating losses to securitization exposures held by
investors or otherwise structured to provide credit enhancement to the securitization (for
example, to purchase non-performing underlying exposures); and
(iii) (A) For a traditional securitization, is only exercisable when 10 percent or
less of the principal amount of the underlying exposures or securitization exposures
(determined as of the inception of the securitization) is outstanding.
(B) For a synthetic securitization, is only exercisable when 10 percent or less of
the principal amount of the reference portfolio of underlying exposures (determined as of
the inception of the securitization) is outstanding.
A number of comments addressed the proposed definitions of clean-up call and
eligible clean-up call. One commenter observed that prudential concerns would also be
satisfied if the call were at the discretion of the originator of the underlying exposures.
The agencies concur with this view and have modified the final rule to state that a cleanup call may permit the servicer or originating bank to call the securitization exposures
before the stated maturity or call date, and that an eligible clean-up call must be
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exercisable solely at the discretion of the servicer or the originating bank. Commenters
also requested clarification whether, for a securitization that involves a master trust, the
10 percent requirement described above in criteria (iii)(A) and (iii)(B) would be
interpreted as applying to each series or tranche of securities issued from the master trust.
The agencies believe this is a reasonable interpretation. Thus, where a securitization SPE
is structured as a master trust, a clean-up call with respect to a particular series or tranche
issued by the master trust would meet criteria (iii)(A) and (iii)(B) so long as the
outstanding principal amount in that series was 10 percent or less of its original amount at
the inception of the series.
Additional supervisory guidance
Over the last several years, the agencies have published a significant amount of
supervisory guidance to assist banks with assessing the extent to which they have
transferred credit risk and, consequently, may recognize any reduction in required
regulatory capital as a result of a securitization or other form of credit risk transfer.94 In
general, the agencies expect banks to continue to use this guidance, most of which
remains applicable to the advanced approaches securitization framework. Banks are
encouraged to consult with their primary Federal supervisor about transactions that
require additional guidance.
2. Ratings-based approach (RBA)
Under the final rule, as under the proposal, a bank must determine the riskweighted asset amount for a securitization exposure that is eligible for the RBA by
multiplying the amount of the exposure by the appropriate risk-weight provided in the
94
See, e.g., OCC Bulletin 99-46 (Dec. 13, 1999) (OCC); FDIC Financial Institution Letter 109-99 (Dec. 13,
1999) (FDIC); SR Letter 99-37 (Dec. 13, 1999) (Board); CEO Ltr. 99-119 (Dec. 14, 1999) (OTS).
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tables in section 43 of the rule. Under the proposal, whether a securitization exposure
was eligible for the RBA would depend on whether the bank holding the securitization
exposure is an originating bank or an investing bank. An originating bank would be
eligible to use the RBA for a securitization exposure if (i) the exposure had two or more
external ratings, or (ii) the exposure had two or more inferred ratings. In contrast, an
investing bank would be eligible to use the RBA for a securitization exposure if the
exposure has one or more external or inferred ratings. A bank would be an originating
bank if it (i) directly or indirectly originated or securitized the underlying exposures
included in the securitization, or (ii) serves as an ABCP program sponsor to the
securitization.
The proposed rule defined an external rating as a credit rating assigned by a
NRSRO to an exposure, provided (i) the credit rating fully reflects the entire amount of
credit risk with regard to all payments owed to the holder of the exposure, and (ii) the
external rating is published in an accessible form and is included in the transition
matrices made publicly available by the NRSRO that summarize the historical
performance of positions it has rated. For example, if a holder is owed principal and
interest on an exposure, the credit rating must fully reflect the credit risk associated with
timely repayment of principal and interest. Under the proposed rule, an exposure’s
applicable external rating was the lowest external rating assigned to the exposure by any
NRSRO.
The proposed two-rating requirement for originating banks was the only material
difference between the treatment of originating banks and investing banks under the
proposed securitization framework. Although the two-rating requirement is not included
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in the New Accord, it is generally consistent with the treatment of originating and
investing banks in the general risk-based capital rules. The agencies sought comment on
whether this treatment was appropriate, and on possible alternative mechanisms that
could be employed to ensure the reliability of external and inferred ratings on
securitization exposures retained by originating banks.
Commenters generally objected to the two-rating requirement for originating
banks. Many asserted that since the credit risk of a given securitization exposure was the
same regardless of the holder, the risk-based capital treatments also should be the same.
Because external ratings would be publicly available, some commenters contended that
NRSROs will have strong reputational reasons to give unbiased ratings—even to nontraded securitization exposures retained by originating banks. The agencies continue to
believe that external ratings for securitization exposures retained by an originating bank,
which typically are not traded, are subject to less market discipline than ratings for
exposures sold to third parties. This disparity in market discipline warrants more
stringent conditions on use of the former for risk-based capital purposes. Accordingly,
the final rule retains the two-rating requirement for originating banks.
Consistent with the New Accord, the final rule states that an unrated securitization
exposure has an inferred rating if another securitization exposure issued by the same
issuer and secured by the same underlying exposures has an external rating and this rated
reference exposure (i) is subordinate in all respects to the unrated securitization exposure;
(ii) does not benefit from any credit enhancement that is not available to the unrated
securitization exposure; and (iii) has an effective remaining maturity that is equal to or
longer than the unrated securitization exposure. Under the RBA, securitization exposures
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with an inferred rating are treated the same as securitization exposures with an identical
external rating. This definition does not permit a bank to assign an inferred rating based
on the ratings of the underlying exposures in a securitization, even when the unrated
securitization exposure is secured by a single, externally rated security. In particular,
such a look-through approach would fail to meet the requirements that the rated reference
exposure must be issued by the same issuer, secured by the same underlying assets, and
subordinated in all respects to the unrated securitization exposure.
The agencies sought comment on whether they should consider other bases for
inferring a rating for an unrated securitization position, such as using an applicable credit
rating on outstanding long-term debt of the issuer or guarantor of the securitization
exposure. In situations where an unrated securitization exposure benefited from a
guarantee that covered all contractual payments associated with the securitization
exposure, several commenters advocated allowing an inferred rating to be assigned based
on the long-term rating of the guarantor. In addition, some commenters recommended
that if a senior, unrated securitization exposure is secured by a single externally rated
underlying security, a bank should be permitted to assign an inferred rating for the
unrated exposure using a look-through approach.
The agencies do not believe there is a compelling need at this time to supplement
the New Accord’s methods for determining an inferred rating. However, if a need
develops in the future, the agencies will seek to revise the New Accord in coordination
with the BCBS and other supervisory and regulatory authorities. In the situations cited
above, the framework already provides simplified methods for calculating a securitization
exposure’s risk-based capital requirement. For example, when a securitization exposure
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benefits from a full guarantee, such as from an externally rated monoline insurance
company, the exposure’s external rating often will reflect that guarantee. When the
guaranteed securitization exposure is not externally rated, subject to the rules for
recognition of guarantees of securitization exposures in section 46, the unrated
securitization exposure may be treated as a direct (wholesale) exposure to the guarantor.
In addition, when a securitization exposure to an ABCP program is secured by a single,
externally rated asset, a look-through approach may be possible under the IAA provided
that such a look-through is no less conservative than the applicable NRSRO rating
methodologies.
Under the proposal, if a securitization exposure had multiple external ratings or
multiple inferred ratings, a bank would be required to use the lowest rating (the rating
that would produce the highest risk-based capital requirement). Commenters objected
that this treatment was significantly more conservative than required by the New Accord,
which permits use of the second most favorable rating, and would unfairly penalize banks
in situations where the lowest rating was unsolicited or an outlier. The agencies
recognize commenters’ concerns regarding unsolicited ratings, and note that the New
Accord states banks should use solicited ratings. To maintain consistency with the
general risk-based capital rules, the final rule defines the applicable external rating of a
securitization exposure to be its lowest solicited external rating and the applicable
inferred rating of a securitization exposure to be the inferred rating based on its lowest
solicited external rating.
For securitization exposures eligible for the RBA, the risk-based capital
requirement per dollar of securitization exposure depends on four factors: (i) the
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DRAFT November 2, 2007
applicable rating of the exposure; (ii) whether the rating reflects a long-term or short-term
assessment of the exposure’s credit risk; (iii) whether the exposure is a “senior”
exposure; and (iv) a measure of the effective number (“N”) of underlying exposures. In
response to a specific question posed by the agencies, commenters generally supported
linking risk weights under the RBA to these factors.
In the proposed rule, a “senior securitization exposure” was defined as a
securitization exposure that has a first priority claim on the cash flows from the
underlying exposures, disregarding the claims of a service provider (such as a swap
counterparty or trustee, custodian, or paying agent for the securitization) to fees from the
securitization. Generally, only the most senior tranche of a securitization would be a
senior securitization exposure. For example, if multiple tranches of a securitization share
the transaction’s highest rating, only the tranche with the shortest remaining maturity
would be treated as senior, since other tranches with the same rating would not have a
first claim to cash flows throughout their lifetimes. A liquidity facility that supports an
ABCP program would be a senior securitization exposure if the liquidity facility
provider’s right to reimbursement of the drawn amounts was senior to all claims on the
cash flows from the underlying exposures except claims of a service provider to fees.
In the final rule, the agencies modified this definition to clarify two points. First,
in the context of an ABCP program, the final rule specifically states that both the most
senior commercial paper issued by the program and a liquidity facility supporting the
program may be ‘senior’ exposures if the liquidity facility provider’s right to
reimbursement of any drawn amounts is senior to all claims on the cash flow from the
underlying exposures. Second, the final rule clarifies that when determining whether a
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securitization exposure is senior, a bank is not required to consider any amounts due
under interest rate or currency derivative contracts, fees due, or other similar payments.
Consistent with the New Accord, a bank must use Table F below when a
securitization exposure qualifies for the RBA based on a long-term external rating or an
inferred rating based on a long-term external rating. A bank may apply the risk weights
in column 1 of Table F to the securitization exposure only if the N is six or more and the
securitization exposure is a senior securitization exposure. If N is six or more but the
securitization exposure is not a senior securitization exposure, the bank must apply the
risk weights in column 2 of Table F. Applying the principle of conservatism, however,
if N is six or more a bank may use the risk weights in column 2 of Table F without
determining whether the exposure is senior. A bank must apply the risk weights in
column 3 of Table F to the securitization exposure if N is less than six.
In certain situations the rule provides a simplified approach for determining N. If
the notional number of underlying exposures of a securitization is 25 or more or if all the
underlying exposures are retail exposures, a bank may assume that N is six or more
(unless the bank knows or has reason to know that N is less than six). However, if the
notional number of underlying exposures of a securitization is less than 25 and one or
more of the underlying exposures is a non-retail exposure, the bank must compute N as
described in the SFA section below.
A few commenters wanted to determine N only at the inception of a securitization
transaction, due to the burden of tracking N over time. The agencies believe that a bank
must track N over time to ensure an appropriate risk-based capital requirement. The
number of underlying exposures in a securitization typically changes over time as some
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underlying exposures are repaid or default. As the number of underlying exposures
changes, the risk profile of the associated securitization exposures changes, and a bank
must reflect this change in risk profile in its risk-based capital requirement.
Table F – Long-Term Credit Rating Risk Weights under RBA and IAA
Applicable
external or
inferred rating
(illustrative
rating example)
Highest
investment grade
(for example,
AAA)
Second highest
investment grade
(for example, AA)
Third-highest
investment grade –
positive
designation (for
example, A+)
Third-highest
investment grade
(for example, A)
Third-highest
investment grade –
negative
designation (for
example, A-)
Lowest investment
grade – positive
designation (for
example, BBB+)
Lowest investment
grade (for
example, BBB)
Lowest investment
grade – negative
designation (for
example, BBB-)
Column 1
Column 2
Column 3
Risk weights for
senior
securitization
exposures backed
by granular pools
7%
Risk weights for
non-senior
securitization
exposures backed
by granular pools
12%
Risk weights for
securitization
exposures backed
by non-granular
pools
20%
8%
15%
25%
10%
18%
35%
12%
20%
20%
35%
35%
50%
60%
75%
100%
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DRAFT November 2, 2007
One category
below investment
grade – positive
designation (for
example, BB+)
One category
below investment
grade (for
example, BB)
One category
below investment
grade – negative
designation (for
example, BB-)
More than one
category below
investment grade
250%
425%
650%
Deduction from tier 1 and tier 2 capital
A bank must apply the risk weights in Table G when the securitization exposure
qualifies for the RBA based on a short-term external rating or an inferred rating based on
a short-term external rating. A bank must apply the decision rules outlined in the
previous paragraph to determine which column of Table G applies.
Table G – Short-Term Credit Rating Risk Weights under RBA and IAA
Applicable
external or
inferred
rating
(Illustrative
rating
example)
Highest
investment
grade (for
example, A1)
Second highest
investment
grade (for
example, A2)
Column 1
Column 2
Column 3
Risk weights for
senior securitization
exposures backed by
granular pools
Risk weights for
non-senior
securitization
exposures backed by
granular pools
Risk weights for
securitization
exposures backed by
non-granular pools
7%
12%
20%
12%
20%
35%
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DRAFT November 2, 2007
Third highest
investment
grade (for
example, A3)
All other
ratings
60%
75%
75%
Deduction from tier 1 and tier 2 capital
Within Tables G and H, risk weights increase as rating grades decline. Under
column 2 of Table F, for example, the risk weights range from 12 percent for exposures
with the highest investment-grade rating to 650 percent for exposures rated one category
below investment grade with a negative designation. This pattern of risk weights is
broadly consistent with analyses employing standard credit risk models and a range of
assumptions regarding correlation effects and the types of exposures being securitized. 95
These analyses imply that, compared with a corporate bond having a given level of standalone credit risk (for example, as measured by its expected loss rate), a securitization
tranche having the same level of stand-alone credit risk – but backed by a reasonably
granular and diversified pool – will tend to exhibit more systematic risk. 96 This effect is
most pronounced for below-investment-grade tranches and is the primary reason why the
RBA risk-weights increase rapidly as ratings deteriorate over this range – much more
rapidly than for similarly rated corporate bonds.
Under the RBA, a securitization exposure that has an investment-grade rating and
has fewer than six effective underlying exposures generally receives a higher risk weight
than a similarly rated securitization exposure with six or more effective underlying
95
See Vladislav Peretyatkin and William Perraudin, “Capital for Asset-Backed Securities,” Bank of
England, February 2003.
96
See, e.g., Michael Pykhtin and Ashish Dev, “Credit Risk in Asset Securitizations: An Analytical
Model,” Risk (May 2002) S16-S20.
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DRAFT November 2, 2007
exposures. This treatment is intended to discourage a bank from engaging in regulatory
capital arbitrage by securitizing very high-quality wholesale exposures (wholesale
exposures with a low PD and LGD), obtaining external ratings on the securitization
exposures issued by the securitization, and retaining essentially all the credit risk of the
pool of underlying exposures.
A bank must deduct from regulatory capital any securitization exposure with an
external or inferred rating lower than one category below investment grade for long-term
ratings or below investment grade for short-term ratings. Although this treatment is more
conservative than suggested by credit risk modeling analyses, the agencies believe that
deducting such exposures from regulatory capital is appropriate in light of significant
modeling uncertainties for such low-rated securitization tranches. Moreover, external
ratings of these tranches are subject to less market discipline because these positions
generally are retained by the bank and are not traded.
The most senior tranches of granular securitizations with long-term investmentgrade external ratings receive a more favorable risk weight as compared to more
subordinated tranches of the same securitizations. To be considered granular, a
securitization must have an N of at least six. Consistent with the New Accord, the lowest
possible risk-weight, 7 percent, applies only to senior securitization exposures receiving
the highest external rating (for example, AAA) and backed by a granular asset pool.
The agencies sought comment on how well the risk weights in Tables G and H
capture the most important risk factors for securitization exposures of varying degrees of
seniority and granularity. A number of commenters contended that, in the interest of
competitive equity, the risk weight for senior securitization exposures having the highest
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DRAFT November 2, 2007
rating and backed by a granular asset pool should be 6 percent, the level specified in the
European Union’s Capital Requirements Directive (CRD). The agencies decided against
making this change. There is no compelling empirical evidence to support a 6 percent
risk weight for all exposures satisfying these conditions and, further, a 6 percent risk
weight is inconsistent with the New Accord. Moreover, estimates of the credit risk
associated with such positions tend to be highly sensitive to subjective modeling
assumptions and to the specific types of underlying assets and structure of the transaction,
which supports the use of the more conservative approach in the New Accord.
3. Internal assessment approach (IAA)
Under the final rule, as under the proposal, a bank is permitted to compute its
risk-based capital requirement for a securitization exposure to an ABCP program (such as
a liquidity facility or credit enhancement) using the bank’s internal assessment of the
credit quality of the securitization exposure. The ABCP program may be sponsored by
the bank itself or by a third party. To apply the IAA, the bank’s internal assessment
process and the ABCP program must meet certain qualification requirements in
section 44 of the final rule, and the securitization exposure must initially be internally
rated at least equivalent to investment grade. A bank that elects to use the IAA for any
securitization exposure to an ABCP program must use the IAA to compute risk-based
capital requirements for all securitization exposures that qualify for the IAA. Under the
IAA, a bank maps its internal credit assessment of a securitization exposure to an
equivalent external credit rating from an NRSRO. The bank must determine the riskweighted asset amount for a securitization exposure by multiplying the amount of the
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DRAFT November 2, 2007
exposure (using the methodology set forth above in the RBA section) by the appropriate
risk weight provided in Table F or G above.
Under the proposal, a bank required prior written approval from its primary
Federal supervisor before it could use the IAA. Several commenters objected to this
requirement maintaining that approval is not required under the New Accord and would
likely delay a bank being authorized to use the IAA for new ABCP programs. Instead,
commenters requested a submission and non-objection approach, under which a bank
would be allowed to use the IAA in the absence of any objection from its supervisor
based on examination findings. The final rule retains the requirement for prior written
approval before a bank can use the IAA. Like other optional approaches in the final rule
(for example, the double default treatment and the internal models methodology), it is
important that the primary Federal supervisor have an opportunity to review a bank’s
practices relative to the final rule before allowing a bank to use the optional approach. If
a bank chooses to implement the IAA at the same time that it implements the advanced
approaches, the IAA review and approval process will be part of the overall qualification
process. If a bank chooses to implement the IAA after it has qualified for the advanced
approaches, prior written approval is a necessary safeguard for ensuring appropriate
application of the IAA. Furthermore, the agencies believe this requirement can be
implemented without impeding future innovations in ABCP programs.
Similar to the proposed rule, under the final rule a bank must demonstrate that its
internal credit assessment process satisfies all the following criteria in order to receive
approval to use the IAA.
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DRAFT November 2, 2007
The bank’s internal credit assessments of securitization exposures to ABCP
programs must be based on publicly available rating criteria used by an NRSRO for
evaluating the credit risk of the underlying exposures. The requirement that an NRSRO’s
rating criteria be publicly available does not mean that these criteria must be published
formally by the NRSRO. While the agencies expect banks to rely on published rating
criteria when these criteria are available, an NRSRO often delays publication of rating
criteria for securitizations involving new asset types until the NRSRO builds sufficient
experience with such assets. Similarly, as securitization structures evolve over time,
published criteria may be revised with some lag. Especially for securitizations involving
new structures or asset types, the requirement that rating criteria be publicly available
should be interpreted broadly to encompass not only published criteria, but also criteria
that are obtained through written correspondence or other communications with an
NRSRO. In such cases, these communications should be documented and available for
review by the bank’s primary Federal supervisor. The agencies believe this flexibility is
appropriate only for unique situations when published rating criteria are not generally
applicable.
A commenter asked whether the applicable NRSRO rating criteria must cover all
contractual payments owed to the bank holding the exposure, or only contractual
principal and interest. For example, liquidity facilities typically obligate the seller to
make certain future fee and indemnity payments directly to the liquidity bank. These
ancillary obligations, however, are not an exposure to the ABCP program and would not
normally be covered by NRSRO rating criteria, which focus on the risks of the
underlying assets and the exposure’s vulnerability to those risks. The agencies agree that
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DRAFT November 2, 2007
such ancillary obligations of the seller need not be covered by the applicable NRSRO
rating criteria for an exposure to be eligible for the IAA.
To be eligible for the IAA, a bank must also demonstrate that its internal credit
assessments of securitization exposures used for regulatory capital purposes are
consistent with those used in its internal risk management process, capital adequacy
assessment process, and management information reporting systems. The bank must also
demonstrate that its internal credit assessment process has sufficient granularity to
identify gradations of risk. Each of the bank’s internal credit assessment categories must
correspond to an external credit rating of an NRSRO. In addition, the bank’s internal
credit assessment process, particularly the stress test factors for determining credit
enhancement requirements, must be at least as conservative as the most conservative of
the publicly available rating criteria of the NRSROs that have provided external credit
ratings to the commercial paper issued by the ABCP program. In light of recent events in
the securitization market, the agencies emphasize that if an NRSRO that provides an
external rating to an ABCP program’s commercial paper changes its methodology, the
bank must evaluate whether to revise its internal assessment process.
Moreover, the bank must have an effective system of controls and oversight that
ensures compliance with these operational requirements and maintains the integrity and
accuracy of the internal credit assessments. The bank must also have an internal audit
function independent from the ABCP program business line and internal credit
assessment process that assesses at least annually whether the controls over the internal
credit assessment process function as intended. The bank must review and update each
internal credit assessment whenever new material information is available, but no less
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DRAFT November 2, 2007
frequently than annually. The bank must also validate its internal credit assessment
process on an ongoing basis, but not less frequently than annually.
Under the proposed rule, in order for a bank to use the IAA on a specific exposure
to an ABCP program, the program had to satisfy the following requirements:
(i) All commercial paper issued by the ABCP program must have an external
rating.
(ii) The ABCP program must have robust credit and investment guidelines
(underwriting standards).
(iii) The ABCP program must perform a detailed credit analysis of the asset
sellers’ risk profiles.
(iv) The ABCP program’s underwriting policy must establish minimum asset
eligibility criteria that include a prohibition of the purchase of assets that are significantly
past due or defaulted, as well as limitations on concentrations to an individual obligor or
geographic area and the tenor of the assets to be purchased.
(v) The aggregate estimate of loss on an asset pool that the ABCP program is
considering purchasing must consider all sources of potential risk, such as credit and
dilution risk.
(vi) The ABCP program must incorporate structural features into each purchase of
assets to mitigate potential credit deterioration of the underlying exposures. Such
features may include wind-down triggers specific to a pool of underlying exposures.
Commenters suggested that the program-level eligibility criteria should apply
only to those elements of the ABCP program that are relevant to the securitization
exposure held by the bank in order to prevent an ABCP program’s purchase of a single
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DRAFT November 2, 2007
asset pool that does not meet the above criteria from disallowing the IAA for
securitization exposures to that program that are unrelated to the non-qualifying asset
pool. The agencies agree that this is a reasonable approach. Accordingly, the final rule
applies criteria (ii) through (vi) to the exposures underlying a securitization exposure,
rather than to the entire ABCP program. For a program-wide credit enhancement facility,
all of the separate seller-specific arrangements benefiting from that facility must meet the
above requirements for the facility to be eligible for the IAA.
Several commenters objected to the requirement that the ABCP program prohibit
purchases of significantly past-due or defaulted assets. Commenters contended that such
purchases should be allowed so long as the applicable NRSRO rating criteria permit and
deal appropriately with such assets. Like the New Accord, the final rule prohibits the
ABCP program from purchasing significantly past-due or defaulted assets in order to
ensure that the IAA is applied only to securitization exposures that are relatively low-risk
at inception. This criterion would be met if the ABCP program does not fund underlying
assets that are significantly past due or defaulted when placed into the program (that is,
the program’s advance rate against such assets is 0 percent) and the securitization
exposure is not subject to potential losses associated with these assets. The agencies
observe that the rule does not set a specific number-of-days-past due criterion. In
addition, the term ‘defaulted assets’ in criterion (iv) does not refer to the wholesale and
retail definitions of default in the final rule, but rather may be interpreted as referring to
assets that have been charged off or written down by the seller prior to being placed into
the ABCP program or to assets that would be charged off or written down under the
program’s governing contracts.
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DRAFT November 2, 2007
In addition, commenters asked the agencies to clarify that a bank may ignore one
or more of the eligibility requirements where the requirement is not relevant to a
particular exposure. For example, in the case of a liquidity facility supporting a static
pool of term loans, it may not be possible to incorporate features into the transaction that
mitigate against a potential deterioration in these assets, and there may be no use for
detailed credit analyses of the seller following the securitization if the seller has no
further involvement with the transaction. The agencies have modified the final criterion
for determining whether an exposure qualifies for the IAA, to specify that where relevant,
the ABCP program must incorporate structural features into each purchase of exposures
underlying the securitization exposure to mitigate potential credit deterioration of the
underlying exposures.
4. Supervisory formula approach (SFA)
General requirements
Under the proposed rule, a bank using the SFA would determine the riskweighted asset amount for a securitization exposure by multiplying the SFA risk-based
capital requirement for the exposure (as determined by the supervisory formula set forth
below) by 12.5. If the SFA risk weight for a securitization exposure was 1,250 percent or
greater, however, the bank would deduct the exposure from total capital rather than risk
weight the exposure. The agencies noted that deduction is consistent with the treatment
of other high-risk securitization exposures, such as CEIOs.
The SFA capital requirement for a securitization exposure depends on the
following seven inputs:
(i) The amount of the underlying exposures (UE);
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DRAFT November 2, 2007
(ii) The securitization exposure’s proportion of the tranche that contains the
securitization exposure (TP);
(iii) The sum of the risk-based capital requirement and ECL for the underlying
exposures (as determined under the final rule as if the underlying exposures were held
directly on the bank’s balance sheet) divided by the amount of the underlying exposures
(KIRB);
(iv) The tranche’s credit enhancement level (L);
(v) The tranche’s thickness (T);
(vi) The securitization’s effective number of underlying exposures (N); and
(vii) The securitization’s exposure-weighted average loss given default
(EWALGD).
A bank may only use the SFA to determine its risk-based capital requirement for a
securitization exposure if the bank can calculate each of these seven inputs on an ongoing
basis. In particular, if a bank cannot compute KIRB because the bank cannot compute the
risk-based capital requirement for all underlying exposures, the bank may not use the
SFA to compute its risk-based capital requirement for the securitization exposure. In
those cases, the bank must deduct the exposure from regulatory capital.
The SFA capital requirement for a securitization exposure is UE multiplied by TP
multiplied by the greater of (i) 0.0056 * T; or (ii) S[L+T] – S[L], where:
when Y ≤ K IRB
⎧Y
⎫
⎪
⎪
20
⋅
(
−
)
K
Y
IRB
(i) S [Y ] = ⎨
⎬
d ⋅ K IRB
K IRB
(1 − e
) when Y > K IRB ⎪
⎪ K IRB + K [Y ] − K [ K IRB ] +
20
⎩
⎭
(ii) K [Y ] = (1 − h ) ⋅ [(1 − β [Y ; a, b]) ⋅ Y + β [Y ; a + 1, b] ⋅ c ]
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DRAFT November 2, 2007
K IRB ⎞
⎛
(iii) h = ⎜1 −
⎟
EWALGD ⎠
⎝
N
(iv) a = g ⋅ c
(v) b = g ⋅ (1 − c)
(vi) c =
K IRB
1− h
g=
(vii)
(1 − c) ⋅ c
−1
f
2
(viii) f =
v + K IRB
(1 − K IRB ) ⋅ K IRB − v
− c2 +
1− h
(1 − h ) ⋅ 1000
(ix) v = K IRB ⋅
( EWALGD − K IRB ) + .25 ⋅ (1 − EWALGD)
N
(x) d = 1 − (1 − h ) ⋅ (1 − β [ K IRB ; a, b])
In these expressions, β [Y; a, b] refers to the cumulative beta distribution with
parameters a and b evaluated at Y. In the case where N = 1 and EWALGD =
100 percent, S[Y] in formula (1) must be calculated with K[Y] set equal to the product of
KIRB and Y, and d set equal to 1- KIRB. The major inputs to the SFA formula (UE, TP,
KIRB, L, T, EWALGD, and N) are defined below and in section 45 of the final rule.
The agencies are modifying the SFA treatment of certain high risk securitization
exposures in the final rule. Under the proposed treatment described above, a bank would
have to deduct from total capital any securitization exposure with a SFA risk weight
equal to 1,250 percent. Under certain circumstances, however, a slight increase in the
thickness of the tranche that contains the securitization exposure (T), holding other SFA
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DRAFT November 2, 2007
risk parameters fixed, could cause the exposure’s SFA risk-weight to fall below 1,250
percent. As a result, the bank would not deduct any part of the exposure from capital and
would, instead, reflect the entire amount of the SFA risk-based capital requirement in its
risk-weighted assets. Consistent with the New Accord, 97 the agencies have removed this
anomaly from the final rule. Under the final rule a bank must deduct from total capital
any part of a securitization exposure that incurs a 1,250 percent risk weight under the
SFA (that is, any part of a securitization exposure covering loss rates on the underlying
assets between zero and KIRB). Any part of a securitization exposure that incurs less than
a 1,250 percent risk weight must be risk weighted rather than deducted.
To illustrate, suppose that an exposure’s SFA capital requirement equaled $15,
and UE, TP, KIRB, and L equaled $1000, 1.0, 0.10, and 0.095, respectively. The bank
must deduct from total capital $5 (UE x TP x (KIRB -L)), and the exposure’s riskweighted asset amount would be $125 (($15-$5) x 12.5).
The specific securitization exposures that are subject to this deduction treatment
under the SFA may change over time in response to variations in the credit quality of the
underlying exposures. For example, if the pool’s IRB capital requirement were to
increase after the inception of a securitization, additional portions of unrated
securitization exposures may fall below KIRB and thus become subject to deduction under
the SFA. Therefore, if at the inception of a securitization a bank owns an unrated
securitization exposure well in excess of KIRB, the capital requirement on the exposure
could climb rapidly in the event of marked deterioration in the credit quality of the
underlying exposures and the bank may be required to deduct the exposure.
97
New Accord, Annex 7.
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DRAFT November 2, 2007
The SFA formula effectively imposes a 56 basis point minimum risk-based
capital requirement (8 percent of the 7 percent risk weight) per dollar of securitization
exposure. Although such a floor may impose a capital requirement that is too high for
some securitization exposures, the agencies continue to believe that some minimum
prudential capital requirement is appropriate in the securitization context. This 7 percent
risk-weight floor is also consistent with the lowest capital requirement available under the
RBA and, thus, should reduce incentives for regulatory capital arbitrage.
The SFA formula is a blend of credit risk modeling results and supervisory
judgment. The function S[Y] incorporates two distinct features. The first is a pure
model-based estimate of the pool’s aggregate systematic or non-diversifiable credit risk
that is attributable to a first loss position covering losses up to and including Y. Because
the tranche of interest covers losses over a specified range (defined in terms of L and T),
the tranche’s systematic risk can be represented as S[L+T] – S[L]. The second feature
involves a supervisory add-on primarily intended to avoid behavioral distortions
associated with what would otherwise be a discontinuity in capital requirements for
relatively thin mezzanine tranches lying just below and just above the KIRB boundary.
Without this add-on, all tranches at or below KIRB would be deducted from capital,
whereas a very thin tranche just above KIRB would incur a pure model-based percentage
capital requirement that could vary between zero and one, depending on the number of
effective underlying exposures (N). The supervisory add-on applies primarily to
positions just above KIRB, and its quantitative effect diminishes rapidly as the distance
from KIRB widens.
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DRAFT November 2, 2007
Apart from the risk-weight floor and other supervisory adjustments described
above, the supervisory formula attempts to be as consistent as possible with the
parameters and assumptions of the IRB approach that would apply to the underlying
exposures if held directly by a bank. 98 The specification of S[Y] assumes that KIRB is an
accurate measure of the total systematic credit risk of the pool of underlying exposures
and that a securitization merely redistributes this systematic risk among its various
tranches. In this way, S[Y] embodies precisely the same asset correlations as are
assumed elsewhere within the IRB approach. In addition, this specification embodies the
result that a pool’s systematic risk (KIRB) tends to be redistributed toward more senior
tranches as N declines. 99 The importance of pool granularity depends on the pool’s
average loss severity rate, EWALGD. For small values of N, the framework implies that,
as EWALGD increases, systematic risk is shifted toward senior tranches. For highly
granular pools, such as securitizations of retail exposures, EWALGD would have no
influence on the SFA capital requirement.
Inputs to the SFA formula
Consistent with the proposal, the final rule defines the seven inputs into the SFA
formula as follows:
(i) Amount of the underlying exposures (UE). This input (measured in dollars) is
the EAD of any underlying wholesale and retail exposures plus the amount of any
underlying exposures that are securitization exposures (as defined in section 42(e) of the
proposed rule) plus the adjusted carrying value of any underlying equity exposures (as
98
The conceptual basis for specification of K[x] is developed in Michael B. Gordy and David Jones,
“Random Tranches,” Risk (March 2003), 16(3), 78-83.
99
See Michael Pykhtin and Ashish Dev, “Coarse-grained CDOs,” Risk (January 2003), 16(1), 113-116.
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defined in section 51(b) of the proposed rule). UE also includes any funded spread
accounts, cash collateral accounts, and other similar funded credit enhancements.
(ii) Tranche percentage (TP). TP is the ratio of (i) the amount of the bank’s
securitization exposure to (ii) the amount of the securitization tranche that contains the
bank’s securitization exposure.
(iii) KIRB. KIRB is the ratio of (i) the risk-based capital requirement for the
underlying exposures plus the ECL of the underlying exposures (all as determined as if
the underlying exposures were directly held by the bank) to (ii) UE. The definition of
KIRB includes the ECL of the underlying exposures in the numerator because if the bank
held the underlying exposures on its balance sheet, the bank also would hold reserves
against the exposures.
The calculation of KIRB must reflect the effects of any credit risk mitigant applied
to the underlying exposures (either to an individual underlying exposure, a group of
underlying exposures, or to the entire pool of underlying exposures). In addition, all
assets related to the securitization must be treated as underlying exposures for purposes
of the SFA, including assets in a reserve account (such as a cash collateral account).
In practice, a bank’s ability to calculate KIRB will often determine whether it can
use the SFA or whether it must instead deduct an unrated securitization exposure from
total capital. As noted above, there is a need for flexibility when the estimation of KIRB
is constrained by data shortcomings, such as when the bank holding the securitization
exposure is not the servicer of the underlying assets. The final rule clarifies that the
simplified approach for eligible purchased wholesale exposures (Section 31) may be used
for calculating KIRB.
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To reduce the operational burden of estimating KIRB, several commenters urged
the agencies to develop a simple look-through approach such that when all of the assets
held by the SPE are externally rated, KIRB could be determined directly from the external
ratings of theses assets. The agencies believe that a look-through approach for estimating
KIRB would be inconsistent with the New Accord and would increase the potential for
capital arbitrage. The agencies note that several simplified methods for estimating riskweighted assets for the underlying exposures for the purposes of computing KIRB are
provided in other parts of the framework. For example, the simplified approach for
eligible purchased wholesale exposures in section 31 may be available when a bank can
estimate risk parameters for segments of underlying wholesale exposures but not for each
of the individual exposures. If the assets held by the SPE are securitization exposures
with external ratings, the RBA would be used to determine risk-weighted assets for the
underlying exposures based on these ratings. If the assets held by the SPE represent
shares in an investment company (that is, unleveraged, pro rata ownership interests in a
pool of financial assets), the bank may be eligible to determine risk-weighted assets for
the underlying exposures using the Alternative Modified Look-Through Approach of
Section 54 (d) based on investment limits specified in the program’s prospectus or similar
documentation.
(iv) Credit enhancement level (L). L is the ratio of (i) the amount of all
securitization exposures subordinated to the securitization tranche that contains the
bank’s securitization exposure to (ii) UE. Banks must determine L before considering the
effects of any tranche-specific credit enhancements (such as third-party guarantees that
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benefit only a single tranche). Any after-tax gain-on-sale or CEIOs associated with the
securitization may not be included in L.
Any reserve account funded by accumulated cash flows from the underlying
exposures that is subordinated to the tranche that contains the bank’s securitization
exposure may be included in the numerator and denominator of L to the extent cash has
accumulated in the account. Unfunded reserve accounts (reserve accounts that are to be
funded from future cash flows from the underlying exposures) may not be included in the
calculation of L.
In some cases, the purchase price of receivables will reflect a discount that
provides credit enhancement (for example, first loss protection) for all or certain tranches.
When this arises, L should be calculated inclusive of this discount if the discount
provides credit enhancement for the securitization exposure.
(v) Thickness of tranche (T). T is the ratio of (i) the size of the tranche that
contains the bank’s securitization exposure to (ii) UE.
(vi) Effective number of exposures (N). As a general matter, the effective number
of exposures is calculated as follows:
N =
(∑ EADi ) 2
i
∑ EAD
2
i
i
where EADi represents the EAD associated with the ith instrument in the pool of
underlying exposures. For purposes of computing N, multiple exposures to one obligor
must be treated as a single underlying exposure. In the case of a re-securitization (a
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securitization in which some or all of the underlying exposures are themselves
securitization exposures), a bank must treat each underlying securitization exposure as a
single exposure and must not look through to the exposures that secure the underlying
securitization exposures.
N represents the granularity of a pool of underlying exposures using an
“effective” number of exposures concept rather than a “gross” number of exposures
concept to appropriately assess the diversification of pools that have individual
underlying exposures of different sizes. An approach that simply counts the gross
number of underlying exposures in a pool treats all exposures in the pool equally. This
simplifying assumption could radically overestimate the granularity of a pool with
numerous small exposures and one very large exposure. The effective exposure approach
captures the notion that the risk profile of such an unbalanced pool is more like a pool of
several medium-sized exposures than like a pool of a large number of equally sized small
exposures.
For example, suppose Pool A contains four loans with EADs of $100 each.
Under the formula set forth above, N for Pool A would be four, precisely equal to the
actual number of exposures. Suppose Pool B also contains four loans: one loan with an
EAD of $100 and three loans with an EAD of $1. Although both pools contain four
loans, Pool B is much less diverse and granular than Pool A because Pool B is dominated
by the presence of a single $100 loan. Intuitively, therefore, N for Pool B should be
closer to one than to four. Under the formula in the rule, N for Pool B is calculated as
follows:
(100 + 1 + 1 + 1) 2
10,609
N =
=
= 1.06
2
2
2
2
10,003
100 + 1 + 1 + 1
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As noted above, when calculating N for a re-securitization, a bank must treat each
underlying securitization exposure as an exposure to a single obligor. This conservative
treatment addresses the concern that AVCs among securitization exposures can be much
greater than the AVCs among the underlying individual assets securing these
securitization exposures. Because the framework’s simple approach to re-securitizations
may result in the differential treatment of economically similar securitization exposures,
the agencies sought comment on alternative approaches for determining the N of a resecuritization. While a number of commenters urged that a bank be permitted to
calculate N for re-securitizations of asset-backed securities by looking through to the
underlying pools of assets securing these securities, none provided theoretical or
empirical evidence to support this recommendation. Absent such evidence, the final rule
remains consistent with New Accord’s measurement of N for re-securitizations.
(vii) Exposure-weighted average loss given default (EWALGD). The EWALGD
is calculated as:
∑ LGD ⋅ EAD
EWALGD =
∑ EAD
i
i
i
i
i
where LGDi represents the average LGD associated with all exposures to the ith obligor.
In the case of a re-securitization, an LGD of 100 percent must be assumed for any
underlying exposure that is a securitization exposure.
Although this treatment of EWALGD is consistent with the New Accord, several
commenters asserted that assigning an LGD of 100 percent to all securitization exposures
in the underlying pool was excessively conservative, particularly for underlying
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DRAFT November 2, 2007
exposures that are senior, highly rated asset-backed securities. The agencies
acknowledge that in many situations an LGD significantly lower than 100 percent may be
appropriate. However, determination of the appropriate LGD depends on many complex
factors, including the characteristics of the underlying assets and structural features of the
securitization, such as the securitization exposure’s thickness. Moreover, for thin
securitization exposures or certain mezzanine positions backed by low-quality assets, the
LGD may in fact be close to 100 percent. In this light, the agencies believe that any
simple alternative to the New Accord’s measurement of EWALGD would increase the
potential for capital arbitrage, and any more risk-sensitive alternative would take
considerable time to develop. Thus, the agencies have retained the proposed treatment,
consistent with the New Accord.
Under certain conditions, a bank may employ the following simplifications to the
SFA. First, for securitizations all of whose underlying exposures are retail exposures, a
bank may set h = 0 and v = 0. In addition, if the share of a securitization corresponding
to the largest underlying exposure (C1) is no more than 0.03 (or 3 percent of the
underlying exposures), then for purposes of the SFA the bank may set N equal to the
following amount:
N
=
1
⎛ C − C1 ⎞
⎟⎟ max ( 1 − m C1 , 0 )
C1 C m + ⎜⎜ m
⎝ m −1 ⎠
where Cm is the ratio of (i) the sum of the amounts of the largest ‘m’ underlying
exposures of the securitization; to (ii) UE. A bank may select the level of ‘m’ using its
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discretion. For example, if the three largest underlying exposures of a securitization
represent 15 percent of the pool of underlying exposures, C3 for the securitization is 0.15.
As an alternative simplification option, if only C1 is available, and C1 is no more than
0.03, then the bank may set N = 1/C1. Under both simplification options a bank may set
EWALGD = 0.50 unless one or more of the underlying exposures is a securitization
exposure. If one or more of the underlying exposures is a securitization exposure, a bank
using a simplification option must set EWALGD = 1.
5. Eligible market disruption liquidity facilities
Under the proposed SFA, there was no special treatment provided for ABCP
liquidity facilities that could be drawn upon only during periods of general market
disruption. In contrast, the New Accord provides a more favorable capital treatment
within the SFA for eligible market disruption liquidity facilities than for other liquidity
facilities. Under the New Accord, an eligible market disruption liquidity facility is a
liquidity facility that supports an ABCP program and that (i) is subject to an asset quality
test that precludes funding of underlying exposures that are in default; (ii) can be used to
fund only those exposures that have an investment-grade external rating at the time of
funding, if the underlying exposures that the facility must fund against are externally
rated exposures at the time that the exposures are sold to the program; and (iii) may only
be drawn in the event of a general market disruption.
The agencies sought comment on the prevalence of eligible market disruption
liquidity facilities that might be subject to the SFA and, by implication, whether the final
rule should incorporate the treatment provided in the New Accord. Commenters
responded that eligible market disruption liquidity facilities currently are not a material
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product line for U.S. banks, but urged international consistency in this area. To limit
additional complexity in the final rule, and because U.S. banks have limited exposure to
eligible market disruption liquidity facilities, the agencies are not including a separate
treatment of eligible market disruption liquidity facilities in the final rule. The agencies
believe that the final rule provide adequate flexibility to determine an appropriate capital
requirement for market disruption liquidity facilities.
6. CRM for securitization exposures
The treatment of CRM for securitization exposures differs from that applicable to
wholesale and retail exposures, and is largely unchanged from the proposal. An
originating bank that has obtained a credit risk mitigant to hedge its securitization
exposure to a synthetic or traditional securitization that satisfies the operational criteria in
section 41 of the final rule may recognize the credit risk mitigant, but only as provided in
section 46 of the final rule. An investing bank that has obtained a credit risk mitigant to
hedge a securitization exposure also may recognize the credit risk mitigant, but only as
provided in section 46. A bank that has used the RBA or IAA to calculate its risk-based
capital requirement for a securitization exposure whose external or inferred rating (or
equivalent internal rating under the IAA) reflects the benefits of a particular credit risk
mitigant provided to the associated securitization or that supports some or all of the
underlying exposures, however, may not use the securitization credit risk mitigation rules
to further reduce its risk-based capital requirement for the exposure based on that credit
risk mitigant. For example, a bank that owns a AAA-rated asset-backed security that
benefits from an insurance wrap that is part of the securitization transaction must
calculate its risk-based capital requirement for the security strictly under the RBA. No
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additional credit is given for the presence of the insurance wrap. On the other hand, if a
bank owns a BBB-rated asset-backed security and obtains a credit default swap from a
AAA-rated counterparty to protect the bank from losses on the security, the bank would
be able to apply the securitization CRM rules to recognize the risk mitigating effects of
the credit default swap and determine the risk-based capital requirement for the position.
As under the proposal, the final rule contains a treatment of CRM for
securitization exposures separate from the treatment for wholesale and retail exposures
because the wholesale and retail exposure CRM approaches rely on substitutions of, or
adjustments to, the risk parameters of the hedged exposure. Because the securitization
framework does not rely on risk parameters to determine risk-based capital requirements
for securitization exposures, a different treatment of CRM for securitization exposures is
necessary.
The securitization CRM rules, like the wholesale and retail CRM rules, address
collateral separately from guarantees and credit derivatives. A bank is not permitted to
recognize collateral other than financial collateral as a credit risk mitigant for
securitization exposures. A bank may recognize financial collateral in determining the
bank’s risk-based capital requirement for a securitization exposure that is not a repo-style
transaction, an eligible margin loan, or an OTC derivative for which the bank has
reflected collateral in its determination of exposure amount under section 32 of the rule
by using a collateral haircut approach. The bank’s risk-based capital requirement for a
collateralized securitization exposure is equal to the risk-based capital requirement for the
securitization exposure as calculated under the RBA or the SFA multiplied by the ratio of
adjusted exposure amount (SE*) to original exposure amount (SE), where:
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(i) SE* = max {0, [SE - C x (1 - Hs - Hfx)]};
(ii) SE = the amount of the securitization exposure (as calculated under
section 42(e) of the rule);
(iii) C = the current market value of the collateral;
(iv) Hs = the haircut appropriate to the collateral type; and
(v) Hfx = the haircut appropriate for any currency mismatch between the
collateral and the exposure.
Where the collateral is a basket of different asset types or a basket of assets denominated
in different currencies, the haircut on the basket is H = ∑ ai H i , where ai is the current
i
market value of the asset in the basket divided by the current market value of all assets in
the basket and Hi is the haircut applicable to that asset.
With the prior written approval of its primary Federal supervisor, a bank may
calculate haircuts using its own internal estimates of market price volatility and foreign
exchange volatility, subject to the requirements for use of own-estimates haircuts
contained in section 32 of the rule. Banks that use own-estimates haircuts for
collateralized securitization exposures must assume a minimum holding period (TM) for
securitization exposures of 65 business days.
A bank that does not qualify for and use own-estimates haircuts must use the
collateral type haircuts (Hs) in Table 3 of the final rule and must use a currency mismatch
haircut (Hfx) of 8 percent if the exposure and the collateral are denominated in different
currencies. To reflect the longer-term nature of securitization exposures as compared to
securities financing transactions, however, these standard supervisory haircuts (which are
based on a ten-business-day holding period and daily marking-to-market and
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remargining) must be adjusted to a 65-business-day holding period (the approximate
number of business days in a calendar quarter) by multiplying them by the square root of
6.5 (2.549510). A bank also must adjust the standard supervisory haircuts upward on the
basis of a holding period longer than 65 business days where and as appropriate to take
into account the illiquidity of the collateral.
A bank may only recognize an eligible guarantee or eligible credit derivative
provided by an eligible securitization guarantor in determining the bank’s risk-based
capital requirement for a securitization exposure. The definitions of eligible guarantee
and eligible credit derivative apply to both the wholesale and retail frameworks and the
securitization framework. An eligible securitization guarantor is defined to mean (i) a
sovereign entity, the Bank for International Settlements, the International Monetary Fund,
the European Central Bank, the European Commission, a Federal Home Loan Bank, the
Federal Agricultural Mortgage Corporation (Farmer Mac), a multilateral development
bank, a depository institution (as defined in section 3 of the Federal Deposit Insurance
Act (12 U.S.C. 1813)), a bank holding company (as defined in section 2 of the Bank
Holding Company Act (12 U.S.C. 1841)), a savings and loan holding company (as
defined in 12 U.S.C. 1467a) provided all or substantially all of the holding company’s
activities are permissible for a financial holding company under 12 U.S.C. 1843(k)), a
foreign bank (as defined in section 211.2 of the Federal Reserve Board’s Regulation K
(12 CFR 211.2)), or a securities firm; (ii) any other entity (other than a securitization
SPE) that has issued and outstanding an unsecured long-term debt security without credit
enhancement that has a long-term applicable external rating in one of the three highest
investment-grade rating categories; or (iii) any other entity (other than a securitization
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SPE) that has a PD assigned by the bank that is lower than or equivalent to the PD
associated with a long-term external rating in the third-highest investment-grade rating
category.
A bank must use the following procedures if the bank chooses to recognize an
eligible guarantee or eligible credit derivative provided by an eligible securitization
guarantor in determining the bank’s risk-based capital requirement for a securitization
exposure. If the protection amount of the eligible guarantee or eligible credit derivative
equals or exceeds the amount of the securitization exposure, the bank must set the riskweighted asset amount for the securitization exposure equal to the risk-weighted asset
amount for a direct exposure to the eligible securitization guarantor (as determined in the
wholesale risk weight function described in section 31 of the final rule), using the bank’s
PD for the guarantor, the bank’s LGD for the guarantee or credit derivative, and an EAD
equal to the amount of the securitization exposure (as determined in section 42(e) of the
final rule).
If the protection amount of the eligible guarantee or eligible credit derivative is
less than the amount of the securitization exposure, the bank must divide the
securitization exposure into two exposures in order to recognize the guarantee or credit
derivative. The risk-weighted asset amount for the securitization exposure is equal to the
sum of the risk-weighted asset amount for the covered portion and the risk-weighted asset
amount for the uncovered portion. The risk-weighted asset amount for the covered
portion is equal to the risk-weighted asset amount for a direct exposure to the eligible
securitization guarantor (as determined in the wholesale risk weight function described in
section 31 of the rule), using the bank’s PD for the guarantor, the bank’s LGD for the
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guarantee or credit derivative, and an EAD equal to the protection amount of the credit
risk mitigant. The risk-weighted asset amount for the uncovered portion is equal to the
product of (i) 1.0 minus the ratio of the protection amount of the eligible guarantee or
eligible credit derivative divided by the amount of the securitization exposure; and (ii) the
risk-weighted asset amount for the securitization exposure without the credit risk mitigant
(as determined in sections 42-45 of the final rule).
For any hedged securitization exposure, the bank must make applicable
adjustments to the protection amount as required by the maturity mismatch, currency
mismatch, and lack of restructuring provisions in paragraphs (d), (e), and (f) of section 33
of the final rule. The agencies have clarified in the final rule that the mismatch
provisions apply to any hedged securitization exposure and any more senior
securitization exposure that benefits from the hedge. In the context of a synthetic
securitization, when an eligible guarantee or eligible credit derivative covers multiple
hedged exposures that have different residual maturities, the bank must use the longest
residual maturity of any of the hedged exposures as the residual maturity of all the
hedged exposures. If the risk-weighted asset amount for a guaranteed securitization
exposure is greater than the risk-weighted asset amount for the securitization exposure
without the guarantee or credit derivative, a bank may elect not to recognize the
guarantee or credit derivative.
When a bank recognizes an eligible guarantee or eligible credit derivative
provided by an eligible securitization guarantor in determining the bank’s risk-based
capital requirement for a securitization exposure, the bank also must (i) calculate ECL for
the protected portion of the exposure using the same risk parameters that it uses for
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calculating the risk-weighted asset amount of the exposure (that is, the PD associated
with the guarantor’s rating grade, the LGD of the guarantee, and an EAD equal to the
protection amount of the credit risk mitigant); and (ii) add this ECL to the bank’s total
ECL.
7. Synthetic securitizations
Background
In a synthetic securitization, an originating bank uses credit derivatives or
guarantees to transfer the credit risk, in whole or in part, of one or more underlying
exposures to third-party protection providers. The credit derivative or guarantee may be
either collateralized or uncollateralized. In the typical synthetic securitization, the
underlying exposures remain on the balance sheet of the originating bank, but a portion
of the originating bank’s credit exposure is transferred to the protection provider or
covered by collateral pledged by the protection provider.
In general, the final rule’s treatment of synthetic securitizations is identical to that
of traditional securitizations and to that described in the proposal. The operational
requirements for synthetic securitizations are more detailed than those for traditional
securitizations and are intended to ensure that the originating bank has truly transferred
credit risk of the underlying exposures to one or more third-party protection providers.
Although synthetic securitizations typically employ credit derivatives, which
might suggest that such transactions would be subject to the CRM rules in section 33 of
the final rule, banks must apply the securitization framework when calculating risk-based
capital requirements for a synthetic securitization exposure. Banks may ultimately be
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redirected to the securitization CRM rules to adjust the securitization framework capital
requirement for an exposure to reflect the CRM technique used in the transaction.
Operational requirements for synthetic securitizations
For synthetic securitizations, an originating bank may recognize for risk-based
capital purposes the use of CRM to hedge, or transfer credit risk associated with,
underlying exposures only if each of the following conditions is satisfied:
(i) The credit risk mitigant is financial collateral, an eligible credit derivative from
an eligible securitization guarantor (defined above), or an eligible guarantee from an
eligible securitization guarantor.
(ii) The bank transfers credit risk associated with the underlying exposures to
third-party investors, and the terms and conditions in the credit risk mitigants employed
do not include provisions that:
(A) Allow for the termination of the credit protection due to deterioration in the
credit quality of the underlying exposures;
(B) Require the bank to alter or replace the underlying exposures to improve the
credit quality of the underlying exposures;
(C) Increase the bank’s cost of credit protection in response to deterioration in the
credit quality of the underlying exposures;
(D) Increase the yield payable to parties other than the bank in response to a
deterioration in the credit quality of the underlying exposures; or
(E) Provide for increases in a retained first loss position or credit enhancement
provided by the bank after the inception of the securitization.
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(iii) The bank obtains a well-reasoned opinion from legal counsel that confirms
the enforceability of the credit risk mitigant in all relevant jurisdictions.
(iv) Any clean-up calls relating to the securitization are eligible clean-up calls (as
discussed above).
Failure to meet the above operational requirements for a synthetic securitization
prevents the originating bank from using the securitization framework and requires the
originating bank to hold risk-based capital against the underlying exposures as if they had
not been synthetically securitized. A bank that provides credit protection to a synthetic
securitization must use the securitization framework to compute risk-based capital
requirements for its exposures to the synthetic securitization even if the originating bank
failed to meet one or more of the operational requirements for a synthetic securitization.
Consistent with the treatment of traditional securitization exposures, a bank must
use the RBA for synthetic securitization exposures that have an appropriate number of
external or inferred ratings. For an originating bank, the RBA will typically be used only
for the most senior tranche of the securitization, which often has an inferred rating. If a
bank has a synthetic securitization exposure that does not have an external or inferred
rating, the bank must apply the SFA to the exposure (if the bank and the exposure qualify
for use of the SFA) without considering any CRM obtained as part of the synthetic
securitization. Then, if the bank has obtained a credit risk mitigant on the exposure as
part of the synthetic securitization, the bank may apply the securitization CRM rules to
reduce its risk-based capital requirement for the exposure. For example, if the credit risk
mitigant is financial collateral, the bank may use the standard supervisory or ownestimates haircuts to reduce its risk-based capital requirement. If the bank is a protection
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provider to a synthetic securitization and has obtained a credit risk mitigant on its
exposure, the bank may also apply the securitization CRM rules in section 46 of the final
rule to reduce its risk-based capital requirement on the exposure. If neither the RBA nor
the SFA is available, a bank must deduct the exposure from regulatory capital.
First-loss tranches
If a bank has a first-loss position in a pool of underlying exposures in connection
with a synthetic securitization, the bank must deduct the position from regulatory capital
unless (i) the position qualifies for use of the RBA or (ii) the bank and the position
qualify for use of the SFA and KIRB is greater than L.
Mezzanine tranches
In a typical synthetic securitization, an originating bank obtains credit protection
on a mezzanine, or second-loss, tranche of a synthetic securitization by either
(i) obtaining a credit default swap or financial guarantee from a third-party financial
institution; or (ii) obtaining a credit default swap or financial guarantee from an SPE
whose obligations are secured by financial collateral.
For a bank that creates a synthetic mezzanine tranche by obtaining an eligible
credit derivative or guarantee from an eligible securitization guarantor, the bank generally
will treat the notional amount of the credit derivative or guarantee (as adjusted to reflect
any maturity mismatch, lack of restructuring coverage, or currency mismatch) as a
wholesale exposure to the protection provider and use the IRB approach for wholesale
exposures to determine the bank’s risk-based capital requirement for the exposure. A
bank that creates the synthetic mezzanine tranche by obtaining from a non-eligible
securitization guarantor a guarantee or credit derivative that is collateralized by financial
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collateral generally will (i) first use the SFA to calculate the risk-based capital
requirement on the exposure (ignoring the guarantee or credit derivative and the
associated collateral); and (ii) then use the securitization CRM rules to calculate any
reductions to the risk-based capital requirement resulting from the associated collateral.
The bank may look only to the protection provider from which it obtains the guarantee or
credit derivative when determining its risk-based capital requirement for the exposure
(that is, if the protection provider hedges the guarantee or credit derivative with a
guarantee or credit derivative from a third party, the bank may not look through the
protection provider to that third party when calculating its risk-based capital requirement
for the exposure).
For a bank providing credit protection on a mezzanine tranche of a synthetic
securitization, the bank must use the RBA to determine the risk-based capital requirement
for the exposure if the exposure has an external or inferred rating. If the exposure does
not have an external or inferred rating and the exposure qualifies for use of the SFA, the
bank may use the SFA to calculate the risk-based capital requirement for the exposure. If
neither the RBA nor the SFA are available, the bank must deduct the exposure from
regulatory capital. If a bank providing credit protection on the mezzanine tranche of a
synthetic securitization obtains a credit risk mitigant to hedge its exposure, the bank may
apply the securitization CRM rules to reflect the risk reduction achieved by the credit risk
mitigant.
Super-senior tranches
A bank that has the most senior position in a pool of underlying exposures in
connection with a synthetic securitization must use the RBA to calculate its risk-based
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capital requirement for the exposure if the exposure has at least one external or inferred
rating (in the case of an investing bank) or at least two external or inferred ratings (in the
case of an originating bank). If the super-senior tranche does not have an external or
inferred rating and the bank and the exposure qualify for use of the SFA, the bank may
use the SFA to calculate the risk-based capital requirement for the exposure. If neither
the RBA nor the SFA are available, the bank must deduct the exposure from regulatory
capital. If an investing bank in the super-senior tranche of a synthetic securitization
obtains a credit risk mitigant to hedge its exposure, however, the investing bank may
apply the securitization CRM rules to reflect the risk reduction achieved by the credit risk
mitigant.
8. Nth–to-default credit derivatives
Credit derivatives that provide credit protection only for the nth defaulting
reference exposure in a group of reference exposures (nth-to-default credit derivatives) are
similar to synthetic securitizations that provide credit protection only after the first-loss
tranche has defaulted or become a loss. A simplified treatment is available to banks that
purchase and provide such credit protection. A bank that obtains credit protection on a
group of underlying exposures through a first-to-default credit derivative must determine
its risk-based capital requirement for the underlying exposures as if the bank had
synthetically securitized only the underlying exposure with the lowest capital requirement
and had obtained no credit risk mitigant on the other (higher capital requirement)
underlying exposures. If the bank purchases credit protection on a group of underlying
exposures through an nth-to-default credit derivative (other than a first-to-default credit
derivative), it may only recognize the credit protection for risk-based capital purposes
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either if it has obtained credit protection on the same underlying exposures in the form of
first-through-(n-1)-to-default credit derivatives, or if n-1 of the underlying exposures
have already defaulted. In such a case, the bank must again determine its risk-based
capital requirement for the underlying exposures as if the bank had only synthetically
securitized the n – 1 underlying exposures with the lowest capital requirement and had
obtained no credit risk mitigant on the other underlying exposures.
A bank that provides credit protection on a group of underlying exposures through
a first-to-default credit derivative must determine its risk-weighted asset amount for the
derivative by applying the RBA (if the derivative qualifies for the RBA) or, if the
derivative does not qualify for the RBA, by setting its risk-weighted asset amount for the
derivative equal to the product of (i) the protection amount of the derivative; (ii) 12.5;
and (iii) the sum of the risk-based capital requirements of the individual underlying
exposures, up to a maximum of 100 percent. If a bank provides credit protection on a
group of underlying exposures through an nth-to-default credit derivative (other than a
first-to-default credit derivative), the bank must determine its risk-weighted asset amount
for the derivative by applying the RBA (if the derivative qualifies for the RBA) or, if the
derivative does not qualify for the RBA, by setting the risk-weighted asset amount for the
derivative equal to the product of (i) the protection amount of the derivative; (ii) 12.5;
and (iii) the sum of the risk-based capital requirements of the individual underlying
exposures (excluding the n-1 underlying exposures with the lowest risk-based capital
requirements), up to a maximum of 100 percent.
For example, a bank provides credit protection in the form of a second-to-default
credit derivative on a basket of five reference exposures. The derivative is unrated and
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the protection amount of the derivative is $100. The risk-based capital requirements of
the underlying exposures are 2.5 percent, 5.0 percent, 10.0 percent, 15.0 percent, and 20
percent. The risk-weighted asset amount of the derivative would be $100 x 12.5 x (.05 +
.10 + .15 + .20) or $625. If the derivative were externally rated in the lowest investmentgrade rating category with a positive designation, the risk-weighted asset amount would
be $100 x 0.50 or $50.
9. Early amortization provisions
Background
Many securitizations of revolving credit facilities (for example, credit card
receivables) contain provisions that require the securitization to be wound down and
investors to be repaid if the excess spread falls below a certain threshold. 100 This
decrease in excess spread may, in some cases, be caused by deterioration in the credit
quality of the underlying exposures. An early amortization event can increase a bank’s
capital needs if new draws on the revolving credit facilities need to be financed by the
bank using on-balance sheet sources of funding. The payment allocations used to
distribute principal and finance charge collections during the amortization phase of these
transactions also can expose a bank to greater risk of loss than in other securitization
transactions. The final rule, consistent with the proposed rule, assesses a risk-based
capital requirement that, in general, is linked to the likelihood of an early amortization
100
The final rule defines excess spread for a period as gross finance charge collections and other income
received by the securitization SPE (including market interchange fees) over the period minus interest paid
to holders of securitization exposures, servicing fees, charge-offs, and other senior trust similar expenses of
the securitization SPE over the period, divided by the principal balance of the underlying exposures at the
end of the period.
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event to address the risks that early amortization of a securitization poses to originating
banks.
Consistent with the proposed rule, the final rule defines an early amortization
provision as a provision in a securitization’s governing documentation that, when
triggered, causes investors in the securitization exposures to be repaid before the original
stated maturity of the securitization exposure, unless the provision is solely triggered by
events not related to the performance of the underlying exposures or the originating bank
(such as material changes in tax laws or regulations).
Under the proposed rule, a bank would not be required to hold regulatory capital
against the investors’ interest if early amortization is solely triggered by events not
related to the performance of the underlying exposures or the originating bank, such as
material changes in tax laws or regulation. Under the New Accord, a bank is also not
required to hold regulatory capital against the investors’ interest if (i) the securitization
has a replenishment structure in which the individual underlying exposures do not
revolve and the early amortization ends the ability of the originating bank to add new
underlying exposures to the securitization; (ii) the securitization involves revolving assets
and contains early amortization features that mimic term structures; or (iii) investors in
the securitization remain fully exposed to future draws by borrowers on the underlying
exposures even after the occurrence of early amortization. The agencies sought comment
on the appropriateness of these additional exemptions in the U.S. markets for revolving
securitizations. Most commenters asserted that the exemptions provided in the New
Accord are prudent and should be adopted by the agencies in order to avoid placing U.S.
banking organizations at a competitive disadvantage relative to foreign competitors. The
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agencies generally agree with this view of exemption (iii), above, and the definition of
early amortization provision in the final rule incorporates this exemption. The agencies
have not included exemption (i) or (ii). The agencies do not believe that the exemption
for non-revolving exposures is meaningful because the early amortization provisions
apply only to securitizations with revolving underlying exposures. The agencies also do
not believe that the exemption for early amortization features that mimic term structures
is meaningful in the U.S. market.
Under the final rule, as under the proposed rule, an originating bank must
generally hold risk-based capital against the sum of the originating bank’s interest and the
investors’ interest arising from a securitization that contains an early amortization
provision. An originating bank must compute its capital requirement for its interest using
the hierarchy of approaches for securitization exposures as described above. The
originating bank’s risk-weighted asset amount for the investors’ interest in the
securitization is equal to the product of the following five quantities: (i) the EAD
associated with the investors’ interest; (ii) the appropriate CF as determined below;
(iii) KIRB; (iv) 12.5; and (v) the proportion of the underlying exposures in which the
borrower is permitted to vary the drawn amount within an agreed limit under a line of
credit. The agencies added (v) to the final rule because, for securitizations containing
both revolving and non-revolving underlying exposures, only the revolving underlying
exposures give rise to the risk of early amortization.
Under the final rule, consistent with the proposal, the investors’ interest with
respect to a revolving securitization captures both the drawn balances and undrawn lines
of the underlying exposures that are allocated to the investors in the securitization. The
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EAD associated with the investors’ interest is equal to the EAD of the underlying
exposures multiplied by the ratio of:
(i) the total amount of securitization exposures issued by the securitization SPE
to investors; divided by
(ii) the outstanding principal amount of underlying exposures.
In general, the applicable CF depends on whether the early amortization provision
repays investors through a controlled or non-controlled mechanism and whether the
underlying exposures are revolving retail credit facilities that are uncommitted
(unconditionally cancelable by the bank to the fullest extent of Federal law, such as credit
card receivables) or are other revolving credit facilities (for example, revolving corporate
credit facilities). Consistent with the New Accord, under the proposed rule a controlled
early amortization provision would meet each of the following conditions:
(i) The originating bank has appropriate policies and procedures to ensure that it
has sufficient capital and liquidity available in the event of an early amortization;
(ii) Throughout the duration of the securitization (including the early amortization
period) there is the same pro rata sharing of interest, principal, expenses, losses, fees,
recoveries, and other cash flows from the underlying exposures, based on the originating
bank’s and the investors’ relative shares of the underlying exposures outstanding
measured on a consistent monthly basis;
(iii) The amortization period is sufficient for at least 90 percent of the total
underlying exposures outstanding at the beginning of the early amortization period to
have been repaid or recognized as in default; and
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(iv) The schedule for repayment of investor principal is not more rapid than
would be allowed by straight-line amortization over an 18-month period.
An early amortization provision that does not meet any of the above criteria is a
non-controlled early amortization provision.
The agencies solicited comment on the distinction between controlled and noncontrolled early amortization provisions and on the extent to which banks use controlled
early amortization provisions. The agencies also invited comment on the proposed
definition of a controlled early amortization provision, including in particular the 18month period set forth above. Commenters generally believed that very few, if any,
revolving securitizations would meet the criteria needed to qualify for treatment as a
controlled early amortization structure. One commenter maintained that a fixed 18month straight-line amortization period was too long for certain exposures, such as prime
credit cards.
The final rule is unchanged from the proposal with respect to controlled and noncontrolled early amortization provisions. The agencies believe that the proposed
eligibility criteria for a controlled early amortization are important indicators of the risks
to which an originating bank would be exposed in the event of any early amortization.
While a fixed 18-month straight-line amortization period is unlikely to be the most
appropriate period in all cases, it is a reasonable period for the vast majority of cases.
The lower operational burden of using a single, fixed amortization period warrants the
potential diminution in risk-sensitivity.
Controlled early amortization
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Under the proposed rule, to calculate the appropriate CF for a securitization of
uncommitted revolving retail exposures that contains a controlled early amortization
provision, a bank would compare the three-month average annualized excess spread for
the securitization to the point at which the bank is required to trap excess spread under
the securitization transaction. In securitizations that do not require excess spread to be
trapped, or that specify a trapping point based primarily on performance measures other
than the three-month average annualized excess spread, the excess spread trapping point
was 4.5 percent. The bank would divide the three-month average annualized excess
spread level by the excess spread trapping point and apply the appropriate CF from Table
H.
Table H − Controlled Early Amortization Provisions
Retail Credit
Lines
Non-retail Credit
Lines
Uncommitted
Three-month average annualized
excess spread
Conversion Factor (CF)
133.33% of trapping point or more
0% CF
less than 133.33% to 100% of
trapping point
1% CF
less than 100% to 75% of trapping
point
2% CF
less than 75% to 50% of trapping
point
10% CF
less than 50% to 25% of trapping
point
20% CF
less than 25% of trapping point
40% CF
Committed
90% CF
90% CF
90% CF
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A bank would apply a 90 percent CF for all other revolving underlying exposures
(committed exposures and nonretail exposures) in securitizations containing a controlled
early amortization provision. The proposed CFs for uncommitted revolving retail credit
lines were much lower than for committed retail credit lines or for non-retail credit lines
because of the demonstrated ability of banks to monitor and, when appropriate, to curtail
promptly uncommitted retail credit lines for customers of deteriorating credit quality.
Such account management tools are unavailable for committed lines, and banks may be
less proactive about using such tools in the case of uncommitted non-retail credit lines
owing to lender liability concerns and the prominence of broad-based, longer-term
customer relationships.
Non-controlled early amortization
Under the proposed rule, to calculate the appropriate CF for securitizations of
uncommitted revolving retail exposures that contain a non-controlled early amortization
provision, a bank would perform the excess spread calculations described in the
controlled early amortization section above and then apply the CFs in Table I.
Table I − Non-Controlled Early Amortization Provisions
Retail Credit Lines
Uncommitted
Three-month average annualized
excess spread
Conversion Factor (CF)
133.33% of trapping point or more
0% CF
less than 133.33% to 100% of
trapping point
5% CF
less than 100% to 75% of trapping
point
15% CF
less than 75% to 50% of trapping
point
Committed
100% CF
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50% CF
less than 50% of trapping point
100% CF
Non-retail Credit
Lines
100% CF
100% CF
A bank would use a 100 percent CF for all other revolving underlying exposures
(committed exposures and nonretail exposures) in securitizations containing a noncontrolled early amortization provision. In other words, no risk transference would be
recognized for these transactions; an originating bank’s IRB capital requirement would
be the same as if the underlying exposures had not been securitized.
A few commenters asserted that the proposed CFs were too high. The agencies
believe, however, that the proposed CFs appropriately capture the risk to the bank of a
potential early amortization event. The agencies also believe that the proposed CFs,
which are consistent with the New Accord, foster consistency across national
jurisdictions. Therefore, the agencies are maintaining the proposed CFs in the final rule
with one exception, discussed below.
In circumstances where a securitization contains a mix of retail and nonretail
exposures or a mix of committed and uncommitted exposures, a bank may take a pro rata
approach to determining the CF for the securitization’s early amortization provision. If a
pro rata approach is not feasible, a bank must treat the securitization as a securitization of
nonretail exposures if a single underlying exposure is a nonretail exposure and must treat
the securitization as a securitization of committed exposures if a single underlying
exposure is a committed exposure.
Securitizations of revolving residential mortgage exposures
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The agencies sought comment on the appropriateness of the proposed 4.5 percent
excess spread trapping point and on whether there were other types and levels of early
amortization triggers used in securitizations of revolving retail exposures that should be
addressed by the agencies. Although some commenters believed the 4.5 percent trapping
point assumption was reasonable, others believed that it was inappropriate for
securitizations of HELOCs. Unlike credit card securitizations, U.S. HELOC
securitizations typically do not generate material excess spread and typically are
structured with credit enhancements and early amortization triggers based on other
factors, such as portfolio loss rates. Under the proposed treatment, banks would be
required to hold capital against the potential early amortization of most U.S. HELOC
securitizations at their inception, rather than only if the credit quality of the underlying
exposures deteriorated. Although the New Accord does not provide an alternative
methodology, the agencies concluded that the features of the U.S. HELOC securitization
market warrant an alternative approach. Accordingly, the final rule allows a bank the
option of applying either (i) the CFs in Tables I and J, as appropriate, or ii) a fixed CF
equal to 10 percent to its securitizations for which all or substantially all of the
underlying exposures are revolving residential mortgage exposures. If a bank chooses
the fixed CF of 10 percent, it must use that CF for all securitizations for which all or
substantially all of the underlying exposures are revolving residential mortgage
exposures. The agencies will monitor the implementation of this alternative approach to
ensure that it is consistent with safety and soundness.
F. Equity exposures
1. Introduction and exposure measurement
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This section describes the final rule’s risk-based capital treatment for equity
exposures. Consistent with the proposal, under the final rule, a bank has the option to use
either a simple risk-weight approach (SRWA) or an internal models approach (IMA) for
equity exposures that are not exposures to an investment fund. A bank must use a lookthrough approach for equity exposures to an investment fund.
Although the New Accord provides national supervisors the option to provide a
grandfathering period for equity exposures – whereby for a maximum of ten years,
supervisors could permit banks to exempt from the IRB treatment equity investments
held at the time of the publication of the New Accord – the proposed rule did not include
such a grandfathering provision. A number of commenters asserted that the proposal was
inconsistent with the New Accord and would subject banks using the agencies’ advanced
approaches to significant competitive inequity.
The agencies continue to believe that it is not appropriate or necessary to
incorporate the New Accord’s optional ten-year grandfathering period for equity
exposures. The grandfathering concept would reduce the risk sensitivity of the SRWA
and IMA. Moreover, the IRB approach does not provide grandfathering for other types
of exposures, and the agencies see no compelling reason to do so for equity exposures.
Further, the agencies believe that the overall final rule approach to equity exposures
sufficiently mitigates potential competitive issues. Accordingly, the final rule does not
provide a grandfathering period for equity exposures.
Under the proposed SRWA, a bank generally would assign a 300 percent risk
weight to publicly traded equity exposures and a 400 percent risk weight to non-publicly
traded equity exposures. Certain equity exposures to sovereigns, multilateral institutions,
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and public sector enterprises would have a risk weight of 0 percent, 20 percent, or 100
percent; and certain community development equity exposures, hedged equity exposures,
and, up to certain limits, non-significant equity exposures would receive a 100 percent
risk weight.
Alternatively, under the proposed rule, a bank that met certain minimum
quantitative and qualitative requirements on an ongoing basis and obtained the prior
written approval of its primary Federal supervisor could use the IMA to determine its
risk-based capital requirement for all modeled equity exposures. A bank that qualified to
use the IMA could apply the IMA to its publicly traded and non-publicly traded equity
exposures, or could apply the IMA only to its publicly traded equity exposures.
However, if the bank applied the IMA to its publicly traded equity exposures, it would be
required to apply the IMA to all such exposures. Similarly, if a bank applied the IMA to
both publicly traded and non-publicly traded equity exposures, it would be required to
apply the IMA to all such exposures. If a bank did not qualify to use the IMA, or elected
not to use the IMA, to compute its risk-based capital requirements for equity exposures,
the bank would apply the SRWA to assign risk weights to its equity exposures.
Several commenters objected to the proposed restrictions on the use of the IMA.
Commenters asserted that banks should be able to apply the SRWA and the IMA for
different portfolios or subsets of equity exposures, provided that banks’ choices are
consistent with internal risk management practices.
The agencies have not relaxed the proposed restrictions regarding use of the
SRWA and IMA. The agencies remain concerned that if banks are permitted to employ
either the SRWA or IMA to different equity portfolios, banks could choose one approach
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over the other to manipulate their risk-based capital requirements and not for risk
management purposes. In addition, because of concerns about lack of transparency, it is
not prudent to allow a bank to apply the IMA only to its non-publicly traded equity
exposures and not its publicly traded equity exposures.
The proposed rule defined publicly traded to mean traded on (i) any exchange
registered with the SEC as a national securities exchange under section 6 of the Securities
Exchange Act of 1934 (15 U.S.C. 78f) or (ii) any non-U.S.-based securities exchange that
is registered with, or approved by, a national securities regulatory authority and that
provides a liquid, two-way market for the exposure (that is, there are enough independent
bona fide offers to buy and sell so that a sales price reasonably related to the last sales
price or current bona fide competitive bid and offer quotations can be determined
promptly and a trade can be settled at such a price within five business days).
Several commenters explicitly supported the proposed definition of publicly
traded, noting that it is reasonable and consistent with industry practice. Other
commenters requested that the agencies revise the proposed definition by eliminating the
requirement that a non-U.S.-based securities exchange provide a liquid, two-way market
for the exposure. Commenters asserted that this requirement goes beyond the definition
in the New Accord, which defines a publicly traded equity exposure as any equity
security traded on a recognized security exchange. They asserted that registration with or
approval by the national securities regulatory authority should suffice, as registration or
approval generally would be predicated on the existence of a two-way market.
The agencies have retained the definition of publicly traded as proposed. The
agencies believe that the liquid, two-way market requirement is not in addition to the
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requirements of the New Accord. Rather, this requirement clarifies the intent of “traded”
in the New Accord and helps to ensure that a sales price reasonably related to the last
sales price or competitive bid and offer quotations can be determined promptly and
settled within five business days.
A bank using either the IMA or the SRWA must determine the adjusted carrying
value for each equity exposure. The proposed rule defined the adjusted carrying value of
an equity exposure as:
(i) For the on-balance sheet component of an equity exposure, the bank’s carrying
value of the exposure reduced by any unrealized gains on the exposure that are reflected
in such carrying value but excluded from the bank’s tier 1 and tier 2 capital;101 and
(ii) For the off-balance sheet component of an equity exposure, the effective
notional principal amount of the exposure, the size of which is equivalent to a
hypothetical on-balance sheet position in the underlying equity instrument that would
evidence the same change in fair value (measured in dollars) for a given small change in
the price of the underlying equity instrument, minus the adjusted carrying value of the
on-balance sheet component of the exposure as calculated in (i).
Commenters generally supported the proposed definition of adjusted carrying
value and the agencies are adopting the definition as proposed with one minor
clarification regarding unfunded equity commitments (discussed below).
The agencies created the definition of the effective notional principal amount of
the off-balance sheet portion of an equity exposure to provide a uniform method for
101
The potential downward adjustment to the carrying value of an equity exposure reflects the fact that
100 percent of the unrealized gains on available-for-sale equity exposures are included in carrying value
but only up to 45 percent of any such unrealized gains are included in regulatory capital.
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banks to measure the on-balance sheet equivalent of an off-balance sheet exposure. For
example, if the value of a derivative contract referencing the common stock of company
X changes the same amount as the value of 150 shares of common stock of company X,
for a small (for example, 1 percent) change in the value of the common stock of company
X, the effective notional principal amount of the derivative contract is the current value
of 150 shares of common stock of company X regardless of the number of shares the
derivative contract references. The adjusted carrying value of the off-balance sheet
component of the derivative is the current value of 150 shares of common stock of
company X minus the adjusted carrying value of any on-balance sheet amount associated
with the derivative.
The final rule clarifies the determination of the effective notional principal
amount of unfunded equity commitments. Under the final rule, for an unfunded equity
commitment that is unconditional, a bank must use the notional amount of the
commitment. If the unfunded equity commitment is conditional, the bank must use its
best estimate of the amount that would be funded during economic downturn conditions.
Hedge transactions
The agencies proposed specific rules for recognizing hedged equity exposures;
they received no substantive comment on these rules and are adopting these rules as
proposed. For purposes of determining risk-weighted assets under both the SRWA and
the IMA, a bank may identify hedge pairs, which the final rule defines as two equity
exposures that form an effective hedge provided each equity exposure is publicly traded
or has a return that is primarily based on a publicly traded equity exposure. A bank may
risk weight only the effective and ineffective portions of a hedge pair rather than the
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entire adjusted carrying value of each exposure that makes up the pair. Two equity
exposures form an effective hedge if the exposures either have the same remaining
maturity or each has a remaining maturity of at least three months; the hedge relationship
is documented formally before the bank acquires at least one of the equity exposures; the
documentation specifies the measure of effectiveness (E) (defined below) the bank will
use for the hedge relationship throughout the life of the transaction; and the hedge
relationship has an E greater than or equal to 0.8. A bank must measure E at least
quarterly and must use one of three alternative measures of E – the dollar-offset method,
the variability-reduction method, or the regression method.
It is possible that only part of a bank’s exposure to a particular equity instrument
is part of a hedge pair. For example, assume a bank has an equity exposure A with a
$300 adjusted carrying value and chooses to hedge a portion of that exposure with an
equity exposure B with an adjusted carrying value of $100. Also assume that the
combination of equity exposure B and $100 of the adjusted carrying value of equity
exposure A form an effective hedge with an E of 0.8. In this situation the bank would
treat $100 of equity exposure A and $100 of equity exposure B as a hedge pair, and the
remaining $200 of its equity exposure A as a separate, stand-alone equity position.
The effective portion of a hedge pair is E multiplied by the greater of the adjusted
carrying values of the equity exposures forming the hedge pair, and the ineffective
portion is (1-E) multiplied by the greater of the adjusted carrying values of the equity
exposures forming the hedge pair. In the above example, the effective portion of the
hedge pair would be 0.8 x $100 = $80 and the ineffective portion of the hedge pair would
be (1 – 0.8) x $100 = $20.
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Measures of hedge effectiveness
Under the dollar-offset method of measuring effectiveness, the bank must
determine the ratio of the cumulative sum of the periodic changes in the value of one
equity exposure to the cumulative sum of the periodic changes in the value of the other
equity exposure, termed the ratio of value change (RVC). If the changes in the values of
the two exposures perfectly offset each other, the RVC will be -1. If RVC is positive,
implying that the values of the two equity exposures move in the same direction, the
hedge is not effective and E = 0. If RVC is negative and greater than or equal to -1 (that
is, between zero and -1), then E equals the absolute value of RVC. If RVC is negative
and less than -1, then E equals 2 plus RVC.
The variability-reduction method of measuring effectiveness compares changes in
the value of the combined position of the two equity exposures in the hedge pair (labeled
X) to changes in the value of one exposure as though that one exposure were not hedged
(labeled A). This measure of E expresses the time-series variability in X as a proportion
of the variability of A. As the variability described by the numerator becomes small
relative to the variability described by the denominator, the measure of effectiveness
improves, but is bounded from above by a value of one. E is computed as:
∑ (X
T
E
=
1
−
t =1
T
∑ (A
t =1
)
t
− X
t
− A t −1 )
t −1
2
, where
2
X t = At − B t
A t = the value at time t of the one exposure in a hedge pair, and
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B t = the value at time t of the other exposure in the hedge pair.
The value of t will range from zero to T, where T is the length of the observation
period for the values of A and B, and is comprised of shorter values each labeled t.
The regression method of measuring effectiveness is based on a regression in
which the change in value of one exposure in a hedge pair is the dependent variable and
the change in value of the other exposure in the hedge pair is the independent variable. E
equals the coefficient of determination of this regression, which is the proportion of the
variation in the dependent variable explained by variation in the independent variable.
However, if the estimated regression coefficient is positive, then the value of E is zero.
The closer the relationship between the values of the two exposures, the higher E will be.
2. Simple risk-weight approach (SRWA)
Under the SRWA in section 52 of the proposed rule, a bank would determine the
risk-weighted asset amount for each equity exposure, other than an equity exposure to an
investment fund, by multiplying the adjusted carrying value of the equity exposure, or the
effective portion and ineffective portion of a hedge pair as described above, by the lowest
applicable risk weight in Table J. A bank would determine the risk-weighted asset
amount for an equity exposure to an investment fund under section 54 of the proposed
rule.
If a bank exclusively uses the SRWA for its equity exposures, the bank’s
aggregate risk-weighted asset amount for its equity exposures (other than equity
exposures to investment funds) would be equal to the sum of the risk-weighted asset
amounts for each of the bank’s individual equity exposures.
Table J
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Risk weight
Equity Exposure
0 Percent
An equity exposure to an entity whose credit exposures are exempt from
the 0.03 percent PD floor
20 Percent
An equity exposure to a Federal Home Loan Bank or Farmer Mac if the
equity exposure is not publicly traded and is held as a condition of
membership in that entity
100 Percent
•
•
•
•
Community development equity exposures
An equity exposure to a Federal Home Loan Bank or Farmer
Mac not subject to a 20 percent risk weight
The effective portion of a hedge pair
Non-significant equity exposures to the extent less than 10
percent of tier 1 plus tier 2 capital
300 Percent
A publicly traded equity exposure (including the ineffective portion of a
hedge pair)
400 Percent
An equity exposure that is not publicly traded
Several commenters addressed the proposed risk weights under the SRWA. A
few commenters asserted that the 100 percent risk weight for the effective portion of a
hedge pair is too high. These commenters suggested that the risk weight for such
exposures should be zero or no more than 7 percent because the effectively hedged
portion of a hedge pair involves negligible credit risk. One commenter remarked that it
does not believe there is an economic basis for the different risk weight for an equity
exposure to a Federal Home Loan Bank depending on whether the equity exposure is
held as a condition of membership.
The agencies do not agree with commenters’ assertion that the effective portion of
a hedge pair entails negligible credit risk. The agencies believe the 100 percent risk
weight under the proposal is an appropriate and prudential safeguard; thus, it is
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maintained in the final rule. Banks that seek to more accurately account for equity
hedging in their risk-based capital requirements should use the IMA.
The agencies agree that different risk weights for an equity exposure to a Federal
Home Loan Bank or Farmer Mac depending on whether the equity exposure is held as a
condition of membership do not have an economic justification, given the similar risk
profile of the exposures. Accordingly, under the final rule SRWA, all equity exposures
to a Federal Home Loan Bank or to Farmer Mac receive a 20 percent risk weight.
Non-significant equity exposures
Under the SRWA, a bank may apply a 100 percent risk weight to non-significant
equity exposures. The proposed rule defined non-significant equity exposures as equity
exposures to the extent that the aggregate adjusted carrying value of the exposures did not
exceed 10 percent of the bank’s tier 1 capital plus tier 2 capital.
Several commenters objected to the 10 percent materiality threshold for
determining significance. They asserted that this standard is more conservative than the
15 percent threshold under the OCC, FDIC, and Board general risk-based capital rules for
nonfinancial equity investments.
The agencies note that the applicable general risk-based capital rules address only
nonfinancial equity investments; that the 15 percent threshold is a percentage only of tier
1 capital; and that the 15 percent threshold was designed for that particular rule. The
proposed materiality threshold of 10 percent of tier 1 plus tier 2 capital is consistent with
the New Accord and is intended to identify non-significant holdings of equity exposures
under a different type of capital framework. Thus, the two threshold limits are not
directly comparable. The agencies believe that the proposed 10 percent threshold for
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determining non-significant equity exposures is appropriate for the advanced approaches
and, thus, are adopting it as proposed.
As discussed above in preamble section V.A.3., the agencies have discretion
under the final rule to exclude from the definition of a traditional securitization those
investment firms that exercise substantially unfettered control over the size and
composition of their assets, liabilities, and off-balance sheet exposures. Equity exposures
to investment firms that would otherwise be a traditional securitization were it not for the
specific agency exclusion are leveraged exposures to the underlying financial assets of
the investment firm. The agencies believe that equity exposure to such firms with greater
than immaterial leverage warrant a 600 percent risk weight under the SRWA, due to their
particularly high risk. Moreover, the agencies believe that the 100 percent risk weight
assigned to non-significant equity exposures is inappropriate for equity exposures to
investment firms with greater than immaterial leverage.
Under the final rule, to compute the aggregate adjusted carrying value of a bank’s
equity exposures for determining non-significance, the bank may exclude (i) equity
exposures that receive less than a 300 percent risk weight under the SRWA (other than
equity exposures determined to be non-significant); (ii) the equity exposure in a hedge
pair with the smaller adjusted carrying value; and (iii) a proportion of each equity
exposure to an investment fund equal to the proportion of the assets of the investment
fund that are not equity exposures or that qualify as community development equity
exposures. If a bank does not know the actual holdings of the investment fund, the bank
may calculate the proportion of the assets of the fund that are not equity exposures based
on the terms of the prospectus, partnership agreement, or similar contract that defines the
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fund’s permissible investments. If the sum of the investment limits for all exposure
classes within the fund exceeds 100 percent, the bank must assume that the investment
fund invests to the maximum extent possible in equity exposures.
When determining which of a bank’s equity exposures qualify for a 100 percent
risk weight based on non-significance, a bank first must include equity exposures to
unconsolidated small business investment companies or held through consolidated small
business investment companies described in section 302 of the Small Business
Investment Act of 1958 (15 U.S.C. 682), then must include publicly traded equity
exposures (including those held indirectly through investment funds), and then must
include non-publicly traded equity exposures (including those held indirectly through
investment funds).
The SRWA is summarized in Table K:
Table K
Risk weight
Equity Exposure
0 Percent
An equity exposure to an entity whose credit exposures are exempt from
the 0.03 percent PD floor
20 Percent
An equity exposure to a Federal Home Loan Bank or Farmer Mac
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Risk weight
100 Percent
Equity Exposure
•
•
•
Community development equity exposures 102
The effective portion of a hedge pair
Non-significant equity exposures to the extent less than 10
percent of tier 1 plus tier 2 capital
300 Percent
A publicly traded equity exposure (other than an equity exposure that
receives a 600 percent risk weight and including the ineffective portion
of a hedge pair)
400 Percent
An equity exposure that is not publicly traded (other than an equity
exposure that receives a 600 percent risk weight)
An equity exposure to an investment firm that (1) would meet the
definition of a traditional securitization were it not for the primary
Federal supervisor’s application of paragraph (8) of that definition and
(2) has greater than immaterial leverage
600 percent
3. Internal models approach (IMA)
The IMA is designed to provide banks with a more sophisticated and risksensitive mechanism for calculating risk-based capital requirements for equity exposures.
To qualify to use the IMA, a bank must receive prior written approval from its primary
Federal supervisor. To receive such approval, the bank must demonstrate to its primary
Federal supervisor’s satisfaction that the bank meets the quantitative and qualitative
criteria discussed below. As noted earlier, a bank may model both publicly traded and
non-publicly traded equity exposures or model only publicly traded equity exposures.
102
The final rule generally defines these exposures as exposures that would qualify as community
development investments under 12 U.S.C. 24(Eleventh), excluding equity exposures to an unconsolidated
small business investment company and equity exposures held through a consolidated small business
investment company described in section 302 of the Small Business Investment Act of 1958 (15 U.S.C.
682). For savings associations, community development investments would be defined to mean equity
investments that are designed primarily to promote community welfare, including the welfare of low- and
moderate-income communities or families, such as by providing services or jobs, and excluding equity
exposures to an unconsolidated small business investment company and equity exposures held through a
consolidated small business investment company described in section 302 of the Small Business
Investment Act of 1958 (15 U.S.C. 682).
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In the final rule, the agencies clarify that under the IMA, a bank may use more
than one model, as appropriate for its equity exposures, provided that it has received
supervisory approval for use of the IMA, and each model meets the qualitative and
quantitative criteria specified below and in section 53 of the rule.
IMA qualification
The bank must have one or more models that (i) assess the potential decline in
value of its modeled equity exposures; (ii) are commensurate with the size, complexity,
and composition of the bank’s modeled equity exposures; and (iii) adequately capture
both general market risk and idiosyncratic risks. The bank’s models must produce an
estimate of potential losses for its modeled equity exposures that is no less than the
estimate of potential losses produced by a VaR methodology employing a 99.0 percent
one-tailed confidence interval of the distribution of quarterly returns for a benchmark
portfolio of equity exposures comparable to the bank’s modeled equity exposures using a
long-term sample period. Banks with equity portfolios containing equity exposures with
values that are highly nonlinear in nature (for example, equity derivatives or convertibles)
must employ an internal model designed to appropriately capture the risks associated
with these instruments.
In addition, the number of risk factors and exposures in the sample and the data
period used for quantification in the bank’s models and benchmarking exercise must be
sufficient to provide confidence in the accuracy and robustness of the bank’s estimates.
The bank’s model and benchmarking exercise also must incorporate data that are relevant
in representing the risk profile of the bank’s modeled equity exposures, and must include
data from at least one equity market cycle containing adverse market movements relevant
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to the risk profile of the bank’s modeled equity exposures. In addition, for the reasons
described below, the final rule adds that the bank’s benchmarking exercise must be based
on daily market prices for the benchmark portfolio. If the bank’s model uses a scenario
methodology, the bank must demonstrate that the model produces a conservative estimate
of potential losses on the bank’s modeled equity exposures over a relevant long-term
market cycle. If the bank employs risk factor models, the bank must demonstrate through
empirical analysis the appropriateness of the risk factors used.
Under the proposed rule, the agencies also required that daily market prices be
available for all modeled equity exposures. The proposed requirement applied to either
direct holdings or proxies. Several commenters objected to the requirement of daily
market prices. A few asserted that proxies for private equity investments are more
relevant than public market proxies and should be permitted even if they are only
available on a monthly basis. The agencies agree with commenters on this issue.
Accordingly, under the final rule, banks are not required to have daily market prices for
all modeled equity exposures, either direct holdings or proxies. However, to ensure
sufficient rigor in the modeling process, the final rule requires that a bank’s
benchmarking exercise be based on daily market prices for the benchmark portfolio, as
noted above.
Finally, the bank must be able to demonstrate, using theoretical arguments and
empirical evidence, that any proxies used in the modeling process are comparable to the
bank’s modeled equity exposures, and that the bank has made appropriate adjustments for
differences. The bank must derive any proxies for its modeled equity exposures or
benchmark portfolio using historical market data that are relevant to the bank’s modeled
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equity exposures or benchmark portfolio (or, where not, must use appropriately adjusted
data), and such proxies must be robust estimates of the risk of the bank’s modeled equity
exposures.
In evaluating whether a bank has met the criteria described above, the bank’s
primary Federal supervisor may consider, among other factors, (i) the nature of the
bank’s equity exposures, including the number and types of equity exposures (for
example, publicly traded, non-publicly traded, long, short); (ii) the risk characteristics
and makeup of the bank’s equity exposures, including the extent to which publicly
available price information is obtainable on the exposures; and (iii) the level and degree
of concentration of, and correlations among, the bank’s equity exposures.
The agencies do not intend to dictate the form or operational details of a bank’s
internal model for equity exposures. Accordingly, the agencies are not prescribing any
particular type of model for determining risk-based capital requirements. Although the
final rule requires a bank that uses the IMA to ensure that its internal model produces an
estimate of potential losses for its modeled equity exposures that is no less than the
estimate of potential losses produced by a VaR methodology employing a 99.0 percent
one-tailed confidence interval of the distribution of quarterly returns for a benchmark
portfolio of equity exposures, the rule does not require a bank to use a VaR-based model.
The agencies recognize that the type and sophistication of internal models will vary
across banks due to differences in the nature, scope, and complexity of business lines in
general and equity exposures in particular. The agencies also recognize that some banks
employ models for internal risk management and capital allocation purposes that can be
more relevant to the bank’s equity exposures than some VaR models. For example, some
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banks employ rigorous historical scenario analysis and other techniques for assessing the
risk of their equity portfolios.
Banks that choose to use a VaR-based internal model under the IMA should use a
historical observation period that includes a sufficient amount of data points to ensure
statistically reliable and robust loss estimates relevant to the long-term risk profile of the
bank’s specific holdings. The data used to represent return distributions should reflect
the longest sample period for which data are available and should meaningfully represent
the risk profile of the bank’s specific equity holdings. The data sample should be longterm in nature and, at a minimum, should encompass at least one complete equity market
cycle containing adverse market movements relevant to the risk profile of the bank’s
modeled exposures. The data used should be sufficient to provide conservative,
statistically reliable, and robust loss estimates that are not based purely on subjective or
judgmental considerations.
The parameters and assumptions used in a VaR model should be subject to a
rigorous and comprehensive regime of stress-testing. Banks utilizing VaR models should
subject their internal model and estimation procedures, including volatility computations,
to either hypothetical or historical scenarios that reflect worst-case losses given
underlying positions in both publicly traded and non-publicly traded equities. At a
minimum, banks that use a VaR model should employ stress tests to provide information
about the effect of tail events beyond the level of confidence assumed in the IMA.
Banks using non-VaR internal models that are based on stress tests or scenario
analyses should estimate losses under worst-case modeled scenarios. These scenarios
should reflect the composition of the bank’s equity portfolio and should produce risk-
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based capital requirements at least as large as those that would be required to be held
against a representative market index or other relevant benchmark portfolio under a VaR
approach. For example, for a portfolio consisting primarily of publicly held equity
securities that are actively traded, risk-based capital requirements produced using
historical scenario analyses should be greater than or equal to risk-based capital
requirements produced by a baseline VaR approach for a major index or sub-index that is
representative of the bank’s holdings.
The loss estimate derived from the bank’s internal model constitutes the riskbased capital requirement for the modeled equity exposures (subject to the supervisory
floors described below). The equity capital requirement is incorporated into a bank’s
risk-based capital ratio through the calculation of risk-weighted equivalent assets. To
convert the equity capital requirement into risk-weighted equivalent assets, a bank must
multiply the capital requirement by 12.5.
Risk-weighted assets under the IMA
Under the proposed and final rules, as noted above, a bank may apply the IMA
only to its publicly traded equity exposures or may apply the IMA to its publicly traded
and non-publicly traded equity exposures. In either case, a bank is not allowed to apply
the IMA to equity exposures that receive a 0 or 20 percent risk weight under the SRWA,
community development equity exposures, and equity exposures to investment funds
(collectively, excluded equity exposures). Unlike the SRWA, the IMA does not provide
for a 10 percent materiality threshold for non-significant equity exposures.
Several commenters objected to the fact that the IMA does not provide a 100
percent risk weight for non-significant equity exposures up to a 10 percent materiality
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threshold. These commenters maintained that the lack of a materiality threshold under
the IMA will discourage use of this methodology relative to the SRWA. Commenters
suggested that the agencies incorporate a materiality threshold into the IMA.
The agencies do not believe that it is necessary or appropriate to incorporate such
a threshold under the IMA. The agencies are concerned that a bank could manipulate
significantly its risk-based capital requirements based on the exposures it chooses to
model and those which it would deem immaterial (and to which it would apply a 100
percent risk weight). The agencies also believe that a flat 100 percent risk weight is
inconsistent with the risk sensitivity of the IMA.
Under the proposal, if a bank applied the IMA to both publicly traded and nonpublicly traded equity exposures, the bank’s aggregate risk-weighted asset amount for its
equity exposures would be equal to the sum of the risk-weighted asset amount of
excluded equity exposures (calculated outside of the IMA) and the risk-weighted asset
amount of the non-excluded equity exposures (calculated under the IMA). The riskweighted asset amount of the non-excluded equity exposures generally would be set
equal to the estimate of potential losses on the bank’s non-excluded equity exposures
generated by the bank’s internal model multiplied by 12.5. To ensure that a bank holds a
minimum amount of risk-based capital against its modeled equity exposures, however,
the proposed rule contained a supervisory floor on the risk-weighted asset amount of the
non-excluded equity exposures. As a result of this floor, the risk-weighted asset amount
of the non-excluded equity exposures could not fall below the sum of (i) 200 percent
multiplied by the aggregate adjusted carrying value or ineffective portion of hedge pairs,
as appropriate, of the bank’s non-excluded publicly traded equity exposures; and
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(ii) 300 percent multiplied by the aggregate adjusted carrying value of the bank’s nonexcluded non-publicly traded equity exposures.
Also under the proposal, if a bank applied the IMA only to its publicly traded
equity exposures, the bank’s aggregate risk-weighted asset amount for its equity
exposures would be equal to the sum of (i) the risk-weighted asset amount of excluded
equity exposures (calculated outside of the IMA); (ii) 400 percent multiplied by the
aggregate adjusted carrying value of the bank’s non-excluded non-publicly traded equity
exposures; and (iii) the aggregate risk-weighted asset amount of its non-excluded
publicly traded equity exposures. The risk-weighted asset amount of the non-excluded
publicly traded equity exposures would be equal to the estimate of potential losses on the
bank’s non-excluded publicly traded equity exposures generated by the bank’s internal
model multiplied by 12.5. Under the proposed rule, the risk-weighted asset amount for
the non-excluded publicly traded equity exposures would be subject to a floor of
200 percent multiplied by the aggregate adjusted carrying value or ineffective portion of
hedge pairs, as appropriate, of the bank’s non-excluded publicly traded equity exposures.
Several commenters did not support the concept of floors in a risk-sensitive
approach that requires a comparison to estimates of potential losses produced by a VaR
methodology. If floors are required in the final rule, however, these commenters noted
that the calculation at the aggregate level would not pose significant operational issues.
A few commenters, in contrast, objected to the proposed aggregate floors, asserting that it
would be operationally difficult to determine compliance with such floors.
The agencies believe that it is prudent to retain the floor requirements in the IMA
and, thus, are adopting the floor requirements as described above. The agencies note that
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the New Accord also imposes a 200 percent and 300 percent floor for publicly traded and
non-publicly traded equity exposures, respectively. Regarding the proposal to calculate
the floors on an aggregate basis, the agencies believe it is appropriate to maintain this
approach, given that for most banks it does not seem to pose significant operational
issues.
4. Equity exposures to investment funds
The proposed rule included a separate treatment for equity exposures to
investment funds. As proposed, a bank would determine the risk-weighted asset amount
for equity exposures to investment funds using one of three approaches: the full lookthrough approach, the simple modified look-through approach, or the alternative
modified look-through approach, unless the equity exposure to an investment fund is a
community development equity exposure. Such equity exposures would be subject to a
100 percent risk weight. If an equity exposure to an investment fund is part of a hedge
pair, a bank could use the ineffective portion of the hedge pair as the adjusted carrying
value for the equity exposure to the investment fund. The risk-weighted asset amount of
the effective portion of the hedge pair is equal to its adjusted carrying value. A bank
could choose to apply a different approach among the three alternatives to different
equity exposures to investment funds.
The agencies proposed a separate treatment for equity exposures to an investment
fund to prevent banks from arbitraging the proposed rule’s risk-based capital
requirements for certain high-risk exposures and to ensure that banks do not receive a
punitive risk-based capital requirement for equity exposures to investment funds that hold
only low-risk assets. Under the proposal, the agencies defined an investment fund as a
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company (i) all or substantially all of the assets of which are financial assets and (ii) that
has no material liabilities.
Generally, commenters supported the separate treatment for equity exposures to
investment funds. However, several commenters objected to the exclusion of investment
funds with material liabilities from this separate treatment, observing that it would
exclude equity exposures to hedge funds. Several commenters suggested that investment
funds with material liabilities should be eligible for the look-through approaches. One
commenter suggested that the agencies should adopt the following definition of
investment fund: “A company in which all or substantially all of the assets are pooled
financial assets that are collectively managed in order to generate a financial return,
including investment companies or funds with material liabilities.” A few commenters
suggested that equity exposures to investment funds with material liabilities should be
treated under the SRWA or IMA as non-publicly traded equity exposures rather than the
separate treatment developed for equity exposures to investment funds.
The agencies do not agree with commenters that the look-through approaches for
investment funds should apply to investment vehicles with material liabilities. The lookthrough treatment is designed to capture the risks of an indirect holding of the underlying
assets of the investment fund. Investment vehicles with material liabilities provide a
leveraged exposure to the underlying financial assets and have a risk profile that may not
be appropriately captured by a look-through approach.
Under the proposal, each of the approaches to equity exposures to investment
funds imposed a 7 percent minimum risk weight on such exposures. This proposed
minimum risk weight was similar to the minimum 7 percent risk weight under the RBA
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for securitization exposures and the effective 56 basis point minimum risk-based capital
requirement per dollar of securitization exposure under the SFA.
Several commenters objected to the proposed 7 percent risk weight floor. A few
commenters suggested that the floor should be decreased or eliminated, particularly for
low-risk investment funds that receive the highest rating from an NRSRO. Others
recommended that the 7 percent risk weight floor should be applied on an aggregate basis
rather than on a fund-by-fund basis.
The agencies proposed the 7 percent risk weight floor as a minimum risk-based
capital requirement for exposures not directly held by a bank. However, the agencies
believe the comments on this issue have merit and recognize that the floor would provide
banks with an incentive to invest in higher-risk investment funds. Consistent with the
New Accord, the final rule does not impose a 7 percent risk weight floor on equity
exposures to investment funds, on either an individual or aggregate basis.
Full look-through approach
A bank may use the full look-through approach only if the bank is able to
compute a risk-weighted asset amount for each of the exposures held by the investment
fund. Under the proposed rule, a bank would be required to calculate the risk-weighted
asset amount for each of the exposures held by the investment fund as if the exposures
were held directly by the bank. Depending on whether the exposures were wholesale,
retail, securitization, or equity exposures, a bank would apply the appropriate IRB riskbased capital treatment.
Several commenters suggested that the agencies should allow a bank with
supervisory approval to use the IMA to model the underlying assets of an investment
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fund by including the bank’s pro rata share of the investment fund’s assets in its equities
model. The commenters believed there is no basis for preventing a bank from using the
IMA, a sophisticated and risk-sensitive approach, when a bank has full position data for
an investment fund.
The agencies agree with commenters’ views in this regard. If a bank has full
position data for an investment fund and has been approved by its primary Federal
supervisor for use of the IMA, it may include the underlying equity exposures held by an
investment fund, after adjustment for proportional ownership, in its equities model under
the IMA. Therefore, in the final rule, under the full look-through approach, a bank must
either (i) set the risk-weighted asset amount of the bank’s equity exposure to the
investment fund equal to product of (A) the aggregate risk-weighted asset amounts of the
exposures held by the fund as if they were held directly by the bank and (B) the bank’s
proportional ownership share of the fund; or (ii) include the bank’s proportional
ownership share of each exposure held by the fund in the bank’s IMA. If the bank
chooses (ii), the risk-weighted asset amount for the equity exposure to the investment
fund is determined together with the risk-weighted asset amount for the bank’s other nonexcluded equity exposures and is subject to the aggregate floors under this approach.
Simple modified look-through approach
Under the proposed simple modified look-through approach, a bank would set the
risk-weighted asset amount for its equity exposure to an investment fund equal to the
adjusted carrying value of the equity exposure multiplied by the highest risk weight in
Table L that applies to any exposure the fund is permitted to hold under its prospectus,
partnership agreement, or similar contract that defines the fund’s permissible
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investments. The bank could exclude derivative contracts that are used for hedging, not
speculative purposes, and do not constitute a material portion of the fund’s exposures.
Commenters generally supported the simple modified look-through approach as a
low-burden yet moderately risk-sensitive way of treating equity exposures to an
investment fund. However, several commenters objected to the large jump in risk
weights (from a 400 percent to a 1,250 percent risk weight) between investment funds
permitted to hold non-publicly traded equity exposures and investment funds permitted to
hold OTC derivative contracts and/or exposures that must be deducted from regulatory
capital or receive a risk weight greater than 400 percent under the IRB approach. In
addition, one commenter objected to the proposed 20 percent risk weight for the most
highly rated money market mutual funds that are subject to SEC rule 2a-7 governing
portfolio maturity, quality, diversification and liquidity. This commenter asserted that a 7
percent risk weight for such exposures would be appropriate.
The agencies agree that the proposed risk-weighting for highly-rated money
market mutual funds subject to SEC rule 2a-7 is conservative, given the generally low
risk of such funds. Accordingly, the agencies added a new investment fund approach—
the Money Market Fund Approach—which applies a 7 percent risk weight to a bank’s
equity exposure to a money market fund that is subject to SEC rule 2a-7 and that has an
applicable external rating in the highest investment-grade rating category.
The agencies have made no changes to address commenters’ concerns about a
lack of intermediate risk weights between 400 percent and 1,250 percent. The agencies
believe the range of risk weights is sufficiently granular to accommodate most equity
exposures to investment funds.
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Table L – Modified Look-Through Approaches for Equity Exposures to
Investment Funds
Risk Weight
Exposure Class or Investment Fund Type
0 Percent
Sovereign exposures with a long-term external rating in the highest
investment-grade rating category and sovereign exposures of the
United States
20 Percent
Exposures with a long-term external rating in the highest or secondhighest investment-grade rating category; exposures with a short-term
external rating in the highest investment-grade rating category; and
exposures to, or guaranteed by, depository institutions, foreign banks
(as defined in 12 CFR 211.2), or securities firms subject to
consolidated supervision or regulation comparable to that imposed on
U.S. securities broker-dealers that are repo-style transactions or
bankers’ acceptances
50 Percent
Exposures with a long-term external rating in the third-highest
investment-grade rating category or a short-term external rating in the
second-highest investment-grade rating category
100 Percent
Exposures with a long-term or short-term external rating in the lowest
investment-grade rating category
200 Percent
Exposures with a long-term external rating one rating category below
investment grade
300 Percent
Publicly traded equity exposures
400 Percent
Non-publicly traded equity exposures; exposures with a long-term
external rating two or more rating categories below investment grade;
and unrated exposures (excluding publicly traded equity exposures)
1,250 Percent
OTC derivative contracts and exposures that must be deducted from
regulatory capital or receive a risk weight greater than 400 percent
under this appendix
Alternative modified look-through approach
Under this approach, a bank may assign the adjusted carrying value of an equity
exposure to an investment fund on a pro rata basis to different risk-weight categories in
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Table L based on the investment limits in the fund’s prospectus, partnership agreement,
or similar contract that defines the fund’s permissible investments. If the sum of the
investment limits for all exposure classes within the fund exceeds 100 percent, the bank
must assume that the fund invests to the maximum extent permitted under its investment
limits in the exposure class with the highest risk weight under Table L, and continues to
make investments in the order of the exposure class with the next highest risk-weight
under Table L until the maximum total investment level is reached. If more than one
exposure class applies to an exposure, the bank must use the highest applicable risk
weight. A bank may exclude derivative contracts held by the fund that are used for
hedging, not speculative, purposes and do not constitute a material portion of the fund’s
exposures. Other than comments addressing the risk weight table and the 7 percent floor
(addressed above), the agencies did not receive significant comment on this approach and
have adopted it without significant change.
VI. Operational Risk
This section describes features of the AMA framework for determining the riskbased capital requirement for operational risk. A bank meeting the AMA qualifying
criteria uses its internal operational risk quantification system to calculate its risk-based
capital requirement for operational risk.
Currently, the agencies’ general risk-based capital rules do not include an explicit
capital charge for operational risk. Rather, the existing risk-based capital rules were
designed to broadly cover all risks, and therefore implicitly cover operational risk. With
the adoption of the more risk-sensitive treatment under the IRB approach for credit risk in
this final rule, there no longer is an implicit capital buffer for other risks.
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The agencies recognize that operational risk is a key risk in banks, and evidence
indicates that a number of factors are driving increases in operational risk. These factors
include greater use of automated technology, proliferation of new and highly complex
products, growth of e-banking transactions and related business applications, large-scale
acquisitions, mergers, and consolidations, and greater use of outsourcing arrangements.
Furthermore, the experience of a number of high-profile, high-severity operational losses
across the banking industry, including those resulting from legal settlements, highlight
operational risk as a major source of unexpected losses. Because the implicit regulatory
capital buffer for operational risk is removed under the final rule, the agencies are
requiring banks using the IRB approach for credit risk to use the AMA to address
operational risk when computing their risk-based capital requirement.
As discussed previously, operational risk exposure is the 99.9th percentile of the
distribution of potential aggregate operational losses as generated by the bank’s
operational risk quantification system over a one-year horizon. EOL is the expected
value of the same distribution of potential aggregate operational losses. Under the
proposal, a bank’s risk-based capital requirement for operational risk would be the sum of
EOL and UOL. A bank would be allowed to recognize (i) certain offsets for EOL (such
as certain reserves and other internal business practices), and (ii) the effect of risk
mitigants such as insurance in calculating its regulatory capital requirement for
operational risk.
Under the proposed rule, the agencies recognized that a bank’s risk-based capital
requirement for operational risk could be based on UOL alone if the bank could
demonstrate it has offset EOL with eligible operational risk offsets. Eligible operational
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risk offsets were defined as amounts, not to exceed EOL, that (i) are generated by internal
business practices to absorb highly predictable and reasonably stable operational losses,
including reserves calculated in a manner consistent with GAAP; and (ii) are available to
cover EOL with a high degree of certainty over a one-year horizon. Eligible operational
risk offsets could only be used to offset EOL, not UOL.
The preamble to the proposed rule stated that in determining whether to accept a
proposed EOL offset, the agencies would consider whether the proposed offset would be
available to cover EOL with a high degree of certainty over a one-year horizon.
Supervisory recognition of EOL offsets would be limited to those business lines and
event types with highly predictable, routine losses. The preamble noted that based on
discussions with the industry and supervisory experience, highly predictable and routine
losses appear to be limited to those relating to securities processing and to credit card
fraud.
The majority of commenters on this issue recommended that the agencies should
allow banks to present evidence of additional areas with highly predictable and
reasonably stable losses for which eligible operational risk offsets could be considered.
These commenters identified fraud losses pertaining to debit or ATM cards, commercial
or business credit cards, HELOCs, and external checks in retail banking as additional
events that have highly predictable and reasonably stable losses. Commenters also
identified legal reserves set aside for small, predictable legal loss events, budgeted funds,
and forecasted funds as other items that should be considered eligible operational risk
offsets. Several commenters also highlighted that the proposed rule was inconsistent
with the New Accord regarding the ability of budgeted funds to serve as EOL offsets.
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One commenter proposed eliminating EOL altogether because the commenter already
factors it into its pricing practices.
The New Accord permits a supervisor to accept expected loss offsets provided a
bank is “able to demonstrate to the satisfaction of its national supervisor that it has
measured and accounted for its EL exposure.” 103 To the extent a bank is permitted to
adjust its estimate of operational risk exposure to reflect potential operational risk offsets,
it is appropriate to consider the degree to which such offsets meet U.S. accounting
standards and can be viewed as regulatory capital substitutes. The final rule retains the
proposed definition described above. The agencies believe that this definition allows for
the supervisory consideration of EOL offsets in a flexible and prudent manner.
In determining its operational risk exposure, the bank may also take into account
the effects of qualifying operational risk mitigants such as insurance. To recognize the
effects of qualifying operational risk mitigants such as insurance for risk-based capital
purposes, the bank must estimate its operational risk exposure with and without such
effects. The reduction in a bank’s risk-based capital requirement for operational risk due
to qualifying operational risk mitigants may not exceed 20 percent of the bank’s riskbased capital requirement for operational risk, after approved adjustments for EOL
offsets.
A risk mitigant must be able to absorb losses with sufficient certainty to warrant
inclusion as a qualifying operational risk mitigant. For insurance to meet this standard, it
must:
(i) be provided by an unaffiliated company that has a claims paying ability
that is rated in one of the three highest rating categories by an NRSRO;
103
New Accord, ¶669(b).
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(ii) have an initial term of at least one year and a residual term of more than
90 days;
(iii) have a minimum notice period for cancellation of 90 days;
(iv) have no exclusions or limitations based upon regulatory action or for the
receiver or liquidator of a failed bank; and
(v) be explicitly mapped to an actual operational risk exposure of the bank.
A bank must receive prior written approval from its primary Federal supervisor to
recognize an operational risk mitigant other than insurance as a qualifying operational
risk mitigant. In evaluating an operational risk mitigant other than insurance, a primary
Federal supervisor will consider whether the operational risk mitigant covers potential
operational losses in a manner equivalent to holding regulatory capital.
The bank’s methodology for incorporating the effects of insurance must capture,
through appropriate discounts in the amount of risk mitigation, the residual term of the
policy, where less than one year; the policy’s cancellation terms, where less than one
year; the policy’s timeliness of payment; and the uncertainty of payment as well as
mismatches in coverage between the policy and the hedged operational loss event. The
bank may not recognize for regulatory capital purposes insurance with a residual term of
90 days or less.
Several commenters criticized the proposal for limiting recognition of noninsurance operational risk mitigants to those mitigants that would cover potential
operational losses in a manner equivalent to holding regulatory capital. The commenters
noted that similar limitations are not included in the New Accord. Other commenters
asserted that qualifying operational risk mitigants should be broader than insurance.
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The New Accord discusses the use of insurance explicitly as an operational risk
mitigant and notes that the BCBS “in due course, may consider revising the criteria for
and limits on the recognition of operational risk mitigants on the basis of growing
experience.” 104 Similarly, under the proposed rule, the agencies provided flexibility that
recognizes the potential for developing operational risk mitigants other than insurance
over time. The agencies continue to believe it is appropriate to consider the degree to
which such mitigants can be viewed as regulatory capital substitutes. Therefore, under
the final rule, in evaluating such mitigants, the agencies will consider whether the
operational risk mitigant covers potential operational losses in a manner equivalent to
holding regulatory capital.
Under the final rule, as under the proposal, if a bank does not qualify to use or
does not have qualifying operational risk mitigants, the bank’s dollar risk-based capital
requirement for operational risk is its operational risk exposure minus eligible operational
risk offsets (if any). If a bank qualifies to use operational risk mitigants and has
qualifying operational risk mitigants, the bank’s dollar risk-based capital requirement for
operational risk is the greater of: (i) the bank’s operational risk exposure adjusted for
qualifying operational risk mitigants minus eligible operational risk offsets (if any); and
(ii) 0.8 multiplied by the difference between the bank’s operational risk exposure and its
eligible operational risk offsets (if any). The dollar risk-based capital requirement for
operational risk is multiplied by 12.5 to convert it into an equivalent risk-weighted asset
amount. The resulting amount is added to the comparable amount for credit risk in
calculating the institution’s risk-based capital denominator.
VII. Disclosure
104
New Accord, footnote 110.
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1. Overview
The agencies have long supported meaningful public disclosure by banks with the
objective of improving market discipline. The agencies recognize the importance of
market discipline in encouraging sound risk management practices and fostering financial
stability.
Pillar 3 of the New Accord, market discipline, complements the minimum capital
requirements and the supervisory review process by encouraging market discipline
through enhanced and meaningful public disclosure. The public disclosure requirements
in the final rule are intended to allow market participants to assess key information about
a bank’s risk profile and its associated level of capital.
The agencies view public disclosure as an important complement to the advanced
approaches to calculating minimum regulatory risk-based capital requirements, which
will be heavily based on internal systems and methodologies. With enhanced
transparency regarding banks’ experiences with the advanced approaches, investors can
better evaluate a bank’s capital structure, risk exposures, and capital adequacy. With
sufficient and relevant information, market participants can better evaluate a bank’s risk
management performance, earnings potential and financial strength.
Improvements in public disclosures come not only from regulatory standards, but
also through efforts by bank management to improve communications to public
shareholders and other market participants. In this regard, improvements to risk
management processes and internal reporting systems provide opportunities to
significantly improve public disclosures over time. Accordingly, the agencies strongly
encourage the management of each bank to regularly review its public disclosures and
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enhance these disclosures, where appropriate, to clearly identify all significant risk
exposures – whether on- or off-balance sheet – and their effects on the bank’s financial
condition and performance, cash flow, and earnings potential.
Comments on the proposed rule
Many commenters expressed concern that the proposed disclosures were
excessive, burdensome and overly prescriptive and would hinder – rather than facilitate –
market discipline by requiring banks to disclose items that would not be well understood
or provide useful information to market participants. In particular, commenters were
concerned that the differences between the proposed rule and the New Accord (such as
the proposed ELGD risk parameter and proposed wholesale definition of default) would
not be meaningful for cross-border comparative purposes, and would increase
compliance burden for banks subject to the agencies’ risk-based capital rules. Some
commenters also believed that the information provided in the disclosures would not be
comparable across banks because each bank would use distinct internal methodologies to
generate the disclosures. Several commenters suggested that the agencies should delay
the disclosure requirements until U.S. implementation of the IRB approach has gained
some maturity. This would allow the agencies and banking industry sufficient time to
ensure usefulness of the public disclosure requirements and comparability across banks.
The agencies believe that it is important to retain the vast majority of the proposed
disclosures, which are consistent with the New Accord. These disclosures will enable
market participants to gain key insights regarding a bank’s capital structure, risk
exposures, risk assessment processes, and ultimately, the capital adequacy of the
institution. The agencies also note that many of the disclosure requirements are already
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required by, or are consistent with, existing GAAP, SEC disclosure requirements, or
regulatory reporting requirements for banks. More generally, the agencies view the
public disclosure requirements as an integral part of the advanced approaches and the
New Accord and are continuing to require their implementation beginning with a bank’s
first transitional floor period.
The agencies are sympathetic, however, to commenters’ concerns about crossborder comparability. The agencies believe that many of the changes they have made to
the final rule (such as eliminating the ELGD risk parameter and adopting the New
Accord’s definition of default for wholesale exposures, as discussed above) will address
commenters’ concerns regarding comparability. In addition, the agencies have made
several changes to the disclosure requirements to make them more consistent with the
New Accord. These changes should increase cross-border comparability and reduce
implementation and compliance burden. These changes are discussed in the relevant
sections below.
2. General requirements
Under the proposed rule, the public disclosure requirements would apply to the
top-tier legal entity that is a core or opt-in bank within a consolidated banking group – the
top-tier U.S. BHC or DI that is a core or opt-in bank.
Several commenters objected to this proposal, noting that it is inconsistent with
the New Accord, which requires such disclosures at the global top consolidated level of a
banking group to which the framework applies. Commenters asserted that public
disclosure at the U.S. BHC or DI level for U.S. banking organizations owned by a foreign
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banking organization is not meaningful and could generate confusion or
misunderstanding in the market.
The agencies agree that commenters’ concerns have merit and believe that it is
important to be consistent with the New Accord. Accordingly, under the final rule, the
public disclosure requirements will generally be required only at the top-tier global
consolidated level. Under exceptional circumstances, a primary Federal supervisor may
require some or all of the public disclosures at the top-tier U.S. level if the primary
Federal supervisor determines that such disclosures are important for market participants
to form appropriate insights regarding the bank’s risk profile and associated level of
capital. A factor the agencies will consider, for example, is whether a U.S. subsidiary of
a foreign banking organization has debt or equity registered and actively traded in the
United States.
In addition, the proposed rule stated that, in general, a DI that is a subsidiary of a
BHC or another DI would not be subject to the disclosure requirements except that every
DI would be required to disclose total and tier 1 capital ratios and their components,
similar to current requirements. Nonetheless, these entities must file applicable bank
regulatory reports and thrift financial reports. In addition, as described below in the
regulatory reporting section, the agencies will require certain additional regulatory
reporting from banks applying the advanced approaches, and a limited amount of the
reported information will be publicly disclosed. If a DI that is a core or opt-in bank and
is not a subsidiary of a BHC or another DI that must make the full set of disclosures, the
DI would be required to make the full set disclosures.
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One commenter objected to the supervisory flexibility provided to require
additional disclosures at the subsidiary level. The commenter maintained that in all cases
DIs that are a subsidiary of a BHC or another DI should not be subject to the disclosure
requirements beyond disclosing their total and tier 1 capital ratios and the ratio
components, as proposed. The commenter suggested that the agencies clarify this issue
in the final rule.
The agencies do not believe, however, that these changes are appropriate. The
agencies believe that it is important to preserve some flexibility in the event that the
primary Federal supervisor believes that disclosures from such a DI are important for
market participants to form appropriate insights regarding the bank’s risk profile and
associated level of capital.
The risks to which a bank is exposed, and the techniques that it uses to identify,
measure, monitor, and control those risks are important factors that market participants
consider in their assessment of the bank. Accordingly, under the proposed and final
rules, each bank that is subject to the disclosure requirements must have a formal
disclosure policy approved by its board of directors that addresses the bank’s approach
for determining the disclosures it should make. The policy should address the associated
internal controls and disclosure controls and procedures. The board of directors and
senior management must ensure that appropriate review of the disclosures takes place and
that effective internal controls and disclosure controls and procedures are maintained.
A bank should decide which disclosures are relevant for it based on the
materiality concept. Information would be regarded as material if its omission or
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misstatement could change or influence the assessment or decision of a user relying on
that information for the purpose of making investment decisions.
To the extent applicable, a bank may fulfill its disclosure requirements under this
final rule by relying on disclosures made in accordance with accounting standards or SEC
mandates that are very similar to the disclosure requirements in this final rule. In these
situations, a bank must explain material differences between the accounting or other
disclosure and the disclosures required under this final rule.
Frequency/timeliness
Under the proposed rule, the agencies required that quantitative disclosures be
made quarterly. Several commenters objected to this requirement. These commenters
asserted that banks subject to the U.S. public disclosure requirements would be placed at
a competitive disadvantage because the New Accord requires banks to make Pillar 3
public disclosures on a semiannual basis.
The agencies believe that quarterly public disclosure requirements are important
to ensure that the market has access to timely and relevant information and therefore have
decided to retain quarterly quantitative disclosure requirements in the final rule. This
disclosure frequency is consistent with longstanding requirements in the United States for
robust quarterly disclosures in financial and regulatory reports, and is appropriate
considering the potential for rapid changes in risk profiles. Moreover, many of the
existing SEC, regulatory reporting, and other disclosure requirements that a bank may use
to help meet its public disclosure requirements in the final rule are already required on a
quarterly basis.
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The proposal stated that the disclosures must be timely and that the agencies
would consider a disclosure to be timely if it was made no later than the reporting
deadlines for regulatory reports (for example, FR Y-9C) and financial reports (for
example, SEC Forms 10-Q and 10-K). When these deadlines differ, the later deadline
should be used.
Several commenters expressed concern that the tight timeframe for public
disclosure requirements would be a burden and requested that the agencies provide
greater flexibility, such as by setting the deadline for public disclosures at 60 days after
quarter-end.
The agencies believe commenters’ concerns must be balanced against the
importance of allowing market participants to have access to timely information that is
reflective of a bank’s risk profile and associated capital levels. Accordingly, the agencies
have decided to interpret the requirement for timely public disclosures for purposes of
this final rule to mean within 45 days after calendar quarter-end.
In some cases, management may determine that a significant change has occurred,
such that the most recent reported amounts do not reflect the bank’s capital adequacy and
risk profile. In those cases, banks should disclose the general nature of these changes and
briefly describe how they are likely to affect public disclosures going forward. These
interim disclosures should be made as soon as practicable after the determination that a
significant change has occurred.
Location of disclosures and audit/attestation requirements
Under the proposed and final rules, the disclosures must be publicly available (for
example, included on a public website) for each of the latest three years (12 quarters) or
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such shorter time period since the bank entered its first transitional floor period. Except
as discussed below, management has discretion to determine the appropriate medium and
location of the disclosures required by this final rule. Furthermore, banks have flexibility
in formatting their public disclosures. The agencies are not specifying a fixed format for
these disclosures.
The agencies encourage management to provide all of the required disclosures in
one place on the entity’s public website. The public website addresses are reported in the
regulatory reports (for example, the FR Y-9C). 105
Disclosure of tier 1 and total capital ratios must be provided in the footnotes to the
year-end audited financial statements. 106 Accordingly, these disclosures must be tested
by external auditors as part of the financial statement audit. Disclosures that are not
included in the footnotes to the audited financial statements are not subject to external
audit reports for financial statements or internal control reports from management and the
external auditor.
The preamble to the proposed rule stated that due to the importance of reliable
disclosures, the agencies would require the chief financial officer to certify that the
disclosures required by the proposed rule were appropriate and that the board of directors
and senior management were responsible for establishing and maintaining an effective
105
Alternatively, banks may provide the disclosures in more than one place, as some of them may be
included in public financial reports (for example, in Management’s Discussion and Analysis included in
SEC filings) or other regulatory reports (for example, FR Y-9C Reports). Banks must provide a summary
table on their public website that specifically indicates where all the disclosures may be found (for
example, regulatory report schedules or page numbers in annual reports).
106
These ratios are required to be disclosed in the footnotes to the audited financial statements pursuant to
existing GAAP requirements in Chapter 17 of the “AICPA Audit and Accounting Guide for Depository and
Lending Institutions: Banks, Savings institutions, Credit unions, Finance companies and Mortgage
companies.”
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internal control structure over financial reporting, including the information required by
the proposed rule.
Several commenters expressed uncertainty regarding the proposed certification
requirement for the chief financial officer. One commenter asked the agencies to
articulate the standard of acceptance required for the certification of disclosure standards
compared with what is required for financial reporting purposes. Another commenter
questioned whether the chief financial officer would have sufficient familiarity with the
risk management disclosures to make such a certification.
To address commenter uncertainty, the agencies have simplified and clarified the
final rule’s accountability requirements. Specifically, the final rule modifies the
certification requirement and instead requires one or more senior officers of the bank to
attest that the disclosures meet the requirements of the final rule. The senior officer may
be the chief financial officer, the chief risk officer, an equivalent senior officer, or a
combination thereof.
Proprietary and confidential information
The agencies stated in the preamble to the proposed rule that they believed the
proposed requirements strike an appropriate balance between the need for meaningful
disclosure and the protection of proprietary and confidential information. 107 Many
commenters, however, expressed concern that the required disclosures would result in the
release of proprietary information. Commenters expressed particular concerns about the
107
Proprietary information encompasses information that, if shared with competitors, would render a
bank’s investment in these products/systems less valuable, and, hence, could undermine its competitive
position. Information about customers is often confidential, in that it is provided under the terms of a legal
agreement or counterparty relationship.
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granularity of the credit loss history and securitization disclosures, as well as disclosures
for portfolios subject to the IRB risk-based capital formulas.
As noted above, the final rule provides banks with considerable discretion with
regard to public disclosure requirements. Bank management determines which
disclosures are relevant based on a materiality concept. In addition, bank management
has flexibility regarding formatting and the level of granularity of disclosures, provided
they meet certain minimum requirements. Accordingly, the agencies believe that banks
generally can provide these disclosures without revealing proprietary and confidential
information. Only in rare circumstances might disclosure of certain items of information
required in the final rule compel a bank to reveal confidential and proprietary
information. In these unusual situations, the final rule requires that if a bank believes that
disclosure of specific commercial or financial information would prejudice seriously the
position of the bank by making public information that is either proprietary or
confidential in nature, the bank need not disclose those specific items, but must disclose
more general information about the subject matter of the requirement, together with the
fact that, and the reason why, the specific items of information have not been disclosed.
This provision of the final rule applies only to those disclosures required by the final rule
and does not apply to disclosure requirements imposed by accounting standards or other
regulatory agencies.
3. Summary of specific public disclosure requirements
As in the proposed rule, the public disclosure requirements are comprised of 11
tables that provide important information to market participants on the scope of
application, capital, risk exposures, risk assessment processes, and, hence, the capital
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adequacy of the institution. The agencies are adopting the tables as proposed, with the
exceptions noted below. Again, the agencies note that the substantive content of the
tables is the focus of the disclosure requirements, not the tables themselves. The table
numbers below refer to the table numbers in the final rule.
Table 11.1 disclosures (Scope of Application) include a description of the level in
the organization to which the disclosures apply and an outline of any differences in
consolidation for accounting and regulatory capital purposes, as well as a description of
any restrictions on the transfer of funds and capital within the organization. These
disclosures provide the basic context underlying regulatory capital calculations.
One commenter questioned item (e) in Table 11.1, which would require the
disclosure of the aggregate amount of capital deficiencies in all subsidiaries and the
name(s) of such subsidiaries. The commenter asserted that the scope of this item should
be limited to those legal subsidiaries that are subject to banking, securities, or insurance
regulators’ capital adequacy rules and should not include unregulated entities that are
consolidated into the top corporate entity or unconsolidated affiliate and joint ventures.
As stated in a footnote to Table 11.1 in the proposed rule, the agencies limited the
proposed requirement to legal subsidiaries that are subject to banking, securities, or
insurance regulators’ capital adequacy rules. The agencies are further clarifying this
disclosure in Table 11.1.
Table 11.2 disclosures (Capital Structure) provide information on various
components of regulatory capital available to absorb losses and allow for an evaluation of
the quality of the capital available to absorb losses within the bank.
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Table 11.3 disclosures (Capital Adequacy) provide information about how a bank
assesses the adequacy of its capital and require that the bank disclose its minimum capital
requirements for significant risk areas and portfolios. The table also requires disclosure
of the regulatory capital ratios of the consolidated group and each DI subsidiary. Such
disclosures provide insight into the overall adequacy of capital based on the risk profile
of the organization.
Tables 11.4, 11.5, and 11.7 disclosures (Credit Risk) provide market participants
with insight into different types and concentrations of credit risk to which the bank is
exposed and the techniques the bank uses to measure, monitor, and mitigate those risks.
These disclosures are intended to enable market participants to assess the credit risk
exposures under the IRB approach, without revealing proprietary information.
Several commenters made suggestions related to Table 11.4. One commenter
addressed item (b), which requires the disclosure of total and average gross credit risk
exposures over the period broken down by major types of credit exposure. The
commenter asked the agencies to clarify that methods used for financial reporting
purposes are allowed for determining averages. Another commenter requested that the
agencies clarify what is meant by “gross” in item (b), given that a related footnote
describes net credit risk exposures in accordance with GAAP.
As with most of the disclosure requirements, the agencies are not prescriptive
regarding the methodologies a bank must use for determining averages. Rather, the bank
must choose whatever methodology it believes to be most reflective of its risk position.
That methodology may be the one the bank uses for financial reporting purposes. The
agencies have deleted “gross” and otherwise simplified the wording of item (b) in Table
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11.4 to enhance clarity. Item (b) now reads “total credit risk exposures and average
credit risk exposures, after accounting offsets in accordance with GAAP, and without
taking into account the effects of credit risk mitigation techniques (for example collateral
and netting not included in GAAP for disclosure), over the period broken down by major
types of credit exposure.”
In addition, a commenter noted that the requirements in Table 11.4 regarding the
breakdown of disclosures by “major types of credit exposure” in items (b) through (e)
and by “counterparty type” for items (d) and (f) are unclear. Moreover, with respect to
items (d), (e), and (f), the commenter recommended that disclosures should be provided
on an annual rather than quarterly basis. The same commenter also asserted that the
disclosure of remaining contractual maturity breakdown in item (e) should be required
annually. Finally, regarding items (f) and (g), a few commenters wanted clarification of
the definition of impaired and past due loans.
The agencies are not prescriptive with regard to what is meant by “major types of
credit exposure,” disclosure by counterparty type, or impaired and past due loans. Bank
management has the discretion to determine the most appropriate disclosure for the
bank’s risk profile consistent with internal practice, GAAP or regulatory reports (such as
the FR Y-9C). As noted in the proposal, for major types of credit exposure a bank could
apply a breakdown similar to that used for accounting purposes, such as (a) loans, offbalance sheet commitments, and other non-derivative off-balance sheet exposures, (b)
debt securities, and (c) OTC derivatives. The agencies do not believe it is appropriate to
make an exception to the general quarterly requirement for quantitative disclosures for
the disclosure in Table 11.4.
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Commenters provided extensive feedback on several aspects of Table 11.5,
(Disclosures for Portfolios Subject to IRB Risk-Based Capital Formulas). Several
commenters were concerned that the required level of detail may compel banks to
disclose proprietary information. With respect to item (c), a couple of commenters noted
that the proposal differs from the New Accord in requiring exposure-weighted average
capital requirements instead of risk weight percentages for groups of wholesale and retail
exposures. One commenter also suggested that the term “actual losses” required in item
(d) needs to be defined. Finally, several commenters objected to the proposal in item (e)
to disclose backtesting results, asserting that such results would not be understood by the
market. Commenters suggested that disclosure of this item be delayed beyond the
proposed commencement date of year-end 2010, to commence instead ten years after a
bank exits from the parallel run period.
As discussed above, the agencies believe that, in most cases, a bank can make the
required disclosures without revealing proprietary information and that the rule contains
appropriate provisions to deal with specific bank concerns. With regard to item (c), the
agencies agree that there is no strong policy reason to differ from the New Accord and
have changed item (c) to require the specified disclosures in risk weight percentages
rather than weighted-average capital requirements. With respect to item (d), the agencies
are not imposing a prescriptive definition of actual losses and believe that banks should
determine actual losses consistent with internal practice. Finally, regarding item (e), the
agencies believe that public disclosure of backtesting results provides important
information to the market and should not be delayed. However, the agencies have
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slightly modified the requirement, consistent with the New Accord, to reinforce that
disclosure of individual risk parameter backtesting is not always required.
Commenters provided feedback on a few aspects of Table 11.7 (Credit Risk
Mitigation). One commenter asserted that the table appears to overlap with the
information on credit risk mitigation required in Table 11.5, item (a) and requested that
the agencies consolidate and simplify the requirements. In addition, several commenters
objected to Table 11.7 item (b), which would require public disclosure of the riskweighted asset amount associated with credit risk exposures that are covered by credit
risk mitigation in the form of guarantees and credit derivatives. The commenter noted
that this requirement is not contained in the New Accord, which only requires the total
exposure amount of such credit risk exposures.
The agencies recognize that there is some duplication between Tables 11.7 and
11.5. At the same time, both requirements are part of the New Accord. The agencies
have decided to address this issue by inserting in Table 11.5, item (a), a note that the
disclosures can be met by completing the disclosures in Table 11.7. With regard to Table
11.7, item (b), the agencies have decided that there is no strong policy reason for
requiring banks to disclose risk-weighted assets associated with credit risk exposures that
are covered by credit risk mitigation in the form of guarantees and credit derivatives. The
agencies have removed this requirement from the final rule, consistent with the New
Accord.
Table 11.6 (General Disclosure for Counterparty Credit Risk of OTC Derivative
Contracts, Repo-Style Transaction, and Eligible Margin Loans) provides the disclosure
requirements related to credit exposures from derivatives. See the July 2005 BCBS
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publication entitled “The Application of Basel II to Trading Activities and the Treatment
of Double Default Effects.”
Commenters raised a few issues with respect to Table 11.6. One commenter
requested that the agencies clarify item (a), which requires a discussion of the impact of
the amount of collateral the bank would have to provide given a credit rating downgrade.
The commenter asked whether this disclosure refers to credit downgrade of the bank, the
counterparty, or some other entity. Another commenter objected to item (b), which
would require the breakdown of counterparty credit exposure by type of exposure. The
commenter asserted that this proposed requirement is burdensome, infeasible for netted
exposures and duplicative of other information generally available in existing GAAP and
U.S. bank regulatory financial statements.
The agencies have decided to clarify that item (a) refers in part to the credit rating
downgrade of the bank making the disclosure. This is consistent with the intent of this
disclosure requirement in the New Accord. With respect to item (b), the agencies
recognize that this proposed requirement may be problematic for banks that have
implemented the internal models methodology. Accordingly, the agencies have decided
to modify the rule to note that this disclosure item is only required for banks not using the
internal models methodology in section 32(d).
Table 11.8 disclosures (Securitization) provide information to market participants
on the amount of credit risk transferred and retained by the organization through
securitization transactions and the types of products securitized by the organization.
These disclosures provide users a better understanding of how securitization transactions
impact the credit risk of the bank.
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One commenter asked the agencies to explicitly acknowledge that they will
accept the definitions and interpretations of the components of securitization exposures
that a bank uses for financial reporting purposes (FAS 140 reporting disclosures).
Generally, as noted above, the agencies expect that a bank will be able to fulfill
some of its disclosure requirements by relying on disclosures made in accordance with
accounting standards, SEC mandates, or regulatory reports. In these situations, a bank
must explain any material differences between the accounting or other disclosure and the
disclosures required under the final rule. The agencies do not believe any changes to the
rule are necessary to accommodate the commenter’s concern.
Table 11.9 disclosures (Operational Risk) provide insight into the bank’s
application of the AMA for operational risk and what internal and external factors are
considered in determining the amount of capital allocated to operational risk.
Table 11.10 disclosures (Equities Not Subject to Market Risk Rule) provide
market participants with an understanding of the types of equity securities held by the
bank and how they are valued. The table also provides information on the capital
allocated to different equity products and the amount of unrealized gains and losses.
Table 11.11 disclosures (Interest Rate Risk in Non-Trading Activities) provide
information about the potential risk of loss that may result from changes in interest rates
and how the bank measures such risk.
4. Regulatory reporting
In addition to the public disclosures required by the consolidated banking
organization subject to the advanced approaches, the agencies will require certain
additional regulatory reporting from BHCs, their subsidiary DIs, and DIs applying the
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advanced approaches that are not subsidiaries of BHCs. The agencies believe that the
reporting of key risk parameter estimates by each DI applying the advanced approaches
will provide the primary Federal supervisor and other relevant supervisors with data
important for assessing the reasonableness and accuracy of the bank’s calculation of its
minimum capital requirements under this final rule and the adequacy of the institution’s
capital in relation to its risks. This information will be collected through regulatory
reports. The agencies believe that requiring certain common reporting across banks will
facilitate comparable application of the final rule.
The agencies will publish in the Federal Register reporting schedules based on the
reporting templates issued for comment in September 2006. Consistent with the
proposed reporting schedules, these reporting schedules will include a summary schedule
with aggregate data that will be available to the general public. It also will include
supporting schedules that will be viewed as confidential supervisory information. These
schedules will be broken out by exposure category and will collect risk parameter and
other pertinent data in a systematic manner. Under the final rule, banks must begin
reporting this information during their parallel run on a confidential basis. The agencies
will share this information with each other for calibration and other analytical purposes.
One commenter expressed concerns that some of the confidential information
requested in the proposed reporting templates was also contained in the public disclosure
requirements under the proposal. As a result, some information would be classified as
confidential in the reporting templates and public under the disclosure requirements in the
final rule.
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The agencies recognize that there may be some overlap between confidential
information required in the regulatory reports and public information required in the
disclosure requirements of the final rule. The agencies will address specific comments on
the reporting templates separately. In general, the agencies believe that given the
different purposes of the regulatory reporting and public disclosure requirements under
the final rule, there may be some instances where the same or similar disclosures may be
required by both sets of requirements. Many of the public disclosures cover only a subset
of the information sought in the proposed regulatory reporting templates. For instance,
banks are required only to disclose publicly information “across a sufficient number of
PD grades to allow a meaningful differentiation of credit risk,” whereas the proposed
reporting templates contemplate a much more granular collection of data by specified PD
bands. Such aggregation of data so as to mask the confidential nature of more granular
information that is reported to regulators is not unique to the advanced approaches
reporting. In addition, the agencies believe that a bank may be able to comply with some
of the public disclosure requirements under this final rule by publicly disclosing, at the
bank’s discretion and judgment, certain information found in the reporting templates that
otherwise would be held confidential by the agencies. A bank could disclose this
information on its website (as described in “location and audit requirements” above) if it
believes that such disclosures will meet the public disclosure requirements required by
the rule.
List of Acronyms
ABCP Asset-Backed Commercial Paper
ALLL Allowance for Loan and Lease Losses
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AMA Advanced Measurement Approaches
ANPR Advance Notice of Proposed Rulemaking
AVC Asset Value Correlation
BCBS Basel Committee on Banking Supervision
BHC Bank Holding Company
CCDS Contingent Credit Default Swap
CF Conversion Factor
CEIO Credit-Enhancing Interest-Only Strip
CRM Credit Risk Mitigation
CUSIP Committee on Uniform Securities Identification Procedures
DI Depository Institution
DvP Delivery versus Payment
E Measure of Effectiveness
EAD Exposure at Default
ECL Expected Credit Loss
EE Expected Exposure
EL Expected Loss
ELGD Expected Loss Given Default
EOL Expected Operational Loss
EPE Expected Positive Exposure
EWALGD Exposure-Weighted Average Loss Given Default
FAS Financial Accounting Standard
FDIC Federal Deposit Insurance Corporation
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FFIEC Federal Financial Institutions Examination Council
GAAP Generally Accepted Accounting Principles
GAO Government Accountability Office
HELOC Home Equity Line of Credit
HOLA Home Owners’ Loan Act
HVCRE High-Volatility Commercial Real Estate
IAA Internal Assessment Approach
ICAAP Internal Capital Adequacy Assessment Process
IMA Internal Models Approach
IRB Internal Ratings-Based
KIRB Capital Requirement for Underlying Pool of Exposures (securitizations)
LGD Loss Given Default
LTV Loan-to-Value Ratio
M Effective Maturity
NRSRO Nationally Recognized Statistical Rating Organization
OCC Office of the Comptroller of the Currency
OTC Over-the-Counter
OTS Office of Thrift Supervision
PCA Prompt Corrective Action
PD Probability of Default
PFE Potential Future Exposure
PMI Private Mortgage Insurance
PvP Payment versus Payment
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QIS-3 Quantitative Impact Study 3
QIS-4 Quantitative Impact Study 4
QIS-5 Quantitative Impact Study 5
QRE Qualifying Revolving Exposure
RBA Ratings-Based Approach
RVC Ratio of Value Change
SEC Securities and Exchange Commission
SFA Supervisory Formula Approach
SME Small- and Medium-Size Enterprise
SPE Special Purpose Entity
SRWA Simple Risk-Weight Approach
TFR Thrift Financial Report
UL Unexpected Loss
UOL Unexpected Operational Loss
VaR Value-at-Risk
Regulatory Flexibility Act Analysis
The Regulatory Flexibility Act (RFA) requires an agency that is issuing a final
rule to prepare and make available a regulatory flexibility analysis that describes the
impact of the final rule on small entities. 5 U.S.C. 603(a). The RFA provides that an
agency is not required to prepare and publish a regulatory flexibility analysis if the
agency certifies that the final rule will not have a significant economic impact on a
substantial number of small entities. 5 U.S.C. 605(b).
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Pursuant to section 605(b) of the RFA (5 U.S.C. 605(b)), the agencies certify that
this final rule will not have a significant economic impact on a substantial number of
small entities. Pursuant to regulations issued by the Small Business Administration (13
CFR 121.201), a “small entity” includes a bank holding company, commercial bank, or
savings association with assets of $165 million or less (collectively, small banking
organizations). The final rule requires a bank holding company, national bank, state
member bank, state nonmember bank, or savings association to calculate its risk-based
capital requirements according to certain internal-ratings-based and internal model
approaches if the bank holding company, bank, or savings association (i) has
consolidated total assets (as reported on its most recent year-end regulatory report) equal
to $250 billion or more; (ii) has consolidated total on-balance sheet foreign exposures at
the most recent year-end equal to $10 billion or more; or (iii) is a subsidiary of a bank
holding company, bank, or savings association that would be required to use the proposed
rule to calculate its risk-based capital requirements.
The agencies estimate that zero small bank holding companies (out of a total of
approximately 2,934 small bank holding companies), 16 small national banks (out of a
total of approximately 942 small national banks), one small state member bank (out of a
total of approximately 491 small state member banks), one small state nonmember bank
(out of a total of approximately 3,249 small state nonmember banks), and zero small
savings associations (out of a total of approximately 419 small savings associations)
would be subject to the final rule on a mandatory basis. In addition, each of the small
banking organizations subject to the final rule on a mandatory basis is a subsidiary of a
bank holding company with over $250 billion in consolidated total assets or over
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$10 billion in consolidated total on-balance sheet foreign exposure. Therefore, the
agencies believe that the final rule will not result in a significant economic impact on a
substantial number of small entities.
Paperwork Reduction Act
In accordance with the requirements of the Paperwork Reduction Act of 1995, the
agencies may not conduct or sponsor, and respondents are not required to respond to, an
information collection unless it displays a currently valid Office of Management and
Budget (OMB) control number. OMB assigned the following control numbers to the
collections of information: 1557-0234 (OCC), 3064-0153 (FDIC), and 1550-0115
(OTS). The Board assigned control number 7100-0313.
In September 2006 the OCC, FDIC, and OTS submitted the information
collections contained in this rule to OMB for review and approval once the proposed rule
was published. The Board, under authority delegated to it by OMB, also submitted the
proposed information collection to OMB.
The agencies (OCC, FDIC, the Board, and OTS) determined that sections 21-24,
42, 44, 53, and 71 of the final rule contain collections of information. The final rule sets
forth a new risk-based capital adequacy framework that would require some banks and
allow other qualifying banks to use an internal ratings-based approach to calculate
regulatory credit risk capital requirements and advanced measurement approaches to
calculate regulatory operational risk capital requirements. The collections of information
are necessary in order to implement the proposed advanced capital adequacy framework.
The agencies received approximately ninety public comments. None of the comment
letters specifically addressed the proposed burden estimates; therefore, the burden
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estimates will remain unchanged, as published in the notice of proposed rulemaking
(71 FR 55830).
The affected public are: national banks and Federal branches and agencies of
foreign banks (OCC); state member banks, bank holding companies, affiliates and certain
non-bank subsidiaries of bank holding companies, uninsured state agencies and branches
of foreign banks, commercial lending companies owned or controlled by foreign banks,
and Edge and agreement corporations (Board); insured nonmember banks, insured state
branches of foreign banks, and certain subsidiaries of these entities (FDIC); and savings
associations and certain of their subsidiaries (OTS).
Comment Request
The agencies have an ongoing interest in your comments. They should be sent
to [Agency] Desk Officer, [OMB No.], by mail to U.S. Office of Management and
Budget, 725 17th Street, NW, #10235, Washington, DC 20503, or by fax to (202) 3956974.
Comments submitted in response to this notice will be shared among the
agencies. All comments will become a matter of public record. Written comments
should address the accuracy of the burden estimates and ways to minimize burden
including the use of automated collection techniques or the use of other forms of
information technology as well as other relevant aspects of the information collection
request.
OCC Executive Order 12866
Executive Order 12866 requires Federal agencies to prepare a regulatory impact
analysis for agency actions that are found to be “significant regulatory actions.”
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“Significant regulatory actions” include, among other things, rulemakings that “have an
annual effect on the economy of $100 million or more or adversely affect in a material
way the economy, a sector of the economy, productivity, competition, jobs, the
environment, public health or safety, or State, local, or tribal governments or
communities.” 108 Regulatory actions that satisfy one or more of these criteria are referred
to as “economically significant regulatory actions.”
The OCC anticipates that the final rule will meet the $100 million criterion and
therefore is an economically significant regulatory action. In conducting the regulatory
analysis for an economically significant regulatory action, Executive Order 12866
requires each Federal agency to provide to the Administrator of the Office of
Management and Budget’s (OMB) Office of Information and Regulatory Affairs (OIRA):
•
The text of the draft regulatory action, together with a reasonably detailed
description of the need for the regulatory action and an explanation of how the
regulatory action will meet that need;
•
An assessment of the potential costs and benefits of the regulatory action,
including an explanation of the manner in which the regulatory action is
consistent with a statutory mandate and, to the extent permitted by law, promotes
the President's priorities and avoids undue interference with State, local, and tribal
governments in the exercise of their governmental functions;
108
Executive Order 12866 (September 30, 1993), 58 FR 51735 (October 4, 1993), as amended by
Executive Order 13258 (February 26, 2002), 67 FR 9385 (February 28, 2002) and by Executive Order
13422 (January 18, 2007), 72 FR 2763 (January 23, 2007). For the complete text of the definition of
"significant regulatory action," see E.O. 12866 at § 3(f). A "regulatory action" is "any substantive action
by an agency (normally published in the Federal Register) that promulgates or is expected to lead to the
promulgation of a final rule or regulation, including notices of inquiry, advance notices of proposed
rulemaking, and notices of proposed rulemaking." E.O. 12866 at § 3(e).
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•
An assessment, including the underlying analysis, of benefits anticipated from the
regulatory action (such as, but not limited to, the promotion of the efficient
functioning of the economy and private markets, the enhancement of health and
safety, the protection of the natural environment, and the elimination or reduction
of discrimination or bias) together with, to the extent feasible, a quantification of
those benefits;
•
An assessment, including the underlying analysis, of costs anticipated from the
regulatory action (such as, but not limited to, the direct cost both to the
government in administering the regulation and to businesses and others in
complying with the regulation, and any adverse effects on the efficient
functioning of the economy, private markets (including productivity,
employment, and competitiveness), health, safety, and the natural environment),
together with, to the extent feasible, a quantification of those costs; and
•
An assessment, including the underlying analysis, of costs and benefits of
potentially effective and reasonably feasible alternatives to the planned regulation,
identified by the agencies or the public (including improving the current
regulation and reasonably viable nonregulatory actions), and an explanation why
the planned regulatory action is preferable to the identified potential alternatives.
Set forth below is a summary of the OCC’s regulatory impact analysis, which can be
found in its entirety at [INSERT UPDATED WEB ADDRESS].
I.
THE NEED FOR THE REGULATORY ACTION
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Federal banking law directs Federal banking agencies including the Office of the
Comptroller of the Currency (OCC) to require banking organizations to hold adequate
capital. The law authorizes Federal banking agencies to set minimum capital levels to
ensure that banking organizations maintain adequate capital. The law also gives Federal
banking agencies broad discretion with respect to capital regulation by authorizing them
to also use any other methods that they deem appropriate to ensure capital adequacy.
Capital regulation seeks to address market failures that stem from several sources.
Asymmetric information about the risk in a bank’s portfolio creates a market failure by
hindering the ability of creditors and outside monitors to discern a bank’s actual risk and
capital adequacy. Moral hazard creates market failure in which the bank’s creditors fail
to restrain the bank from taking excessive risks because deposit insurance either fully or
partially protects them from losses. Public policy addresses these market failures because
individual banks fail to adequately consider the positive externality or public benefit that
adequate capital brings to financial markets and the economy as a whole.
Capital regulations cannot be static. Innovation in and transformation of financial
markets require periodic reassessments of what may count as capital and what amount of
capital is adequate. Continuing changes in financial markets create both a need and an
opportunity to refine capital standards in banking. The Basel Committee on Banking
Supervision’s “International Convergence of Capital Measurement and Capital
Standards: A Revised Framework” (New Accord), and its implementation in the United
States, reflects an appropriate step forward in addressing these changes.
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II.
REGULATORY BACKGROUND
The capital regulation examined in this analysis will apply to commercial banks
and savings associations (collectively, banks). Three banking agencies, the OCC, the
Board of Governors of the Federal Reserve System (Board), and the FDIC regulate
commercial banks, while the Office of Thrift Supervision (OTS) regulates all federally
chartered and many state-chartered savings associations. Throughout this document, the
four are jointly referred to as the Federal banking agencies.
The New Accord comprises three mutually reinforcing “pillars” as summarized
below.
1. Minimum capital requirements (Pillar 1)
The first pillar establishes a method for calculating minimum regulatory capital.
It sets new requirements for assessing credit risk and operational risk while retaining the
approach to market risk as developed in the 1996 amendments to the 1988 Accord.
The New Accord offers banks a choice of three methodologies for calculating a
capital charge for credit risk. The first approach, called the Standardized Approach,
essentially refines the risk-weighting framework of the 1988 Accord. The other two
approaches are variations on an internal ratings-based (IRB) approach that leverages
banks’ internal credit-rating systems: a “foundation” methodology in which banks
estimate the probability of borrower or obligor default, and an “advanced” approach in
which banks also supply other inputs needed for the capital calculation. In addition, the
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new framework uses more risk-sensitive methods for dealing with collateral, guarantees,
credit derivatives, securitizations, and receivables.
The New Accord also introduces an explicit capital requirement for operational
risk. 109 The New Accord offers banks a choice of three methodologies for calculating
their capital charge for operational risk. The first method, called the Basic Indicator
Approach, requires banks to hold capital for operational risk equal to 15 percent of
annual gross income (averaged over the most recent three years). The second option,
called the Standardized Approach, uses a formula that divides a bank’s activities into
eight business lines, calculates the capital charge for each business line as a fixed
percentage of gross income (12 percent, 15 percent, or 18 percent depending on the
nature of the business, again averaged over the most recent three years), and then sums
across business lines. The third option, called the Advanced Measurement Approaches
(AMA), uses an bank’s internal operational risk measurement system to determine the
capital requirement.
2. Supervisory review process (Pillar 2)
The second pillar calls upon banks to have an internal capital assessment process
and banking supervisors to evaluate each bank’s overall risk profile as well as its risk
management and internal control processes. This pillar establishes an expectation that
banks hold capital beyond the minimums computed under Pillar 1, including additional
109
Operational risk is the risk of loss resulting from inadequate or failed processes, people, and systems or
from external events. It includes legal risk, but excludes strategic risk and reputation risk.
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capital for any risks that are not adequately captured under Pillar 1. It encourages banks
to develop better risk management techniques for monitoring and managing their risks.
Pillar 2 also charges supervisors with the responsibility to ensure that banks using
advanced Pillar 1 techniques, such as the IRB approach to credit risk and the AMA for
operational risk (collectively, advanced approaches), comply with the minimum
standards and disclosure requirements of those methods, and take action promptly if
capital is not adequate.
3. Market discipline (Pillar 3)
The third pillar of the New Accord sets minimum disclosure requirements for
banks. The disclosures, covering the composition and structure of the bank’s capital, the
nature of its risk exposures, its risk management and internal control processes, and its
capital adequacy, are intended to improve transparency and strengthen market discipline.
By establishing a common set of disclosure requirements, Pillar 3 seeks to provide a
consistent and understandable disclosure framework that market participants can use to
assess key pieces of information on the risks and capital adequacy of a bank.
B. U.S. implementation
The rule for implementing the New Accord’s advanced approaches in the United
States will apply the new framework to the largest and most internationally active banks.
All banks will fall into one of three regulatory categories. The first category, called
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“mandatory” banks, consists of banks with consolidated assets of at least $250 billion or
consolidated on-balance-sheet foreign exposures of $10 billion or more. Mandatory
banks will have to use the New Accord’s most advanced methods only: the Advanced
IRB approach to determine capital for credit risk and the AMA to determine capital for
operational risk. A second category of banks, called “opt-in” banks, includes banks that
do not meet either size criteria of a mandatory bank but choose voluntarily to comply
with the advanced approaches specified under the New Accord. The third category,
called “general” banks, encompasses all other banks, and these will continue to operate
under existing risk-based capital rules, subject to any amendments.
Various changes to the rules that apply to non-mandatory banks are under
consideration. The Federal banking agencies have decided to issue for comment a
proposal that would allow the voluntary adoption of the standardized approach for credit
risk and the basic indicator approach for operational risk for non-mandatory banks
(referred to hereafter as the Standardized Option). Because the Standardized Option
would be a separate rulemaking, our analysis will focus just on the implementation of the
Advanced Approaches. However, we will note how the Standardized Option might affect
the outcome of our analysis if we anticipate the possibility that its adoption could lead to
a significantly different outcome.
While introducing many significant changes, the U.S. implementation of the New
Accord retains many components of the capital rules currently in effect. For example, it
preserves existing Prompt Corrective Action provisions for all banks. The U.S.
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implementation of the New Accord also keeps intact most elements of the definition of
what comprises regulatory capital.
III.
COSTS AND BENEFITS OF THE RULE
This analysis considers the costs and benefits of the fully phased-in rule. Under
the rule, current capital rules will remain in effect in 2008 during a parallel run using both
old and new capital rules. For three years following the parallel run, the final rule will
apply limits on the amount by which minimum required capital may decrease. This
analysis, however, considers the costs and benefits of the rule as fully phased in.
Cost and benefit analysis of changes in minimum capital requirements entail
considerable measurement problems. On the cost side, it can be difficult to attribute
particular expenditures incurred by banks to the costs of implementation because banks
would likely incur some of these costs as part of their ongoing efforts to improve risk
measurement and management systems. On the benefits side, measurement problems are
even greater because the benefits of the rule are more qualitative than quantitative.
Measurement problems exist even with an apparently measurable effect such as lower
minimum capital because lower minimum requirements do not necessarily mean lower
capital levels held by banks. Healthy banks generally hold capital well above regulatory
minimums for a variety of reasons, and the effect of reducing the regulatory minimum is
uncertain and may vary across regulated banks.
Benefits of the Rule
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1.
Better allocation of capital and reduced impact of moral hazard through
reduction in the scope for regulatory arbitrage: By assessing the amount of
capital required for each exposure or pool of exposures, the advanced
approaches do away with the simplistic risk buckets of current capital rules.
Getting rid of categorical risk weighting and assigning capital based on
measured risk instead greatly curtails or eliminates the ability of troubled
banks to “game” regulatory capital requirements by finding ways to comply
technically with the requirements while evading their intent and spirit.
2.
Improved signal quality of capital as an indicator of solvency: The advanced
approaches are designed to more accurately align regulatory capital with
risk, which should improve the signal quality of capital as an indicator of
solvency. The improved signaling quality of capital will enhance banking
supervision and market discipline.
3.
Encourages banks to improve credit risk management: One of the principal
objectives of the rule is to more closely align capital charges and risk. For
any type of credit, risk increases as either the probability of default or the
loss given default increases. Under the final rule, the capital charge for
credit risk depends on these risk parameter measures and consequently
capital requirements will more closely reflect risk. This enhanced link
between capital requirements and risk will encourage banks to improve
credit risk management.
4.
More efficient use of required bank capital: Increased risk sensitivity and
improvements in risk measurement will allow prudential objectives to be
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achieved more efficiently. If capital rules can better align capital with risk
across the system, a given level of capital will be able to support a higher
level of banking activity while maintaining the same degree of confidence
regarding the safety and soundness of the banking system. Social welfare is
enhanced by either the stronger condition of the banking system or the
increased economic activity the additional banking services facilitate.
5.
Incorporates and encourages advances in risk measurement and risk
management: The rule seeks to improve upon existing capital regulations by
incorporating advances in risk measurement and risk management made
over the past 15 years. An objective of the rule is to speed adoption of new
risk management techniques and to promote the further development of risk
measurement and management through the regulatory process.
6.
Recognizes new developments and accommodates continuing innovation in
financial products by focusing on risk: The rule also has the benefit of
facilitating recognition of new developments in financial products by
focusing on the fundamentals behind risk rather than on static product
categories.
7.
Better aligns capital and operational risk and encourages banks to mitigate
operational risk: Introducing an explicit capital calculation for operational
risk eliminates the implicit and imprecise “buffer” that covers operational
risk under current capital rules. Introducing an explicit capital requirement
for operational risk improves assessments of the protection capital provides,
particularly at banks where operational risk dominates other risks. The
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explicit treatment also increases the transparency of operational risk, which
could encourage banks to take further steps to mitigate operational risk.
8.
Enhanced supervisory feedback: Although U.S. banks have long been
subject to close supervision, aspects of all three pillars of the rule aim to
enhance supervisory feedback from Federal banking agencies to managers
of banks. Enhanced feedback could further strengthen the safety and
soundness of the banking system.
9.
Enhanced disclosure promotes market discipline: The rule seeks to aid
market discipline through the regulatory framework by requiring specific
disclosures relating to risk measurement and risk management. Market
discipline could complement regulatory supervision to bolster safety and
soundness.
10. Preserves the benefits of international consistency and coordination
achieved with the 1988 Basel Accord: An important objective of the 1988
Accord was competitive consistency of capital requirements for banks
competing in global markets. The New Accord continues to pursue this
objective. Because achieving this objective depends on the consistency of
implementation in the United States and abroad, the Basel Committee on
Banking Supervision (BCBS) has established an Accord Implementation
Group to promote consistency in the implementation of the New Accord.
11. Ability to opt in offers long-term flexibility to nonmandatory banks: The
U.S. implementation of the New Accord allows non-mandatory banks to
individually judge when the benefits they expect to realize from adopting
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the advanced approaches outweigh their costs. Even though the cost and
complexity of adopting the advanced methods may present non-mandatory
banks with a substantial hurdle to opting in at present, the potential longterm benefits of allowing non-mandatory banks to partake in the benefits
described above may be similarly substantial.
Costs of the Rule
Because banks are constantly developing programs and systems to improve how
they measure and manage risk, it is difficult to distinguish between expenditures
explicitly caused by adoption of this final rule and costs that would have occurred
irrespective of any new regulation. In an effort to identify how much banks expect to
spend to comply with the U.S. implementation of the New Accord’s advanced
approaches, the Federal banking agencies included several questions related to
compliance costs in the fourth Quantitative Impact Study (QIS-4). 110
1.
Overall Costs: According to the 19 out of 26 QIS-4 questionnaire
respondents that provided estimates of their implementation costs, banks
will spend roughly $42 million on average to adapt to capital requirements
implementing the New Accord’s advanced approaches. Not all of these
respondents are likely mandatory banks. Counting just the likely mandatory
110
For more information on QIS-4, see Office of the Comptroller of the Currency, Board of Governors of
the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of Thrift Supervision,
“Summary Findings of the Fourth Quantitative Impact Study,” February 2006, available online at
http://www.occ.treas.gov/ftp/release/2006-23a.pdf.
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banks, the average is approximately $46 million, so there is little difference
between banks that meet a mandatory threshold and those that do not.
Aggregating estimated expenditures from all 19 respondents indicates that
these banks will spend a total of $791 million over several years to
implement the rule. Estimated costs for nine respondents meeting one of the
mandatory thresholds come to $412 million.
2.
Estimate of costs specific to the rule: Ten QIS-4 respondents provided
estimates of the portion of costs they would have incurred even if current
capital rules remain in effect. Those ten indicated that they would have
spent 45 percent on average, or roughly half of their advanced approaches
expenditures on improving risk management anyway. This suggests that of
the $42 million banks expect to spend on implementation, approximately
$21 million may represent expenditures each bank would have undertaken
even without the New Accord. Thus, pure implementation costs may be
closer to roughly $395 million for the 19 QIS-4 respondents.
3.
Ongoing costs: Seven QIS-4 respondents were able to estimate what their
recurring costs might be under the U.S implementation of the New Accord.
On average, the seven banks estimate that annual recurring expenses
attributable to the revised capital framework will be $2.4 million per bank.
Banks indicated that the ongoing costs to maintain related technology reflect
costs for increased personnel and system maintenance. The larger one-time
expenditures to adopt this final rule primarily involve money for system
development and software purchases.
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4.
Implicit costs: In addition to explicit setup and recurring costs, banks may
also face implicit costs arising from the time and inconvenience of having to
adapt to new capital regulations. At a minimum this involves the increased
time and attention required of senior bank management to introduce new
programs and procedures and the need to closely monitor the new activities
during the inevitable rough patches when the rule first takes effect.
5.
Government Administrative Costs: OCC expenditures fall into three broad
categories: training, guidance, and supervision. Training includes expenses
for AMA and IRB workshops, and other training courses and seminars for
examiners. Guidance expenses reflect expenditures on the development of
IRB and AMA guidance. Supervision expenses reflect bank-specific
supervisory activities related to the development and implementation of the
New Accord. The largest OCC expenditures have been on the development
of IRB and AMA policy guidance. The $5.4 million spent on guidance
represents 54 percent of the estimated total OCC advanced approachesrelated expenditure of $10.0 million through the 2006 fiscal year. In part,
this large share reflects the absence of data for training and supervision costs
for several years, but it also is indicative of the large guidance expenses in
2002 and 2003 when the New Accord was in development. To date, New
Accord expenditures have not been a large part of overall OCC
expenditures. The $3 million spent on the advanced approaches in fiscal
year 2006 represents less than one percent of the OCC’s $579 million
budget for the year.
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6.
Total Cost: The OCC’s estimate of the total cost of the rule includes
expenditures by banks and the OCC from the present through 2011, the final
year of the transition period. Combining expenditures by mandatory banks
and the OCC provides a present value estimate of $498.9 million for the
total cost of the rule.
7.
Procyclicality: Procyclicality refers to the possibility that banks may reduce
lending during economic downturns and increase lending during economic
expansions as a consequence of minimum capital requirements. There is
some concern that the risk-sensitivity of the Advanced IRB approach may
cause capital requirements for credit risk to increase during an economic
downturn. Although procyclicality may be inherent in banking to some
extent, elements of the advanced approaches could reduce inherent
procyclicality. Risk management and information systems may provide
bank managers with more forward-looking information about risk that will
allow them to adjust portfolios gradually and with more foresight as the
economic outlook changes over the business cycle. Regulatory stresstesting requirements included in the rule also will help ensure that banks
anticipate cyclicality in capital requirements to the greatest extent possible,
reducing the potential economic impact of changes in capital requirements.
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IV.
COMPETITION AMONG PROVIDERS OF FINANCIAL SERVICES
One potential concern with any regulatory change is the possibility that it might
create a competitive advantage for some banks relative to others, a possibility that
certainly applies to a change with the scope of this final rule. However, measurement
difficulties described in the preceding discussion of costs and benefits also extend to any
consideration of the impact on competition. Despite the inherent difficulty of drawing
definitive conclusions, this section considers various ways in which competitive effects
might be manifest, as well as available evidence related to those potential effects.
1.
Explicit Capital for Operational Risk: Some have noted that the explicit
computation of required capital for operational risk could lead to an increase
in total minimum regulatory capital for U.S. "processing" banks, generally
defined as banks that tend to engage in a variety of activities related to
securities clearing, asset management, and custodial services. Some have
suggested that the increase in required capital could place such firms at a
competitive disadvantage relative to competitors that do not face a similar
capital requirement. A careful analysis by Fontnouvelle et al 111 considers
the potential competitive impact of the explicit capital requirement for
operational risk. Overall, the study concludes that competitive effects from
an explicit operational risk capital requirement should be, at most, extremely
modest.
111
Patrick de Fontnouvelle, Victoria Garrity, Scott Chu, and Eric Rosengren, “The Potential Impact of
Explicit Basel II Operational Risk Capital Charges on the Competitive Environment of Processing Banks in
the United States,” manuscript, Federal Reserve Bank of Boston, January 12, 2005. Available at
www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
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2.
Residential Mortgage Lending: The issue of competitive effects has received
substantial attention with respect to the residential mortgage market. The
focus on the residential mortgage market stems from the size and
importance of the market in the United States, and the fact that the rule may
lead to substantial reductions in credit-risk capital for residential mortgages.
To the extent that corresponding operational-risk capital requirements do not
offset these credit-risk-related reductions, overall capital requirements for
residential mortgages could decline under the rule. Studies by Calem and
Follain 112 and Hancock, Lennert, Passmore, and Sherlund 113 suggest that
banks operating under rules based on the New Accord’s advance approaches
may increase their holdings of residential mortgages. Calem and Follain
argue that the increase would be significant and come at the expense of
general banks. Hancock et al foresee a more modest increase in residential
mortgage holdings at banks operating under the advanced approaches rule,
and they see this increase primarily as a shift away from the large
government sponsored mortgage enterprises.
3.
Small Business Lending: One potential avenue for competitive effects is
small-business lending. Smaller banks – those that are less likely to adopt
the advanced approaches to regulatory capital under the rule – tend to rely
more heavily on smaller loans within their commercial loan portfolios. To
112
Paul S. Calem and James R. Follain, “Regulatory Capital Arbitrage and the Potential Competitive
Impact of Basel II in the Market for Residential Mortgages”, The Journal of Real Estate Finance and
Economics, Vol. 35, pp. 197-219, August 2007.
113
Diana Hancock, Andreas Lennert, Wayne Passmore, and Shane M. Sherlund, “An Analysis of the
Potential Competitive Impact of Basel II Capital Standards on U.S. Mortgage Rates and Mortgage
Securitization”, manuscript, Federal Reserve Board, April 2005. Available at
www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
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the extent that the rule reduces required capital for such loans, general banks
not operating under the rule might be placed at a competitive disadvantage.
A study by Berger 114 finds some potential for a relatively small competitive
effect on smaller banks in small business lending. However, Berger
concludes that the small business market for large banks is very different
from the small business market for smaller banks. For instance, a “small
business” at a larger bank is usually much larger than small businesses at
community banks.
4.
Mergers and Acquisitions: Another concern related to potential changes in
competitive conditions under the rule is that bifurcation of capital standards
might change the landscape with regard to mergers and acquisitions in
banking and financial services. For example, banks operating under this
final rule might be placed in a better position to acquire banks operating
under the old rules, possibly leading to an undesirable consolidation of the
banking sector. Research by Hannan and Pilloff 115 suggests that the rule is
unlikely to have a significant impact on merger and acquisition activity in
banking.
5.
Credit Card Competition: The U.S. implementation of the New Accord
might also affect competition in the credit card market. Overall capital
requirements for credit card loans could increase under the rule. This raises
114
Allen N. Berger, “Potential Competitive Effects of Basel II on Banks in SME Credit Markets in the
United States,” Journal of Financial Services Research, 29:1, pp. 5-36, 2006. Also available at
www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
115
Timothy H. Hannan and Steven J. Pilloff, “Will the Proposed Application of Basel II in the United
States Encourage Increased Bank Merger Activity? Evidence from Past Merger Activity,” Federal Reserve
Board Finance and Economics Discussion Series, 2004-13, February 2004. Available at
www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
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the possibility of a change in the competitive environment among banks
subject to the new rules, nonbank credit card issuers, and banks not subject
to this final rule. A study by Lang, Mester, and Vermilyea 116 finds that
implementation of a rule based on the New Accord will not affect credit
card competition at most community and regional banks. The authors also
suggest that higher capital requirements for credit cards may only pose a
modest disadvantage to banks that are subject to this final rule.
Overall, the evidence regarding the impact of this final rule on competitive equity
is mixed. The body of recent economic research discussed in the body of this report does
not reveal persuasive evidence of any sizeable competitive effects. Nonetheless, the
Federal banking agencies recognize the need to closely monitor the competitive
landscape subsequent to any regulatory change. In particular, the OCC and other Federal
banking agencies will be alert for early signs of competitive inequities that might result
from this final rule. A multi-year transition period before full implementation of this
final rule should provide ample opportunity for the Federal banking agencies to identify
any emerging problems. In particular, after the end of the second transition year, the
agencies will conduct and publish a study that evaluates the advanced approaches to
determine if there are any material deficiencies. 117 The Federal banking agencies will
consider any egregious competitive effects associated with New Accord implementation,
whether domestic or international in context, to be a material deficiency. To the extent
116
William W. Lang, Loretta J. Mester, and Todd A. Vermilyea, “Potential Competitive Effects on U.S.
Bank Credit Card Lending from the Proposed Bifurcated Application of Basel II,” manuscript, Federal
Reserve Bank of Philadelphia, December 2005. Available at
http://www.philadelphiafed.org/files/wps/2005/wp05-29.pdf
117
The full text of the Regulatory Impact Analysis describes the factors that the interagency study will
consider.
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that undesirable competitive inequities emerge, the agencies have the power to respond to
them through many channels, including but not limited to suitable changes to the capital
adequacy regulations.
V.
ANALYSIS OF BASELINE AND ALTERNATIVES
In order to place the costs and benefits of the rule in context, Executive Order
12866 requires a comparison between this final rule, a baseline of what the world would
look like without this final rule, and several reasonable alternatives to the rule. In this
regulatory impact analysis, we analyze a baseline and three alternatives to the rule. The
baseline analyzes the situation where the Federal banking agencies do not adopt this final
rule, but other countries with internationally active banks do adopt the New Accord. 118
1.
Baseline Scenario: Current capital standards based on the 1988 Basel
Accord continue to apply to banks operating in the United States, but the
rest of the world adopts the New Accord: Abandoning the New Accord in
favor of current capital rules would eliminate essentially all of the benefits
of the rule described earlier. In place of these lost or diminished benefits,
the only advantage of continuing to apply current capital rules to all banks is
that maintaining the status quo should alleviate concerns regarding
competition among domestic financial service providers. Although the
effect of the rule on competition is uncertain in our estimation, staying with
current capital rules (or universally applying a revised rule that might
118
In addition to the United States, members of the BCBS implementing Basel II are Belgium, Canada,
France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, and the United
Kingdom.
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emerge from the Standardized Option) eliminates bifurcation. Concerns
regarding competition usually center on this characteristic of the rule.
However, the emergence of different capital rules across national borders
would at least partially offset this advantage. Thus, while concerns
regarding competition among U.S. financial service providers might
diminish in this scenario, concerns regarding cross-border competition
would likely increase. While continuing to use current capital rules
eliminates most of the benefits of adopting the capital rule, it does not
eliminate many costs associated with the New Accord. Because the New
Accord-related costs are difficult to separate from the bank’s ordinary
development costs and ordinary supervisory costs at the Federal banking
agencies, not implementing the New Accord would reduce but not eliminate
many of these costs associated with the final rule. 119 Furthermore, because
banks in the United States would be operating under a set of capital rules
different from the rest of the world, U.S. banks that are internationally active
may face higher costs because they will have to track and comply with more
than one set of capital requirements.
2.
Alternative A: Permit U.S. banks to choose among all three New Accord
credit risk approaches: The principal benefit of Alternative A that the rule
does not achieve is the increased flexibility of the regulation for banks that
would be mandatory banks under the final rule. Banks that are not prepared
for the adoption of the advanced approach to credit risk under the final rule
119
Cost estimates for adopting a rule that might result from the Standardized Option are not currently
available.
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could choose to use the Foundation IRB methodology or even the
Standardized Approach. How Alternative A might affect benefits depends
entirely on how many banks select each of the three available options. The
most significant drawback to Alternative A is the increased cost of applying
a new set of capital rules to all U.S. banks. The vast majority of banks in
the United States would incur no direct costs from new capital rules. Under
Alternative A, direct costs would increase for every U.S. bank that would
have continued with current capital rules. Although it is not clear how high
these costs might be, general banks would face higher costs because they
would be changing capital rules regardless of which option they choose
under Alternative A.
3.
Alternative B: Permit U.S. banks to choose among all three New Accord
operational risk approaches: The operational risk approach that banks
ultimately selected would determine how the overall benefits of the new
capital regulations would change under Alternative B. Just as Alternative A
increases the flexibility of credit risk rules for mandatory banks, Alternative
B is more flexible with respect to operational risk. Because the
Standardized Approach tries to be more sensitive to variations in operational
risk than the Basic Indicator Approach and AMA is more sensitive than the
Standardized Approach, the effect of implementing Alternative B depends
on how many banks select the more risk sensitive approaches. As was the
case with Alternative A, the most significant drawback to Alternative B is
the increased cost of applying a new set of capital rules to all U.S. banks.
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Under Alternative B, direct costs would increase for every U.S. bank that
would have continued with current capital rules. It is not clear how much it
might cost banks to adopt these capital measures for operational risk, but
general banks would face higher costs because they would be changing
capital rules regardless of which option they choose under Alternative B.
4.
Alternative C: Use a different asset amount to determine a mandatory bank:
The number of mandatory banks decreases slowly as the size thresholds
increase, and the number of banks grows more quickly as the thresholds
decrease. Under Alternative C, the framework of the final rule would
remain the same and only the number of mandatory banks would change.
Because the structure of the implementation would remain intact,
Alternative C would capture all of the benefits of the final rule. However,
because these benefits derive from applying the final rule to individual
banks, changing the number of banks affected by the rule will change the
cumulative level of the benefits achieved. Generally, the benefits associated
with the rule will rise and fall with the number of mandatory banks.
Because Alternative C would change the number of mandatory banks
subject to the rule, aggregate costs will also rise or fall with the number of
mandatory banks.
Overall Comparison of the Rule with Baselines and Alternatives
The New Accord and its U.S. implementation seek to incorporate risk
measurement and risk management advances into capital requirements. Risk-
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DRAFT November 2, 2007
sensitive capital requirements are integral to ensuring an adequate capital cushion
to absorb financial losses at large complex financial banks. In implementing the
New Accord’s advanced approaches in the United States, the agencies’ intent is to
achieve risk-sensitivity while maintaining a regulatory capital regime that is as
rigorous as the current system. Total capital requirements under the advanced
approaches, including capital for operational risk, will better allocate capital in the
system. This will occur regardless of whether the minimum required capital at a
particular bank is greater or less than it would be under current capital rules. In
order to ensure that we achieve our goal of increased risk sensitivity without loss
of rigor, the final rule provides a means for the agencies to identify and address
deficiencies in the capital requirements that may become apparent during the
transition period.
Although the anticipated benefits of the final rule are difficult to quantify in dollar
terms because of measurement problems, the OCC is confident that the
anticipated benefits well exceed the anticipated costs of this regulation. On the
basis of our analysis, we believe that the benefits of the final rule are significant,
durable, and hold the potential to increase with time. The offsetting costs of
implementing the final rule are also significant, but appear to be largely because
of considerable start-up costs. However, much of the apparent start-up costs
reflect activities that the banks would undertake as part of their ongoing efforts to
improve the quality of their internal risk measurement and management, even in
the absence of the New Accord and this final rule. The advanced approaches
seem to have fairly modest ongoing expenses. Against these costs, the significant
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DRAFT November 2, 2007
benefits of the New Accord suggest that the final rule offers an improvement over
the baseline scenario.
(1)
With regard to the three alternative approaches we consider, the final rule
offers an important degree of flexibility while significantly restricting costs by limiting its
application to large, internationally active banks. Alternatives A and B introduce more
flexibility from the perspective of the large mandatory banks, but each is less flexible
with respect to other banks. Either Alternative A or B would compel these nonmandatory banks to select a new set of capital rules and require them to undertake the
time and expense of adjusting to this final rule. Alternative C would change the number
of mandatory banks. If the number of mandatory banks increases, then the new rule
would lose some of the flexibility it achieves with the opt-in option. Furthermore, costs
would increase as the final rule would compel more banks to incur the expense of
adopting the advanced approaches. Decreasing the number of mandatory banks would
decrease the aggregate social good of each benefit achieved with the final rule. The final
rule offers a better balance between costs and benefits than any of the three alternatives.
OTS Executive Order 12866 Determination
OTS commented on the development of, and concurs with, OCC’s RIA. Rather
than replicate that analysis, OTS drafted an RIA incorporating OCC’s analysis by
reference and adding appropriate material reflecting the unique aspects of the thrift
industry. The full text of OTS’s RIA is available at the locations for viewing the OTS
docket indicated in the ADDRESSES section above. OTS believes that its analysis meets
the requirements of Executive Order 12866.
The following discussion supplements OCC’s summary of its RIA.
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The final rule will apply to approximately six mandatory and potential opt-in
savings associations representing approximately 52 percent of total thrift industry assets.
Approximately 76 percent of the total assets in these six institutions are concentrated in
residential mortgage-related assets. By contrast, national banks tend to concentrate their
assets in commercial loans and other kinds of non-mortgage loans. Only about 35
percent of national bank’s total assets are residential mortgage-related assets. As a result,
the costs and benefits of the final rule for OTS-regulated savings associations will differ
in important ways from OCC-regulated national banks. These differences are the focus
of OTS’s analysis.
Benefits. Among the benefits of the final rule, OCC cites: (i) Better allocation of
capital and reduced impact of moral hazard through reduction in the scope for regulatory
arbitrage; (ii) improved signal quality of capital as an indicator of institution solvency;
and (iii) more efficient use of required bank capital. From OTS’s perspective, however,
the final rule may not provide the degree of benefits anticipated by OCC from these
sources.
Because of the typically low credit risk associated with residential mortgagerelated assets, OTS believes that the risk-insensitive leverage ratio, rather than the riskbased capital ratio, may be more binding on savings association institutions. 120 As a
result, these institutions may be required to hold more capital than would be required
under Basel II risk-based standards alone. Therefore, the final rule may cause these
120
The leverage ratio is the ratio of core capital to adjusted total assets. Under prompt corrective action
requirements, savings associations must maintain a leverage ratio of at least five percent to be well
capitalized and at least four percent to be adequately capitalized. Basel II will primarily affect the
calculation of risk-weighted assets, rather than the calculation of total assets and will have only a modest
impact on the calculation of core capital. Thus, the proposed Basel II changes should not significantly
affect the calculated leverage ratio and a savings association that is currently constrained by the leverage
ratio would not significantly benefit from the Basel II changes.
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institutions to incur much the same implementation costs as banks with riskier assets, but
with reduced benefits.
Costs. OTS adopts the OCC cost analysis with the following supplemental
information on OTS’s administrative costs. OTS did not incur a meaningful amount of
direct expenditures until 2002 when it transitioned from a monitoring role to active
involvement in Basel II. Thereafter, expenditures increased rapidly. The OTS
expenditures fall into two broad categories: policymaking expenses incurred in the
development of the ANPR, the NPR, the final rule and related guidance; and supervision
expenses that reflect institution-specific supervisory activities. OTS estimates that it
incurred total expenses of $6,420,000 for fiscal years 2002 through 2006, including
$4,080,000 in policymaking expenses and $2,340,000 in supervision expenses. OTS
anticipates that supervision expenses will continue to grow as a percentage of the total
expense as it moves from policy development to implementation and training. To date,
Basel II expenditures have not been a large part of overall expenditures.
Competition. OTS agrees with OCC’s analysis of competition among providers
of financial services. OTS adds, however, that some institutions with low credit risk
portfolios face an existing competitive disadvantage because they are bound by a nonrisk-based capital requirement – the leverage ratio. Thus, the agencies regulate a class of
institutions that currently receive fewer capital benefits from risk-based capital rules
because they are bound by the risk-insensitive leverage ratio. This anomaly will likely
continue under the final rule.
In addition, the results from QIS-3 and QIS-4 suggest that the largest reductions
in regulatory credit-risk capital requirements from the application of revised rules would
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occur in the residential mortgage loan area. Thus, to the extent regulatory credit-risk
capital requirements affect pricing of such loans, it is possible that core and opt-in
institutions who are not constrained by the leverage ratio may experience an
improvement in their competitive standing vis-à-vis non-adopters and vis-à-vis adopters
who are bound by the leverage ratio. Two research papers – one by Calem and
Follain, 121 and another by Hancock, Lenhert, Passmore, and Sherlund 122 addressed this
topic. The Calem and Follain paper argues that Basel II will significantly affect the
competitive environment in mortgage lending; Hancock, et al. argue that it will not. Both
papers are predicated, however, on the current capital regime for non-adopters. The
agencies recently announced that they have agreed to issue a proposed rule that would
provide non-core banks with the option to adopt an approach consistent with the
standardized approach included in the Basel II framework. The standardized proposal
will replace the earlier proposed rule (the Basel IA proposed rule), and would be
available as an alternative to the existing risk-based capital rules for all U.S. banks other
than banks that adopt the final Basel II rule. Such modifications, if implemented, would
likely reduce the competitive advantage of Basel II adopters.
The final rule also has a ten percent floor on loss given default parameter
estimates for residential mortgage segments that persists beyond the two-year period
articulated in the international Basel II framework, providing a disincentive for core
institutions to hold the least risky residential mortgages. This may have the effect of
121
Paul S. Calem and James R. Follain, “An Examination of How the Proposed Bifurcated Implementation
of Basel II in the U.S. May Affect Competition Among Banking Organizations for Residential Mortgages,”
manuscript, January 14, 2005.
122
Diana Hancock, Andreas Lenhert, Wayne Passmore, and Shane M Sherlund, “An Analysis of the
Competitive Impacts of Basel II Capital Standards on U.S. Mortgage Rates and Mortgage Securitization,
March 7, 2005, Board of Governors of the Federal Reserve System, working paper.
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reducing the core banks’ advantage vis-à-vis both non-adopters and their international
competitors.
Further, residential mortgages are subject to substantial interest rate risk. The
agencies will retain the authority to require additional capital to cover interest rate risk. If
regulatory capital requirements affect asset pricing, a substantial regulatory capital
interest rate risk component could mitigate any competitive advantages of the proposed
rule. Moreover, the capital requirement for interest rate risk would be subject to
interpretation by each agency. A consistent evaluation of interest rate risk by the
supervisory agencies would present a level playing field among the adopters -- an
important consideration given the potential size of the capital requirement.
OCC Unfunded Mandates Reform Act of 1995 Determination
The Unfunded Mandates Reform Act of 1995 (Pub. L. 104-4) (UMRA) requires
cost-benefit and other analyses for a rule that would include any Federal mandate that
may result in the expenditure by State, local, and tribal governments, in the aggregate, or
by the private sector of $100 million or more (adjusted annually for inflation) in any one
year. The current inflation-adjusted expenditure threshold is $119.6 million. The
requirements of the UMRA include assessing a rule’s effects on future compliance costs;
particular regions or State, local, or tribal governments; communities; segments of the
private sector; productivity; economic growth; full employment; creation of productive
jobs; and the international competitiveness of U.S. goods and services. The final rule
qualifies as a significant regulatory action under the UMRA because its Federal mandates
may result in the expenditure by the private sector of $119.6 million or more in any one
year. As permitted by section 202(c) of the UMRA, the required analyses have been
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prepared in conjunction with the Executive Order 12866 analysis document titled
Regulatory Impact Analysis for Risk-Based Capital Standards: Revised Capital
Adequacy Guidelines. The analysis is available on the Internet at
http://www.occ.treas.gov/law/basel.htm under the link of “Regulatory Impact Analysis
for Risk-Based Capital Standards: Revised Capital Adequacy Guidelines (Basel II),
Office of the Comptroller of the Currency, International and Economic Affairs (2006)”.
OTS Unfunded Mandates Reform Act of 1995 Determination
The Unfunded Mandates Reform Act of 1995 (Pub. L. 104-4) (UMRA) requires
cost-benefit and other analyses for a rule that would include any Federal mandate that
may result in the expenditure by State, local, and tribal governments, in the aggregate, or
by the private sector of $100 million or more (adjusted annually for inflation) in any one
year. The current inflation-adjusted expenditure threshold is $119.6 million. The
requirements of the UMRA include assessing a rule’s effects on future compliance costs;
particular regions or State, local, or tribal governments; communities; segments of the
private sector; productivity; economic growth; full employment; creation of productive
jobs; and the international competitiveness of U.S. goods and services. The final rule
qualifies as a significant regulatory action under the UMRA because its Federal mandates
may result in the expenditure by the private sector of $119.6 or more in any one year. As
permitted by section 202(c) of the UMRA, the required analyses have been prepared in
conjunction with the Executive Order 12866 analysis document titled Regulatory Impact
Analysis for Risk-Based Capital Standards: Revised Capital Adequacy Guidelines. The
analysis is available at the locations for viewing the OTS docket indicated in the
ADDRESSES section above.
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Text of Common Appendix (All Agencies)
The text of the agencies’ common appendix appears below:
[Appendix __ to Part __] – Capital Adequacy Guidelines for [Banks]: 1 InternalRatings-Based and Advanced Measurement Approaches
Part I General Provisions
Section 1
Section 2
Section 3
Purpose, Applicability, Reservation of Authority, and Principle of
Conservatism
Definitions
Minimum Risk-Based Capital Requirements
Part II Qualifying Capital
Section 11
Additional Deductions
Section 12
Deductions and Limitations Not Required
Section 13
Eligible Credit Reserves
Part III Qualification
Section 21
Section 22
Section 23
Section 24
Qualification Process
Qualification Requirements
Ongoing Qualification
Merger and Acquisition Transitional Arrangements
Part IV Risk-Weighted Assets for General Credit Risk
Section 31
Mechanics for Calculating Total Wholesale and Retail RiskWeighted Assets
Section 32
Counterparty Credit Risk of Repo-Style Transactions, Eligible
Margin Loans, and OTC Derivative Contracts
Section 33
Guarantees and Credit Derivatives: PD Substitution and LGD
Adjustment Approaches
Section 34
Guarantees and Credit Derivatives: Double Default Treatment
Section 35
Risk-Based Capital Requirement for Unsettled Transactions
Part V Risk-Weighted Assets for Securitization Exposures
Section 41
Operational Criteria for Recognizing the Transfer of Risk
Section 42
Risk-Based Capital Requirement for Securitization Exposures
Section 43
Ratings-Based Approach (RBA)
Section 44
Internal Assessment Approach (IAA)
1
For simplicity, and unless otherwise noted, this final rule uses the term [bank] to include banks, savings
associations, and bank holding companies. [AGENCY] refers to the primary Federal supervisor of the
bank applying the rule.
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Section 45
Section 46
Section 47
Supervisory Formula Approach (SFA)
Recognition of Credit Risk Mitigants for Securitization Exposures
Risk-Based Capital Requirement for Early Amortization
Provisions
Part VI Risk-Weighted Assets for Equity Exposures
Section 51
Introduction and Exposure Measurement
Section 52
Simple Risk Weight Approach (SRWA)
Section 53
Internal Models Approach (IMA)
Section 54
Equity Exposures to Investment Funds
Section 55
Equity Derivative Contracts
Part VII Risk-Weighted Assets for Operational Risk
Section 61
Qualification Requirements for Incorporation of Operational Risk
Mitigants
Section 62
Mechanics of Risk-Weighted Asset Calculation
Part VIII Disclosure
Section 71
Disclosure Requirements
Part I. General Provisions
Section 1. Purpose, Applicability, Reservation of Authority, and Principle of
Conservatism
(a) Purpose. This appendix establishes:
(1) Minimum qualifying criteria for [banks] using [bank]-specific internal risk
measurement and management processes for calculating risk-based capital requirements;
(2) Methodologies for such [banks] to calculate their risk-based capital
requirements; and
(3) Public disclosure requirements for such [banks].
(b) Applicability. (1) This appendix applies to a [bank] that:
(i) Has consolidated total assets, as reported on the most recent year-end
Consolidated Report of Condition and Income (Call Report) or Thrift Financial Report
(TFR), equal to $250 billion or more;
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(ii) Has consolidated total on-balance sheet foreign exposure at the most recent
year-end equal to $10 billion or more (where total on-balance sheet foreign exposure
equals total cross-border claims less claims with head office or guarantor located in
another country plus redistributed guaranteed amounts to the country of head office or
guarantor plus local country claims on local residents plus revaluation gains on foreign
exchange and derivative products, calculated in accordance with the Federal Financial
Institutions Examination Council (FFIEC) 009 Country Exposure Report);
(iii) Is a subsidiary of a depository institution that uses 12 CFR part 3,
Appendix C, 12 CFR part 208, Appendix F, 12 CFR part 325, Appendix D, or 12 CFR
part 567, Appendix C, to calculate its risk-based capital requirements; or
(iv) Is a subsidiary of a bank holding company that uses 12 CFR part 225,
Appendix G, to calculate its risk-based capital requirements.
(2) Any [bank] may elect to use this appendix to calculate its risk-based capital
requirements.
(3) A [bank] that is subject to this appendix must use this appendix unless the
[AGENCY] determines in writing that application of this appendix is not appropriate in
light of the [bank]’s asset size, level of complexity, risk profile, or scope of operations.
In making a determination under this paragraph, the [AGENCY] will apply notice and
response procedures in the same manner and to the same extent as the notice and
response procedures in 12 CFR 3.12 (for national banks), 12 CFR 263.202 (for bank
holding companies and state member banks), 12 CFR 325.6(c) (for state nonmember
banks), and 12 CFR 567.3(d) (for savings associations).
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(c) Reservation of authority - (1) Additional capital in the aggregate. The
[AGENCY] may require a [bank] to hold an amount of capital greater than otherwise
required under this appendix if the [AGENCY] determines that the [bank]’s risk-based
capital requirement under this appendix is not commensurate with the [bank]’s credit,
market, operational, or other risks. In making a determination under this paragraph, the
[AGENCY] will apply notice and response procedures in the same manner and to the
same extent as the notice and response procedures in 12 CFR 3.12 (for national banks),
12 CFR 263.202 (for bank holding companies and state member banks), 12 CFR 325.6(c)
(for state nonmember banks), and 12 CFR 567.3(d) (for savings associations).
(2) Specific risk-weighted asset amounts. (i) If the [AGENCY] determines that
the risk-weighted asset amount calculated under this appendix by the [bank] for one or
more exposures is not commensurate with the risks associated with those exposures, the
[AGENCY] may require the [bank] to assign a different risk-weighted asset amount to
the exposures, to assign different risk parameters to the exposures (if the exposures are
wholesale or retail exposures), or to use different model assumptions for the exposures (if
relevant), all as specified by the [AGENCY].
(ii) If the [AGENCY] determines that the risk-weighted asset amount for
operational risk produced by the [bank] under this appendix is not commensurate with the
operational risks of the [bank], the [AGENCY] may require the [bank] to assign a
different risk-weighted asset amount for operational risk, to change elements of its
operational risk analytical framework, including distributional and dependence
assumptions, or to make other changes to the [bank]’s operational risk management
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processes, data and assessment systems, or quantification systems, all as specified by the
[AGENCY].
(3) Other supervisory authority. Nothing in this appendix limits the authority of
the [AGENCY] under any other provision of law or regulation to take supervisory or
enforcement action, including action to address unsafe or unsound practices or
conditions, deficient capital levels, or violations of law.
(d) Principle of conservatism. Notwithstanding the requirements of this appendix,
a [bank] may choose not to apply a provision of this appendix to one or more exposures,
provided that:
(1) The [bank] can demonstrate on an ongoing basis to the satisfaction of the
[AGENCY] that not applying the provision would, in all circumstances, unambiguously
generate a risk-based capital requirement for each such exposure greater than that which
would otherwise be required under this appendix;
(2) The [bank] appropriately manages the risk of each such exposure;
(3) The [bank] notifies the [AGENCY] in writing prior to applying this principle
to each such exposure; and
(4) The exposures to which the [bank] applies this principle are not, in the
aggregate, material to the [bank].
Section 2. Definitions
Advanced internal ratings-based (IRB) systems means a [bank]’s internal risk
rating and segmentation system; risk parameter quantification system; data management
and maintenance system; and control, oversight, and validation system for credit risk of
wholesale and retail exposures.
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Advanced systems means a [bank]’s advanced IRB systems, operational risk
management processes, operational risk data and assessment systems, operational risk
quantification systems, and, to the extent the [bank] uses the following systems, the
internal models methodology, double default excessive correlation detection process,
IMA for equity exposures, and IAA for securitization exposures to ABCP programs.
Affiliate with respect to a company means any company that controls, is
controlled by, or is under common control with, the company.
Applicable external rating means:
(1) With respect to an exposure that has multiple external ratings assigned by
NRSROs, the lowest solicited external rating assigned to the exposure by any NRSRO;
and
(2) With respect to an exposure that has a single external rating assigned by an
NRSRO, the external rating assigned to the exposure by the NRSRO.
Applicable inferred rating means:
(1) With respect to an exposure that has multiple inferred ratings, the lowest
inferred rating based on a solicited external rating; and
(2) With respect to an exposure that has a single inferred rating, the inferred
rating.
Asset-backed commercial paper (ABCP) program means a program that primarily
issues commercial paper that:
(1) Has an external rating; and
(2) Is backed by underlying exposures held in a bankruptcy-remote SPE.
Asset-backed commercial paper (ABCP) program sponsor means a [bank] that:
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(1) Establishes an ABCP program;
(2) Approves the sellers permitted to participate in an ABCP program;
(3) Approves the exposures to be purchased by an ABCP program; or
(4) Administers the ABCP program by monitoring the underlying exposures,
underwriting or otherwise arranging for the placement of debt or other obligations issued
by the program, compiling monthly reports, or ensuring compliance with the program
documents and with the program’s credit and investment policy.
Backtesting means the comparison of a [bank]’s internal estimates with actual
outcomes during a sample period not used in model development. In this context,
backtesting is one form of out-of-sample testing.
Bank holding company is defined in section 2 of the Bank Holding Company Act
(12 U.S.C. 1841).
Benchmarking means the comparison of a [bank]’s internal estimates with
relevant internal and external data or with estimates based on other estimation techniques.
Business environment and internal control factors means the indicators of a
[bank]’s operational risk profile that reflect a current and forward-looking assessment of
the [bank]’s underlying business risk factors and internal control environment.
Carrying value means, with respect to an asset, the value of the asset on the
balance sheet of the [bank], determined in accordance with GAAP.
Clean-up call means a contractual provision that permits an originating [bank] or
servicer to call securitization exposures before their stated maturity or call date. See also
eligible clean-up call.
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Commodity derivative contract means a commodity-linked swap, purchased
commodity-linked option, forward commodity-linked contract, or any other instrument
linked to commodities that gives rise to similar counterparty credit risks.
Company means a corporation, partnership, limited liability company, depository
institution, business trust, special purpose entity, association, or similar organization.
Control. A person or company controls a company if it:
(1) Owns, controls, or holds with power to vote 25 percent or more of a class of
voting securities of the company; or
(2) Consolidates the company for financial reporting purposes.
Controlled early amortization provision means an early amortization provision
that meets all the following conditions:
(1) The originating [bank] has appropriate policies and procedures to ensure that it
has sufficient capital and liquidity available in the event of an early amortization;
(2) Throughout the duration of the securitization (including the early amortization
period), there is the same pro rata sharing of interest, principal, expenses, losses, fees,
recoveries, and other cash flows from the underlying exposures based on the originating
[bank]’s and the investors’ relative shares of the underlying exposures outstanding
measured on a consistent monthly basis;
(3) The amortization period is sufficient for at least 90 percent of the total
underlying exposures outstanding at the beginning of the early amortization period to be
repaid or recognized as in default; and
(4) The schedule for repayment of investor principal is not more rapid than would
be allowed by straight-line amortization over an 18-month period.
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Credit derivative means a financial contract executed under standard industry
credit derivative documentation that allows one party (the protection purchaser) to
transfer the credit risk of one or more exposures (reference exposure) to another party
(the protection provider). See also eligible credit derivative.
Credit-enhancing interest-only strip (CEIO) means an on-balance sheet asset that,
in form or in substance:
(1) Represents a contractual right to receive some or all of the interest and no
more than a minimal amount of principal due on the underlying exposures of a
securitization; and
(2) Exposes the holder to credit risk directly or indirectly associated with the
underlying exposures that exceeds a pro rata share of the holder’s claim on the underlying
exposures, whether through subordination provisions or other credit-enhancement
techniques.
Credit-enhancing representations and warranties means representations and
warranties that are made or assumed in connection with a transfer of underlying
exposures (including loan servicing assets) and that obligate a [bank] to protect another
party from losses arising from the credit risk of the underlying exposures. Creditenhancing representations and warranties include provisions to protect a party from
losses resulting from the default or nonperformance of the obligors of the underlying
exposures or from an insufficiency in the value of the collateral backing the underlying
exposures. Credit-enhancing representations and warranties do not include:
(1) Early default clauses and similar warranties that permit the return of, or
premium refund clauses that cover, first-lien residential mortgage exposures for a period
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not to exceed 120 days from the date of transfer, provided that the date of transfer is
within one year of origination of the residential mortgage exposure;
(2) Premium refund clauses that cover underlying exposures guaranteed, in whole
or in part, by the U.S. government, a U.S. government agency, or a U.S. government
sponsored enterprise, provided that the clauses are for a period not to exceed 120 days
from the date of transfer; or
(3) Warranties that permit the return of underlying exposures in instances of
misrepresentation, fraud, or incomplete documentation.
Credit risk mitigant means collateral, a credit derivative, or a guarantee.
Credit-risk-weighted assets means 1.06 multiplied by the sum of:
(1) Total wholesale and retail risk-weighted assets;
(2) Risk-weighted assets for securitization exposures; and
(3) Risk-weighted assets for equity exposures.
Current exposure means, with respect to a netting set, the larger of zero or the
market value of a transaction or portfolio of transactions within the netting set that would
be lost upon default of the counterparty, assuming no recovery on the value of the
transactions. Current exposure is also called replacement cost.
Default - (1) Retail. (i) A retail exposure of a [bank] is in default if:
(A) The exposure is 180 days past due, in the case of a residential mortgage
exposure or revolving exposure;
(B) The exposure is 120 days past due, in the case of all other retail exposures; or
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(C) The [bank] has taken a full or partial charge-off, write-down of principal, or
material negative fair value adjustment of principal on the exposure for credit-related
reasons.
(ii) Notwithstanding paragraph (1)(i) of this definition, for a retail exposure held
by a non-U.S. subsidiary of the [bank] that is subject to an internal ratings-based
approach to capital adequacy consistent with the Basel Committee on Banking
Supervision’s “International Convergence of Capital Measurement and Capital
Standards: A Revised Framework” in a non-U.S. jurisdiction, the [bank] may elect to use
the definition of default that is used in that jurisdiction, provided that the [bank] has
obtained prior approval from the [AGENCY] to use the definition of default in that
jurisdiction.
(iii) A retail exposure in default remains in default until the [bank] has reasonable
assurance of repayment and performance for all contractual principal and interest
payments on the exposure.
(2) Wholesale. (i) A [bank]’s wholesale obligor is in default if:
(A) The [bank] determines that the obligor is unlikely to pay its credit obligations
to the [bank] in full, without recourse by the [bank] to actions such as realizing collateral
(if held); or
(B) The obligor is past due more than 90 days on any material credit obligation(s)
to the [bank]. 2
(ii) An obligor in default remains in default until the [bank] has reasonable
assurance of repayment and performance for all contractual principal and interest
2
Overdrafts are past due once the obligor has breached an advised limit or been advised of a limit smaller
than the current outstanding balance.
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payments on all exposures of the [bank] to the obligor (other than exposures that have
been fully written-down or charged-off).
Dependence means a measure of the association among operational losses across
and within units of measure.
Depository institution is defined in section 3 of the Federal Deposit Insurance Act
(12 U.S.C. 1813).
Derivative contract means a financial contract whose value is derived from the
values of one or more underlying assets, reference rates, or indices of asset values or
reference rates. Derivative contracts include interest rate derivative contracts, exchange
rate derivative contracts, equity derivative contracts, commodity derivative contracts,
credit derivatives, and any other instrument that poses similar counterparty credit risks.
Derivative contracts also include unsettled securities, commodities, and foreign exchange
transactions with a contractual settlement or delivery lag that is longer than the lesser of
the market standard for the particular instrument or five business days.
Early amortization provision means a provision in the documentation governing a
securitization that, when triggered, causes investors in the securitization exposures to be
repaid before the original stated maturity of the securitization exposures, unless the
provision:
(1) Is triggered solely by events not directly related to the performance of the
underlying exposures or the originating [bank] (such as material changes in tax laws or
regulations); or
(2) Leaves investors fully exposed to future draws by obligors on the underlying
exposures even after the provision is triggered.
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Economic downturn conditions means, with respect to an exposure held by the
[bank], those conditions in which the aggregate default rates for that exposure’s
wholesale or retail exposure subcategory (or subdivision of such subcategory selected by
the [bank]) in the exposure’s national jurisdiction (or subdivision of such jurisdiction
selected by the [bank]) are significantly higher than average.
Effective maturity (M) of a wholesale exposure means:
(1) For wholesale exposures other than repo-style transactions, eligible margin
loans, and OTC derivative contracts described in paragraph (2) or (3) of this definition:
(i) The weighted-average remaining maturity (measured in years, whole or
fractional) of the expected contractual cash flows from the exposure, using the
undiscounted amounts of the cash flows as weights; or
(ii) The nominal remaining maturity (measured in years, whole or fractional) of
the exposure.
(2) For repo-style transactions, eligible margin loans, and OTC derivative
contracts subject to a qualifying master netting agreement for which the [bank] does not
apply the internal models approach in paragraph (d) of section 32, the weighted-average
remaining maturity (measured in years, whole or fractional) of the individual transactions
subject to the qualifying master netting agreement, with the weight of each individual
transaction set equal to the notional amount of the transaction.
(3) For repo-style transactions, eligible margin loans, and OTC derivative
contracts for which the [bank] applies the internal models approach in paragraph (d) of
section 32, the value determined in paragraph (d)(4) of section 32.
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Effective notional amount means, for an eligible guarantee or eligible credit
derivative, the lesser of the contractual notional amount of the credit risk mitigant and the
EAD of the hedged exposure, multiplied by the percentage coverage of the credit risk
mitigant. For example, the effective notional amount of an eligible guarantee that covers,
on a pro rata basis, 40 percent of any losses on a $100 bond would be $40.
Eligible clean-up call means a clean-up call that:
(1) Is exercisable solely at the discretion of the originating [bank] or servicer;
(2) Is not structured to avoid allocating losses to securitization exposures held by
investors or otherwise structured to provide credit enhancement to the securitization; and
(3) (i) For a traditional securitization, is only exercisable when 10 percent or less
of the principal amount of the underlying exposures or securitization exposures
(determined as of the inception of the securitization) is outstanding; or
(ii) For a synthetic securitization, is only exercisable when 10 percent or less of
the principal amount of the reference portfolio of underlying exposures (determined as of
the inception of the securitization) is outstanding.
Eligible credit derivative means a credit derivative in the form of a credit default
swap, nth-to-default swap, total return swap, or any other form of credit derivative
approved by the [AGENCY], provided that:
(1) The contract meets the requirements of an eligible guarantee and has been
confirmed by the protection purchaser and the protection provider;
(2) Any assignment of the contract has been confirmed by all relevant parties;
(3) If the credit derivative is a credit default swap or nth-to-default swap, the
contract includes the following credit events:
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(i) Failure to pay any amount due under the terms of the reference exposure,
subject to any applicable minimal payment threshold that is consistent with standard
market practice and with a grace period that is closely in line with the grace period of the
reference exposure; and
(ii) Bankruptcy, insolvency, or inability of the obligor on the reference exposure
to pay its debts, or its failure or admission in writing of its inability generally to pay its
debts as they become due, and similar events;
(4) The terms and conditions dictating the manner in which the contract is to be
settled are incorporated into the contract;
(5) If the contract allows for cash settlement, the contract incorporates a robust
valuation process to estimate loss reliably and specifies a reasonable period for obtaining
post-credit event valuations of the reference exposure;
(6) If the contract requires the protection purchaser to transfer an exposure to the
protection provider at settlement, the terms of at least one of the exposures that is
permitted to be transferred under the contract provides that any required consent to
transfer may not be unreasonably withheld;
(7) If the credit derivative is a credit default swap or nth-to-default swap, the
contract clearly identifies the parties responsible for determining whether a credit event
has occurred, specifies that this determination is not the sole responsibility of the
protection provider, and gives the protection purchaser the right to notify the protection
provider of the occurrence of a credit event; and
(8) If the credit derivative is a total return swap and the [bank] records net
payments received on the swap as net income, the [bank] records offsetting deterioration
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in the value of the hedged exposure (either through reductions in fair value or by an
addition to reserves).
Eligible credit reserves means all general allowances that have been established
through a charge against earnings to absorb credit losses associated with on- or offbalance sheet wholesale and retail exposures, including the allowance for loan and lease
losses (ALLL) associated with such exposures but excluding allocated transfer risk
reserves established pursuant to 12 U.S.C. 3904 and other specific reserves created
against recognized losses.
Eligible double default guarantor, with respect to a guarantee or credit derivative
obtained by a [bank], means:
(1) U.S.-based entities. A depository institution, a bank holding company, a
savings and loan holding company (as defined in 12 U.S.C. 1467a) provided all or
substantially all of the holding company’s activities are permissible for a financial
holding company under 12 U.S.C. 1843(k), a securities broker or dealer registered with
the SEC under the Securities Exchange Act of 1934 (15 U.S.C. 78o et seq.), or an
insurance company in the business of providing credit protection (such as a monoline
bond insurer or re-insurer) that is subject to supervision by a State insurance regulator, if:
(i) At the time the guarantor issued the guarantee or credit derivative or at any
time thereafter, the [bank] assigned a PD to the guarantor’s rating grade that was equal to
or lower than the PD associated with a long-term external rating in the third-highest
investment-grade rating category; and
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(ii) The [bank] currently assigns a PD to the guarantor’s rating grade that is equal
to or lower than the PD associated with a long-term external rating in the lowest
investment-grade rating category; or
(2) Non-U.S.-based entities. A foreign bank (as defined in section 211.2 of the
Federal Reserve Board’s Regulation K (12 CFR 211.2)), a non-U.S.-based securities
firm, or a non-U.S.-based insurance company in the business of providing credit
protection, if:
(i) The [bank] demonstrates that the guarantor is subject to consolidated
supervision and regulation comparable to that imposed on U.S. depository institutions,
securities broker-dealers, or insurance companies (as the case may be), or has issued and
outstanding an unsecured long-term debt security without credit enhancement that has a
long-term applicable external rating of at least investment grade;
(ii) At the time the guarantor issued the guarantee or credit derivative or at any
time thereafter, the [bank] assigned a PD to the guarantor’s rating grade that was equal to
or lower than the PD associated with a long-term external rating in the third-highest
investment-grade rating category; and
(iii) The [bank] currently assigns a PD to the guarantor’s rating grade that is equal
to or lower than the PD associated with a long-term external rating in the lowest
investment-grade rating category.
Eligible guarantee means a guarantee that:
(1) Is written and unconditional;
(2) Covers all or a pro rata portion of all contractual payments of the obligor on
the reference exposure;
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(3) Gives the beneficiary a direct claim against the protection provider;
(4) Is not unilaterally cancelable by the protection provider for reasons other than
the breach of the contract by the beneficiary;
(5) Is legally enforceable against the protection provider in a jurisdiction where
the protection provider has sufficient assets against which a judgment may be attached
and enforced;
(6) Requires the protection provider to make payment to the beneficiary on the
occurrence of a default (as defined in the guarantee) of the obligor on the reference
exposure in a timely manner without the beneficiary first having to take legal actions to
pursue the obligor for payment;
(7) Does not increase the beneficiary’s cost of credit protection on the guarantee
in response to deterioration in the credit quality of the reference exposure; and
(8) Is not provided by an affiliate of the [bank], unless the affiliate is an insured
depository institution, bank, securities broker or dealer, or insurance company that:
(i) Does not control the [bank]; and
(ii) Is subject to consolidated supervision and regulation comparable to that
imposed on U.S. depository institutions, securities broker-dealers, or insurance
companies (as the case may be).
Eligible margin loan means an extension of credit where:
(1) The extension of credit is collateralized exclusively by liquid and readily
marketable debt or equity securities, gold, or conforming residential mortgages;
(2) The collateral is marked to market daily, and the transaction is subject to daily
margin maintenance requirements;
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(3) The extension of credit is conducted under an agreement that provides the
[bank] the right to accelerate and terminate the extension of credit and to liquidate or set
off collateral promptly upon an event of default (including upon an event of bankruptcy,
insolvency, or similar proceeding) of the counterparty, provided that, in any such case,
any exercise of rights under the agreement will not be stayed or avoided under applicable
law in the relevant jurisdictions; 3 and
(4) The [bank] has conducted sufficient legal review to conclude with a wellfounded basis (and maintains sufficient written documentation of that legal review) that
the agreement meets the requirements of paragraph (3) of this definition and is legal,
valid, binding, and enforceable under applicable law in the relevant jurisdictions.
Eligible operational risk offsets means amounts, not to exceed expected
operational loss, that:
(1) Are generated by internal business practices to absorb highly predictable and
reasonably stable operational losses, including reserves calculated consistent with GAAP;
and
(2) Are available to cover expected operational losses with a high degree of
certainty over a one-year horizon.
Eligible purchased wholesale exposure means a purchased wholesale exposure
that:
3
This requirement is met where all transactions under the agreement are (i) executed under U.S. law and
(ii) constitute “securities contracts” under section 555 of the Bankruptcy Code (11 U.S.C. 555), qualified
financial contracts under section 11(e)(8) of the Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or
netting contracts between or among financial institutions under sections 401-407 of the Federal Deposit
Insurance Corporation Improvement Act of 1991 (12 U.S.C. 4401-4407) or the Federal Reserve Board’s
Regulation EE (12 CFR part 231).
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(1) The [bank] or securitization SPE purchased from an unaffiliated seller and did
not directly or indirectly originate;
(2) Was generated on an arm’s-length basis between the seller and the obligor
(intercompany accounts receivable and receivables subject to contra-accounts between
firms that buy and sell to each other do not satisfy this criterion);
(3) Provides the [bank] or securitization SPE with a claim on all proceeds from
the exposure or a pro rata interest in the proceeds from the exposure;
(4) Has an M of less than one year; and
(5) When consolidated by obligor, does not represent a concentrated exposure
relative to the portfolio of purchased wholesale exposures.
Eligible securitization guarantor means:
(1) A sovereign entity, the Bank for International Settlements, the International
Monetary Fund, the European Central Bank, the European Commission, a Federal Home
Loan Bank, Federal Agricultural Mortgage Corporation (Farmer Mac), a multilateral
development bank, a depository institution, a bank holding company, a savings and loan
holding company (as defined in 12 U.S.C. 1467a) provided all or substantially all of the
holding company’s activities are permissible for a financial holding company under 12
U.S.C. 1843(k), a foreign bank (as defined in section 211.2 of the Federal Reserve
Board’s Regulation K (12 CFR 211.2)), or a securities firm;
(2) Any other entity (other than a securitization SPE) that has issued and
outstanding an unsecured long-term debt security without credit enhancement that has a
long-term applicable external rating in one of the three highest investment-grade rating
categories; or
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(3) Any other entity (other than a securitization SPE) that has a PD assigned by
the [bank] that is lower than or equal to the PD associated with a long-term external
rating in the third highest investment-grade rating category.
Eligible servicer cash advance facility means a servicer cash advance facility in
which:
(1) The servicer is entitled to full reimbursement of advances, except that a
servicer may be obligated to make non-reimbursable advances for a particular underlying
exposure if any such advance is contractually limited to an insignificant amount of the
outstanding principal balance of that exposure;
(2) The servicer’s right to reimbursement is senior in right of payment to all other
claims on the cash flows from the underlying exposures of the securitization; and
(3) The servicer has no legal obligation to, and does not, make advances to the
securitization if the servicer concludes the advances are unlikely to be repaid.
Equity derivative contract means an equity-linked swap, purchased equity-linked
option, forward equity-linked contract, or any other instrument linked to equities that
gives rise to similar counterparty credit risks.
Equity exposure means:
(1) A security or instrument (whether voting or non-voting) that represents a
direct or indirect ownership interest in, and is a residual claim on, the assets and income
of a company, unless:
(i) The issuing company is consolidated with the [bank] under GAAP;
(ii) The [bank] is required to deduct the ownership interest from tier 1 or tier 2
capital under this appendix;
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(iii) The ownership interest incorporates a payment or other similar obligation on
the part of the issuing company (such as an obligation to make periodic payments); or
(iv) The ownership interest is a securitization exposure;
(2) A security or instrument that is mandatorily convertible into a security or
instrument described in paragraph (1) of this definition;
(3) An option or warrant that is exercisable for a security or instrument described
in paragraph (1) of this definition; or
(4) Any other security or instrument (other than a securitization exposure) to the
extent the return on the security or instrument is based on the performance of a security
or instrument described in paragraph (1) of this definition.
Excess spread for a period means:
(1) Gross finance charge collections and other income received by a securitization
SPE (including market interchange fees) over a period minus interest paid to the holders
of the securitization exposures, servicing fees, charge-offs, and other senior trust or
similar expenses of the SPE over the period; divided by
(2) The principal balance of the underlying exposures at the end of the period.
Exchange rate derivative contract means a cross-currency interest rate swap,
forward foreign-exchange contract, currency option purchased, or any other instrument
linked to exchange rates that gives rise to similar counterparty credit risks.
Excluded mortgage exposure means any one- to four-family residential pre-sold
construction loan for a residence for which the purchase contract is cancelled that would
receive a 100 percent risk weight under section 618(a)(2) of the Resolution Trust
Corporation Refinancing, Restructuring, and Improvement Act and under 12 CFR part 3,
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Appendix A, section 3(a)(3)(iii) (for national banks), 12 CFR part 208, Appendix A,
section III.C.3. (for state member banks), 12 CFR part 225, Appendix A, section III.C.3.
(for bank holding companies), 12 CFR part 325, Appendix A, section II.C.a. (for state
nonmember banks), or 12 CFR 567.1 (definition of “qualifying residential construction
loan”) and 12 CFR 567.6(a)(1)(iv) (for savings associations).
Expected credit loss (ECL) means:
(1) For a wholesale exposure to a non-defaulted obligor or segment of nondefaulted retail exposures that is carried at fair value with gains and losses flowing
through earnings or that is classified as held-for-sale and is carried at the lower of cost or
fair value with losses flowing through earnings, zero.
(2) For all other wholesale exposures to non-defaulted obligors or segments of
non-defaulted retail exposures, the product of PD times LGD times EAD for the exposure
or segment.
(3) For a wholesale exposure to a defaulted obligor or segment of defaulted retail
exposures, the [bank]’s impairment estimate for allowance purposes for the exposure or
segment.
(4) Total ECL is the sum of expected credit losses for all wholesale and retail
exposures other than exposures for which the [bank] has applied the double default
treatment in section 34.
Expected exposure (EE) means the expected value of the probability distribution
of non-negative credit risk exposures to a counterparty at any specified future date before
the maturity date of the longest term transaction in the netting set. Any negative market
values in the probability distribution of market values to a counterparty at a specified
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future date are set to zero to convert the probability distribution of market values to the
probability distribution of credit risk exposures.
Expected operational loss (EOL) means the expected value of the distribution of
potential aggregate operational losses, as generated by the [bank]’s operational risk
quantification system using a one-year horizon.
Expected positive exposure (EPE) means the weighted average over time of
expected (non-negative) exposures to a counterparty where the weights are the proportion
of the time interval that an individual expected exposure represents. When calculating
risk-based capital requirements, the average is taken over a one-year horizon.
Exposure at default (EAD). (1) For the on-balance sheet component of a
wholesale exposure or segment of retail exposures (other than an OTC derivative
contract, or a repo-style transaction or eligible margin loan for which the [bank]
determines EAD under section 32), EAD means:
(i) If the exposure or segment is a security classified as available-for-sale, the
[bank]’s carrying value (including net accrued but unpaid interest and fees) for the
exposure or segment less any allocated transfer risk reserve for the exposure or segment,
less any unrealized gains on the exposure or segment, and plus any unrealized losses on
the exposure or segment; or
(ii) If the exposure or segment is not a security classified as available-for-sale, the
[bank]’s carrying value (including net accrued but unpaid interest and fees) for the
exposure or segment less any allocated transfer risk reserve for the exposure or segment.
(2) For the off-balance sheet component of a wholesale exposure or segment of
retail exposures (other than an OTC derivative contract, or a repo-style transaction or
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eligible margin loan for which the [bank] determines EAD under section 32) in the form
of a loan commitment, line of credit, trade-related letter of credit, or transaction-related
contingency, EAD means the [bank]’s best estimate of net additions to the outstanding
amount owed the [bank], including estimated future additional draws of principal and
accrued but unpaid interest and fees, that are likely to occur over a one-year horizon
assuming the wholesale exposure or the retail exposures in the segment were to go into
default. This estimate of net additions must reflect what would be expected during
economic downturn conditions. Trade-related letters of credit are short-term, selfliquidating instruments that are used to finance the movement of goods and are
collateralized by the underlying goods. Transaction-related contingencies relate to a
particular transaction and include, among other things, performance bonds and
performance-based letters of credit.
(3) For the off-balance sheet component of a wholesale exposure or segment of
retail exposures (other than an OTC derivative contract, or a repo-style transaction or
eligible margin loan for which the [bank] determines EAD under section 32) in the form
of anything other than a loan commitment, line of credit, trade-related letter of credit, or
transaction-related contingency, EAD means the notional amount of the exposure or
segment.
(4) EAD for OTC derivative contracts is calculated as described in section 32. A
[bank] also may determine EAD for repo-style transactions and eligible margin loans as
described in section 32.
(5) For wholesale or retail exposures in which only the drawn balance has been
securitized, the [bank] must reflect its share of the exposures’ undrawn balances in EAD.
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Undrawn balances of revolving exposures for which the drawn balances have been
securitized must be allocated between the seller’s and investors’ interests on a pro rata
basis, based on the proportions of the seller’s and investors’ shares of the securitized
drawn balances.
Exposure category means any of the wholesale, retail, securitization, or equity
exposure categories.
External operational loss event data means, with respect to a [bank], gross
operational loss amounts, dates, recoveries, and relevant causal information for
operational loss events occurring at organizations other than the [bank].
External rating means a credit rating that is assigned by an NRSRO to an
exposure, provided:
(1) The credit rating fully reflects the entire amount of credit risk with regard to
all payments owed to the holder of the exposure. If a holder is owed principal and
interest on an exposure, the credit rating must fully reflect the credit risk associated with
timely repayment of principal and interest. If a holder is owed only principal on an
exposure, the credit rating must fully reflect only the credit risk associated with timely
repayment of principal; and
(2) The credit rating is published in an accessible form and is or will be included
in the transition matrices made publicly available by the NRSRO that summarize the
historical performance of positions rated by the NRSRO.
Financial collateral means collateral:
(1) In the form of:
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(i) Cash on deposit with the [bank] (including cash held for the [bank] by a thirdparty custodian or trustee);
(ii) Gold bullion;
(iii) Long-term debt securities that have an applicable external rating of one
category below investment grade or higher;
(iv) Short-term debt instruments that have an applicable external rating of at least
investment grade;
(v) Equity securities that are publicly traded;
(vi) Convertible bonds that are publicly traded;
(vii) Money market mutual fund shares and other mutual fund shares if a price for
the shares is publicly quoted daily; or
(viii) Conforming residential mortgages; and
(2) In which the [bank] has a perfected, first priority security interest or, outside
of the United States, the legal equivalent thereof (with the exception of cash on deposit
and notwithstanding the prior security interest of any custodial agent).
GAAP means generally accepted accounting principles as used in the United
States.
Gain-on-sale means an increase in the equity capital (as reported on Schedule RC
of the Call Report, Schedule HC of the FR Y-9C Report, or Schedule SC of the Thrift
Financial Report) of a [bank] that results from a securitization (other than an increase in
equity capital that results from the [bank]’s receipt of cash in connection with the
securitization).
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Guarantee means a financial guarantee, letter of credit, insurance, or other similar
financial instrument (other than a credit derivative) that allows one party (beneficiary) to
transfer the credit risk of one or more specific exposures (reference exposure) to another
party (protection provider). See also eligible guarantee.
High volatility commercial real estate (HVCRE) exposure means a credit facility
that finances or has financed the acquisition, development, or construction (ADC) of real
property, unless the facility finances:
(1) One- to four-family residential properties; or
(2) Commercial real estate projects in which:
(i) The loan-to-value ratio is less than or equal to the applicable maximum
supervisory loan-to-value ratio in the [AGENCY]’s real estate lending standards at 12
CFR part 34, Subpart D (OCC); 12 CFR part 208, Appendix C (Board); 12 CFR part 365,
Subpart D (FDIC); and 12 CFR 560.100-560.101 (OTS);
(ii) The borrower has contributed capital to the project in the form of cash or
unencumbered readily marketable assets (or has paid development expenses out-ofpocket) of at least 15 percent of the real estate’s appraised “as completed” value; and
(iii) The borrower contributed the amount of capital required by paragraph (2)(ii)
of this definition before the [bank] advances funds under the credit facility, and the
capital contributed by the borrower, or internally generated by the project, is
contractually required to remain in the project throughout the life of the project. The life
of a project concludes only when the credit facility is converted to permanent financing
or is sold or paid in full. Permanent financing may be provided by the [bank] that
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provided the ADC facility as long as the permanent financing is subject to the [bank]’s
underwriting criteria for long-term mortgage loans.
Inferred rating. A securitization exposure has an inferred rating equal to the
external rating referenced in paragraph (2)(i) of this definition if:
(1) The securitization exposure does not have an external rating; and
(2) Another securitization exposure issued by the same issuer and secured by the
same underlying exposures:
(i) Has an external rating;
(ii) Is subordinated in all respects to the unrated securitization exposure;
(iii) Does not benefit from any credit enhancement that is not available to the
unrated securitization exposure; and
(iv) Has an effective remaining maturity that is equal to or longer than that of the
unrated securitization exposure.
Interest rate derivative contract means a single-currency interest rate swap, basis
swap, forward rate agreement, purchased interest rate option, when-issued securities, or
any other instrument linked to interest rates that gives rise to similar counterparty credit
risks.
Internal operational loss event data means, with respect to a [bank], gross
operational loss amounts, dates, recoveries, and relevant causal information for
operational loss events occurring at the [bank].
Investing [bank] means, with respect to a securitization, a [bank] that assumes the
credit risk of a securitization exposure (other than an originating [bank] of the
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securitization). In the typical synthetic securitization, the investing [bank] sells credit
protection on a pool of underlying exposures to the originating [bank].
Investment fund means a company:
(1) All or substantially all of the assets of which are financial assets; and
(2) That has no material liabilities.
Investors’ interest EAD means, with respect to a securitization, the EAD of the
underlying exposures multiplied by the ratio of:
(1) The total amount of securitization exposures issued by the securitization SPE
to investors; divided by
(2) The outstanding principal amount of underlying exposures.
Loss given default (LGD) means:
(1) For a wholesale exposure, the greatest of:
(i) Zero;
(ii) The [bank]’s empirically based best estimate of the long-run default-weighted
average economic loss, per dollar of EAD, the [bank] would expect to incur if the obligor
(or a typical obligor in the loss severity grade assigned by the [bank] to the exposure)
were to default within a one-year horizon over a mix of economic conditions, including
economic downturn conditions; or
(iii) The [bank]’s empirically based best estimate of the economic loss, per dollar
of EAD, the [bank] would expect to incur if the obligor (or a typical obligor in the loss
severity grade assigned by the [bank] to the exposure) were to default within a one-year
horizon during economic downturn conditions.
(2) For a segment of retail exposures, the greatest of:
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(i) Zero;
(ii) The [bank]’s empirically based best estimate of the long-run default-weighted
average economic loss, per dollar of EAD, the [bank] would expect to incur if the
exposures in the segment were to default within a one-year horizon over a mix of
economic conditions, including economic downturn conditions; or
(iii) The [bank]’s empirically based best estimate of the economic loss, per dollar
of EAD, the [bank] would expect to incur if the exposures in the segment were to default
within a one-year horizon during economic downturn conditions.
(3) The economic loss on an exposure in the event of default is all material creditrelated losses on the exposure (including accrued but unpaid interest or fees, losses on the
sale of collateral, direct workout costs, and an appropriate allocation of indirect workout
costs). Where positive or negative cash flows on a wholesale exposure to a defaulted
obligor or a defaulted retail exposure (including proceeds from the sale of collateral,
workout costs, additional extensions of credit to facilitate repayment of the exposure, and
draw-downs of unused credit lines) occur after the date of default, the economic loss
must reflect the net present value of cash flows as of the default date using a discount rate
appropriate to the risk of the defaulted exposure.
Main index means the Standard & Poor’s 500 Index, the FTSE All-World Index,
and any other index for which the [bank] can demonstrate to the satisfaction of the
[AGENCY] that the equities represented in the index have comparable liquidity, depth of
market, and size of bid-ask spreads as equities in the Standard & Poor’s 500 Index and
FTSE All-World Index.
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Multilateral development bank means the International Bank for Reconstruction
and Development, the International Finance Corporation, the Inter-American
Development Bank, the Asian Development Bank, the African Development Bank, the
European Bank for Reconstruction and Development, the European Investment Bank, the
European Investment Fund, the Nordic Investment Bank, the Caribbean Development
Bank, the Islamic Development Bank, the Council of Europe Development Bank, and
any other multilateral lending institution or regional development bank in which the U.S.
government is a shareholder or contributing member or which the [AGENCY]
determines poses comparable credit risk.
Nationally recognized statistical rating organization (NRSRO) means an entity
registered with the SEC as a nationally recognized statistical rating organization under
section 15E of the Securities Exchange Act of 1934 (15 U.S.C. 78o-7).
Netting set means a group of transactions with a single counterparty that are
subject to a qualifying master netting agreement or qualifying cross-product master
netting agreement. For purposes of the internal models methodology in paragraph (d) of
section 32, each transaction that is not subject to such a master netting agreement is its
own netting set.
Nth-to-default credit derivative means a credit derivative that provides credit
protection only for the nth-defaulting reference exposure in a group of reference
exposures.
Obligor means the legal entity or natural person contractually obligated on a
wholesale exposure, except that a [bank] may treat the following exposures as having
separate obligors:
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(1) Exposures to the same legal entity or natural person denominated in different
currencies;
(2) (i) An income-producing real estate exposure for which all or substantially all
of the repayment of the exposure is reliant on the cash flows of the real estate serving as
collateral for the exposure; the [bank], in economic substance, does not have recourse to
the borrower beyond the real estate collateral; and no cross-default or cross-acceleration
clauses are in place other than clauses obtained solely out of an abundance of caution;
and
(ii) Other credit exposures to the same legal entity or natural person; and
(3) (i) A wholesale exposure authorized under section 364 of the U.S. Bankruptcy
Code (11 U.S.C. 364) to a legal entity or natural person who is a debtor-in-possession for
purposes of Chapter 11 of the Bankruptcy Code; and
(ii) Other credit exposures to the same legal entity or natural person.
Operational loss means a loss (excluding insurance or tax effects) resulting from
an operational loss event. Operational loss includes all expenses associated with an
operational loss event except for opportunity costs, forgone revenue, and costs related to
risk management and control enhancements implemented to prevent future operational
losses.
Operational loss event means an event that results in loss and is associated with
any of the following seven operational loss event type categories:
(1) Internal fraud, which means the operational loss event type category that
comprises operational losses resulting from an act involving at least one internal party of
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a type intended to defraud, misappropriate property, or circumvent regulations, the law,
or company policy, excluding diversity- and discrimination-type events.
(2) External fraud, which means the operational loss event type category that
comprises operational losses resulting from an act by a third party of a type intended to
defraud, misappropriate property, or circumvent the law. Retail credit card losses arising
from non-contractual, third-party initiated fraud (for example, identity theft) are external
fraud operational losses. All other third-party initiated credit losses are to be treated as
credit risk losses.
(3) Employment practices and workplace safety, which means the operational loss
event type category that comprises operational losses resulting from an act inconsistent
with employment, health, or safety laws or agreements, payment of personal injury
claims, or payment arising from diversity- and discrimination-type events.
(4) Clients, products, and business practices, which means the operational loss
event type category that comprises operational losses resulting from the nature or design
of a product or from an unintentional or negligent failure to meet a professional
obligation to specific clients (including fiduciary and suitability requirements).
(5) Damage to physical assets, which means the operational loss event type
category that comprises operational losses resulting from the loss of or damage to
physical assets from natural disaster or other events.
(6) Business disruption and system failures, which means the operational loss
event type category that comprises operational losses resulting from disruption of
business or system failures.
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(7) Execution, delivery, and process management, which means the operational
loss event type category that comprises operational losses resulting from failed
transaction processing or process management or losses arising from relations with trade
counterparties and vendors.
Operational risk means the risk of loss resulting from inadequate or failed internal
processes, people, and systems or from external events (including legal risk but excluding
strategic and reputational risk).
Operational risk exposure means the 99.9th percentile of the distribution of
potential aggregate operational losses, as generated by the [bank]’s operational risk
quantification system over a one-year horizon (and not incorporating eligible operational
risk offsets or qualifying operational risk mitigants).
Originating [bank], with respect to a securitization, means a [bank] that:
(1) Directly or indirectly originated or securitized the underlying exposures
included in the securitization; or
(2) Serves as an ABCP program sponsor to the securitization.
Other retail exposure means an exposure (other than a securitization exposure, an
equity exposure, a residential mortgage exposure, an excluded mortgage exposure, a
qualifying revolving exposure, or the residual value portion of a lease exposure) that is
managed as part of a segment of exposures with homogeneous risk characteristics, not on
an individual-exposure basis, and is either:
(1) An exposure to an individual for non-business purposes; or
(2) An exposure to an individual or company for business purposes if the [bank]’s
consolidated business credit exposure to the individual or company is $1 million or less.
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Over-the-counter (OTC) derivative contract means a derivative contract that is not
traded on an exchange that requires the daily receipt and payment of cash-variation
margin.
Probability of default (PD) means:
(1) For a wholesale exposure to a non-defaulted obligor, the [bank]’s empirically
based best estimate of the long-run average one-year default rate for the rating grade
assigned by the [bank] to the obligor, capturing the average default experience for
obligors in the rating grade over a mix of economic conditions (including economic
downturn conditions) sufficient to provide a reasonable estimate of the average one-year
default rate over the economic cycle for the rating grade.
(2) For a segment of non-defaulted retail exposures, the [bank]’s empirically
based best estimate of the long-run average one-year default rate for the exposures in the
segment, capturing the average default experience for exposures in the segment over a
mix of economic conditions (including economic downturn conditions) sufficient to
provide a reasonable estimate of the average one-year default rate over the economic
cycle for the segment and adjusted upward as appropriate for segments for which
seasoning effects are material. For purposes of this definition, a segment for which
seasoning effects are material is a segment where there is a material relationship between
the time since origination of exposures within the segment and the [bank]’s best estimate
of the long-run average one-year default rate for the exposures in the segment.
(3) For a wholesale exposure to a defaulted obligor or segment of defaulted retail
exposures, 100 percent.
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Protection amount (P) means, with respect to an exposure hedged by an eligible
guarantee or eligible credit derivative, the effective notional amount of the guarantee or
credit derivative, reduced to reflect any currency mismatch, maturity mismatch, or lack of
restructuring coverage (as provided in section 33).
Publicly traded means traded on:
(1) Any exchange registered with the SEC as a national securities exchange under
section 6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f); or
(2) Any non-U.S.-based securities exchange that:
(i) Is registered with, or approved by, a national securities regulatory authority;
and
(ii) Provides a liquid, two-way market for the instrument in question, meaning
that there are enough independent bona fide offers to buy and sell so that a sales price
reasonably related to the last sales price or current bona fide competitive bid and offer
quotations can be determined promptly and a trade can be settled at such a price within
five business days.
Qualifying central counterparty means a counterparty (for example, a clearing
house) that:
(1) Facilitates trades between counterparties in one or more financial markets by
either guaranteeing trades or novating contracts;
(2) Requires all participants in its arrangements to be fully collateralized on a
daily basis; and
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(3) The [bank] demonstrates to the satisfaction of the [AGENCY] is in sound
financial condition and is subject to effective oversight by a national supervisory
authority.
Qualifying cross-product master netting agreement means a qualifying master
netting agreement that provides for termination and close-out netting across multiple
types of financial transactions or qualifying master netting agreements in the event of a
counterparty’s default, provided that:
(1) The underlying financial transactions are OTC derivative contracts, eligible
margin loans, or repo-style transactions; and
(2) The [bank] obtains a written legal opinion verifying the validity and
enforceability of the agreement under applicable law of the relevant jurisdictions if the
counterparty fails to perform upon an event of default, including upon an event of
bankruptcy, insolvency, or similar proceeding.
Qualifying master netting agreement means any written, legally enforceable
bilateral agreement, provided that:
(1) The agreement creates a single legal obligation for all individual transactions
covered by the agreement upon an event of default, including bankruptcy, insolvency, or
similar proceeding, of the counterparty;
(2) The agreement provides the [bank] the right to accelerate, terminate, and
close-out on a net basis all transactions under the agreement and to liquidate or set off
collateral promptly upon an event of default, including upon an event of bankruptcy,
insolvency, or similar proceeding, of the counterparty, provided that, in any such case,
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any exercise of rights under the agreement will not be stayed or avoided under applicable
law in the relevant jurisdictions;
(3) The [bank] has conducted sufficient legal review to conclude with a wellfounded basis (and maintains sufficient written documentation of that legal review) that:
(i) The agreement meets the requirements of paragraph (2) of this definition; and
(ii) In the event of a legal challenge (including one resulting from default or from
bankruptcy, insolvency, or similar proceeding) the relevant court and administrative
authorities would find the agreement to be legal, valid, binding, and enforceable under
the law of the relevant jurisdictions;
(4) The [bank] establishes and maintains procedures to monitor possible changes
in relevant law and to ensure that the agreement continues to satisfy the requirements of
this definition; and
(5) The agreement does not contain a walkaway clause (that is, a provision that
permits a non-defaulting counterparty to make a lower payment than it would make
otherwise under the agreement, or no payment at all, to a defaulter or the estate of a
defaulter, even if the defaulter or the estate of the defaulter is a net creditor under the
agreement).
Qualifying revolving exposure (QRE) means an exposure (other than a
securitization exposure or equity exposure) to an individual that is managed as part of a
segment of exposures with homogeneous risk characteristics, not on an individualexposure basis, and:
(1) Is revolving (that is, the amount outstanding fluctuates, determined largely by
the borrower’s decision to borrow and repay, up to a pre-established maximum amount);
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(2) Is unsecured and unconditionally cancelable by the [bank] to the fullest extent
permitted by Federal law; and
(3) Has a maximum exposure amount (drawn plus undrawn) of up to $100,000.
Repo-style transaction means a repurchase or reverse repurchase transaction, or a
securities borrowing or securities lending transaction, including a transaction in which the
[bank] acts as agent for a customer and indemnifies the customer against loss, provided
that:
(1) The transaction is based solely on liquid and readily marketable securities,
cash, gold, or conforming residential mortgages;
(2) The transaction is marked-to-market daily and subject to daily margin
maintenance requirements;
(3) (i) The transaction is a “securities contract” or “repurchase agreement” under
section 555 or 559, respectively, of the Bankruptcy Code (11 U.S.C. 555 or 559), a
qualified financial contract under section 11(e)(8) of the Federal Deposit Insurance Act
(12 U.S.C. 1821(e)(8)), or a netting contract between or among financial institutions
under sections 401-407 of the Federal Deposit Insurance Corporation Improvement Act
of 1991 (12 U.S.C. 4401-4407) or the Federal Reserve Board’s Regulation EE (12 CFR
part 231); or
(ii) If the transaction does not meet the criteria set forth in paragraph (3)(i) of this
definition, then either:
(A) The transaction is executed under an agreement that provides the [bank] the
right to accelerate, terminate, and close-out the transaction on a net basis and to liquidate
or set off collateral promptly upon an event of default (including upon an event of
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bankruptcy, insolvency, or similar proceeding) of the counterparty, provided that, in any
such case, any exercise of rights under the agreement will not be stayed or avoided under
applicable law in the relevant jurisdictions; or
(B) The transaction is:
(1) Either overnight or unconditionally cancelable at any time by the [bank]; and
(2) Executed under an agreement that provides the [bank] the right to accelerate,
terminate, and close-out the transaction on a net basis and to liquidate or set off collateral
promptly upon an event of counterparty default; and
(4) The [bank] has conducted sufficient legal review to conclude with a wellfounded basis (and maintains sufficient written documentation of that legal review) that
the agreement meets the requirements of paragraph (3) of this definition and is legal,
valid, binding, and enforceable under applicable law in the relevant jurisdictions.
Residential mortgage exposure means an exposure (other than a securitization
exposure, equity exposure, or excluded mortgage exposure) that is managed as part of a
segment of exposures with homogeneous risk characteristics, not on an individualexposure basis, and is:
(1) An exposure that is primarily secured by a first or subsequent lien on one- to
four-family residential property; or
(2) An exposure with an original and outstanding amount of $1 million or less that
is primarily secured by a first or subsequent lien on residential property that is not one to
four family.
Retail exposure means a residential mortgage exposure, a qualifying revolving
exposure, or an other retail exposure.
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Retail exposure subcategory means the residential mortgage exposure, qualifying
revolving exposure, or other retail exposure subcategory.
Risk parameter means a variable used in determining risk-based capital
requirements for wholesale and retail exposures, specifically probability of default (PD),
loss given default (LGD), exposure at default (EAD), or effective maturity (M).
Scenario analysis means a systematic process of obtaining expert opinions from
business managers and risk management experts to derive reasoned assessments of the
likelihood and loss impact of plausible high-severity operational losses. Scenario
analysis may include the well-reasoned evaluation and use of external operational loss
event data, adjusted as appropriate to ensure relevance to a [bank]’s operational risk
profile and control structure.
SEC means the U.S. Securities and Exchange Commission.
Securitization means a traditional securitization or a synthetic securitization.
Securitization exposure means an on-balance sheet or off-balance sheet credit
exposure that arises from a traditional or synthetic securitization (including creditenhancing representations and warranties).
Securitization special purpose entity (securitization SPE) means a corporation,
trust, or other entity organized for the specific purpose of holding underlying exposures
of a securitization, the activities of which are limited to those appropriate to accomplish
this purpose, and the structure of which is intended to isolate the underlying exposures
held by the entity from the credit risk of the seller of the underlying exposures to the
entity.
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Senior securitization exposure means a securitization exposure that has a first
priority claim on the cash flows from the underlying exposures. When determining
whether a securitization exposure has a first priority claim on the cash flows from the
underlying exposures, a [bank] is not required to consider amounts due under interest rate
or currency derivative contracts, fees due, or other similar payments. Both the most
senior commercial paper issued by an ABCP program and a liquidity facility that
supports the ABCP program may be senior securitization exposures if the liquidity
facility provider’s right to reimbursement of the drawn amounts is senior to all claims on
the cash flows from the underlying exposures except amounts due under interest rate or
currency derivative contracts, fees due, or other similar payments.
Servicer cash advance facility means a facility under which the servicer of the
underlying exposures of a securitization may advance cash to ensure an uninterrupted
flow of payments to investors in the securitization, including advances made to cover
foreclosure costs or other expenses to facilitate the timely collection of the underlying
exposures. See also eligible servicer cash advance facility.
Sovereign entity means a central government (including the U.S. government) or
an agency, department, ministry, or central bank of a central government.
Sovereign exposure means:
(1) A direct exposure to a sovereign entity; or
(2) An exposure directly and unconditionally backed by the full faith and credit of
a sovereign entity.
Subsidiary means, with respect to a company, a company controlled by that
company.
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Synthetic securitization means a transaction in which:
(1) All or a portion of the credit risk of one or more underlying exposures is
transferred to one or more third parties through the use of one or more credit derivatives
or guarantees (other than a guarantee that transfers only the credit risk of an individual
retail exposure);
(2) The credit risk associated with the underlying exposures has been separated
into at least two tranches reflecting different levels of seniority;
(3) Performance of the securitization exposures depends upon the performance of
the underlying exposures; and
(4) All or substantially all of the underlying exposures are financial exposures
(such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed
securities, mortgage-backed securities, other debt securities, or equity securities).
Tier 1 capital is defined in [the general risk-based capital rules], as modified in
part II of this appendix.
Tier 2 capital is defined in [the general risk-based capital rules], as modified in
part II of this appendix.
Total qualifying capital means the sum of tier 1 capital and tier 2 capital, after all
deductions required in this appendix.
Total risk-weighted assets means:
(1) The sum of:
(i) Credit risk-weighted assets; and
(ii) Risk-weighted assets for operational risk; minus
(2) Excess eligible credit reserves not included in tier 2 capital.
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Total wholesale and retail risk-weighted assets means the sum of risk-weighted
assets for wholesale exposures to non-defaulted obligors and segments of non-defaulted
retail exposures; risk-weighted assets for wholesale exposures to defaulted obligors and
segments of defaulted retail exposures; risk-weighted assets for assets not defined by an
exposure category; and risk-weighted assets for non-material portfolios of exposures (all
as determined in section 31) and risk-weighted assets for unsettled transactions (as
determined in section 35) minus the amounts deducted from capital pursuant to [the
general risk-based capital rules] (excluding those deductions reversed in section 12).
Traditional securitization means a transaction in which:
(1) All or a portion of the credit risk of one or more underlying exposures is
transferred to one or more third parties other than through the use of credit derivatives or
guarantees;
(2) The credit risk associated with the underlying exposures has been separated
into at least two tranches reflecting different levels of seniority;
(3) Performance of the securitization exposures depends upon the performance of
the underlying exposures;
(4) All or substantially all of the underlying exposures are financial exposures
(such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed
securities, mortgage-backed securities, other debt securities, or equity securities);
(5) The underlying exposures are not owned by an operating company;
(6) The underlying exposures are not owned by a small business investment
company described in section 302 of the Small Business Investment Act of 1958 (15
U.S.C. 682); and
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(7) The underlying exposures are not owned by a firm an investment in which
qualifies as a community development investment under 12 U.S.C. 24(Eleventh).
(8) The [AGENCY] may determine that a transaction in which the underlying
exposures are owned by an investment firm that exercises substantially unfettered control
over the size and composition of its assets, liabilities, and off-balance sheet exposures is
not a traditional securitization based on the transaction’s leverage, risk profile, or
economic substance.
(9) The [AGENCY] may deem a transaction that meets the definition of a
traditional securitization, notwithstanding paragraph (5), (6), or (7) of this definition, to
be a traditional securitization based on the transaction’s leverage, risk profile, or
economic substance.
Tranche means all securitization exposures associated with a securitization that
have the same seniority level.
Underlying exposures means one or more exposures that have been securitized in
a securitization transaction.
Unexpected operational loss (UOL) means the difference between the [bank]’s
operational risk exposure and the [bank]’s expected operational loss.
Unit of measure means the level (for example, organizational unit or operational
loss event type) at which the [bank]’s operational risk quantification system generates a
separate distribution of potential operational losses.
Value-at-Risk (VaR) means the estimate of the maximum amount that the value
of one or more exposures could decline due to market price or rate movements during a
fixed holding period within a stated confidence interval.
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Wholesale exposure means a credit exposure to a company, natural person,
sovereign entity, or governmental entity (other than a securitization exposure, retail
exposure, excluded mortgage exposure, or equity exposure). Examples of a wholesale
exposure include:
(1) A non-tranched guarantee issued by a [bank] on behalf of a company;
(2) A repo-style transaction entered into by a [bank] with a company and any
other transaction in which a [bank] posts collateral to a company and faces counterparty
credit risk;
(3) An exposure that a [bank] treats as a covered position under [the market risk
rule] for which there is a counterparty credit risk capital requirement;
(4) A sale of corporate loans by a [bank] to a third party in which the [bank]
retains full recourse;
(5) An OTC derivative contract entered into by a [bank] with a company;
(6) An exposure to an individual that is not managed by a [bank] as part of a
segment of exposures with homogeneous risk characteristics; and
(7) A commercial lease.
Wholesale exposure subcategory means the HVCRE or non-HVCRE wholesale
exposure subcategory.
Section 3. Minimum Risk-Based Capital Requirements
(a) Except as modified by paragraph (c) of this section or by section 23, each
[bank] must meet a minimum ratio of:
(1) Total qualifying capital to total risk-weighted assets of 8.0 percent; and
(2) Tier 1 capital to total risk-weighted assets of 4.0 percent.
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(b) Each [bank] must hold capital commensurate with the level and nature of all
risks to which the [bank] is exposed.
(c) When a [bank] subject to [the market risk rule] calculates its risk-based capital
requirements under this appendix, the [bank] must also refer to [the market risk rule] for
supplemental rules to calculate risk-based capital requirements adjusted for market risk.
Part II. Qualifying Capital
Section 11. Additional Deductions
(a) General. A [bank] that uses this appendix must make the same deductions
from its tier 1 capital and tier 2 capital required in [the general risk-based capital rules],
except that:
(1) A [bank] is not required to deduct certain equity investments and CEIOs (as
provided in section 12 of this appendix); and
(2) A [bank] also must make the deductions from capital required by paragraphs
(b) and (c) of this section.
(b) Deductions from tier 1 capital. A [bank] must deduct from tier 1 capital any
gain-on-sale associated with a securitization exposure as provided in paragraph (a) of
section 41 and paragraphs (a)(1), (c), (g)(1), and (h)(1) of section 42.
(c) Deductions from tier 1 and tier 2 capital. A [bank] must deduct the exposures
specified in paragraphs (c)(1) through (c)(7) in this section 50 percent from tier 1 capital
and 50 percent from tier 2 capital. If the amount deductible from tier 2 capital exceeds
the [bank]’s actual tier 2 capital, however, the [bank] must deduct the excess from tier 1
capital.
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(1) Credit-enhancing interest-only strips (CEIOs). In accordance with paragraphs
(a)(1) and (c) of section 42, any CEIO that does not constitute gain-on-sale.
(2) Non-qualifying securitization exposures. In accordance with paragraphs (a)(4)
and (c) of section 42, any securitization exposure that does not qualify for the RatingsBased Approach, the Internal Assessment Approach, or the Supervisory Formula
Approach under sections 43, 44, and 45, respectively.
(3) Securitizations of non-IRB exposures. In accordance with paragraphs (c) and
(g)(4) of section 42, certain exposures to a securitization any underlying exposure of
which is not a wholesale exposure, retail exposure, securitization exposure, or equity
exposure.
(4) Low-rated securitization exposures. In accordance with section 43 and
paragraph (c) of section 42, any securitization exposure that qualifies for and must be
deducted under the Ratings-Based Approach.
(5) High-risk securitization exposures subject to the Supervisory Formula
Approach. In accordance with paragraphs (b) and (c) of section 45 and paragraph (c) of
section 42, certain high-risk securitization exposures (or portions thereof) that qualify for
the Supervisory Formula Approach.
(6) Eligible credit reserves shortfall. In accordance with paragraph (a)(1) of
section 13, any eligible credit reserves shortfall.
(7) Certain failed capital markets transactions. In accordance with paragraph
(e)(3) of section 35, the [bank]’s exposure on certain failed capital markets transactions.
Section 12. Deductions and Limitations Not Required
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(a) Deduction of CEIOs. A [bank] is not required to make the deductions from
capital for CEIOs in 12 CFR part 3, Appendix A, § 2(c) (for national banks), 12 CFR part
208, Appendix A, § II.B.1.e. (for state member banks), 12 CFR part 225, Appendix A,
§ II.B.1.e. (for bank holding companies), 12 CFR part 325, Appendix A, § II.B.5. (for
state nonmember banks), and 12 CFR 567.5(a)(2)(iii) and 567.12(e) (for savings
associations).
(b) Deduction of certain equity investments. A [bank] is not required to make the
deductions from capital for nonfinancial equity investments in 12 CFR part 3, Appendix
A, § 2(c) (for national banks), 12 CFR part 208, Appendix A, § II.B.5. (for state member
banks), 12 CFR part 225, Appendix A, § II.B.5. (for bank holding companies), and 12
CFR part 325, Appendix A, § II.B. (for state nonmember banks).
Section 13. Eligible Credit Reserves
(a) Comparison of eligible credit reserves to expected credit losses - (1) Shortfall
of eligible credit reserves. If a [bank]’s eligible credit reserves are less than the [bank]’s
total expected credit losses, the [bank] must deduct the shortfall amount 50 percent from
tier 1 capital and 50 percent from tier 2 capital. If the amount deductible from tier 2
capital exceeds the [bank]’s actual tier 2 capital, the [bank] must deduct the excess
amount from tier 1 capital.
(2) Excess eligible credit reserves. If a [bank]’s eligible credit reserves exceed the
[bank]’s total expected credit losses, the [bank] may include the excess amount in tier 2
capital to the extent that the excess amount does not exceed 0.6 percent of the [bank]’s
credit-risk-weighted assets.
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(b) Treatment of allowance for loan and lease losses. Regardless of any provision
in [the general risk-based capital rules], the ALLL is included in tier 2 capital only to the
extent provided in paragraph (a)(2) of this section and in section 24.
Part III. Qualification
Section 21. Qualification Process
(a) Timing. (1) A [bank] that is described in paragraph (b)(1) of section 1 must
adopt a written implementation plan no later than six months after the later of [INSERT
EFFECTIVE DATE] or the date the [bank] meets a criterion in that section. The
implementation plan must incorporate an explicit first floor period start date no later than
36 months after the later of [INSERT EFFECTIVE DATE] or the date the [bank] meets
at least one criterion under paragraph (b)(1) of section 1. The [AGENCY] may extend
the first floor period start date.
(2) A [bank] that elects to be subject to this appendix under paragraph (b)(2) of
section 1 must adopt a written implementation plan.
(b) Implementation plan. (1) The [bank]’s implementation plan must address in
detail how the [bank] complies, or plans to comply, with the qualification requirements in
section 22. The [bank] also must maintain a comprehensive and sound planning and
governance process to oversee the implementation efforts described in the plan. At a
minimum, the plan must:
(i) Comprehensively address the qualification requirements in section 22 for the
[bank] and each consolidated subsidiary (U.S. and foreign-based) of the [bank] with
respect to all portfolios and exposures of the [bank] and each of its consolidated
subsidiaries;
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(ii) Justify and support any proposed temporary or permanent exclusion of
business lines, portfolios, or exposures from application of the advanced approaches in
this appendix (which business lines, portfolios, and exposures must be, in the aggregate,
immaterial to the [bank]);
(iii) Include the [bank]’s self-assessment of:
(A) The [bank]’s current status in meeting the qualification requirements in
section 22; and
(B) The consistency of the [bank]’s current practices with the [AGENCY]’s
supervisory guidance on the qualification requirements;
(iv) Based on the [bank]’s self-assessment, identify and describe the areas in
which the [bank] proposes to undertake additional work to comply with the qualification
requirements in section 22 or to improve the consistency of the [bank]’s current practices
with the [AGENCY]’s supervisory guidance on the qualification requirements (gap
analysis);
(v) Describe what specific actions the [bank] will take to address the areas
identified in the gap analysis required by paragraph (b)(1)(iv) of this section;
(vi) Identify objective, measurable milestones, including delivery dates and a date
when the [bank]’s implementation of the methodologies described in this appendix will
be fully operational;
(vii) Describe resources that have been budgeted and are available to implement
the plan; and
(viii) Receive approval of the [bank]’s board of directors.
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(2) The [bank] must submit the implementation plan, together with a copy of the
minutes of the board of directors’ approval, to the [AGENCY] at least 60 days before the
[bank] proposes to begin its parallel run, unless the [AGENCY] waives prior notice.
(c) Parallel run. Before determining its risk-based capital requirements under this
appendix and following adoption of the implementation plan, the [bank] must conduct a
satisfactory parallel run. A satisfactory parallel run is a period of no less than four
consecutive calendar quarters during which the [bank] complies with the qualification
requirements in section 22 to the satisfaction of the [AGENCY]. During the parallel run,
the [bank] must report to the [AGENCY] on a calendar quarterly basis its risk-based
capital ratios using [the general risk-based capital rules] and the risk-based capital
requirements described in this appendix. During this period, the [bank] is subject to [the
general risk-based capital rules].
(d) Approval to calculate risk-based capital requirements under this appendix.
The [AGENCY] will notify the [bank] of the date that the [bank] may begin its first floor
period if the [AGENCY] determines that:
(1) The [bank] fully complies with all the qualification requirements in section 22;
(2) The [bank] has conducted a satisfactory parallel run under paragraph (c) of
this section; and
(3) The [bank] has an adequate process to ensure ongoing compliance with the
qualification requirements in section 22.
(e) Transitional floor periods. Following a satisfactory parallel run, a [bank] is
subject to three transitional floor periods.
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(1) Risk-based capital ratios during the transitional floor periods - (i) Tier 1 riskbased capital ratio. During a [bank]’s transitional floor periods, the [bank]’s tier 1 riskbased capital ratio is equal to the lower of:
(A) The [bank]’s floor-adjusted tier 1 risk-based capital ratio; or
(B) The [bank]’s advanced approaches tier 1 risk-based capital ratio.
(ii) Total risk-based capital ratio. During a [bank]’s transitional floor periods, the
[bank]’s total risk-based capital ratio is equal to the lower of:
(A) The [bank]’s floor-adjusted total risk-based capital ratio; or
(B) The [bank]’s advanced approaches total risk-based capital ratio.
(2) Floor-adjusted risk-based capital ratios. (i) A [bank]’s floor-adjusted tier 1
risk-based capital ratio during a transitional floor period is equal to the [bank]’s tier 1
capital as calculated under [the general risk-based capital rules], divided by the product
of:
(A) The [bank]’s total risk-weighted assets as calculated under [the general riskbased capital rules]; and
(B) The appropriate transitional floor percentage in Table 1.
(ii) A [bank]’s floor-adjusted total risk-based capital ratio during a transitional
floor period is equal to the sum of the [bank]’s tier 1 and tier 2 capital as calculated under
[the general risk-based capital rules], divided by the product of:
(A) The [bank]’s total risk-weighted assets as calculated under [the general riskbased capital rules]; and
(B) The appropriate transitional floor percentage in Table 1.
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(iii) A [bank] that meets the criteria in paragraph (b)(1) or (b)(2) of section 1 as of
[INSERT EFFECTIVE DATE] must use [the general risk-based capital rules] during the
parallel run and as the basis for its transitional floors.
Table 1 – Transitional Floors
Transitional floor period
Transitional floor percentage
First floor period
95 percent
Second floor period
90 percent
Third floor period
85 percent
(3) Advanced approaches risk-based capital ratios. (i) A [bank]’s advanced
approaches tier 1 risk-based capital ratio equals the [bank]’s tier 1 risk-based capital ratio
as calculated under this appendix (other than this section on transitional floor periods).
(ii) A [bank]’s advanced approaches total risk-based capital ratio equals the
[bank]’s total risk-based capital ratio as calculated under this appendix (other than this
section on transitional floor periods).
(4) Reporting. During the transitional floor periods, a [bank] must report to the
[AGENCY] on a calendar quarterly basis both floor-adjusted risk-based capital ratios and
both advanced approaches risk-based capital ratios.
(5) Exiting a transitional floor period. A [bank] may not exit a transitional floor
period until the [bank] has spent a minimum of four consecutive calendar quarters in the
period and the [AGENCY] has determined that the [bank] may exit the floor period. The
[AGENCY]’s determination will be based on an assessment of the [bank]’s ongoing
compliance with the qualification requirements in section 22.
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(6) Interagency study. After the end of the second transition year (2010), the
Federal banking agencies will publish a study that evaluates the advanced approaches to
determine if there are any material deficiencies. For any primary Federal supervisor to
authorize any institution to exit the third transitional floor period, the study must
determine that there are no such material deficiencies that cannot be addressed by thenexisting tools, or, if such deficiencies are found, they are first remedied by changes to this
appendix. Notwithstanding the preceding sentence, a primary Federal supervisor that
disagrees with the finding of material deficiency may not authorize any institution under
its jurisdiction to exit the third transitional floor period unless it provides a public report
explaining its reasoning.
Section 22. Qualification Requirements
(a) Process and systems requirements. (1) A [bank] must have a rigorous process
for assessing its overall capital adequacy in relation to its risk profile and a
comprehensive strategy for maintaining an appropriate level of capital.
(2) The systems and processes used by a [bank] for risk-based capital purposes
under this appendix must be consistent with the [bank]’s internal risk management
processes and management information reporting systems.
(3) Each [bank] must have an appropriate infrastructure with risk measurement
and management processes that meet the qualification requirements of this section and
are appropriate given the [bank]’s size and level of complexity. Regardless of whether
the systems and models that generate the risk parameters necessary for calculating a
[bank]’s risk-based capital requirements are located at any affiliate of the [bank], the
[bank] itself must ensure that the risk parameters and reference data used to determine its
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risk-based capital requirements are representative of its own credit risk and operational
risk exposures.
(b) Risk rating and segmentation systems for wholesale and retail exposures. (1)
A [bank] must have an internal risk rating and segmentation system that accurately and
reliably differentiates among degrees of credit risk for the [bank]’s wholesale and retail
exposures.
(2) For wholesale exposures:
(i) A [bank] must have an internal risk rating system that accurately and reliably
assigns each obligor to a single rating grade (reflecting the obligor’s likelihood of
default). A [bank] may elect, however, not to assign to a rating grade an obligor to whom
the [bank] extends credit based solely on the financial strength of a guarantor, provided
that all of the [bank]’s exposures to the obligor are fully covered by eligible guarantees,
the [bank] applies the PD substitution approach in paragraph (c)(1) of section 33 to all
exposures to that obligor, and the [bank] immediately assigns the obligor to a rating grade
if a guarantee can no longer be recognized under this appendix. The [bank]’s wholesale
obligor rating system must have at least seven discrete rating grades for non-defaulted
obligors and at least one rating grade for defaulted obligors.
(ii) Unless the [bank] has chosen to directly assign LGD estimates to each
wholesale exposure, the [bank] must have an internal risk rating system that accurately
and reliably assigns each wholesale exposure to a loss severity rating grade (reflecting the
[bank]’s estimate of the LGD of the exposure). A [bank] employing loss severity rating
grades must have a sufficiently granular loss severity grading system to avoid grouping
together exposures with widely ranging LGDs.
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(3) For retail exposures, a [bank] must have an internal system that groups retail
exposures into the appropriate retail exposure subcategory, groups the retail exposures in
each retail exposure subcategory into separate segments with homogeneous risk
characteristics, and assigns accurate and reliable PD and LGD estimates for each segment
on a consistent basis. The [bank]’s system must identify and group in separate segments
by subcategories exposures identified in paragraphs (c)(2)(ii) and (iii) of section 31.
(4) The [bank]’s internal risk rating policy for wholesale exposures must describe
the [bank]’s rating philosophy (that is, must describe how wholesale obligor rating
assignments are affected by the [bank]’s choice of the range of economic, business, and
industry conditions that are considered in the obligor rating process).
(5) The [bank]’s internal risk rating system for wholesale exposures must provide
for the review and update (as appropriate) of each obligor rating and (if applicable) each
loss severity rating whenever the [bank] receives new material information, but no less
frequently than annually. The [bank]’s retail exposure segmentation system must provide
for the review and update (as appropriate) of assignments of retail exposures to segments
whenever the [bank] receives new material information, but generally no less frequently
than quarterly.
(c) Quantification of risk parameters for wholesale and retail exposures. (1) The
[bank] must have a comprehensive risk parameter quantification process that produces
accurate, timely, and reliable estimates of the risk parameters for the [bank]’s wholesale
and retail exposures.
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(2) Data used to estimate the risk parameters must be relevant to the [bank]’s
actual wholesale and retail exposures, and of sufficient quality to support the
determination of risk-based capital requirements for the exposures.
(3) The [bank]’s risk parameter quantification process must produce appropriately
conservative risk parameter estimates where the [bank] has limited relevant data, and any
adjustments that are part of the quantification process must not result in a pattern of bias
toward lower risk parameter estimates.
(4) Where the [bank]’s quantifications of LGD directly or indirectly incorporate
estimates of the effectiveness of its credit risk management practices in reducing its
exposure to troubled obligors prior to default, the [bank] must support such estimates
with empirical analysis showing that the estimates are consistent with its historical
experience in dealing with such exposures during economic downturn conditions.
(5) PD estimates for wholesale obligors and retail segments must be based on at
least five years of default data. LGD estimates for wholesale exposures must be based on
at least seven years of loss severity data, and LGD estimates for retail segments must be
based on at least five years of loss severity data. EAD estimates for wholesale exposures
must be based on at least seven years of exposure amount data, and EAD estimates for
retail segments must be based on at least five years of exposure amount data.
(6) Default, loss severity, and exposure amount data must include periods of
economic downturn conditions, or the [bank] must adjust its estimates of risk parameters
to compensate for the lack of data from periods of economic downturn conditions.
(7) The [bank]’s PD, LGD, and EAD estimates must be based on the definition of
default in this appendix.
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(8) The [bank] must review and update (as appropriate) its risk parameters and its
risk parameter quantification process at least annually.
(9) The [bank] must at least annually conduct a comprehensive review and
analysis of reference data to determine relevance of reference data to the [bank]’s
exposures, quality of reference data to support PD, LGD, and EAD estimates, and
consistency of reference data to the definition of default contained in this appendix.
(d) Counterparty credit risk model. A [bank] must obtain the prior written
approval of the [AGENCY] under section 32 to use the internal models methodology for
counterparty credit risk.
(e) Double default treatment. A [bank] must obtain the prior written approval of
the [AGENCY] under section 34 to use the double default treatment.
(f) Securitization exposures. A [bank] must obtain the prior written approval of
the [AGENCY] under section 44 to use the Internal Assessment Approach for
securitization exposures to ABCP programs.
(g) Equity exposures model. A [bank] must obtain the prior written approval of
the [AGENCY] under section 53 to use the Internal Models Approach for equity
exposures.
(h) Operational risk - (1) Operational risk management processes. A [bank] must:
(i) Have an operational risk management function that:
(A) Is independent of business line management; and
(B) Is responsible for designing, implementing, and overseeing the [bank]’s
operational risk data and assessment systems, operational risk quantification systems, and
related processes;
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(ii) Have and document a process (which must capture business environment and
internal control factors affecting the [bank]’s operational risk profile) to identify,
measure, monitor, and control operational risk in [bank] products, activities, processes,
and systems; and
(iii) Report operational risk exposures, operational loss events, and other relevant
operational risk information to business unit management, senior management, and the
board of directors (or a designated committee of the board).
(2) Operational risk data and assessment systems. A [bank] must have
operational risk data and assessment systems that capture operational risks to which the
[bank] is exposed. The [bank]’s operational risk data and assessment systems must:
(i) Be structured in a manner consistent with the [bank]’s current business
activities, risk profile, technological processes, and risk management processes; and
(ii) Include credible, transparent, systematic, and verifiable processes that
incorporate the following elements on an ongoing basis:
(A) Internal operational loss event data. The [bank] must have a systematic
process for capturing and using internal operational loss event data in its operational risk
data and assessment systems.
(1) The [bank]’s operational risk data and assessment systems must include a
historical observation period of at least five years for internal operational loss event data
(or such shorter period approved by the [AGENCY] to address transitional situations,
such as integrating a new business line).
(2) The [bank] must be able to map its internal operational loss event data into the
seven operational loss event type categories.
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(3) The [bank] may refrain from collecting internal operational loss event data for
individual operational losses below established dollar threshold amounts if the [bank] can
demonstrate to the satisfaction of the [AGENCY] that the thresholds are reasonable, do
not exclude important internal operational loss event data, and permit the [bank] to
capture substantially all the dollar value of the [bank]’s operational losses.
(B) External operational loss event data. The [bank] must have a systematic
process for determining its methodologies for incorporating external operational loss
event data into its operational risk data and assessment systems.
(C) Scenario analysis. The [bank] must have a systematic process for determining
its methodologies for incorporating scenario analysis into its operational risk data and
assessment systems.
(D) Business environment and internal control factors. The [bank] must
incorporate business environment and internal control factors into its operational risk data
and assessment systems. The [bank] must also periodically compare the results of its
prior business environment and internal control factor assessments against its actual
operational losses incurred in the intervening period.
(3) Operational risk quantification systems. (i) The [bank]’s operational risk
quantification systems:
(A) Must generate estimates of the [bank]’s operational risk exposure using its
operational risk data and assessment systems;
(B) Must employ a unit of measure that is appropriate for the [bank]’s range of
business activities and the variety of operational loss events to which it is exposed, and
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that does not combine business activities or operational loss events with demonstrably
different risk profiles within the same loss distribution;
(C) Must include a credible, transparent, systematic, and verifiable approach for
weighting each of the four elements, described in paragraph (h)(2)(ii) of this section, that
a [bank] is required to incorporate into its operational risk data and assessment systems;
(D) May use internal estimates of dependence among operational losses across
and within units of measure if the [bank] can demonstrate to the satisfaction of the
[AGENCY] that its process for estimating dependence is sound, robust to a variety of
scenarios, and implemented with integrity, and allows for the uncertainty surrounding the
estimates. If the [bank] has not made such a demonstration, it must sum operational risk
exposure estimates across units of measure to calculate its total operational risk exposure;
and
(E) Must be reviewed and updated (as appropriate) whenever the [bank] becomes
aware of information that may have a material effect on the [bank]’s estimate of
operational risk exposure, but the review and update must occur no less frequently than
annually.
(ii) With the prior written approval of the [AGENCY], a [bank] may generate an
estimate of its operational risk exposure using an alternative approach to that specified in
paragraph (h)(3)(i) of this section. A [bank] proposing to use such an alternative
operational risk quantification system must submit a proposal to the [AGENCY]. In
determining whether to approve a [bank]’s proposal to use an alternative operational risk
quantification system, the [AGENCY] will consider the following principles:
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(A) Use of the alternative operational risk quantification system will be allowed
only on an exception basis, considering the size, complexity, and risk profile of the
[bank];
(B) The [bank] must demonstrate that its estimate of its operational risk exposure
generated under the alternative operational risk quantification system is appropriate and
can be supported empirically; and
(C) A [bank] must not use an allocation of operational risk capital requirements
that includes entities other than depository institutions or the benefits of diversification
across entities.
(i) Data management and maintenance. (1) A [bank] must have data management
and maintenance systems that adequately support all aspects of its advanced systems and
the timely and accurate reporting of risk-based capital requirements.
(2) A [bank] must retain data using an electronic format that allows timely
retrieval of data for analysis, validation, reporting, and disclosure purposes.
(3) A [bank] must retain sufficient data elements related to key risk drivers to
permit adequate monitoring, validation, and refinement of its advanced systems.
(j) Control, oversight, and validation mechanisms. (1) The [bank]’s senior
management must ensure that all components of the [bank]’s advanced systems function
effectively and comply with the qualification requirements in this section.
(2) The [bank]’s board of directors (or a designated committee of the board) must
at least annually review the effectiveness of, and approve, the [bank]’s advanced systems.
(3) A [bank] must have an effective system of controls and oversight that:
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(i) Ensures ongoing compliance with the qualification requirements in this
section;
(ii) Maintains the integrity, reliability, and accuracy of the [bank]’s advanced
systems; and
(iii) Includes adequate governance and project management processes.
(4) The [bank] must validate, on an ongoing basis, its advanced systems. The
[bank]’s validation process must be independent of the advanced systems’ development,
implementation, and operation, or the validation process must be subjected to an
independent review of its adequacy and effectiveness. Validation must include:
(i) An evaluation of the conceptual soundness of (including developmental
evidence supporting) the advanced systems;
(ii) An ongoing monitoring process that includes verification of processes and
benchmarking; and
(iii) An outcomes analysis process that includes back-testing.
(5) The [bank] must have an internal audit function independent of business-line
management that at least annually assesses the effectiveness of the controls supporting
the [bank]’s advanced systems and reports its findings to the [bank]’s board of directors
(or a committee thereof).
(6) The [bank] must periodically stress test its advanced systems. The stress
testing must include a consideration of how economic cycles, especially downturns,
affect risk-based capital requirements (including migration across rating grades and
segments and the credit risk mitigation benefits of double default treatment).
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(k) Documentation. The [bank] must adequately document all material aspects of
its advanced systems.
Section 23. Ongoing Qualification
(a) Changes to advanced systems. A [bank] must meet all the qualification
requirements in section 22 on an ongoing basis. A [bank] must notify the [AGENCY]
when the [bank] makes any change to an advanced system that would result in a material
change in the [bank]’s risk-weighted asset amount for an exposure type, or when the
[bank] makes any significant change to its modeling assumptions.
(b) Failure to comply with qualification requirements. (1) If the [AGENCY]
determines that a [bank] that uses this appendix and has conducted a satisfactory parallel
run fails to comply with the qualification requirements in section 22, the [AGENCY] will
notify the [bank] in writing of the [bank]’s failure to comply.
(2) The [bank] must establish and submit a plan satisfactory to the [AGENCY] to
return to compliance with the qualification requirements.
(3) In addition, if the [AGENCY] determines that the [bank]’s risk-based capital
requirements are not commensurate with the [bank]’s credit, market, operational, or other
risks, the [AGENCY] may require such a [bank] to calculate its risk-based capital
requirements:
(i) Under [the general risk-based capital rules]; or
(ii) Under this appendix with any modifications provided by the [AGENCY].
Section 24. Merger and Acquisition Transitional Arrangements
(a) Mergers and acquisitions of companies without advanced systems. If a [bank]
merges with or acquires a company that does not calculate its risk-based capital
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requirements using advanced systems, the [bank] may use [the general risk-based capital
rules] to determine the risk-weighted asset amounts for, and deductions from capital
associated with, the merged or acquired company’s exposures for up to 24 months after
the calendar quarter during which the merger or acquisition consummates. The
[AGENCY] may extend this transition period for up to an additional 12 months. Within
90 days of consummating the merger or acquisition, the [bank] must submit to the
[AGENCY] an implementation plan for using its advanced systems for the acquired
company. During the period when [the general risk-based capital rules] apply to the
merged or acquired company, any ALLL, net of allocated transfer risk reserves
established pursuant to 12 U.S.C. 3904, associated with the merged or acquired
company’s exposures may be included in the acquiring [bank]’s tier 2 capital up to 1.25
percent of the acquired company’s risk-weighted assets. All general allowances of the
merged or acquired company must be excluded from the [bank]’s eligible credit reserves.
In addition, the risk-weighted assets of the merged or acquired company are not included
in the [bank]’s credit-risk-weighted assets but are included in total risk-weighted assets.
If a [bank] relies on this paragraph, the [bank] must disclose publicly the amounts of riskweighted assets and qualifying capital calculated under this appendix for the acquiring
[bank] and under [the general risk-based capital rules] for the acquired company.
(b) Mergers and acquisitions of companies with advanced systems - (1) If a
[bank] merges with or acquires a company that calculates its risk-based capital
requirements using advanced systems, the [bank] may use the acquired company’s
advanced systems to determine the risk-weighted asset amounts for, and deductions from
capital associated with, the merged or acquired company’s exposures for up to 24 months
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after the calendar quarter during which the acquisition or merger consummates. The
[AGENCY] may extend this transition period for up to an additional 12 months. Within
90 days of consummating the merger or acquisition, the [bank] must submit to the
[AGENCY] an implementation plan for using its advanced systems for the merged or
acquired company.
(2) If the acquiring [bank] is not subject to the advanced approaches in this
appendix at the time of acquisition or merger, during the period when [the general riskbased capital rules] apply to the acquiring [bank], the ALLL associated with the
exposures of the merged or acquired company may not be directly included in tier 2
capital. Rather, any excess eligible credit reserves associated with the merged or
acquired company’s exposures may be included in the [bank]’s tier 2 capital up to 0.6
percent of the credit-risk-weighted assets associated with those exposures.
Part IV. Risk-Weighted Assets for General Credit Risk
Section 31. Mechanics for Calculating Total Wholesale and Retail Risk-Weighted
Assets
(a) Overview. A [bank] must calculate its total wholesale and retail risk-weighted
asset amount in four distinct phases:
(1) Phase 1 – categorization of exposures;
(2) Phase 2 – assignment of wholesale obligors and exposures to rating grades and
segmentation of retail exposures;
(3) Phase 3 – assignment of risk parameters to wholesale exposures and segments
of retail exposures; and
(4) Phase 4 – calculation of risk-weighted asset amounts.
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DRAFT November 2, 2007
(b) Phase 1 − Categorization. The [bank] must determine which of its exposures
are wholesale exposures, retail exposures, securitization exposures, or equity exposures.
The [bank] must categorize each retail exposure as a residential mortgage exposure, a
QRE, or an other retail exposure. The [bank] must identify which wholesale exposures
are HVCRE exposures, sovereign exposures, OTC derivative contracts, repo-style
transactions, eligible margin loans, eligible purchased wholesale exposures, unsettled
transactions to which section 35 applies, and eligible guarantees or eligible credit
derivatives that are used as credit risk mitigants. The [bank] must identify any onbalance sheet asset that does not meet the definition of a wholesale, retail, equity, or
securitization exposure, as well as any non-material portfolio of exposures described in
paragraph (e)(4) of this section.
(c) Phase 2 – Assignment of wholesale obligors and exposures to rating grades
and retail exposures to segments - (1) Assignment of wholesale obligors and exposures to
rating grades.
(i) The [bank] must assign each obligor of a wholesale exposure to a single
obligor rating grade and must assign each wholesale exposure to which it does not
directly assign an LGD estimate to a loss severity rating grade.
(ii) The [bank] must identify which of its wholesale obligors are in default.
(2) Segmentation of retail exposures. (i) The [bank] must group the retail
exposures in each retail subcategory into segments that have homogeneous risk
characteristics.
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DRAFT November 2, 2007
(ii) The [bank] must identify which of its retail exposures are in default. The
[bank] must segment defaulted retail exposures separately from non-defaulted retail
exposures.
(iii) If the [bank] determines the EAD for eligible margin loans using the
approach in paragraph (b) of section 32, the [bank] must identify which of its retail
exposures are eligible margin loans for which the [bank] uses this EAD approach and
must segment such eligible margin loans separately from other retail exposures.
(3) Eligible purchased wholesale exposures. A [bank] may group its eligible
purchased wholesale exposures into segments that have homogeneous risk characteristics.
A [bank] must use the wholesale exposure formula in Table 2 in this section to determine
the risk-based capital requirement for each segment of eligible purchased wholesale
exposures.
(d) Phase 3 − Assignment of risk parameters to wholesale exposures and
segments of retail exposures - (1) Quantification process. Subject to the limitations in
this paragraph (d), the [bank] must:
(i) Associate a PD with each wholesale obligor rating grade;
(ii) Associate an LGD with each wholesale loss severity rating grade or assign an
LGD to each wholesale exposure;
(iii) Assign an EAD and M to each wholesale exposure; and
(iv) Assign a PD, LGD, and EAD to each segment of retail exposures.
(2) Floor on PD assignment. The PD for each wholesale obligor or retail segment
may not be less than 0.03 percent, except for exposures to or directly and unconditionally
guaranteed by a sovereign entity, the Bank for International Settlements, the International
519
DRAFT November 2, 2007
Monetary Fund, the European Commission, the European Central Bank, or a multilateral
development bank, to which the [bank] assigns a rating grade associated with a PD of less
than 0.03 percent.
(3) Floor on LGD estimation. The LGD for each segment of residential mortgage
exposures (other than segments of residential mortgage exposures for which all or
substantially all of the principal of each exposure is directly and unconditionally
guaranteed by the full faith and credit of a sovereign entity) may not be less than
10 percent.
(4) Eligible purchased wholesale exposures. A [bank] must assign a PD, LGD,
EAD, and M to each segment of eligible purchased wholesale exposures. If the [bank]
can estimate ECL (but not PD or LGD) for a segment of eligible purchased wholesale
exposures, the [bank] must assume that the LGD of the segment equals 100 percent and
that the PD of the segment equals ECL divided by EAD. The estimated ECL must be
calculated for the exposures without regard to any assumption of recourse or guarantees
from the seller or other parties.
(5) Credit risk mitigation − credit derivatives, guarantees, and collateral. (i) A
[bank] may take into account the risk reducing effects of eligible guarantees and eligible
credit derivatives in support of a wholesale exposure by applying the PD substitution or
LGD adjustment treatment to the exposure as provided in section 33 or, if applicable,
applying double default treatment to the exposure as provided in section 34. A [bank]
may decide separately for each wholesale exposure that qualifies for the double default
treatment under section 34 whether to apply the double default treatment or to use the PD
substitution or LGD adjustment treatment without recognizing double default effects.
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DRAFT November 2, 2007
(ii) A [bank] may take into account the risk reducing effects of guarantees and
credit derivatives in support of retail exposures in a segment when quantifying the PD
and LGD of the segment.
(iii) Except as provided in paragraph (d)(6) of this section, a [bank] may take into
account the risk reducing effects of collateral in support of a wholesale exposure when
quantifying the LGD of the exposure and may take into account the risk reducing effects
of collateral in support of retail exposures when quantifying the PD and LGD of the
segment.
(6) EAD for OTC derivative contracts, repo-style transactions, and eligible
margin loans. (i) A [bank] must calculate its EAD for an OTC derivative contract as
provided in paragraphs (c) and (d) of section 32. A [bank] may take into account the
risk-reducing effects of financial collateral in support of a repo-style transaction or
eligible margin loan and of any collateral in support of a repo-style transaction that is
included in the [bank]’s VaR-based measure under [the market risk rule] through an
adjustment to EAD as provided in paragraphs (b) and (d) of section 32. A [bank] that
takes collateral into account through such an adjustment to EAD under section 32 may
not reflect such collateral in LGD.
(ii) A [bank] may attribute an EAD of zero to:
(A) Derivative contracts that are publicly traded on an exchange that requires the
daily receipt and payment of cash-variation margin;
(B) Derivative contracts and repo-style transactions that are outstanding with a
qualifying central counterparty (but not for those transactions that a qualifying central
counterparty has rejected); and
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DRAFT November 2, 2007
(C) Credit risk exposures to a qualifying central counterparty in the form of
clearing deposits and posted collateral that arise from transactions described in paragraph
(d)(6)(ii)(B) of this section.
(7) Effective maturity. An exposure’s M must be no greater than five years and
no less than one year, except that an exposure’s M must be no less than one day if the
exposure has an original maturity of less than one year and is not part of a [bank]’s
ongoing financing of the obligor. An exposure is not part of a [bank]’s ongoing financing
of the obligor if the [bank]:
(i) Has a legal and practical ability not to renew or roll over the exposure in the
event of credit deterioration of the obligor;
(ii) Makes an independent credit decision at the inception of the exposure and at
every renewal or roll over; and
(iii) Has no substantial commercial incentive to continue its credit relationship
with the obligor in the event of credit deterioration of the obligor.
(e) Phase 4 − Calculation of risk-weighted assets - (1) Non-defaulted exposures.
(i) A [bank] must calculate the dollar risk-based capital requirement for each of its
wholesale exposures to a non-defaulted obligor (except eligible guarantees and eligible
credit derivatives that hedge another wholesale exposure and exposures to which the
[bank] applies the double default treatment in section 34) and segments of non-defaulted
retail exposures by inserting the assigned risk parameters for the wholesale obligor and
exposure or retail segment into the appropriate risk-based capital formula specified in
Table 2 and multiplying the output of the formula (K) by the EAD of the exposure or
segment. Alternatively, a [bank] may apply a 300 percent risk weight to the EAD of an
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DRAFT November 2, 2007
eligible margin loan if the [bank] is not able to meet the agencies’ requirements for
estimation of PD and LGD for the margin loan.
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DRAFT November 2, 2007
Retail
Table 2 – IRB Risk-Based Capital Formulas for Wholesale Exposures to Non-Defaulted Obligors
and Segments of Non-Defaulted Retail Exposures1
Capital
Requirement
(K)
NonDefaulted
Exposures
⎡
⎤
⎛ N −1 ( PD ) + R × N −1 ( 0 .999 ) ⎞
⎟ − (LGD × PD )⎥
K = ⎢ LGD × N ⎜
⎜
⎟
1− R
⎝
⎠
⎣⎢
⎦⎥
For residential mortgage exposures: R = 0.15
Correlation
Factor (R)
For qualifying revolving exposures: R = 0.04
For other retail exposures: R = 0.03 + 0.13 × e −35×PD
Wholesale
Capital
⎡
⎤
⎛ N −1 ( PD ) + R × N −1 ( 0 . 999 ) ⎞
⎟ − (LGD × PD )⎥ × ⎛⎜ 1 + ( M − 2 .5 ) × b ⎞⎟
⎜
K
LGD
N
=
×
⎢
Requirement
⎟
⎜
1 − 1 .5 × b
1− R
⎠
⎠
⎝
⎣⎢
⎦⎥ ⎝
(K)
NonDefaulted
Exposures
For HVCRE exposures:
Correlation
Factor (R)
R = 0.12 + 0.18 × e−50× PD
For wholesale exposures other than HVCRE exposures:
R = 0.12 + 0.12 × e −50×PD
Maturity
Adjustment
(b)
b = (0.11852 − 0.05478 × ln( PD) )
2
1
N(.) means the cumulative distribution function for a standard normal random variable.
N-1(.) means the inverse cumulative distribution function for a standard normal random
variable. The symbol e refers to the base of the natural logarithms, and the function ln(.)
refers to the natural logarithm of the expression within parentheses. The formulas apply
when PD is greater than zero. If PD equals zero, the capital requirement K is set equal to
zero.
(ii) The sum of all the dollar risk-based capital requirements for each wholesale
exposure to a non-defaulted obligor and segment of non-defaulted retail exposures
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DRAFT November 2, 2007
calculated in paragraph (e)(1)(i) of this section and in paragraph (e) of section 34 equals
the total dollar risk-based capital requirement for those exposures and segments.
(iii) The aggregate risk-weighted asset amount for wholesale exposures to nondefaulted obligors and segments of non-defaulted retail exposures equals the total dollar
risk-based capital requirement calculated in paragraph (e)(1)(ii) of this section multiplied
by 12.5.
(2) Wholesale exposures to defaulted obligors and segments of defaulted retail
exposures. (i) The dollar risk-based capital requirement for each wholesale exposure to a
defaulted obligor equals 0.08 multiplied by the EAD of the exposure.
(ii) The dollar risk-based capital requirement for a segment of defaulted retail
exposures equals 0.08 multiplied by the EAD of the segment.
(iii) The sum of all the dollar risk-based capital requirements for each wholesale
exposure to a defaulted obligor calculated in paragraph (e)(2)(i) of this section plus the
dollar risk-based capital requirements for each segment of defaulted retail exposures
calculated in paragraph (e)(2)(ii) of this section equals the total dollar risk-based capital
requirement for those exposures and segments.
(iv) The aggregate risk-weighted asset amount for wholesale exposures to
defaulted obligors and segments of defaulted retail exposures equals the total dollar riskbased capital requirement calculated in paragraph (e)(2)(iii) of this section multiplied by
12.5.
(3) Assets not included in a defined exposure category. (i) A [bank] may assign a
risk-weighted asset amount of zero to cash owned and held in all offices of the [bank] or
in transit and for gold bullion held in the [bank]’s own vaults, or held in another [bank]’s
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vaults on an allocated basis, to the extent the gold bullion assets are offset by gold bullion
liabilities.
(ii) The risk-weighted asset amount for the residual value of a retail lease
exposure equals such residual value.
(iii) The risk-weighted asset amount for any other on-balance-sheet asset that does
not meet the definition of a wholesale, retail, securitization, or equity exposure equals the
carrying value of the asset.
(4) Non-material portfolios of exposures. The risk-weighted asset amount of a
portfolio of exposures for which the [bank] has demonstrated to the [AGENCY]’s
satisfaction that the portfolio (when combined with all other portfolios of exposures that
the [bank] seeks to treat under this paragraph) is not material to the [bank] is the sum of
the carrying values of on-balance sheet exposures plus the notional amounts of offbalance sheet exposures in the portfolio. For purposes of this paragraph (e)(4), the
notional amount of an OTC derivative contract that is not a credit derivative is the EAD
of the derivative as calculated in section 32.
Section 32. Counterparty Credit Risk of Repo-Style Transactions, Eligible Margin
Loans, and OTC Derivative Contracts
(a) In General. (1) This section describes two methodologies – a collateral haircut
approach and an internal models methodology – that a [bank] may use instead of an LGD
estimation methodology to recognize the benefits of financial collateral in mitigating the
counterparty credit risk of repo-style transactions, eligible margin loans, collateralized
OTC derivative contracts, and single product netting sets of such transactions and to
recognize the benefits of any collateral in mitigating the counterparty credit risk of repo-
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DRAFT November 2, 2007
style transactions that are included in a [bank]’s VaR-based measure under [the market
risk rule]. A third methodology, the simple VaR methodology, is available for single
product netting sets of repo-style transactions and eligible margin loans.
(2) This section also describes the methodology for calculating EAD for an OTC
derivative contract or a set of OTC derivative contracts subject to a qualifying master
netting agreement. A [bank] also may use the internal models methodology to estimate
EAD for qualifying cross-product master netting agreements.
(3) A [bank] may only use the standard supervisory haircut approach with a
minimum 10-business-day holding period to recognize in EAD the benefits of
conforming residential mortgage collateral that secures repo-style transactions (other than
repo-style transactions included in the [bank]’s VaR-based measure under [the market
risk rule]), eligible margin loans, and OTC derivative contracts.
(4) A [bank] may use any combination of the three methodologies for collateral
recognition; however, it must use the same methodology for similar exposures.
(b) EAD for eligible margin loans and repo-style transactions - (1) General. A
[bank] may recognize the credit risk mitigation benefits of financial collateral that secures
an eligible margin loan, repo-style transaction, or single-product netting set of such
transactions by factoring the collateral into its LGD estimates for the exposure.
Alternatively, a [bank] may estimate an unsecured LGD for the exposure, as well as for
any repo-style transaction that is included in the [bank]’s VaR-based measure under [the
market risk rule], and determine the EAD of the exposure using:
(i) The collateral haircut approach described in paragraph (b)(2) of this section;
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DRAFT November 2, 2007
(ii) For netting sets only, the simple VaR methodology described in
paragraph (b)(3) of this section; or
(iii) The internal models methodology described in paragraph (d) of this section.
(2) Collateral haircut approach - (i) EAD equation. A [bank] may determine EAD
for an eligible margin loan, repo-style transaction, or netting set by setting EAD equal to
max {0, [(∑E - ∑C) + ∑(Es x Hs) + ∑(Efx x Hfx)]}, where:
(A) ∑E equals the value of the exposure (the sum of the current market values of
all instruments, gold, and cash the [bank] has lent, sold subject to repurchase, or posted as
collateral to the counterparty under the transaction (or netting set));
(B) ∑C equals the value of the collateral (the sum of the current market values of
all instruments, gold, and cash the [bank] has borrowed, purchased subject to resale, or
taken as collateral from the counterparty under the transaction (or netting set));
(C) Es equals the absolute value of the net position in a given instrument or in
gold (where the net position in a given instrument or in gold equals the sum of the current
market values of the instrument or gold the [bank] has lent, sold subject to repurchase, or
posted as collateral to the counterparty minus the sum of the current market values of that
same instrument or gold the [bank] has borrowed, purchased subject to resale, or taken as
collateral from the counterparty);
(D) Hs equals the market price volatility haircut appropriate to the instrument or
gold referenced in Es;
(E) Efx equals the absolute value of the net position of instruments and cash in a
currency that is different from the settlement currency (where the net position in a given
currency equals the sum of the current market values of any instruments or cash in the
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DRAFT November 2, 2007
currency the [bank] has lent, sold subject to repurchase, or posted as collateral to the
counterparty minus the sum of the current market values of any instruments or cash in the
currency the [bank] has borrowed, purchased subject to resale, or taken as collateral from
the counterparty); and
(F) Hfx equals the haircut appropriate to the mismatch between the currency
referenced in Efx and the settlement currency.
(ii) Standard supervisory haircuts. (A) Under the standard supervisory haircuts
approach:
(1) A [bank] must use the haircuts for market price volatility (Hs) in Table 3, as
adjusted in certain circumstances as provided in paragraph (b)(2)(ii)(A)(3) and (4) of this
section;
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DRAFT November 2, 2007
Table 3 – Standard Supervisory Market Price Volatility Haircuts1
Applicable external
rating grade category
for debt securities
Residual maturity for debt
securities
Two highest
≤ 1 year
investment-grade
>1 year, ≤ 5 years
rating categories for
long-term
> 5 years
ratings/highest
investment-grade
rating category for
short-term ratings
Two lowest
≤ 1 year
investment-grade
>1 year, ≤ 5 years
rating categories for
both short- and long> 5 years
term ratings
One rating category
All
below investment
grade
Main index equities (including convertible bonds) and gold
Other publicly traded equities (including convertible
bonds), conforming residential mortgages, and
nonfinancial collateral
Mutual funds
Issuers
exempt from
the 3 basis
point floor
0.005
Other issuers
0.01
0.02
0.04
0.04
0.08
0.01
0.02
0.03
0.06
0.06
0.12
0.15
0.25
0.15
0.25
Highest haircut applicable to
any security in which the fund
can invest
0
Cash on deposit with the [bank] (including a certificate of
deposit issued by the [bank])
1
The market price volatility haircuts in Table 3 are based on a ten-business-day holding
period.
(2) For currency mismatches, a [bank] must use a haircut for foreign exchange
rate volatility (Hfx) of 8 percent, as adjusted in certain circumstances as provided in
paragraph (b)(2)(ii)(A)(3) and (4) of this section.
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DRAFT November 2, 2007
(3) For repo-style transactions, a [bank] may multiply the supervisory haircuts
provided in paragraphs (b)(2)(ii)(A)(1) and (2) of this section by the square root of ½
(which equals 0.707107).
(4) A [bank] must adjust the supervisory haircuts upward on the basis of a holding
period longer than ten business days (for eligible margin loans) or five business days (for
repo-style transactions) where and as appropriate to take into account the illiquidity of an
instrument.
(iii) Own internal estimates for haircuts. With the prior written approval of the
[AGENCY], a [bank] may calculate haircuts (Hs and Hfx) using its own internal
estimates of the volatilities of market prices and foreign exchange rates.
(A) To receive [AGENCY] approval to use its own internal estimates, a [bank]
must satisfy the following minimum quantitative standards:
(1) A [bank] must use a 99th percentile one-tailed confidence interval.
(2) The minimum holding period for a repo-style transaction is five business days
and for an eligible margin loan is ten business days. When a [bank] calculates an ownestimates haircut on a TN-day holding period, which is different from the minimum
holding period for the transaction type, the applicable haircut (HM) is calculated using the
following square root of time formula:
HM = HN
TM
, where
TN
(i) TM equals 5 for repo-style transactions and 10 for eligible margin loans;
(ii) TN equals the holding period used by the [bank] to derive HN; and
(iii) HN equals the haircut based on the holding period TN.
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DRAFT November 2, 2007
(3) A [bank] must adjust holding periods upwards where and as appropriate to
take into account the illiquidity of an instrument.
(4) The historical observation period must be at least one year.
(5) A [bank] must update its data sets and recompute haircuts no less frequently
than quarterly and must also reassess data sets and haircuts whenever market prices
change materially.
(B) With respect to debt securities that have an applicable external rating of
investment grade, a [bank] may calculate haircuts for categories of securities. For a
category of securities, the [bank] must calculate the haircut on the basis of internal
volatility estimates for securities in that category that are representative of the securities
in that category that the [bank] has lent, sold subject to repurchase, posted as collateral,
borrowed, purchased subject to resale, or taken as collateral. In determining relevant
categories, the [bank] must at a minimum take into account:
(1) The type of issuer of the security;
(2) The applicable external rating of the security;
(3) The maturity of the security; and
(4) The interest rate sensitivity of the security.
(C) With respect to debt securities that have an applicable external rating of below
investment grade and equity securities, a [bank] must calculate a separate haircut for each
individual security.
(D) Where an exposure or collateral (whether in the form of cash or securities) is
denominated in a currency that differs from the settlement currency, the [bank] must
calculate a separate currency mismatch haircut for its net position in each mismatched
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DRAFT November 2, 2007
currency based on estimated volatilities of foreign exchange rates between the
mismatched currency and the settlement currency.
(E) A [bank]’s own estimates of market price and foreign exchange rate
volatilities may not take into account the correlations among securities and foreign
exchange rates on either the exposure or collateral side of a transaction (or netting set) or
the correlations among securities and foreign exchange rates between the exposure and
collateral sides of the transaction (or netting set).
(3) Simple VaR methodology. With the prior written approval of the [AGENCY],
a [bank] may estimate EAD for a netting set using a VaR model that meets the
requirements in paragraph (b)(3)(iii) of this section. In such event, the [bank] must set
EAD equal to max {0, [(∑E - ∑C) + PFE]}, where:
(i) ∑E equals the value of the exposure (the sum of the current market values of
all securities and cash the [bank] has lent, sold subject to repurchase, or posted as
collateral to the counterparty under the netting set);
(ii) ∑C equals the value of the collateral (the sum of the current market values of
all securities and cash the [bank] has borrowed, purchased subject to resale, or taken as
collateral from the counterparty under the netting set); and
(iii) PFE (potential future exposure) equals the [bank]’s empirically based best
estimate of the 99th percentile, one-tailed confidence interval for an increase in the value
of (∑E - ∑C) over a five-business-day holding period for repo-style transactions or over a
ten-business-day holding period for eligible margin loans using a minimum one-year
historical observation period of price data representing the instruments that the [bank] has
lent, sold subject to repurchase, posted as collateral, borrowed, purchased subject to
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DRAFT November 2, 2007
resale, or taken as collateral. The [bank] must validate its VaR model, including by
establishing and maintaining a rigorous and regular back-testing regime.
(c) EAD for OTC derivative contracts. (1) A [bank] must determine the EAD for
an OTC derivative contract that is not subject to a qualifying master netting agreement
using the current exposure methodology in paragraph (c)(5) of this section or using the
internal models methodology described in paragraph (d) of this section.
(2) A [bank] must determine the EAD for multiple OTC derivative contracts that
are subject to a qualifying master netting agreement using the current exposure
methodology in paragraph (c)(6) of this section or using the internal models methodology
described in paragraph (d) of this section.
(3) Counterparty credit risk for credit derivatives. Notwithstanding the above,
(i) A [bank] that purchases a credit derivative that is recognized under section 33
or 34 as a credit risk mitigant for an exposure that is not a covered position under [the
market risk rule] need not compute a separate counterparty credit risk capital requirement
under this section so long as the [bank] does so consistently for all such credit derivatives
and either includes all or excludes all such credit derivatives that are subject to a master
netting agreement from any measure used to determine counterparty credit risk exposure
to all relevant counterparties for risk-based capital purposes.
(ii) A [bank] that is the protection provider in a credit derivative must treat the
credit derivative as a wholesale exposure to the reference obligor and need not compute a
counterparty credit risk capital requirement for the credit derivative under this section, so
long as it does so consistently for all such credit derivatives and either includes all or
excludes all such credit derivatives that are subject to a master netting agreement from
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DRAFT November 2, 2007
any measure used to determine counterparty credit risk exposure to all relevant
counterparties for risk-based capital purposes (unless the [bank] is treating the credit
derivative as a covered position under [the market risk rule], in which case the [bank]
must compute a supplemental counterparty credit risk capital requirement under this
section).
(4) Counterparty credit risk for equity derivatives. A [bank] must treat an equity
derivative contract as an equity exposure and compute a risk-weighted asset amount for
the equity derivative contract under part VI (unless the [bank] is treating the contract as a
covered position under [the market risk rule]). In addition, if the [bank] is treating the
contract as a covered position under [the market risk rule] and in certain other cases
described in section 55, the [bank] must also calculate a risk-based capital requirement
for the counterparty credit risk of an equity derivative contract under this part.
(5) Single OTC derivative contract. Except as modified by paragraph (c)(7) of
this section, the EAD for a single OTC derivative contract that is not subject to a
qualifying master netting agreement is equal to the sum of the [bank]’s current credit
exposure and potential future credit exposure (PFE) on the derivative contract.
(i) Current credit exposure. The current credit exposure for a single OTC
derivative contract is the greater of the mark-to-market value of the derivative contract or
zero.
(ii) PFE. The PFE for a single OTC derivative contract, including an OTC
derivative contract with a negative mark-to-market value, is calculated by multiplying the
notional principal amount of the derivative contract by the appropriate conversion factor
in Table 4. For purposes of calculating either the PFE under this paragraph or the gross
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DRAFT November 2, 2007
PFE under paragraph (c)(6) of this section for exchange rate contracts and other similar
contracts in which the notional principal amount is equivalent to the cash flows, notional
principal amount is the net receipts to each party falling due on each value date in each
currency. For any OTC derivative contract that does not fall within one of the specified
categories in Table 4, the PFE must be calculated using the “other” conversion factors. A
[bank] must use an OTC derivative contract’s effective notional principal amount (that is,
its apparent or stated notional principal amount multiplied by any multiplier in the OTC
derivative contract) rather than its apparent or stated notional principal amount in
calculating PFE. PFE of the protection provider of a credit derivative is capped at the net
present value of the amount of unpaid premiums.
Table 4 – Conversion Factor Matrix for OTC Derivative Contracts1
Remaining
maturity2
Interest Foreign
rate
exchange
rate and
gold
Credit
(investmentgrade
reference
obligor)3
Credit
Equity Precious Other
(nonmetals
investment(except
grade
gold)
reference
obligor)
0.10
0.06
0.07
0.10
One year or
0.00
0.01
0.05
less
Over one to
0.005
0.05
0.05
0.10
0.08
0.07
0.12
five years
Over five
0.015
0.075
0.05
0.10
0.10
0.08
0.15
years
1
For an OTC derivative contract with multiple exchanges of principal, the conversion
factor is multiplied by the number of remaining payments in the derivative contract.
2
For an OTC derivative contract that is structured such that on specified dates any
outstanding exposure is settled and the terms are reset so that the market value of the
contract is zero, the remaining maturity equals the time until the next reset date. For an
interest rate derivative contract with a remaining maturity of greater than one year that
meets these criteria, the minimum conversion factor is 0.005.
3
A [bank] must use the column labeled “Credit (investment-grade reference obligor)” for
a credit derivative whose reference obligor has an outstanding unsecured long-term debt
security without credit enhancement that has a long-term applicable external rating of at
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DRAFT November 2, 2007
least investment grade. A [bank] must use the column labeled “Credit (non-investmentgrade reference obligor)” for all other credit derivatives.
(6) Multiple OTC derivative contracts subject to a qualifying master netting
agreement. Except as modified by paragraph (c)(7) of this section, the EAD for multiple
OTC derivative contracts subject to a qualifying master netting agreement is equal to the
sum of the net current credit exposure and the adjusted sum of the PFE exposure for all
OTC derivative contracts subject to the qualifying master netting agreement.
(i) Net current credit exposure. The net current credit exposure is the greater of:
(A) The net sum of all positive and negative mark-to-market values of the
individual OTC derivative contracts subject to the qualifying master netting agreement;
or
(B) zero.
(ii) Adjusted sum of the PFE. The adjusted sum of the PFE, Anet, is calculated as
Anet = (0.4×Agross)+(0.6×NGR×Agross), where:
(A) Agross = the gross PFE (that is, the sum of the PFE amounts (as determined
under paragraph (c)(5)(ii) of this section) for each individual OTC derivative contract
subject to the qualifying master netting agreement); and
(B) NGR = the net to gross ratio (that is, the ratio of the net current credit
exposure to the gross current credit exposure). In calculating the NGR, the gross current
credit exposure equals the sum of the positive current credit exposures (as determined
under paragraph (c)(5)(i) of this section) of all individual OTC derivative contracts
subject to the qualifying master netting agreement.
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(7) Collateralized OTC derivative contracts. A [bank] may recognize the credit
risk mitigation benefits of financial collateral that secures an OTC derivative contract or
single-product netting set of OTC derivatives by factoring the collateral into its LGD
estimates for the contract or netting set. Alternatively, a [bank] may recognize the credit
risk mitigation benefits of financial collateral that secures such a contract or netting set
that is marked to market on a daily basis and subject to a daily margin maintenance
requirement by estimating an unsecured LGD for the contract or netting set and adjusting
the EAD calculated under paragraph (c)(5) or (c)(6) of this section using the collateral
haircut approach in paragraph (b)(2) of this section. The [bank] must substitute the EAD
calculated under paragraph (c)(5) or (c)(6) of this section for ∑E in the equation in
paragraph (b)(2)(i) of this section and must use a ten-business-day minimum holding
period (TM = 10).
(d) Internal models methodology. (1) With prior written approval from the
[AGENCY], a [bank] may use the internal models methodology in this paragraph (d) to
determine EAD for counterparty credit risk for OTC derivative contracts (collateralized
or uncollateralized) and single-product netting sets thereof, for eligible margin loans and
single-product netting sets thereof, and for repo-style transactions and single-product
netting sets thereof. A [bank] that uses the internal models methodology for a particular
transaction type (OTC derivative contracts, eligible margin loans, or repo-style
transactions) must use the internal models methodology for all transactions of that
transaction type. A [bank] may choose to use the internal models methodology for one or
two of these three types of exposures and not the other types. A [bank] may also use the
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DRAFT November 2, 2007
internal models methodology for OTC derivative contracts, eligible margin loans, and
repo-style transactions subject to a qualifying cross-product netting agreement if:
(i) The [bank] effectively integrates the risk mitigating effects of cross-product
netting into its risk management and other information technology systems; and
(ii) The [bank] obtains the prior written approval of the [AGENCY].
A [bank] that uses the internal models methodology for a transaction type must receive
approval from the [AGENCY] to cease using the methodology for that transaction type or
to make a material change to its internal model.
(2) Under the internal models methodology, a [bank] uses an internal model to
estimate the expected exposure (EE) for a netting set and then calculates EAD based on
that EE.
(i) The [bank] must use its internal model’s probability distribution for changes in
the market value of a netting set that are attributable to changes in market variables to
determine EE.
(ii) Under the internal models methodology, EAD = α x effective EPE, or, subject
to [AGENCY] approval as provided in paragraph (d)(7), a more conservative measure of
EAD.
n
(A) EffectiveEPEt = ∑ EffectiveEEt xΔt k (that is, effective EPE is the timek
k
k =1
weighted average of effective EE where the weights are the proportion that an individual
effective EE represents in a one-year time interval) where:
(
)
(1) EffectiveEEtk = max EffectiveEEtk −1 , EEtk (that is, for a specific date tk,
effective EE is the greater of EE at that date or the effective EE at the previous date); and
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DRAFT November 2, 2007
(2) tk represents the kth future time period in the model and there are n time
periods represented in the model over the first year; and
(B) α = 1.4 except as provided in paragraph (d)(6), or when the [AGENCY] has
determined that the [bank] must set α higher based on the [bank]’s specific characteristics
of counterparty credit risk.
(iii) A [bank] may include financial collateral currently posted by the counterparty
as collateral (but may not include other forms of collateral) when calculating EE.
(iv) If a [bank] hedges some or all of the counterparty credit risk associated with a
netting set using an eligible credit derivative, the [bank] may take the reduction in
exposure to the counterparty into account when estimating EE. If the [bank] recognizes
this reduction in exposure to the counterparty in its estimate of EE, it must also use its
internal model to estimate a separate EAD for the [bank]’s exposure to the protection
provider of the credit derivative.
(3) To obtain [AGENCY] approval to calculate the distributions of exposures
upon which the EAD calculation is based, the [bank] must demonstrate to the satisfaction
of the [AGENCY] that it has been using for at least one year an internal model that
broadly meets the following minimum standards, with which the [bank] must maintain
compliance:
(i) The model must have the systems capability to estimate the expected exposure
to the counterparty on a daily basis (but is not expected to estimate or report expected
exposure on a daily basis).
(ii) The model must estimate expected exposure at enough future dates to reflect
accurately all the future cash flows of contracts in the netting set.
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(iii) The model must account for the possible non-normality of the exposure
distribution, where appropriate.
(iv) The [bank] must measure, monitor, and control current counterparty exposure
and the exposure to the counterparty over the whole life of all contracts in the netting set.
(v) The [bank] must be able to measure and manage current exposures gross and
net of collateral held, where appropriate. The [bank] must estimate expected exposures
for OTC derivative contracts both with and without the effect of collateral agreements.
(vi) The [bank] must have procedures to identify, monitor, and control specific
wrong-way risk throughout the life of an exposure. Wrong-way risk in this context is the
risk that future exposure to a counterparty will be high when the counterparty’s
probability of default is also high.
(vii) The model must use current market data to compute current exposures.
When estimating model parameters based on historical data, at least three years of
historical data that cover a wide range of economic conditions must be used and must be
updated quarterly or more frequently if market conditions warrant. The [bank] should
consider using model parameters based on forward-looking measures, where appropriate.
(viii) A [bank] must subject its internal model to an initial validation and annual
model review process. The model review should consider whether the inputs and risk
factors, as well as the model outputs, are appropriate.
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(4) Maturity. (i) If the remaining maturity of the exposure or the longest-dated
contract in the netting set is greater than one year, the [bank] must set M for the exposure
or netting set equal to the lower of five years or M(EPE), 4 where:
maturity
(A) M ( EPE ) = 1 +
∑ EE
k
× Δt k × df k
tk >1 year
tk ≤1 year
∑ effectiveEE
k =1
;
k
× Δt k × df k
(B) dfk is the risk-free discount factor for future time period tk; and
(C) Δ t k = t k − t k −1 .
(ii) If the remaining maturity of the exposure or the longest-dated contract in the
netting set is one year or less, the [bank] must set M for the exposure or netting set equal
to one year, except as provided in paragraph (d)(7) of section 31.
(5) Collateral agreements. A [bank] may capture the effect on EAD of a collateral
agreement that requires receipt of collateral when exposure to the counterparty increases
but may not capture the effect on EAD of a collateral agreement that requires receipt of
collateral when counterparty credit quality deteriorates. For this purpose, a collateral
agreement means a legal contract that specifies the time when, and circumstances under
which, the counterparty is required to pledge collateral to the [bank] for a single financial
contract or for all financial contracts in a netting set and confers upon the [bank] a
perfected, first priority security interest (notwithstanding the prior security interest of any
custodial agent), or the legal equivalent thereof, in the collateral posted by the
counterparty under the agreement. This security interest must provide the [bank] with a
right to close out the financial positions and liquidate the collateral upon an event of
4
Alternatively, a [bank] that uses an internal model to calculate a one-sided credit valuation adjustment
may use the effective credit duration estimated by the model as M(EPE) in place of the formula in
paragraph (d)(4).
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DRAFT November 2, 2007
default of, or failure to perform by, the counterparty under the collateral agreement. A
contract would not satisfy this requirement if the [bank]’s exercise of rights under the
agreement may be stayed or avoided under applicable law in the relevant jurisdictions.
Two methods are available to capture the effect of a collateral agreement:
(i) With prior written approval from the [AGENCY], a [bank] may include the
effect of a collateral agreement within its internal model used to calculate EAD. The
[bank] may set EAD equal to the expected exposure at the end of the margin period of
risk. The margin period of risk means, with respect to a netting set subject to a collateral
agreement, the time period from the most recent exchange of collateral with a
counterparty until the next required exchange of collateral plus the period of time
required to sell and realize the proceeds of the least liquid collateral that can be delivered
under the terms of the collateral agreement and, where applicable, the period of time
required to re-hedge the resulting market risk, upon the default of the counterparty. The
minimum margin period of risk is five business days for repo-style transactions and ten
business days for other transactions when liquid financial collateral is posted under a
daily margin maintenance requirement. This period should be extended to cover any
additional time between margin calls; any potential closeout difficulties; any delays in
selling collateral, particularly if the collateral is illiquid; and any impediments to prompt
re-hedging of any market risk.
(ii) A [bank] that can model EPE without collateral agreements but cannot
achieve the higher level of modeling sophistication to model EPE with collateral
agreements can set effective EPE for a collateralized netting set equal to the lesser of:
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DRAFT November 2, 2007
(A) The threshold, defined as the exposure amount at which the counterparty is
required to post collateral under the collateral agreement, if the threshold is positive, plus
an add-on that reflects the potential increase in exposure of the netting set over the
margin period of risk. The add-on is computed as the expected increase in the netting
set’s exposure beginning from current exposure of zero over the margin period of risk.
The margin period of risk must be at least five business days for netting sets consisting
only of repo-style transactions subject to daily re-margining and daily marking-to-market,
and ten business days for all other netting sets; or
(B) Effective EPE without a collateral agreement.
(6) Own estimate of alpha. With prior written approval of the [AGENCY], a
[bank] may calculate alpha as the ratio of economic capital from a full simulation of
counterparty exposure across counterparties that incorporates a joint simulation of market
and credit risk factors (numerator) and economic capital based on EPE (denominator),
subject to a floor of 1.2. For purposes of this calculation, economic capital is the
unexpected losses for all counterparty credit risks measured at a 99.9 percent confidence
level over a one-year horizon. To receive approval, the [bank] must meet the following
minimum standards to the satisfaction of the [AGENCY]:
(i) The [bank]’s own estimate of alpha must capture in the numerator the effects
of:
(A) The material sources of stochastic dependency of distributions of market
values of transactions or portfolios of transactions across counterparties;
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DRAFT November 2, 2007
(B) Volatilities and correlations of market risk factors used in the joint simulation,
which must be related to the credit risk factor used in the simulation to reflect potential
increases in volatility or correlation in an economic downturn, where appropriate; and
(C) The granularity of exposures (that is, the effect of a concentration in the
proportion of each counterparty’s exposure that is driven by a particular risk factor).
(ii) The [bank] must assess the potential model uncertainty in its estimates of
alpha.
(iii) The [bank] must calculate the numerator and denominator of alpha in a
consistent fashion with respect to modeling methodology, parameter specifications, and
portfolio composition.
(iv) The [bank] must review and adjust as appropriate its estimates of the
numerator and denominator of alpha on at least a quarterly basis and more frequently
when the composition of the portfolio varies over time.
(7) Other measures of counterparty exposure. With prior written approval of the
[AGENCY], a [bank] may set EAD equal to a measure of counterparty credit risk
exposure, such as peak EAD, that is more conservative than an alpha of 1.4 (or higher
under the terms of paragraph (d)(2)(ii)(B)) times EPE for every counterparty whose EAD
will be measured under the alternative measure of counterparty exposure. The [bank]
must demonstrate the conservatism of the measure of counterparty credit risk exposure
used for EAD. For material portfolios of new OTC derivative products, the [bank] may
assume that the current exposure methodology in paragraphs (c)(5) and (c)(6) of this
section meets the conservatism requirement of this paragraph for a period not to exceed
180 days. For immaterial portfolios of OTC derivative contracts, the [bank] generally
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may assume that the current exposure methodology in paragraphs (c)(5) and (c)(6) of this
section meets the conservatism requirement of this paragraph.
Section 33. Guarantees and Credit Derivatives: PD Substitution and LGD
Adjustment Approaches
(a) Scope. (1) This section applies to wholesale exposures for which:
(i) Credit risk is fully covered by an eligible guarantee or eligible credit
derivative; or
(ii) Credit risk is covered on a pro rata basis (that is, on a basis in which the
[bank] and the protection provider share losses proportionately) by an eligible guarantee
or eligible credit derivative.
(2) Wholesale exposures on which there is a tranching of credit risk (reflecting at
least two different levels of seniority) are securitization exposures subject to the
securitization framework in part V.
(3) A [bank] may elect to recognize the credit risk mitigation benefits of an
eligible guarantee or eligible credit derivative covering an exposure described in
paragraph (a)(1) of this section by using the PD substitution approach or the LGD
adjustment approach in paragraph (c) of this section or, if the transaction qualifies, using
the double default treatment in section 34. A [bank]’s PD and LGD for the hedged
exposure may not be lower than the PD and LGD floors described in paragraphs (d)(2)
and (d)(3) of section 31.
(4) If multiple eligible guarantees or eligible credit derivatives cover a single
exposure described in paragraph (a)(1) of this section, a [bank] may treat the hedged
exposure as multiple separate exposures each covered by a single eligible guarantee or
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DRAFT November 2, 2007
eligible credit derivative and may calculate a separate risk-based capital requirement for
each separate exposure as described in paragraph (a)(3) of this section.
(5) If a single eligible guarantee or eligible credit derivative covers multiple
hedged wholesale exposures described in paragraph (a)(1) of this section, a [bank] must
treat each hedged exposure as covered by a separate eligible guarantee or eligible credit
derivative and must calculate a separate risk-based capital requirement for each exposure
as described in paragraph (a)(3) of this section.
(6) A [bank] must use the same risk parameters for calculating ECL as it uses for
calculating the risk-based capital requirement for the exposure.
(b) Rules of recognition. (1) A [bank] may only recognize the credit risk
mitigation benefits of eligible guarantees and eligible credit derivatives.
(2) A [bank] may only recognize the credit risk mitigation benefits of an eligible
credit derivative to hedge an exposure that is different from the credit derivative’s
reference exposure used for determining the derivative’s cash settlement value,
deliverable obligation, or occurrence of a credit event if:
(i) The reference exposure ranks pari passu (that is, equally) with or is junior to
the hedged exposure; and
(ii) The reference exposure and the hedged exposure are exposures to the same
legal entity, and legally enforceable cross-default or cross-acceleration clauses are in
place to assure payments under the credit derivative are triggered when the obligor fails
to pay under the terms of the hedged exposure.
(c) Risk parameters for hedged exposures - (1) PD substitution approach - (i) Full
coverage. If an eligible guarantee or eligible credit derivative meets the conditions in
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DRAFT November 2, 2007
paragraphs (a) and (b) of this section and the protection amount (P) of the guarantee or
credit derivative is greater than or equal to the EAD of the hedged exposure, a [bank]
may recognize the guarantee or credit derivative in determining the [bank]’s risk-based
capital requirement for the hedged exposure by substituting the PD associated with the
rating grade of the protection provider for the PD associated with the rating grade of the
obligor in the risk-based capital formula applicable to the guarantee or credit derivative in
Table 2 and using the appropriate LGD as described in paragraph (c)(1)(iii) of this
section. If the [bank] determines that full substitution of the protection provider’s PD
leads to an inappropriate degree of risk mitigation, the [bank] may substitute a higher PD
than that of the protection provider.
(ii) Partial coverage. If an eligible guarantee or eligible credit derivative meets
the conditions in paragraphs (a) and (b) of this section and the protection amount (P) of
the guarantee or credit derivative is less than the EAD of the hedged exposure, the [bank]
must treat the hedged exposure as two separate exposures (protected and unprotected) in
order to recognize the credit risk mitigation benefit of the guarantee or credit derivative.
(A) The [bank] must calculate its risk-based capital requirement for the protected
exposure under section 31, where PD is the protection provider’s PD, LGD is determined
under paragraph (c)(1)(iii) of this section, and EAD is P. If the [bank] determines that
full substitution leads to an inappropriate degree of risk mitigation, the [bank] may use a
higher PD than that of the protection provider.
(B) The [bank] must calculate its risk-based capital requirement for the
unprotected exposure under section 31, where PD is the obligor’s PD, LGD is the hedged
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DRAFT November 2, 2007
exposure’s LGD (not adjusted to reflect the guarantee or credit derivative), and EAD is
the EAD of the original hedged exposure minus P.
(C) The treatment in this paragraph (c)(1)(ii) is applicable when the credit risk of
a wholesale exposure is covered on a partial pro rata basis or when an adjustment is made
to the effective notional amount of the guarantee or credit derivative under paragraph (d),
(e), or (f) of this section.
(iii) LGD of hedged exposures. The LGD of a hedged exposure under the PD
substitution approach is equal to:
(A) The lower of the LGD of the hedged exposure (not adjusted to reflect the
guarantee or credit derivative) and the LGD of the guarantee or credit derivative, if the
guarantee or credit derivative provides the [bank] with the option to receive immediate
payout upon triggering the protection; or
(B) The LGD of the guarantee or credit derivative, if the guarantee or credit
derivative does not provide the [bank] with the option to receive immediate payout upon
triggering the protection.
(2) LGD adjustment approach - (i) Full coverage. If an eligible guarantee or
eligible credit derivative meets the conditions in paragraphs (a) and (b) of this section and
the protection amount (P) of the guarantee or credit derivative is greater than or equal to
the EAD of the hedged exposure, the [bank]’s risk-based capital requirement for the
hedged exposure is the greater of:
(A) The risk-based capital requirement for the exposure as calculated under
section 31, with the LGD of the exposure adjusted to reflect the guarantee or credit
derivative; or
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DRAFT November 2, 2007
(B) The risk-based capital requirement for a direct exposure to the protection
provider as calculated under section 31, using the PD for the protection provider, the
LGD for the guarantee or credit derivative, and an EAD equal to the EAD of the hedged
exposure.
(ii) Partial coverage. If an eligible guarantee or eligible credit derivative meets
the conditions in paragraphs (a) and (b) of this section and the protection amount (P) of
the guarantee or credit derivative is less than the EAD of the hedged exposure, the [bank]
must treat the hedged exposure as two separate exposures (protected and unprotected) in
order to recognize the credit risk mitigation benefit of the guarantee or credit derivative.
(A) The [bank]’s risk-based capital requirement for the protected exposure would
be the greater of:
(1) The risk-based capital requirement for the protected exposure as calculated
under section 31, with the LGD of the exposure adjusted to reflect the guarantee or credit
derivative and EAD set equal to P; or
(2) The risk-based capital requirement for a direct exposure to the guarantor as
calculated under section 31, using the PD for the protection provider, the LGD for the
guarantee or credit derivative, and an EAD set equal to P.
(B) The [bank] must calculate its risk-based capital requirement for the
unprotected exposure under section 31, where PD is the obligor’s PD, LGD is the hedged
exposure’s LGD (not adjusted to reflect the guarantee or credit derivative), and EAD is
the EAD of the original hedged exposure minus P.
(3) M of hedged exposures. The M of the hedged exposure is the same as the M
of the exposure if it were unhedged.
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DRAFT November 2, 2007
(d) Maturity mismatch. (1) A [bank] that recognizes an eligible guarantee or
eligible credit derivative in determining its risk-based capital requirement for a hedged
exposure must adjust the effective notional amount of the credit risk mitigant to reflect
any maturity mismatch between the hedged exposure and the credit risk mitigant.
(2) A maturity mismatch occurs when the residual maturity of a credit risk
mitigant is less than that of the hedged exposure(s).
(3) The residual maturity of a hedged exposure is the longest possible remaining
time before the obligor is scheduled to fulfill its obligation on the exposure. If a credit
risk mitigant has embedded options that may reduce its term, the [bank] (protection
purchaser) must use the shortest possible residual maturity for the credit risk mitigant. If
a call is at the discretion of the protection provider, the residual maturity of the credit risk
mitigant is at the first call date. If the call is at the discretion of the [bank] (protection
purchaser), but the terms of the arrangement at origination of the credit risk mitigant
contain a positive incentive for the [bank] to call the transaction before contractual
maturity, the remaining time to the first call date is the residual maturity of the credit risk
mitigant. For example, where there is a step-up in cost in conjunction with a call feature
or where the effective cost of protection increases over time even if credit quality remains
the same or improves, the residual maturity of the credit risk mitigant will be the
remaining time to the first call.
(4) A credit risk mitigant with a maturity mismatch may be recognized only if its
original maturity is greater than or equal to one year and its residual maturity is greater
than three months.
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DRAFT November 2, 2007
(5) When a maturity mismatch exists, the [bank] must apply the following
adjustment to the effective notional amount of the credit risk mitigant: Pm = E x (t0.25)/(T-0.25), where:
(i) Pm = effective notional amount of the credit risk mitigant, adjusted for
maturity mismatch;
(ii) E = effective notional amount of the credit risk mitigant;
(iii) t = the lesser of T or the residual maturity of the credit risk mitigant,
expressed in years; and
(iv) T = the lesser of five or the residual maturity of the hedged exposure,
expressed in years.
(e) Credit derivatives without restructuring as a credit event. If a [bank]
recognizes an eligible credit derivative that does not include as a credit event a
restructuring of the hedged exposure involving forgiveness or postponement of principal,
interest, or fees that results in a credit loss event (that is, a charge-off, specific provision,
or other similar debit to the profit and loss account), the [bank] must apply the following
adjustment to the effective notional amount of the credit derivative: Pr = Pm x 0.60,
where:
(1) Pr = effective notional amount of the credit risk mitigant, adjusted for lack of
restructuring event (and maturity mismatch, if applicable); and
(2) Pm = effective notional amount of the credit risk mitigant adjusted for
maturity mismatch (if applicable).
(f) Currency mismatch. (1) If a [bank] recognizes an eligible guarantee or eligible
credit derivative that is denominated in a currency different from that in which the
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hedged exposure is denominated, the [bank] must apply the following formula to the
effective notional amount of the guarantee or credit derivative: Pc = Pr x (1-HFX), where:
(i) Pc = effective notional amount of the credit risk mitigant, adjusted for currency
mismatch (and maturity mismatch and lack of restructuring event, if applicable);
(ii) Pr = effective notional amount of the credit risk mitigant (adjusted for
maturity mismatch and lack of restructuring event, if applicable); and
(iii) HFX = haircut appropriate for the currency mismatch between the credit risk
mitigant and the hedged exposure.
(2) A [bank] must set HFX equal to 8 percent unless it qualifies for the use of and
uses its own internal estimates of foreign exchange volatility based on a ten-business-day
holding period and daily marking-to-market and remargining. A [bank] qualifies for the
use of its own internal estimates of foreign exchange volatility if it qualifies for:
(i) The own-estimates haircuts in paragraph (b)(2)(iii) of section 32;
(ii) The simple VaR methodology in paragraph (b)(3) of section 32; or
(iii) The internal models methodology in paragraph (d) of section 32.
(3) A [bank] must adjust HFX calculated in paragraph (f)(2) of this section upward
if the [bank] revalues the guarantee or credit derivative less frequently than once every
ten business days using the square root of time formula provided in paragraph
(b)(2)(iii)(A)(2) of section 32.
Section 34. Guarantees and Credit Derivatives: Double Default Treatment
(a) Eligibility and operational criteria for double default treatment. A [bank] may
recognize the credit risk mitigation benefits of a guarantee or credit derivative covering
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an exposure described in paragraph (a)(1) of section 33 by applying the double default
treatment in this section if all the following criteria are satisfied.
(1) The hedged exposure is fully covered or covered on a pro rata basis by:
(i) An eligible guarantee issued by an eligible double default guarantor; or
(ii) An eligible credit derivative that meets the requirements of paragraph (b)(2) of
section 33 and is issued by an eligible double default guarantor.
(2) The guarantee or credit derivative is:
(i) An uncollateralized guarantee or uncollateralized credit derivative (for
example, a credit default swap) that provides protection with respect to a single reference
obligor; or
(ii) An nth-to-default credit derivative (subject to the requirements of
paragraph (m) of section 42).
(3) The hedged exposure is a wholesale exposure (other than a sovereign
exposure).
(4) The obligor of the hedged exposure is not:
(i) An eligible double default guarantor or an affiliate of an eligible double default
guarantor; or
(ii) An affiliate of the guarantor.
(5) The [bank] does not recognize any credit risk mitigation benefits of the
guarantee or credit derivative for the hedged exposure other than through application of
the double default treatment as provided in this section.
(6) The [bank] has implemented a process (which has received the prior, written
approval of the [AGENCY]) to detect excessive correlation between the creditworthiness
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of the obligor of the hedged exposure and the protection provider. If excessive
correlation is present, the [bank] may not use the double default treatment for the hedged
exposure.
(b) Full coverage. If the transaction meets the criteria in paragraph (a) of this
section and the protection amount (P) of the guarantee or credit derivative is at least equal
to the EAD of the hedged exposure, the [bank] may determine its risk-weighted asset
amount for the hedged exposure under paragraph (e) of this section.
(c) Partial coverage. If the transaction meets the criteria in paragraph (a) of this
section and the protection amount (P) of the guarantee or credit derivative is less than the
EAD of the hedged exposure, the [bank] must treat the hedged exposure as two separate
exposures (protected and unprotected) in order to recognize double default treatment on
the protected portion of the exposure.
(1) For the protected exposure, the [bank] must set EAD equal to P and calculate
its risk-weighted asset amount as provided in paragraph (e) of this section.
(2) For the unprotected exposure, the [bank] must set EAD equal to the EAD of
the original exposure minus P and then calculate its risk-weighted asset amount as
provided in section 31.
(d) Mismatches. For any hedged exposure to which a [bank] applies double
default treatment, the [bank] must make applicable adjustments to the protection amount
as required in paragraphs (d), (e), and (f) of section 33.
(e) The double default dollar risk-based capital requirement. The dollar riskbased capital requirement for a hedged exposure to which a [bank] has applied double
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DRAFT November 2, 2007
default treatment is KDD multiplied by the EAD of the exposure. KDD is calculated
according to the following formula: KDD = Ko x (0.15 + 160 x PDg),
where:
(1)
KO =
⎡ ⎛ N −1 ( PD o ) + N −1 (0.999 ) ρ os
LGD g × ⎢ N ⎜
1 − ρ os
⎢⎣ ⎜⎝
⎤
⎞
⎟ − PD ⎥ × ⎡1 + ( M − 2.5 ) × b ⎤
o
⎥
⎢
⎟
⎥⎦ ⎣ 1 − 1.5 × b
⎦
⎠
(2) PDg = PD of the protection provider.
(3) PDo = PD of the obligor of the hedged exposure.
(4) LGDg = (i) The lower of the LGD of the hedged exposure (not adjusted to
reflect the guarantee or credit derivative) and the LGD of the guarantee or credit
derivative, if the guarantee or credit derivative provides the [bank] with the option to
receive immediate payout on triggering the protection; or
(ii) The LGD of the guarantee or credit derivative, if the guarantee or credit
derivative does not provide the [bank] with the option to receive immediate payout on
triggering the protection.
(5) ρos (asset value correlation of the obligor) is calculated according to the
appropriate formula for (R) provided in Table 2 in section 31, with PD equal to PDo.
(6) b (maturity adjustment coefficient) is calculated according to the formula for b
provided in Table 2 in section 31, with PD equal to the lesser of PDo and PDg.
(7) M (maturity) is the effective maturity of the guarantee or credit derivative,
which may not be less than one year or greater than five years.
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Section 35. Risk-Based Capital Requirement for Unsettled Transactions
(a) Definitions. For purposes of this section:
(1) Delivery-versus-payment (DvP) transaction means a securities or commodities
transaction in which the buyer is obligated to make payment only if the seller has made
delivery of the securities or commodities and the seller is obligated to deliver the
securities or commodities only if the buyer has made payment.
(2) Payment-versus-payment (PvP) transaction means a foreign exchange
transaction in which each counterparty is obligated to make a final transfer of one or
more currencies only if the other counterparty has made a final transfer of one or more
currencies.
(3) Normal settlement period. A transaction has a normal settlement period if the
contractual settlement period for the transaction is equal to or less than the market
standard for the instrument underlying the transaction and equal to or less than five
business days.
(4) Positive current exposure. The positive current exposure of a [bank] for a
transaction is the difference between the transaction value at the agreed settlement price
and the current market price of the transaction, if the difference results in a credit
exposure of the [bank] to the counterparty.
(b) Scope. This section applies to all transactions involving securities, foreign
exchange instruments, and commodities that have a risk of delayed settlement or
delivery. This section does not apply to:
(1) Transactions accepted by a qualifying central counterparty that are subject to
daily marking-to-market and daily receipt and payment of variation margin;
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DRAFT November 2, 2007
(2) Repo-style transactions, including unsettled repo-style transactions (which are
addressed in sections 31 and 32);
(3) One-way cash payments on OTC derivative contracts (which are addressed in
sections 31 and 32); or
(4) Transactions with a contractual settlement period that is longer than the
normal settlement period (which are treated as OTC derivative contracts and addressed in
sections 31 and 32).
(c) System-wide failures. In the case of a system-wide failure of a settlement or
clearing system, the [AGENCY] may waive risk-based capital requirements for unsettled
and failed transactions until the situation is rectified.
(d) Delivery-versus-payment (DvP) and payment-versus-payment (PvP)
transactions. A [bank] must hold risk-based capital against any DvP or PvP transaction
with a normal settlement period if the [bank]’s counterparty has not made delivery or
payment within five business days after the settlement date. The [bank] must determine
its risk-weighted asset amount for such a transaction by multiplying the positive current
exposure of the transaction for the [bank] by the appropriate risk weight in Table 5.
Table 5 – Risk Weights for Unsettled DvP and PvP Transactions
Number of business days
after contractual
settlement date
From 5 to 15
From 16 to 30
From 31 to 45
46 or more
Risk weight to be
applied to positive
current exposure
100%
625%
937.5%
1,250%
(e) Non-DvP/non-PvP (non-delivery-versus-payment/non-payment-versuspayment) transactions. (1) A [bank] must hold risk-based capital against any non-
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DRAFT November 2, 2007
DvP/non-PvP transaction with a normal settlement period if the [bank] has delivered
cash, securities, commodities, or currencies to its counterparty but has not received its
corresponding deliverables by the end of the same business day. The [bank] must
continue to hold risk-based capital against the transaction until the [bank] has received its
corresponding deliverables.
(2) From the business day after the [bank] has made its delivery until five
business days after the counterparty delivery is due, the [bank] must calculate its riskbased capital requirement for the transaction by treating the current market value of the
deliverables owed to the [bank] as a wholesale exposure.
(i) A [bank] may assign an obligor rating to a counterparty for which it is not
otherwise required under this appendix to assign an obligor rating on the basis of the
applicable external rating of any outstanding unsecured long-term debt security without
credit enhancement issued by the counterparty.
(ii) A [bank] may use a 45 percent LGD for the transaction rather than estimating
LGD for the transaction provided the [bank] uses the 45 percent LGD for all transactions
described in paragraphs (e)(1) and (e)(2) of this section.
(iii) A [bank] may use a 100 percent risk weight for the transaction provided the
[bank] uses this risk weight for all transactions described in paragraphs (e)(1) and (e)(2)
of this section.
(3) If the [bank] has not received its deliverables by the fifth business day after
the counterparty delivery was due, the [bank] must deduct the current market value of the
deliverables owed to the [bank] 50 percent from tier 1 capital and 50 percent from tier 2
capital.
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(f) Total risk-weighted assets for unsettled transactions. Total risk-weighted
assets for unsettled transactions is the sum of the risk-weighted asset amounts of all DvP,
PvP, and non-DvP/non-PvP transactions.
Part V. Risk-Weighted Assets for Securitization Exposures
Section 41. Operational Criteria for Recognizing the Transfer of Risk
(a) Operational criteria for traditional securitizations. A [bank] that transfers
exposures it has originated or purchased to a securitization SPE or other third party in
connection with a traditional securitization may exclude the exposures from the
calculation of its risk-weighted assets only if each of the conditions in this paragraph (a)
is satisfied. A [bank] that meets these conditions must hold risk-based capital against any
securitization exposures it retains in connection with the securitization. A [bank] that
fails to meet these conditions must hold risk-based capital against the transferred
exposures as if they had not been securitized and must deduct from tier 1 capital any
after-tax gain-on-sale resulting from the transaction. The conditions are:
(1) The transfer is considered a sale under GAAP;
(2) The [bank] has transferred to third parties credit risk associated with the
underlying exposures; and
(3) Any clean-up calls relating to the securitization are eligible clean-up calls.
(b) Operational criteria for synthetic securitizations. For synthetic securitizations,
a [bank] may recognize for risk-based capital purposes the use of a credit risk mitigant to
hedge underlying exposures only if each of the conditions in this paragraph (b) is
satisfied. A [bank] that fails to meet these conditions must hold risk-based capital against
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DRAFT November 2, 2007
the underlying exposures as if they had not been synthetically securitized. The conditions
are:
(1) The credit risk mitigant is an eligible credit derivative from an eligible
securitization guarantor or an eligible guarantee from an eligible securitization guarantor;
(2) The [bank] transfers credit risk associated with the underlying exposures to
third parties, and the terms and conditions in the credit risk mitigants employed do not
include provisions that:
(i) Allow for the termination of the credit protection due to deterioration in the
credit quality of the underlying exposures;
(ii) Require the [bank] to alter or replace the underlying exposures to improve the
credit quality of the pool of underlying exposures;
(iii) Increase the [bank]’s cost of credit protection in response to deterioration in
the credit quality of the underlying exposures;
(iv) Increase the yield payable to parties other than the [bank] in response to a
deterioration in the credit quality of the underlying exposures; or
(v) Provide for increases in a retained first loss position or credit enhancement
provided by the [bank] after the inception of the securitization;
(3) The [bank] obtains a well-reasoned opinion from legal counsel that confirms
the enforceability of the credit risk mitigant in all relevant jurisdictions; and
(4) Any clean-up calls relating to the securitization are eligible clean-up calls.
Section 42. Risk-Based Capital Requirement for Securitization Exposures
(a) Hierarchy of approaches. Except as provided elsewhere in this section:
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DRAFT November 2, 2007
(1) A [bank] must deduct from tier 1 capital any after-tax gain-on-sale resulting
from a securitization and must deduct from total capital in accordance with paragraph (c)
of this section the portion of any CEIO that does not constitute gain-on-sale.
(2) If a securitization exposure does not require deduction under paragraph (a)(1)
of this section and qualifies for the Ratings-Based Approach in section 43, a [bank] must
apply the Ratings-Based Approach to the exposure.
(3) If a securitization exposure does not require deduction under paragraph (a)(1)
of this section and does not qualify for the Ratings-Based Approach, the [bank] may
either apply the Internal Assessment Approach in section 44 to the exposure (if the
[bank], the exposure, and the relevant ABCP program qualify for the Internal Assessment
Approach) or the Supervisory Formula Approach in section 45 to the exposure (if the
[bank] and the exposure qualify for the Supervisory Formula Approach).
(4) If a securitization exposure does not require deduction under paragraph (a)(1)
of this section and does not qualify for the Ratings-Based Approach, the Internal
Assessment Approach, or the Supervisory Formula Approach, the [bank] must deduct the
exposure from total capital in accordance with paragraph (c) of this section.
(5) If a securitization exposure is an OTC derivative contract (other than a credit
derivative) that has a first priority claim on the cash flows from the underlying exposures
(notwithstanding amounts due under interest rate or currency derivative contracts, fees
due, or other similar payments), with approval of the [AGENCY], a [bank] may choose
to set the risk-weighted asset amount of the exposure equal to the amount of the exposure
as determined in paragraph (e) of this section rather than apply the hierarchy of
approaches described in paragraphs (a)(1) through (4) of this section.
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DRAFT November 2, 2007
(b) Total risk-weighted assets for securitization exposures. A [bank]’s total riskweighted assets for securitization exposures is equal to the sum of its risk-weighted assets
calculated using the Ratings-Based Approach in section 43, the Internal Assessment
Approach in section 44, and the Supervisory Formula Approach in section 45, and its
risk-weighted assets amount for early amortization provisions calculated in section 47.
(c) Deductions. (1) If a [bank] must deduct a securitization exposure from total
capital, the [bank] must take the deduction 50 percent from tier 1 capital and 50 percent
from tier 2 capital. If the amount deductible from tier 2 capital exceeds the [bank]’s tier 2
capital, the [bank] must deduct the excess from tier 1 capital.
(2) A [bank] may calculate any deduction from tier 1 capital and tier 2 capital for
a securitization exposure net of any deferred tax liabilities associated with the
securitization exposure.
(d) Maximum risk-based capital requirement. Regardless of any other provisions
of this part, unless one or more underlying exposures does not meet the definition of a
wholesale, retail, securitization, or equity exposure, the total risk-based capital
requirement for all securitization exposures held by a single [bank] associated with a
single securitization (including any risk-based capital requirements that relate to an early
amortization provision of the securitization but excluding any risk-based capital
requirements that relate to the [bank]’s gain-on-sale or CEIOs associated with the
securitization) may not exceed the sum of:
(1) The [bank]’s total risk-based capital requirement for the underlying exposures
as if the [bank] directly held the underlying exposures; and
(2) The total ECL of the underlying exposures.
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DRAFT November 2, 2007
(e) Amount of a securitization exposure. (1) The amount of an on-balance sheet
securitization exposure that is not a repo-style transaction, eligible margin loan, or OTC
derivative contract (other than a credit derivative) is:
(i) The [bank]’s carrying value minus any unrealized gains and plus any
unrealized losses on the exposure, if the exposure is a security classified as available-forsale; or
(ii) The [bank]’s carrying value, if the exposure is not a security classified as
available-for-sale.
(2) The amount of an off-balance sheet securitization exposure that is not an OTC
derivative contract (other than a credit derivative) is the notional amount of the exposure.
For an off-balance-sheet securitization exposure to an ABCP program, such as a liquidity
facility, the notional amount may be reduced to the maximum potential amount that the
[bank] could be required to fund given the ABCP program’s current underlying assets
(calculated without regard to the current credit quality of those assets).
(3) The amount of a securitization exposure that is a repo-style transaction,
eligible margin loan, or OTC derivative contract (other than a credit derivative) is the
EAD of the exposure as calculated in section 32.
(f) Overlapping exposures. If a [bank] has multiple securitization exposures that
provide duplicative coverage of the underlying exposures of a securitization (such as
when a [bank] provides a program-wide credit enhancement and multiple pool-specific
liquidity facilities to an ABCP program), the [bank] is not required to hold duplicative
risk-based capital against the overlapping position. Instead, the [bank] may apply to the
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overlapping position the applicable risk-based capital treatment that results in the highest
risk-based capital requirement.
(g) Securitizations of non-IRB exposures. If a [bank] has a securitization
exposure where any underlying exposure is not a wholesale exposure, retail exposure,
securitization exposure, or equity exposure, the [bank] must:
(1) If the [bank] is an originating [bank], deduct from tier 1 capital any after-tax
gain-on-sale resulting from the securitization and deduct from total capital in accordance
with paragraph (c) of this section the portion of any CEIO that does not constitute gainon-sale;
(2) If the securitization exposure does not require deduction under
paragraph (g)(1), apply the RBA in section 43 to the securitization exposure if the
exposure qualifies for the RBA;
(3) If the securitization exposure does not require deduction under
paragraph (g)(1) and does not qualify for the RBA, apply the IAA in section 44 to the
exposure (if the [bank], the exposure, and the relevant ABCP program qualify for the
IAA); and
(4) If the securitization exposure does not require deduction under
paragraph (g)(1) and does not qualify for the RBA or the IAA, deduct the exposure from
total capital in accordance with paragraph (c) of this section.
(h) Implicit support. If a [bank] provides support to a securitization in excess of
the [bank]’s contractual obligation to provide credit support to the securitization (implicit
support):
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DRAFT November 2, 2007
(1) The [bank] must hold regulatory capital against all of the underlying
exposures associated with the securitization as if the exposures had not been securitized
and must deduct from tier 1 capital any after-tax gain-on-sale resulting from the
securitization; and
(2) The [bank] must disclose publicly:
(i) That it has provided implicit support to the securitization; and
(ii) The regulatory capital impact to the [bank] of providing such implicit support.
(i) Eligible servicer cash advance facilities. Regardless of any other provisions of
this part, a [bank] is not required to hold risk-based capital against the undrawn portion of
an eligible servicer cash advance facility.
(j) Interest-only mortgage-backed securities. Regardless of any other provisions
of this part, the risk weight for a non-credit-enhancing interest-only mortgage-backed
security may not be less than 100 percent.
(k) Small-business loans and leases on personal property transferred with
recourse. (1) Regardless of any other provisions of this appendix, a [bank] that has
transferred small-business loans and leases on personal property (small-business
obligations) with recourse must include in risk-weighted assets only the contractual
amount of retained recourse if all the following conditions are met:
(i) The transaction is a sale under GAAP.
(ii) The [bank] establishes and maintains, pursuant to GAAP, a non-capital
reserve sufficient to meet the [bank]'s reasonably estimated liability under the recourse
arrangement.
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(iii) The loans and leases are to businesses that meet the criteria for a smallbusiness concern established by the Small Business Administration under section 3(a) of
the Small Business Act (15 USC 632).
(iv) The [bank] is well capitalized, as defined in the [AGENCY]’s prompt
corrective action regulation -- 12 CFR part 6 (for national banks), 12 CFR part 208,
subpart D (for state member banks or bank holding companies), 12 CFR part 325, subpart
B (for state nonmember banks), and 12 CFR part 565 (for savings associations). For
purposes of determining whether a [bank] is well capitalized for purposes of this
paragraph, the [bank]’s capital ratios must be calculated without regard to the capital
treatment for transfers of small-business obligations with recourse specified in paragraph
(k)(1) of this section.
(2) The total outstanding amount of recourse retained by a [bank] on transfers of
small-business obligations receiving the capital treatment specified in paragraph (k)(1) of
this section cannot exceed 15 percent of the [bank]’s total qualifying capital.
(3) If a [bank] ceases to be well capitalized or exceeds the 15 percent capital
limitation, the preferential capital treatment specified in paragraph (k)(1) of this section
will continue to apply to any transfers of small-business obligations with recourse that
occurred during the time that the [bank] was well capitalized and did not exceed the
capital limit.
(4) The risk-based capital ratios of the [bank] must be calculated without regard to
the capital treatment for transfers of small-business obligations with recourse specified in
paragraph (k)(1) of this section as provided in 12 CFR part 3, Appendix A (for national
banks), 12 CFR part 208, Appendix A (for state member banks), 12 CFR part 225,
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Appendix A (for bank holding companies), 12 CFR part 325, Appendix A (for state
nonmember banks), and 12 CFR 567.6(b)(5)(v) (for savings associations).
(l) Consolidated ABCP programs. (1) A [bank] that qualifies as a primary
beneficiary and must consolidate an ABCP program as a variable interest entity under
GAAP may exclude the consolidated ABCP program assets from risk-weighted assets if
the [bank] is the sponsor of the ABCP program. If a [bank] excludes such consolidated
ABCP program assets from risk-weighted assets, the [bank] must hold risk-based capital
against any securitization exposures of the [bank] to the ABCP program in accordance
with this part.
(2) If a [bank] either is not permitted, or elects not, to exclude consolidated ABCP
program assets from its risk-weighted assets, the [bank] must hold risk-based capital
against the consolidated ABCP program assets in accordance with this appendix but is
not required to hold risk-based capital against any securitization exposures of the [bank]
to the ABCP program.
(m) Nth-to-default credit derivatives - (1) First-to-default credit derivatives - (i)
Protection purchaser. A [bank] that obtains credit protection on a group of underlying
exposures through a first-to-default credit derivative must determine its risk-based capital
requirement for the underlying exposures as if the [bank] synthetically securitized the
underlying exposure with the lowest risk-based capital requirement and had obtained no
credit risk mitigant on the other underlying exposures.
(ii) Protection provider. A [bank] that provides credit protection on a group of
underlying exposures through a first-to-default credit derivative must determine its riskweighted asset amount for the derivative by applying the RBA in section 43 (if the
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derivative qualifies for the RBA) or, if the derivative does not qualify for the RBA, by
setting its risk-weighted asset amount for the derivative equal to the product of:
(A) The protection amount of the derivative;
(B) 12.5; and
(C) The sum of the risk-based capital requirements of the individual underlying
exposures, up to a maximum of 100 percent.
(2) Second-or-subsequent-to-default credit derivatives - (i) Protection purchaser.
(A) A [bank] that obtains credit protection on a group of underlying exposures through a
nth-to-default credit derivative (other than a first-to-default credit derivative) may
recognize the credit risk mitigation benefits of the derivative only if:
(1) The [bank] also has obtained credit protection on the same underlying
exposures in the form of first-through-(n-1)-to-default credit derivatives; or
(2) If n-1 of the underlying exposures have already defaulted.
(B) If a [bank] satisfies the requirements of paragraph (m)(2)(i)(A) of this section,
the [bank] must determine its risk-based capital requirement for the underlying exposures
as if the [bank] had only synthetically securitized the underlying exposure with the nth
lowest risk-based capital requirement and had obtained no credit risk mitigant on the
other underlying exposures.
(ii) Protection provider. A [bank] that provides credit protection on a group of
underlying exposures through a nth-to-default credit derivative (other than a first-todefault credit derivative) must determine its risk-weighted asset amount for the derivative
by applying the RBA in section 43 (if the derivative qualifies for the RBA) or, if the
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derivative does not qualify for the RBA, by setting its risk-weighted asset amount for the
derivative equal to the product of:
(A) The protection amount of the derivative;
(B) 12.5; and
(C) The sum of the risk-based capital requirements of the individual underlying
exposures (excluding the n-1 underlying exposures with the lowest risk-based capital
requirements), up to a maximum of 100 percent.
Section 43. Ratings-Based Approach (RBA)
(a) Eligibility requirements for use of the RBA - (1) Originating [bank]. An
originating [bank] must use the RBA to calculate its risk-based capital requirement for a
securitization exposure if the exposure has two or more external ratings or inferred
ratings (and may not use the RBA if the exposure has fewer than two external ratings or
inferred ratings).
(2) Investing [bank]. An investing [bank] must use the RBA to calculate its riskbased capital requirement for a securitization exposure if the exposure has one or more
external or inferred ratings (and may not use the RBA if the exposure has no external or
inferred rating).
(b) Ratings-based approach. (1) A [bank] must determine the risk-weighted asset
amount for a securitization exposure by multiplying the amount of the exposure (as
defined in paragraph (e) of section 42) by the appropriate risk weight provided in Table 6
and Table 7.
(2) A [bank] must apply the risk weights in Table 6 when the securitization
exposure’s applicable external or applicable inferred rating represents a long-term credit
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rating, and must apply the risk weights in Table 7 when the securitization exposure’s
applicable external or applicable inferred rating represents a short-term credit rating.
(i) A [bank] must apply the risk weights in column 1 of Table 6 or Table 7 to the
securitization exposure if:
(A) N (as calculated under paragraph (e)(6) of section 45) is six or more (for
purposes of this section only, if the notional number of underlying exposures is 25 or
more or if all of the underlying exposures are retail exposures, a [bank] may assume that
N is six or more unless the [bank] knows or has reason to know that N is less than six);
and
(B) The securitization exposure is a senior securitization exposure.
(ii) A [bank] must apply the risk weights in column 3 of Table 6 or Table 7 to the
securitization exposure if N is less than six, regardless of the seniority of the
securitization exposure.
(iii) Otherwise, a [bank] must apply the risk weights in column 2 of Table 6 or
Table 7.
Table 6 – Long-Term Credit Rating Risk Weights under RBA and IAA
Applicable external
or inferred rating
(Illustrative rating
example)
Highest investment
grade (for example,
AAA)
Second highest
investment grade (for
example, AA)
Column 1
Column 2
Column 3
Risk weights for
senior
securitization
exposures
backed by
granular pools
7%
Risk weights for
non-senior
securitization
exposures backed
by granular pools
Risk weights for
securitization
exposures backed
by non-granular
pools
12%
20%
8%
15%
25%
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Third-highest
investment grade –
positive designation
(for example, A+)
Third-highest
investment grade (for
example, A)
Third-highest
investment grade –
negative designation
(for example, A-)
Lowest investment
grade—positive
designation (for
example, BBB+)
Lowest investment
grade (for example,
BBB)
Lowest investment
grade—negative
designation (for
example, BBB-)
One category below
investment grade—
positive designation
(for example, BB+)
One category below
investment grade (for
example, BB)
One category below
investment grade—
negative designation
(for example, BB-)
More than one
category below
investment grade
10%
18%
12%
20%
20%
35%
35%
35%
50%
60%
75%
100%
250%
425%
650%
Deduction from tier 1 and tier 2 capital
Table 7 – Short-Term Credit Rating Risk Weights under RBA and IAA
Applicable external
or inferred rating
(Illustrative rating
example)
Column 1
Column 2
Column 3
Risk weights for
senior
securitization
exposures backed
Risk weights for
non-senior
securitization
exposures backed
Risk weights for
securitization
exposures backed by
non-granular pools
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by granular pools
by granular pools
7%
12%
20%
12%
20%
35%
60%
75%
75%
Highest investment
grade (for example,
A1)
Second highest
investment grade
(for example, A2)
Third highest
investment grade
(for example, A3)
All other ratings
Deduction from tier 1 and tier 2 capital
Section 44. Internal Assessment Approach (IAA)
(a) Eligibility requirements. A [bank] may apply the IAA to calculate the riskweighted asset amount for a securitization exposure that the [bank] has to an ABCP
program (such as a liquidity facility or credit enhancement) if the [bank], the ABCP
program, and the exposure qualify for use of the IAA.
(1) [Bank] qualification criteria. A [bank] qualifies for use of the IAA if the
[bank] has received the prior written approval of the [AGENCY]. To receive such
approval, the [bank] must demonstrate to the [AGENCY]’s satisfaction that the [bank]’s
internal assessment process meets the following criteria:
(i) The [bank]’s internal credit assessments of securitization exposures must be
based on publicly available rating criteria used by an NRSRO.
(ii) The [bank]’s internal credit assessments of securitization exposures used for
risk-based capital purposes must be consistent with those used in the [bank]’s internal
risk management process, management information reporting systems, and capital
adequacy assessment process.
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(iii) The [bank]’s internal credit assessment process must have sufficient
granularity to identify gradations of risk. Each of the [bank]’s internal credit assessment
categories must correspond to an external rating of an NRSRO.
(iv) The [bank]’s internal credit assessment process, particularly the stress test
factors for determining credit enhancement requirements, must be at least as conservative
as the most conservative of the publicly available rating criteria of the NRSROs that have
provided external ratings to the commercial paper issued by the ABCP program.
(A) Where the commercial paper issued by an ABCP program has an external
rating from two or more NRSROs and the different NRSROs’ benchmark stress factors
require different levels of credit enhancement to achieve the same external rating
equivalent, the [bank] must apply the NRSRO stress factor that requires the highest level
of credit enhancement.
(B) If any NRSRO that provides an external rating to the ABCP program’s
commercial paper changes its methodology (including stress factors), the [bank] must
evaluate whether to revise its internal assessment process.
(v) The [bank] must have an effective system of controls and oversight that
ensures compliance with these operational requirements and maintains the integrity and
accuracy of the internal credit assessments. The [bank] must have an internal audit
function independent from the ABCP program business line and internal credit
assessment process that assesses at least annually whether the controls over the internal
credit assessment process function as intended.
(vi) The [bank] must review and update each internal credit assessment whenever
new material information is available, but no less frequently than annually.
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(vii) The [bank] must validate its internal credit assessment process on an ongoing
basis and at least annually.
(2) ABCP-program qualification criteria. An ABCP program qualifies for use of
the IAA if all commercial paper issued by the ABCP program has an external rating.
(3) Exposure qualification criteria. A securitization exposure qualifies for use of
the IAA if the exposure meets the following criteria:
(i) The [bank] initially rated the exposure at least the equivalent of investment
grade.
(ii) The ABCP program has robust credit and investment guidelines (that is,
underwriting standards) for the exposures underlying the securitization exposure.
(iii) The ABCP program performs a detailed credit analysis of the sellers of the
exposures underlying the securitization exposure.
(iv) The ABCP program’s underwriting policy for the exposures underlying the
securitization exposure establishes minimum asset eligibility criteria that include the
prohibition of the purchase of assets that are significantly past due or of assets that are
defaulted (that is, assets that have been charged off or written down by the seller prior to
being placed into the ABCP program or assets that would be charged off or written down
under the program’s governing contracts), as well as limitations on concentration to
individual obligors or geographic areas and the tenor of the assets to be purchased.
(v) The aggregate estimate of loss on the exposures underlying the securitization
exposure considers all sources of potential risk, such as credit and dilution risk.
(vi) Where relevant, the ABCP program incorporates structural features into each
purchase of exposures underlying the securitization exposure to mitigate potential credit
575
DRAFT November 2, 2007
deterioration of the underlying exposures. Such features may include wind-down triggers
specific to a pool of underlying exposures.
(b) Mechanics. A [bank] that elects to use the IAA to calculate the risk-based
capital requirement for any securitization exposure must use the IAA to calculate the
risk-based capital requirements for all securitization exposures that qualify for the IAA
approach. Under the IAA, a [bank] must map its internal assessment of such a
securitization exposure to an equivalent external rating from an NRSRO. Under the IAA,
a [bank] must determine the risk-weighted asset amount for such a securitization
exposure by multiplying the amount of the exposure (as defined in paragraph (e) of
section 42) by the appropriate risk weight in Table 6 and Table 7 in paragraph (b) of
section 43.
Section 45. Supervisory Formula Approach (SFA)
(a) Eligibility requirements. A [bank] may use the SFA to determine its riskbased capital requirement for a securitization exposure only if the [bank] can calculate on
an ongoing basis each of the SFA parameters in paragraph (e) of this section.
(b) Mechanics. Under the SFA, a securitization exposure incurs a deduction from
total capital (as described in paragraph (c) of section 42) and/or an SFA risk-based capital
requirement, as determined in paragraph (c) of this section. The risk-weighted asset
amount for the securitization exposure equals the SFA risk-based capital requirement for
the exposure multiplied by 12.5.
(c) The SFA risk-based capital requirement. (1) If KIRB is greater than or equal to
L+T, the entire exposure must be deducted from total capital.
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DRAFT November 2, 2007
(2) If KIRB is less than or equal to L, the exposure’s SFA risk-based capital
requirement is UE multiplied by TP multiplied by the greater of:
(i) 0.0056 * T; or
(ii) S[L+T] – S[L].
(3) If KIRB is greater than L and less than L+T, the [bank] must deduct from total
capital an amount equal to UE*TP*(KIRB –L), and the exposure’s SFA risk-based capital
requirement is UE multiplied by TP multiplied by the greater of:
(i) 0.0056 * (T – (KIRB – L)); or
(ii) S[L+T] – S[KIRB].
(d) The supervisory formula:
when Y ≤ K IRB
⎧Y
⎫
⎪
⎪
20
⋅
(
−
)
K
Y
IRB
(1) S [Y ] = ⎨
⎬
d ⋅ K IRB
K IRB
(1 − e
) when Y > K IRB ⎪
⎪ K IRB + K [Y ] − K [ K IRB ] +
20
⎩
⎭
(2) K [Y ] = (1 − h ) ⋅ [(1 − β [Y ; a, b]) ⋅ Y + β [Y ; a + 1, b] ⋅ c ]
K IRB ⎞
⎛
(3) h = ⎜1 −
⎟
EWALGD ⎠
⎝
N
(4) a = g ⋅ c
(5) b = g ⋅ (1 − c)
(6) c =
K IRB
1− h
(7) g =
(1 − c) ⋅ c
−1
f
(8) f =
v + K IRB
(1 − K IRB ) ⋅ K IRB − v
− c2 +
1− h
(1 − h ) ⋅ 1000
2
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DRAFT November 2, 2007
(9) v = K IRB ⋅
( EWALGD − K IRB ) + .25 ⋅ (1 − EWALGD)
N
(10) d = 1 − (1 − h ) ⋅ (1 − β [ K IRB ; a, b]) .
578
DRAFT November 2, 2007
(11) In these expressions, β [Y; a, b] refers to the cumulative beta distribution
with parameters a and b evaluated at Y. In the case where N = 1 and EWALGD =
100 percent, S[Y] in formula (1) must be calculated with K[Y] set equal to the product of
KIRB and Y, and d set equal to 1- KIRB.
(e) SFA parameters - (1) Amount of the underlying exposures (UE). UE is the
EAD of any underlying exposures that are wholesale and retail exposures (including the
amount of any funded spread accounts, cash collateral accounts, and other similar funded
credit enhancements) plus the amount of any underlying exposures that are securitization
exposures (as defined in paragraph (e) of section 42) plus the adjusted carrying value of
any underlying exposures that are equity exposures (as defined in paragraph (b) of
section 51).
(2) Tranche percentage (TP). TP is the ratio of the amount of the [bank]’s
securitization exposure to the amount of the tranche that contains the securitization
exposure.
(3) Capital requirement on underlying exposures (KIRB). (i) KIRB is the ratio of:
(A) The sum of the risk-based capital requirements for the underlying exposures
plus the expected credit losses of the underlying exposures (as determined under this
appendix as if the underlying exposures were directly held by the [bank]); to
(B) UE.
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DRAFT November 2, 2007
(ii) The calculation of KIRB must reflect the effects of any credit risk mitigant
applied to the underlying exposures (either to an individual underlying exposure, to a
group of underlying exposures, or to the entire pool of underlying exposures).
(iii) All assets related to the securitization are treated as underlying exposures,
including assets in a reserve account (such as a cash collateral account).
(4) Credit enhancement level (L). (i) L is the ratio of:
(A) The amount of all securitization exposures subordinated to the tranche that
contains the [bank]’s securitization exposure; to
(B) UE.
(ii) A [bank] must determine L before considering the effects of any tranchespecific credit enhancements.
(iii) Any gain-on-sale or CEIO associated with the securitization may not be
included in L.
(iv) Any reserve account funded by accumulated cash flows from the underlying
exposures that is subordinated to the tranche that contains the [bank]’s securitization
exposure may be included in the numerator and denominator of L to the extent cash has
accumulated in the account. Unfunded reserve accounts (that is, reserve accounts that are
to be funded from future cash flows from the underlying exposures) may not be included
in the calculation of L.
(v) In some cases, the purchase price of receivables will reflect a discount that
provides credit enhancement (for example, first loss protection) for all or certain tranches
of the securitization. When this arises, L should be calculated inclusive of this discount if
the discount provides credit enhancement for the securitization exposure.
580
DRAFT November 2, 2007
(5) Thickness of tranche (T). T is the ratio of:
(i) The amount of the tranche that contains the [bank]’s securitization exposure; to
(ii) UE.
(6) Effective number of exposures (N). (i) Unless the [bank] elects to use the
formula provided in paragraph (f),
N =
(∑ EADi ) 2
i
∑ EAD
2
i
i
where EADi represents the EAD associated with the ith instrument in the pool of
underlying exposures.
(ii) Multiple exposures to one obligor must be treated as a single underlying
exposure.
(iii) In the case of a re-securitization (that is, a securitization in which some or all
of the underlying exposures are themselves securitization exposures), the [bank] must
treat each underlying exposure as a single underlying exposure and must not look through
to the originally securitized underlying exposures.
(7) Exposure-weighted average loss given default (EWALGD). EWALGD is
calculated as:
∑ LGD ⋅ EAD
EWALGD =
∑ EAD
i
i
i
i
i
where LGDi represents the average LGD associated with all exposures to the ith obligor.
In the case of a re-securitization, an LGD of 100 percent must be assumed for the
underlying exposures that are themselves securitization exposures.
581
DRAFT November 2, 2007
(f) Simplified method for computing N and EWALGD. (1) If all underlying
exposures of a securitization are retail exposures, a [bank] may apply the SFA using the
following simplifications:
(i) h = 0; and
(ii) v = 0.
(2) Under the conditions in paragraphs (f)(3) and (f)(4), a [bank] may employ a
simplified method for calculating N and EWALGD.
(3) If C1 is no more than 0.03, a [bank] may set EWALGD = 0.50 if none of the
underlying exposures is a securitization exposure or EWALGD = 1 if one or more of the
underlying exposures is a securitization exposure, and may set N equal to the following
amount:
N
=
1
⎛ C − C1 ⎞
⎟⎟ max ( 1 − m C1 , 0 )
C1 C m + ⎜⎜ m
⎝ m −1 ⎠
where:
(i) Cm is the ratio of the sum of the amounts of the ‘m’ largest underlying
exposures to UE; and
(ii) The level of m is to be selected by the [bank].
(4) Alternatively, if only C1 is available and C1 is no more than 0.03, the [bank]
may set EWALGD = 0.50 if none of the underlying exposures is a securitization
exposure or EWALGD = 1 if one or more of the underlying exposures is a securitization
exposure and may set N = 1/C1.
Section 46. Recognition of Credit Risk Mitigants for Securitization Exposures
582
DRAFT November 2, 2007
(a) General. An originating [bank] that has obtained a credit risk mitigant to
hedge its securitization exposure to a synthetic or traditional securitization that satisfies
the operational criteria in section 41 may recognize the credit risk mitigant, but only as
provided in this section. An investing [bank] that has obtained a credit risk mitigant to
hedge a securitization exposure may recognize the credit risk mitigant, but only as
provided in this section. A [bank] that has used the RBA in section 43 or the IAA in
section 44 to calculate its risk-based capital requirement for a securitization exposure
whose external or inferred rating (or equivalent internal rating under the IAA) reflects the
benefits of a credit risk mitigant provided to the associated securitization or that supports
some or all of the underlying exposures may not use the credit risk mitigation rules in this
section to further reduce its risk-based capital requirement for the exposure to reflect that
credit risk mitigant.
(b) Collateral - (1) Rules of recognition. A [bank] may recognize financial
collateral in determining the [bank]’s risk-based capital requirement for a securitization
exposure (other than a repo-style transaction, an eligible margin loan, or an OTC
derivative contract for which the [bank] has reflected collateral in its determination of
exposure amount under section 32) as follows. The [bank]’s risk-based capital
requirement for the collateralized securitization exposure is equal to the risk-based capital
requirement for the securitization exposure as calculated under the RBA in section 43 or
under the SFA in section 45 multiplied by the ratio of adjusted exposure amount (SE*) to
original exposure amount (SE), where:
(i) SE* = max {0, [SE - C x (1 - Hs - Hfx)]};
583
DRAFT November 2, 2007
(ii) SE = the amount of the securitization exposure calculated under paragraph (e)
of section 42;
(iii) C = the current market value of the collateral;
(iv) Hs = the haircut appropriate to the collateral type; and
(v) Hfx = the haircut appropriate for any currency mismatch between the
collateral and the exposure.
(2) Mixed collateral. Where the collateral is a basket of different asset types or a
basket of assets denominated in different currencies, the haircut on the basket will be
H = ∑ ai H i , where ai is the current market value of the asset in the basket divided by
i
the current market value of all assets in the basket and Hi is the haircut applicable to that
asset.
(3) Standard supervisory haircuts. Unless a [bank] qualifies for use of and uses
own-estimates haircuts in paragraph (b)(4) of this section:
(i) A [bank] must use the collateral type haircuts (Hs) in Table 3;
(ii) A [bank] must use a currency mismatch haircut (Hfx) of 8 percent if the
exposure and the collateral are denominated in different currencies;
(iii) A [bank] must multiply the supervisory haircuts obtained in
paragraphs (b)(3)(i) and (ii) by the square root of 6.5 (which equals 2.549510); and
(iv) A [bank] must adjust the supervisory haircuts upward on the basis of a
holding period longer than 65 business days where and as appropriate to take into account
the illiquidity of the collateral.
(4) Own estimates for haircuts. With the prior written approval of the
[AGENCY], a [bank] may calculate haircuts using its own internal estimates of market
584
DRAFT November 2, 2007
price volatility and foreign exchange volatility, subject to paragraph (b)(2)(iii) of
section 32. The minimum holding period (TM) for securitization exposures is 6
@FedFRASER