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Friday,
December 7, 2007
Part II
Department of the Treasury
Office of the Comptroller of the
Currency
12 CFR Part 3
Federal Reserve System
12 CFR Parts 208 and 225
Federal Deposit Insurance
Corporation
12 CFR Part 325
Department of the Treasury
Office of Thrift Supervision
12 CFR Parts 559, 560, 563, and 567
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Risk-Based Capital Standards: Advanced
Capital Adequacy Framework—Basel II;
Final Rule
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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the
Currency
12 CFR Part 3
[Docket No. OCC–2007–0018]
RIN 1557–AC91
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[Regulations H and Y; Docket No. R–1261]
FEDERAL DEPOSIT INSURANCE
CORPORATION
12 CFR Part 325
RIN 3064–AC73
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
12 CFR Parts 559, 560, 563, and 567
RIN 1550–AB56; Docket No. OTS 2007–0021
Risk-Based Capital Standards:
Advanced Capital Adequacy
Framework — Basel II
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.
AGENCIES:
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SUMMARY: The Office of the Comptroller
of the Currency (OCC), the Board of
Governors of the Federal Reserve
System (Board), the Federal Deposit
Insurance Corporation (FDIC), and the
Office of Thrift Supervision (OTS)
(collectively, the agencies) are adopting
a new risk-based capital adequacy
framework that requires some and
permits other qualifying banks 1 to use
an internal ratings-based approach to
calculate regulatory credit risk capital
requirements and advanced
measurement approaches to calculate
regulatory operational risk capital
requirements. The final rule describes
the qualifying criteria for banks required
or seeking to operate under the new
framework and the applicable risk-based
1 For simplicity, and unless otherwise indicated,
this final rule uses the term ‘‘bank’’ to include
banks, savings associations, and bank holding
companies (BHCs). The terms ‘‘bank holding
company’’ and ‘‘BHC’’ refer only to bank holding
companies regulated by the Board and do not
include savings and loan holding companies
regulated by the OTS.
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capital requirements for banks that
operate under the framework.
DATES: This final rule is effective April
1, 2008.
FOR FURTHER INFORMATION CONTACT:
OCC: Mark Ginsberg, Risk Expert,
Capital Policy (202–927–4580) or Ron
Shimabukuro, Senior Counsel,
Legislative and Regulatory Activities
Division (202–874–5090). Office of the
Comptroller of the Currency, 250 E
Street, SW., Washington, DC 20219.
Board: Barbara Bouchard, Deputy
Associate Director (202–452–3072 or
barbara.bouchard@frb.gov) or Anna Lee
Hewko, Senior Supervisory Financial
Analyst (202–530–6260 or
anna.hewko@frb.gov), Division of
Banking Supervision and Regulation; or
Mark E. Van Der Weide, Senior Counsel
(202–452–2263 or
mark.vanderweide@frb.gov), Legal
Division. For users of
Telecommunications Device for the Deaf
(‘‘TDD’’) only, contact 202–263–4869.
FDIC: Jason C. Cave, Associate
Director, Capital Markets Branch, (202)
898–3548, Bobby R. Bean, Chief, Policy
Section, Capital Markets Branch, (202)
898–3575, Kenton Fox, Senior Policy
Analyst, Capital Markets Branch, (202)
898–7119, Division of Supervision and
Consumer Protection; or Michael B.
Phillips, Counsel, (202) 898–3581,
Supervision and Legislation Branch,
Legal Division, Federal Deposit
Insurance Corporation, 550 17th Street,
NW., Washington, DC 20429.
OTS: Michael D. Solomon, Director,
Capital Policy, Supervision Policy (202)
906–5654; David W. Riley, Senior
Analyst, Capital Policy (202) 906–6669;
Austin Hong, Senior Analyst, Capital
Policy (202) 906–6389; or Karen
Osterloh, Special Counsel, Regulations
and Legislation Division (202) 906–
6639, Office of Thrift Supervision, 1700
G Street, NW., Washington, DC 20552.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Executive Summary of the Final Rule
B. Conceptual Overview
1. The IRB Approach for Credit Risk
2. The AMA for Operational Risk
C. Overview of Final Rule
D. Structure of Final Rule
E. Overall Capital Objectives
F. Competitive Considerations
II. Scope
A. Core and Opt-In Banks
B. U.S. Subsidiaries of Foreign Banks
C. Reservation of Authority
D. Principle of Conservatism
III. Qualification
A. The Qualification Process
1. In General
2. Parallel Run and Transitional Floor
Periods
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B. Qualification Requirements
1. Process and Systems Requirements
2. Risk rating and Segmentation Systems
for Wholesale and Retail Exposures
Wholesale Exposures
Retail Exposures
Rating Philosophy
Rating and Segmentation Reviews and
Updates
3. Quantification of Risk Parameters for
Wholesale and Retail Exposures
Probability of Default (PD)
Loss Given Default (LGD)
Expected Loss Given Default (ELGD)
Economic Loss and Post-Default
Extensions of Credit
Economic Downturn Conditions
Supervisory Mapping Function
Pre-default Reductions in Exposure
Exposure at Default (EAD)
General Quantification Principles
Portfolios With Limited Data or Limited
Defaults
4. Optional Approaches That Require Prior
Supervisory Approval
5. Operational Risk
Operational Risk Data and Assessment
System
Operational risk Quantification System
6. Data management and maintenance
7. Control and oversight mechanisms
Validation
Internal Audit
Stress Testing
8. Documentation
C. Ongoing Qualification
D. Merger and Acquisition Transition
Provisions
IV. Calculation of Tier 1 Capital and Total
Qualifying Capital
V. Calculation of Risk-Weighted Assets
A. Categorization of Exposures
1. Wholesale Exposures
2. Retail Exposures
3. Securitization Exposures
4. Equity Exposures
5. Boundary Between Operational Risk and
Other Risks
6. Boundary Between the Final Rule and
the Market Risk Rule
B. Risk-Weighted Assets for General Credit
Risk (Wholesale Exposures, Retail
Exposures, On-Balance Sheet Assets that
Are Not Defined by Exposure Category,
and Immaterial Credit Exposures)
1. Phase 1 — Categorization of Exposures
2. Phase 2 — Assignment of Wholesale
Obligors and Exposures to Rating Grades
and retail exposures to segments
Purchased Wholesale Exposures
Wholesale Lease Residuals
3. Phase 3 — Assignment of risk
Parameters to Wholesale Obligors and
Exposures and Retail Segments
4. Phase 4 — Calculation of Risk-Weighted
Assets
5. Statutory Provisions on the Regulatory
Capital Treatment of Certain Mortgage
Loans
C. Credit Risk Mitigation (CRM)
Techniques
1. Collateral
2. Counterparty Credit Risk of Repo-Style
Transactions, Eligible Margin Loans, and
OTC Derivative Contracts
Qualifying master netting agreement
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EAD for Repo-Style Transactions and
Eligible Margin Loans
Collateral Haircut Approach
Simple VaR Methodology
3. EAD for OTC derivative Contracts
Current Exposure Methodology
4. Internal Models Methodology
Maturity Under the Internal Models
Methodology
Collateral Agreements Under the Internal
Models Methodology
Alternative Methods
5. Guarantees and Credit Derivatives That
Cover Wholesale Exposures
Eligible Guarantees and Eligible Credit
Derivatives
PD Substitution Approach
LGD Adjustment Approach
Maturity Mismatch Haircut
Restructuring Haircut
Currency Mismatch Haircut
Example
Multiple Credit Risk Mitigants
Double Default Treatment
6. Guarantees and Credit Derivatives That
Cover Retail Exposures
D. Unsettled Securities, Foreign Exchange,
and Commodity Transactions
E. Securitization Exposures
1. Hierarchy of Approaches
Gains-on-Sale and CEIOs
The Ratings-Based Approach (RBA)
The Internal Assessment Approach (IAA)
The Supervisory Formula Approach (SFA)
Deduction
Exceptions to the General Hierarchy of
Approaches
Servicer Cash Advances
Amount of a Securitization Exposure
Implicit Support
Operational Requirements for Traditional
Securitizations
Clean-Up Calls
Additional Supervisory Guidance
2. Ratings-Based Approach (RBA)
3. Internal Assessment Approach (IAA)
4. Supervisory Formula Approach (SFA)
General Requirements
Inputs to the SFA Formula
5. Eligible Disruption Liquidity Facilities
6. CRM for Securitization Exposures
7. Synthetic Securitizations
Background
Operational Requirements for Synthetic
Securitizations
First-Loss Tranches
Mezzanine Tranches
Super-Senior Tranches
8. Nth-to-Default Credit Derivatives
9. Early Amortization Provisions
Background
Controlled Early Amortization
Non-Controlled Early Amortization
Securitization of Revolving Residential
Mortgage Exposures
F. Equity Exposures
1. Introduction and Exposure Measurement
Hedge Transactions
Measures of Hedge Effectiveness
2. Simple Risk-Weight Approach (SRWA)
Non-Significant Equity Exposures
3. Internal Models Approach (IMA)
IMA Qualification
Risk-Weighted Assets Under the IMA
4. Equity Exposures to Investment Funds
Full Look-Through Approach
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Simple Modified Look-Through Approach
Alternative modified look-through
approach
VI. Operational Risk
VII. Disclosure
1. Overview
Comments on the Proposed Rule
2. General Requirements
Frequency/Timeliness
Location of Disclosures and Audit/
Attestation Requirements
Proprietary and Confidential Information
3. Summary of Specific Public Disclosure
Requirements
4. Regulatory Reporting
I. Introduction
A. Executive Summary of the Final Rule
On September 25, 2006, the agencies
issued a joint notice of proposed
rulemaking (proposed rule or proposal)
(71 FR 55830) seeking public comment
on a new risk-based regulatory capital
framework for banks.2 The agencies
previously issued an advance notice of
proposed rulemaking (ANPR) related to
the new risk-based regulatory capital
framework (68 FR 45900, August 4,
2003). The proposed rule was based on
a series of releases from the Basel
Committee on Banking Supervision
(BCBS), culminating in the BCBS’s
comprehensive June 2006 release
entitled ‘‘International Convergence of
Capital Measurement and Capital
Standards: A Revised Framework’’ (New
Accord).3 The New Accord sets forth a
‘‘three pillar’’ framework encompassing
risk-based capital requirements for
credit risk, market risk, and operational
risk (Pillar 1); supervisory review of
capital adequacy (Pillar 2); and market
discipline through enhanced public
disclosures (Pillar 3). The New Accord
includes several methodologies for
determining a bank’s risk-based capital
requirements for credit, market, and
operational risk.
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
2 The agencies also issued proposed changes to
the risk-based capital rule for market risk in a
separate notice of proposed rulemaking (71 FR
55958, September 25, 2006). A final rule on that
proposal is under development and will be issued
in the near future.
3 The BCBS is a committee of banking supervisory
authorities established by the central bank
governors of the G–10 countries in 1975. The BCBS
issued the New Accord to modernize its first capital
Accord, which was endorsed by the BCBS members
in 1988 and implemented by the agencies in 1989.
The New Accord, the 1988 Accord, and other
documents issued by the BCBS are available
through the Bank for International Settlements’ Web
site at http://www.bis.org.
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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 riskbased regulatory capital framework,
based on the New Accord, that is
mandatory for some U.S. banks and
optional for others. While the New
Accord includes several methodologies
for determining risk-based capital
requirements, the agencies are adopting
only the advanced approaches at this
time.
The agencies received approximately
90 public comments on the proposed
rule from banking organizations, trade
associations representing the banking or
financial services industry, supervisory
authorities, and other interested parties.
This section of the preamble highlights
several fundamental issues that
commenters raised about the agencies’
proposal and briefly describes how the
agencies have responded to those issues
in the final rule. More detail is provided
in the preamble sections below. Overall,
commenters supported the development
of the framework and the move to more
risk-sensitive capital requirements. One
overarching issue, however, was the
areas where the proposal differed from
the New Accord. Commenters said the
divergences generally created
competitive problems, raised home-host
issues, entailed extra cost and regulatory
burden, and did not necessarily improve
the overall safety and soundness of
banks subject to the rule.
Commenters also generally disagreed
with the agencies’ proposal to adopt
only the advanced approaches from the
New Accord. Further, commenters
objected to the agencies’ retention of the
leverage ratio, the transitional
arrangements in the proposal, and the
10 percent numerical benchmark for
identifying material aggregate
reductions in risk-based capital
requirements to be used for evaluating
and responding to capital outcomes
during the parallel run and transitional
floor periods (discussed below).
Commenters also noted numerous
technical issues with the proposed rule.
As noted in an interagency press
release issued July 20, 2007 (Banking
Agencies Reach Agreement on Basel II
Implementation), the agencies have
agreed to eliminate the language from
4 The agencies issued draft guidance on the
advanced approaches. See 72 FR 9084 (February 28,
2007).
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the preamble concerning a 10 percent
limitation on aggregate reductions in
risk-based capital requirements. The
press release also stated that the
agencies are retaining intact the
transitional floor periods (see preamble
sections I.E. and III.A.2.). In addition,
while not specifically mentioned in the
press release, the agencies are retaining
the leverage ratio and the prompt
corrective action (PCA) regulations
without modification.
The final rule adopts without change
the proposed criteria for identifying core
banks (banks required to apply the
advanced approaches) and continues to
permit other banks (opt-in banks) to
adopt the advanced approaches if they
meet the applicable qualification
requirements. Core banks are those with
consolidated total assets (excluding
assets held by an insurance
underwriting subsidiary of a bank
holding company) of $250 billion or
more or with consolidated total onbalance-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
5 71
FR 77445 (Dec. 26, 2006).
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satisfaction of its primary Federal
supervisor that not applying the
provision would, in all circumstances,
unambiguously generate a risk-based
capital requirement for each such
exposure that is greater than that which
would otherwise be required under the
regulation, and the bank meets other
specified requirements (see preamble
section II.D.).
In the proposal, the agencies modified
the definition of default for wholesale
exposures from that in the New Accord
to address issues commenters had raised
on the ANPR. Commenters objected to
the agencies’ modified definition of
default for wholesale exposures,
however, asserting that a definition
different from the New Accord would
result in competitive inequities and
significant implementation burden
without associated supervisory benefit.
In response to these concerns, the
agencies have adopted a definition of
default for wholesale exposures that is
consistent with the New Accord (see
preamble section III.B.2.). For retail
exposures, the final rule retains the
proposed definition of default and
clarifies that, subject to certain
considerations, a foreign subsidiary of a
U.S. bank may, in its consolidated riskbased capital calculations, use the
applicable host jurisdiction definition of
default for retail exposures of the
foreign subsidiary in that jurisdiction
(see preamble section III.B.2.).
Another concept introduced in the
proposal that was not in the New
Accord was the expected loss given
default (ELGD) risk parameter. ELGD
had four functions in the proposed
rule—as a component of the calculation
of expected credit loss (ECL) in the
numerator of the risk-based capital
ratios; in the expected loss (EL)
component of the IRB risk-based capital
formulas; as a floor on the value of the
loss given default (LGD) risk parameter;
and as an input into a supervisory
mapping function. Many commenters
objected to the inclusion of ELGD as a
departure from the New Accord that
would create regulatory burden and
competitive inequity. Many commenters
also objected to the supervisory
mapping function, which the agencies
intended as an alternative for banks that
were not able to estimate reliably the
LGD risk parameter. The agencies have
eliminated ELGD from the final rule.
Banks are required to estimate only the
LGD risk parameter, which reflects
economic downturn conditions (see
preamble section III.B.3.). The
supervisory mapping function also has
been eliminated from the rule.
Commenters also objected to the
agencies’ decision not to include a
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distinct risk weight function for
exposures to small- and medium-size
enterprises (SMEs) as provided in the
New Accord. In the proposal, the
agencies noted they were not aware of
compelling evidence that smaller firms
with the same probability of default
(PD) and LGD as larger firms are subject
to less systemic risk than is already
reflected in the wholesale risk-based
capital functions. The agencies continue
to believe an SME-specific risk weight
function is not supported by sufficient
evidence and might give rise to
competitive inequities across U.S.
banks, and have not adopted such a
function in the final rule (see preamble
section V.A.1.)
With regard to the proposed treatment
for securitization exposures,
commenters raised a number of
technical issues. Many objected to the
proposed definition of a securitization
exposure, which included exposures to
investment funds with material
liabilities (including exposures to hedge
funds). The agencies agree with
commenters that the proposed
definition for securitization exposures
was quite broad and captured some
exposures that would more
appropriately be treated under the
wholesale or equity frameworks. To
limit the scope of the IRB securitization
framework, the agencies have modified
the definition of traditional
securitization in the final rule as
described in preamble section V.A.3.
Technical issues related to
securitization exposures are discussed
in preamble sections V.A.3. and V.E.
For equity exposures, commenters
focused on the proposal’s lack of a
grandfathering period. The New Accord
provides national discretion for each
implementing jurisdiction to adopt a
grandfather period for equity exposures.
Commenters asserted that this omission
would result in competitive inequity for
U.S. banks as compared to other
internationally active institutions. The
agencies believe that, overall, the
proposal’s approach to equity exposures
results in a competitive risk-based
capital requirement. The final rule does
not include a grandfathering provision,
and the agencies have adopted the
proposed treatment for equity exposures
without significant change (see
preamble section V.F.).
A number of commenters raised
issues related to operational risk. Most
significantly, commenters noted that
activities besides securities processing
and credit card fraud have highly
predictable and reasonably stable losses
and should be considered for
operational risk offsets. The agencies
believe that the proposed definition of
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eligible operational risk offsets allows
for the consideration of other activities
in a flexible and prudent manner and,
thus, are retaining the proposed
definition in the final rule. Commenters
also noted that the proposal appeared to
place limits on the use of operational
risk mitigants. The agencies have
provided flexibility in this regard and
under the final rule will take into
consideration whether a particular
operational risk mitigant covers
potential operational losses in a manner
equivalent to holding regulatory capital
(see preamble sections III.B.5. and V.I.).
Many commenters expressed concern
that the proposed public disclosures
were excessive and would hinder, rather
than facilitate, market discipline by
requiring banks to disclose information
that would not be well understood by or
useful to the market. Commenters also
expressed concern about possible
disclosure of proprietary information.
The agencies believe that it is important
to retain the vast majority of the
proposed disclosures, which are
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 riskbased capital formulas that must be
used to transform these risk parameters
into risk-based capital requirements.
The framework is based on ‘‘value-atrisk’’ (VaR) modeling techniques that
measure credit risk and operational risk.
Because bank risk measurement
practices are both continually evolving
and subject to uncertainty, the
framework should be viewed as an effort
to improve the risk sensitivity of the
risk-based capital requirements for
banks, rather than as an effort to
produce a statistically precise
measurement of risk.
The framework’s conceptual
foundation is based on the view that
risk can be quantified through the
estimation of specific characteristics of
the probability distribution of potential
losses over a given time horizon. This
approach assumes that a suitable
estimate of that probability distribution,
or at least of the specific characteristics
to be measured, can be produced. Figure
1 illustrates some of the key concepts
associated with the framework. The
figure shows a probability distribution
of potential losses associated with some
time horizon (for example, one year). It
could reflect, for example, credit losses,
operational losses, or other types of
losses.
The area under the curve to the right
of a particular loss amount is the
probability of experiencing losses
exceeding this amount within a given
time horizon. The figure also shows the
statistical mean of the loss distribution,
which is equivalent to the amount of
loss that is ‘‘expected’’ over the time
horizon. The concept of ‘‘expected loss’’
(EL) is distinguished from that of
‘‘unexpected loss’’ (UL), which
represents potential losses over and
above the EL amount. A given level of
UL can be defined by reference to a
particular percentile threshold of the
probability distribution. For example, in
the figure UL is measured at the 99.9th
percentile level and thus is equal to the
value of the loss distribution
corresponding to the 99.9th percentile,
less the amount of EL. This is shown
graphically at the bottom of the figure.
The particular percentile level chosen
for the measurement of UL is referred to
as the ‘‘confidence level’’ or the
‘‘soundness standard’’ associated with
the measurement. If capital is available
to cover losses up to and including this
percentile level, then the bank should
remain solvent in the face of actual
losses of that magnitude. Typically, the
choice of confidence level or soundness
standard reflects a very high percentile
level, so that there is a very low
estimated probability that actual losses
would exceed the UL amount associated
with that confidence level or soundness
standard.
Assessing risk and assigning
regulatory capital requirements by
reference to a specific percentile of a
probability distribution of potential
losses is commonly referred to as a VaR
approach. Such an approach was
adopted by the FDIC, Board, and OCC
for assessing a bank’s risk-based capital
requirements for market risk in 1996
(market risk rule). Under the market risk
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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.
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rule, a bank’s own internal models are
used to estimate the 99th percentile of
the bank’s market risk loss distribution
over a ten-business-day horizon. The
bank’s market risk capital requirement
is based on this VaR estimate, generally
multiplied by a factor of three. The
agencies implemented this
multiplication factor to provide a
prudential buffer for market volatility
and modeling uncertainty.
1. The IRB Approach for Credit Risk
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The conceptual foundation of this
final rule’s approach to credit risk
capital requirements is similar to the
market risk rule’s approach to market
risk capital requirements, in the sense
that each is VaR-oriented. Nevertheless,
there are important differences between
the IRB approach and the market risk
rule. The current market risk rule
specifies a nominal confidence level of
99.0 percent and a ten-business-day
horizon, but otherwise provides banks
with substantial modeling flexibility in
determining their market risk loss
distribution and capital requirements. In
contrast, the IRB approach for assessing
credit risk capital requirements is based
on a 99.9 percent nominal confidence
level, a one-year horizon, and a
supervisory model of credit losses
embodying particular assumptions
about the underlying drivers of portfolio
credit risk, including loss correlations
among different asset types.6
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
6 The theoretical underpinnings for the
supervisory model of credit risk underlying the IRB
approach are provided in a paper by Michael
Gordy, ‘‘A Risk-Factor Model Foundation for
Ratings-Based Bank Capital Rules,’’ Journal of
Financial Intermediation, July 2003. The IRB
formulas are derived as an application of these
results to a single-factor CreditMetricsTM-style
model. For mathematical details on this model, see
Michael Gordy, ‘‘A Comparative Anatomy of Credit
Risk Models,’’ Journal of Banking and Finance,
January 2000, or H.U. Koyluogu and A. Hickman,
‘‘Reconcilable Differences,’’ Risk, October 1998. For
a less technical overview of the IRB formulas, see
the BCBS’s ‘‘An Explanatory Note on the Basel II
Risk Weight Functions,’’ July 2005 (BCBS
Explanatory Note). The document can be found on
the Bank for International Settlements Web site at
http://www.bis.org.
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small percentage of the time. The
agencies believe that a one-year horizon
is appropriate because it balances the
difficulty of easily or rapidly exiting
non-trading positions against the
possibility that in many cases a bank
can cover credit losses by raising
additional capital should the underlying
credit problems manifest themselves
gradually. The nominal confidence level
of the IRB risk-based capital formulas
(99.9 percent) means that if all the
assumptions in the IRB supervisory
model for credit risk were correct for a
bank, there would be less than a 0.1
percent probability that credit losses at
the bank in any year would exceed the
IRB risk-based capital requirement.7
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) riskbased 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 riskbased capital rules.
7 Banks’ internal economic capital models
typically focus on measures of equity capital,
whereas the total regulatory capital measure
underlying this rule includes not only equity
capital, but also certain debt and hybrid
instruments, such as subordinated debt. Thus, the
99.9 percent nominal confidence level embodied in
the IRB approach is not directly compatable to the
nominal solvency standards underpinning banks’
economic capital models.
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A number of important explicit
general assumptions and specific
parameters are built into the IRB
approach to make the framework
applicable to a range of banks and to
obtain tractable information for
calculating risk-based capital
requirements. Chief among the
assumptions embodied in the IRB
approach are: (i) Assumptions that a
bank’s credit portfolio is infinitely
granular; (ii) assumptions that loan
defaults at a bank are driven by a single,
systematic risk factor; (iii) assumptions
that systematic and non-systematic risk
factors are log-normal random variables;
and (iv) assumptions regarding
correlations among credit losses on
various types of assets.
The specific risk-based capital
formulas in this final rule require the
bank to estimate certain risk parameters
for its wholesale and retail exposures,
which the bank may do using a variety
of techniques. These risk parameters are
PD, LGD, exposure at default (EAD),
and, for wholesale exposures, effective
remaining maturity (M). The proposed
rule included an additional risk
parameter, ELGD. As discussed in
section III.B.3. of the preamble, the
agencies have eliminated the ELGD risk
parameter from the final rule. The riskbased capital formulas into which the
estimated risk parameters are inserted
are simpler than the economic capital
methodologies typically employed by
banks, which often require complex
computer simulations. In particular, an
important property of the IRB risk-based
capital formulas is portfolio invariance.
That is, the risk-based capital
requirement for a particular exposure
generally does not depend on the other
exposures held by the bank. Like the
general risk-based capital rules, the total
credit risk capital requirement for a
bank’s wholesale and retail exposures is
the sum of the credit risk capital
requirements on individual wholesale
exposures and segments of retail
exposures.
The IRB risk-based capital formulas
contain supervisory asset value
correlation (AVC) factors, which have a
significant impact on the capital
requirements generated by the formulas.
The AVC assigned to a given portfolio
of exposures is an estimate of the degree
to which any unanticipated changes in
the financial conditions of the
underlying obligors of the exposures are
correlated (that is, would likely move
up and down together). High correlation
of exposures in a period of economic
downturn conditions is an area of
supervisory concern. For a portfolio of
exposures having the same risk
parameters, a larger AVC implies less
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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 riskbased 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 riskbased capital formulas for wholesale
exposures fixed rather than a decreasing
function of PD. The AVCs included in
the IRB risk-based capital formulas for
both wholesale and retail exposures
reflect a combination of supervisory
judgment and empirical evidence.9
However, the historical data available
for estimating correlations among retail
exposures, particularly for non-mortgage
retail exposures, was more limited than
was the case with wholesale exposures.
As a result, supervisory judgment
played a greater role. Moreover, the flat
15 percent AVC for residential mortgage
exposures is based largely on
supervisory experience with and
analysis of traditional long-term, fixedrate 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
8 See
9 See
BCBS Explanatory Note.
BCBS Explanatory Note, section 5.3.
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shorter maturity relative to traditional
mortgage exposures.
However, most commenters
recognized that the proposed AVCs
were consistent with those in the New
Accord and recommended that the
agencies use the AVCs contained in the
New Accord to avoid international
competitive inequity and unnecessary
burden. Several commenters suggested
that the agencies should reconsider the
AVCs going forward, working with the
BCBS.
The agencies agree with the prevailing
view of the commenters that using the
AVCs in the New Accord alleviates a
potential source of international
inconsistency and implementation
burden. The final rule therefore
maintains the proposed AVCs. As the
agencies gain more experience with the
advanced approaches, they may revisit
the AVCs for wholesale exposures and
retail exposures, along with other
calibration issues identified during the
parallel run and transitional floor
periods (as described below) and make
changes to the rule as necessary. The
agencies would address this issue
working with the BCBS and other
supervisory and regulatory authorities,
as appropriate.
Another important conceptual
element of the IRB approach concerns
the treatment of ECL. The IRB approach
assumes that reserves should cover ECL
while capital should cover credit losses
exceeding ECL (that is, unexpected
credit losses). Accordingly, the final
rule, consistent with the proposal and
the New Accord, removes ECL from the
risk-weighted assets calculation but
requires a bank to compare its ECL to its
eligible credit reserves (as defined
below). If a bank’s ECL exceeds its
eligible credit reserves, the bank must
deduct the excess ECL amount 50
percent from tier 1 capital and 50
percent from tier 2 capital. If a bank’s
eligible credit reserves exceed its ECL,
the bank may include the excess eligible
credit reserves amount in tier 2 capital,
up to 0.6 percent of the bank’s credit
risk-weighted assets.10 This treatment is
intended to maintain a capital incentive
to reserve prudently and ensure that
ECL over a one-year horizon is covered
either by reserves or capital. This
treatment also recognizes that prudent
reserving that considers probable losses
over the life of a loan may result in a
bank holding reserves in excess of ECL
measured with a one-year horizon. The
BCBS calibrated the 0.6 percent limit on
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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inclusion of excess reserves in tier 2
capital to be approximately as restrictive
as the existing cap on the inclusion of
allowance for loan and lease losses
(ALLL) under the 1988 Accord, based
on data obtained in the BCBS’s Third
Quantitative Impact Study (QIS–3).11
In developing the New Accord, the
BCBS sought broadly to maintain the
current overall level of minimum riskbased 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 riskweighted 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.
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,
11 BCBS, ‘‘QIS 3: Third Quantitative Impact
Study,’’ May 2003.
12 BCBS press release, ‘‘Basel Committee
maintains calibration of Base II Framework,’’ May
24, 2006.
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settlements, and regulatory fines)
resulting from the failure of the bank to
comply with laws, regulations, prudent
ethical standards, and contractual
obligations in any aspect of the bank’s
business—but excludes strategic and
reputational risks.
Under the AMA, a bank must use its
internal operational risk management
systems and processes to assess its
exposure to operational risk. Given the
complexities involved in measuring
operational risk, the AMA provides
banks with substantial flexibility and,
therefore, does not require a bank to use
specific methodologies or distributional
assumptions. Nevertheless, a bank using
the AMA must demonstrate to the
satisfaction of its primary Federal
supervisor that its systems for managing
and measuring operational risk meet
established standards, including
producing an estimate of operational
risk exposure that meets a one-year,
99.9th percentile soundness standard. A
bank’s estimate of operational risk
exposure includes both expected
operational loss (EOL) and unexpected
operational loss (UOL) and forms the
basis of the bank’s risk-based capital
requirement for operational risk.
The AMA allows a bank to base its
risk-based capital requirement for
operational risk on UOL alone if the
bank can demonstrate to the satisfaction
of its primary Federal supervisor that
the bank has eligible operational risk
offsets, such as certain operational risk
reserves, that equal or exceed the bank’s
EOL. To the extent that eligible
operational risk offsets are less than
EOL, the bank’s risk-based capital
requirement for operational risk must
incorporate the shortfall.
C. Overview of Final Rule
The final rule maintains the general
risk-based capital rules’ minimum tier 1
risk-based capital ratio of 4.0 percent
and total risk-based capital ratio of 8.0
percent. The components of tier 1 and
total capital in the final rule are also the
same as in the general risk-based capital
rules, with a few adjustments described
in more detail below. The primary
difference between the general riskbased 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
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determine risk-weighted asset amounts.
Each of these areas is discussed below.
Banks using the final rule also are
subject to supervisory review of their
capital adequacy (Pillar 2) and certain
public disclosure requirements to foster
transparency and market discipline
(Pillar 3). In addition, each bank using
the advanced approaches remains
subject to the tier 1 leverage ratio
requirement,13 and each DI (as defined
in section 3 of the Federal Deposit
Insurance Act (12 U.S.C. 1813)) using
the advanced approaches remains
subject to the prompt corrective action
(PCA) thresholds.14 Banks using the
advanced approaches also remain
subject to the market risk rule, where
applicable.
Under the final rule, a bank must
identify whether each of its on- and offbalance sheet exposures is a wholesale,
retail, securitization, or equity exposure.
Assets that are not defined by any
exposure category (and certain
immaterial portfolios of exposures)
generally are assigned risk-weighted
asset amounts equal to their carrying
value (for on-balance sheet exposures)
or notional amount (for off-balance
sheet exposures).
Wholesale exposures under the final
rule include most credit exposures to
companies, sovereigns, and other
governmental entities. For each
wholesale exposure, a bank must assign
four quantitative risk parameters: PD
(which is expressed as a decimal (that
is, 0.01 corresponds to 1 percent) and is
an estimate of the probability that an
obligor will default over a one-year
horizon); LGD (which is expressed as a
decimal and reflects an estimate of the
economic loss rate if a default occurs
during economic downturn conditions);
EAD (which is measured in dollars and
is an estimate of the amount that would
be owed to the bank at the time of
default); and M (which is measured in
years and reflects the effective
remaining maturity of the exposure).
Banks may factor into their risk
parameter estimates the risk mitigating
impact of collateral, credit derivatives,
and guarantees that meet certain
criteria. Banks must input the risk
parameters for each wholesale exposure
into an IRB risk-based capital formula to
13 See 12 CFR part 3.6(b) and (c) (national banks);
12 CFR part 208, appendix B (state member banks);
12 CFR part 225, appendix D (bank holding
companies); 12 CFR 325.3 (state nonmember banks);
12 CFR 567.2(a)(2) and 567.8 (savings associations).
14 See 12 CFR part 6 (national banks); 12 CFR part
208, subpart D (state member banks); 12 CFR
325.103 (state nonmember banks); 12 CFR part 565
(savings associations). In addition, savings
associations remain subject to the tangible capital
requirement at 12 CFR 567.2(a)(3) and 567.9.
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determine the risk-based capital
requirement for the exposure.
Retail exposures under the final rule
include most credit exposures to
individuals and small credit exposures
to businesses that are managed as part
of a segment of exposures with similar
risk characteristics and not managed on
an individual-exposure basis. A bank
must classify each of its retail exposures
into one of three retail subcategories—
residential mortgage exposures; QREs,
such as credit cards and overdraft lines;
and other retail exposures. Within these
three subcategories, the bank must
group exposures into segments with
similar risk characteristics. The bank
must then assign the risk parameters PD,
LGD, and EAD to each retail segment.
The bank may take into account the risk
mitigating impact of collateral and
guarantees in the segmentation process
and in the assignment of risk parameters
to retail segments. Like wholesale
exposures, the risk parameters for each
retail segment are used as inputs into an
IRB risk-based capital formula to
determine the risk-based capital
requirement for the segment.
For securitization exposures, the bank
must apply one of three general
approaches, subject to various
conditions and qualifying criteria: the
Ratings-Based Approach (RBA), which
uses external ratings to risk-weight
exposures; the Internal Assessment
Approach (IAA), which uses internal
ratings to risk-weight exposures to assetbacked 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.
Banks may use an internal models
approach (IMA) for determining riskbased 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
15 A CEIO is an on-balance sheet asset that, in
form or in substance, (i) represents the contractual
right to receive some or all of the interest and no
more than a minimal amount of principal due on
the underlying exposures of a securitization and (ii)
exposes the holder to credit risk directly or
indirectly associated with the underlying exposures
that exceeds its pro rata claim on the underlying
exposures, whether through subordination
provisions or other credit-enhancement techniques.
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generally are assigned a 300 percent risk
weight and non-publicly traded equity
exposures generally are assigned a 400
percent risk weight. Under both the IMA
and the SRWA, equity exposures to
certain entities or made pursuant to
certain statutory authorities (such as
community development laws) are
subject to a 0 to 100 percent risk weight.
Banks must develop qualifying AMA
systems to determine risk-based capital
requirements for operational risk. Under
the AMA, a bank must use its own
methodology to identify operational loss
events, measure its exposure to
operational risk, and assess a risk-based
capital requirement for operational risk.
Under the final rule, a bank must
calculate its tier 1 and total risk-based
capital ratios by dividing tier 1 capital
by total risk-weighted assets and by
dividing total qualifying capital by total
risk-weighted assets, respectively. To
calculate total risk-weighted assets, a
bank must first convert the dollar riskbased capital requirements for
exposures produced by the IRB riskbased capital approaches and the AMA
into risk-weighted asset amounts by
multiplying the capital requirements by
12.5 (the inverse of the overall 8.0
percent risk-based capital requirement).
After determining the risk-weighted
asset amounts for credit risk and
operational risk, a bank must sum these
amounts and then subtract any excess
eligible credit reserves not included in
tier 2 capital to determine total riskweighted assets.
The final rule contains specific public
disclosure requirements to provide
important information to market
participants on the capital structure,
risk exposures, risk assessment
processes, and, hence, the capital
adequacy of a bank. The public
disclosure requirements apply only to
the DI or bank holding company
representing the top consolidated level
of the banking group that is subject to
the advanced approaches, unless the
entity is a subsidiary of a non-U.S.
banking organization that is subject to
comparable disclosure requirements in
its home jurisdiction. All banks subject
to the rule, however, must disclose total
and tier 1 risk-based capital ratios and
the components of these ratios. The
agencies also proposed a package of
regulatory reporting templates for the
agencies’ use in assessing and
monitoring the levels and components
of bank risk-based capital requirements
under the advanced approaches.16
These templates will be finalized
shortly.
16 71
FR 55981 (September 25, 2006).
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The agencies are aware that the fair
value option in generally accepted
accounting principles as used in the
United States (GAAP) raises potential
risk-based capital issues not
contemplated in the development of the
New Accord. The agencies will continue
to analyze these issues and may make
changes to this rule at a future date as
necessary. The agencies would address
these issues working with the BCBS and
other supervisory and regulatory
authorities, as appropriate.
D. Structure of Final Rule
The agencies are implementing a
regulatory framework for the advanced
approaches in which each agency has an
advanced approaches appendix that
incorporates (i) definitions of tier 1 and
tier 2 capital and associated adjustments
to the risk-based capital ratio
numerators, (ii) the qualification
requirements for using the advanced
approaches, and (iii) the details of the
advanced approaches.17 The agencies
also are incorporating their respective
market risk rules, by cross-reference.18
In this final rule, as in the proposed
rule, the agencies are not restating the
elements of tier 1 and tier 2 capital,
which largely remain the same as under
the general risk-based capital rules.
Adjustments to the risk-based capital
ratio numerators specific to banks
applying the final rule are in part II of
the rule and explained in greater detail
in section IV of this preamble.
The final rule has eight parts. Part I
identifies criteria for determining which
banks are subject to the rule, provides
key definitions, and sets forth the
minimum risk-based capital ratios. Part
II describes the adjustments to the
numerator of the regulatory capital
ratios for banks using the advanced
approaches. Part III describes the
qualification process and provides
qualification requirements for obtaining
supervisory approval for use of the
advanced approaches. This part
incorporates critical elements of
supervisory oversight of capital
adequacy (Pillar 2).
Parts IV through VII address the
calculation of risk-weighted assets. Part
IV provides the risk-weighted assets
calculation methodologies for wholesale
and retail exposures; on-balance sheet
assets that do not meet the regulatory
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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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-thecounter (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.
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
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rules during the bank’s first, second,
and third transitional floor periods,
respectively. The proposal stated that
banks would be required to receive the
approval of their primary Federal
supervisor before entering each
transitional floor period.
The preamble to the proposal noted
that if there was a material reduction in
aggregate minimum regulatory capital
upon implementation of the advanced
approaches, the agencies would propose
regulatory changes or adjustments
during the transitional floor periods.
The preamble further noted that in this
context, materiality would depend on a
number of factors, including the size,
source, and nature of any reduction; the
risk profiles of banks authorized to use
the advanced approaches; and other
considerations relevant to the
maintenance of a safe and sound
banking system. The agencies also
stated that they would view a 10 percent
or greater decline in aggregate minimum
required risk-based capital (without
reference to the effects of the
transitional floors), compared to
minimum required risk-based capital as
determined under the general risk-based
capital rules, as a material reduction
warranting modification to the
supervisory risk functions or other
aspects of the framework.
Further, the agencies stated that they
were ‘‘identifying a numerical
benchmark for evaluating and
responding to capital outcomes during
the parallel run and transitional floor
periods that do not comport with the
overall capital objectives.’’ The agencies
also stated that ‘‘[a]t the end of the
transitional floor periods, the agencies
would reevaluate the consistency of the
framework, as (possibly) revised during
the transitional floor periods, with the
capital goals outlined in the ANPR and
with the maintenance of broad
competitive parity between banks
adopting the framework and other
banks, and would be prepared to make
further changes to the framework if
warranted.’’ The agencies viewed the
parallel run and transitional floor
periods as ‘‘a trial of the new framework
under controlled conditions.’’ 19
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
19 71
FR 55839–40 (September 25, 2006).
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New Accord and the rules implemented
by foreign supervisory authorities. In
particular, commenters expressed
concerns that the aggregate 10 percent
limit added a degree of uncertainty to
their capital planning process, since the
limit was beyond the control of any
individual bank. They maintained that
it might take only a few banks that
decided to reallocate funds toward
lower-risk activities during the
transition period to impose a penalty on
all U.S. banks using the advanced
approaches. Other commenters stated
that the benchmark lacked transparency
and would be operationally difficult to
apply.
Commenters also criticized the
duration, level, and construct of the
transitional floors in the proposed rule.
Commenters believed it was
inappropriate to extend the transitional
floors by an additional year (to three
years), and raised concerns that the
floors were more binding than those
proposed in the New Accord.
Commenters strongly urged the agencies
to adopt the transition periods and
floors in the New Accord to limit any
competitive inequities that could arise
among internationally active banks.
To better balance commenters’
concerns and the agencies’ capital
adequacy objectives, the agencies have
decided not to include the 10 percent
benchmark language in this preamble.
This will alleviate uncertainty and
enable each bank to develop capital
plans in accordance with its individual
risk profile and business model. The
agencies have taken a number of steps
to address their capital adequacy
objectives. Specifically, the agencies are
retaining the existing leverage ratio and
PCA requirements and are adopting the
three transitional floor periods at the
proposed numerical levels.
Under the final rule, the agencies will
jointly evaluate the effectiveness of the
new capital framework. The agencies
will issue a series of annual reports
during the transition period that will
provide timely and relevant information
on the implementation of the advanced
approaches. In addition, after the end of
the second transition year, the agencies
will publish a study (interagency study)
that will evaluate the advanced
approaches to determine if there are any
material deficiencies. For any primary
Federal supervisor to authorize any
bank to exit the third transitional floor
period, the study must determine that
there are no such material deficiencies
that cannot be addressed by thenexisting tools, or, if such deficiencies
are found, they must be first remedied
by changes to regulation.
Notwithstanding the preceding
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sentence, a primary Federal supervisor
that disagrees with the finding of
material deficiency may not authorize a
bank under its jurisdiction to exit the
third transitional floor period unless the
supervisor first provides a public report
explaining its reasoning.
The agencies intend to establish a
transparent and collaborative process
for conducting the interagency study,
consistent with the recommendations
made by the U.S. Government
Accountability Office (GAO) in its
report on implementation of the New
Accord in the United States.20 In
conducting the interagency study the
agencies would consider, for example,
the following:
• The level of minimum required
regulatory capital under U.S. advanced
approaches compared to the capital
required by other international and
domestic regulatory capital standards.
• Peer comparisons of minimum
regulatory capital requirements,
including but not limited to banks’
estimates of risk parameters for
portfolios of similar risk.
• The processes banks use to develop
and assess risk parameters and
advanced systems, and supervisory
assessments of their accuracy and
reliability.
• Potential cyclical implications.
• Changes in portfolio composition or
business mix, including those that
might result in changes in capital
requirements per dollar of credit
exposure.
• Comparison of regulatory capital
requirements to market-based measures
of capital adequacy to assess relative
minimum capital requirements across
banks and broad asset categories.
Market-based measures might include
credit default swap spreads,
subordinated debt spreads, external
rating agency ratings, and other market
measures of risk.
• Examination of the quality and
robustness of advanced risk
management processes related to
assessment of capital adequacy, as in
the comprehensive supervisory
assessments performed under Pillar 2.
• Additional reviews, including
analysis of interest rate and
concentration risks that might suggest
the need for higher regulatory capital
requirements.
F. Competitive Considerations
A fundamental objective of the New
Accord is to strengthen the soundness
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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and stability of the international
banking system while maintaining
sufficient consistency in capital
adequacy regulation to ensure that the
New Accord will not be a significant
source of competitive inequity among
internationally active banks. The
agencies support this objective and
believe that it is important to promote
continual advancement of the risk
measurement and management practices
of large and internationally active
banks.
While all banks should work to
enhance their risk management
practices, the advanced approaches and
the systems required to support their
use may not be appropriate for many
banks from a cost-benefit point of view.
For a number of banks, the agencies
believe that the general risk-based
capital rules continue to provide a
reasonable alternative for regulatory
risk-based capital measurement
purposes. However, the agencies
recognize that a bifurcated risk-based
capital framework inevitably raises
competitive considerations. The
agencies have received comments on
risk-based capital proposals issued in
the past several years 21 stating that for
some portfolios, competitive inequities
would be worse under a bifurcated
framework. These commenters
expressed concern that banks operating
under the general risk-based capital
rules would be at a competitive
disadvantage relative to banks applying
the advanced approaches because the
IRB approach would likely result in
lower risk-based capital requirements
for certain types of exposures.
The agencies recognize the potential
competitive inequities associated with a
bifurcated risk-based capital framework.
As part of their effort to develop a riskbased 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.
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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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 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
22 See
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69297
implementation issues, maintain a
constructive dialogue about
implementation processes, and
harmonize approaches as much as
possible within the range of national
discretion embedded in the New
Accord. The BCBS also has established
a Capital Interpretation Group to foster
consistency in applying the New Accord
on an ongoing basis. The agencies
intend to participate fully in these
groups to ensure that issues relating to
international implementation and
competitive effects are addressed. While
supervisory judgment will play a critical
role in the evaluation of risk
measurement and management practices
at individual banks, supervisors remain
committed to and have made significant
progress toward developing protocols
and information-sharing arrangements
that should minimize burdens on banks
operating in multiple countries and
ensure that supervisory authorities are
implementing the New Accord as
consistently as possible.
With regard to implementation timing
concerns, the agencies believe that the
transitional arrangements described in
preamble section III.A.2. below provide
a prudent and reasonable framework for
moving to the advanced approaches.
Where international implementation
differences affect an individual bank,
the agencies are working with the bank
and appropriate national supervisory
authorities to ensure that
implementation proceeds as efficiently
as possible.
II. Scope
The agencies have identified three
groups of banks: (i) Large or
internationally active banks that are
required to adopt the advanced
approaches (core banks); (ii) banks that
voluntarily decide to adopt the
advanced approaches (opt-in banks);
and (iii) banks that do not adopt the
advanced approaches (general banks).
Each core and opt-in bank is required to
meet certain qualification requirements
to the satisfaction of its primary Federal
supervisor, which in turn will consult
with other relevant supervisors, before
the bank may use the advanced
approaches for risk-based capital
purposes.
Pillar 1 of the New Accord requires all
banks subject to the New Accord to
calculate capital requirements for
exposure to credit risk and operational
risk. The New Accord sets forth three
approaches to calculating the credit risk
capital requirement and three
approaches to calculating the
operational risk capital requirement.
Outside the United States, countries that
are replacing Basel I with the New
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Accord generally have required all
banks to comply with the New Accord,
but have provided banks the option of
choosing among the New Accord’s
various approaches for calculating
credit risk and operational risk capital
requirements.
For banks in the United States, the
agencies have taken a different
approach. This final rule focuses on the
largest and most internationally active
banks and requires those banks to
comply with the most advanced
approaches for calculating credit and
operational risk capital requirements
(the IRB and the AMA). The final rule
allows other U.S. banks to ‘‘opt in’’ to
the advanced approaches. The agencies
have decided at this time to require
large, internationally active U.S. banks
to use the most advanced approaches of
the New Accord. The less advanced
approaches of the New Accord lack the
degree of risk sensitivity of the
advanced approaches. The agencies
have the view that risk-sensitive
regulatory capital requirements are
integral to ensuring that large,
sophisticated banks and the financial
system have an adequate capital
cushion to absorb financial losses. Also,
the advanced approaches provide more
substantial incentives for banks to
improve their risk measurement and
management practices than do the other
approaches. The agencies do not believe
that competitive equity concerns are
sufficiently compelling to warrant
permitting large, internationally active
U.S. banks to adopt the standardized
approaches in the New Accord.
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A. Core and Opt-In Banks
Under section 1(b) of the proposed
rule, a DI would be a core bank if it met
either of two independent threshold
criteria: (i) Consolidated total assets of
$250 billion or more, as reported on the
most recent year-end regulatory reports;
or (ii) consolidated total on-balance
sheet foreign exposure of $10 billion or
more at the most recent year end. To
determine total on-balance sheet foreign
exposure, a bank would sum its
adjusted cross-border claims, local
country claims, and cross-border
revaluation gains calculated in
accordance with the Federal Financial
Institutions Examination Council
(FFIEC) Country Exposure Report
(FFIEC 009). Adjusted cross-border
claims would equal total cross-border
claims less claims with the head office
or guarantor located in another country,
plus redistributed guaranteed amounts
to the country of head office or
guarantor. The agencies also proposed
that a DI would be a core bank if it is
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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 optin bank.
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.
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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In the preamble to the proposed rule,
the agencies also included a question on
potential regulatory burden associated
with requiring a bank that applies the
advanced approaches to implement the
advanced approaches at each subsidiary
DI—even if those subsidiary DIs do not
individually meet a threshold criterion.
A number of commenters addressed this
issue. While they expressed a range of
views, most commenters maintained
that small DI subsidiaries of core banks
should not be required to implement the
advanced approaches. Rather,
commenters asserted that these DIs
should be permitted to use simpler
methodologies, such as the New
Accord’s standardized approach.
Commenters asserted there would be
regulatory burden and costs associated
with the proposed push-down
approach, particularly if a stand-alone
AMA is required at each DI.
The agencies have considered
comments on this issue and have
decided to retain the proposed
approach. Thus, under the final rule,
each DI subsidiary of a core or opt-in
bank is itself a core bank required to
apply the advanced approaches. The
agencies believe that this approach
serves as an important safeguard against
regulatory capital arbitrage among
affiliated banks that would otherwise be
subject to substantially different capital
rules. Moreover, to calculate its
consolidated IRB risk-based capital
requirements, a bank must estimate risk
parameters for all credit exposures
within the bank except for exposures in
portfolios that, in the aggregate, are
immaterial to the bank. Because the
consolidated bank must already
estimate risk parameters for all material
portfolios of wholesale and retail
exposures in all of its consolidated
subsidiaries, the agencies believe that
there is limited additional regulatory
burden associated with application of
the IRB approach at each subsidiary DI.
Likewise, to calculate its consolidated
AMA risk-based capital requirements, a
bank must estimate its operational risk
exposure using a unit of measure
(defined below) that does not combine
business activities or operational loss
events with demonstrably different risk
profiles within the same loss
distribution. Each subsidiary DI could
have a demonstrably different risk
profile that would require the
generation of separate loss distributions.
However, the agencies recognize there
may be situations where application of
the advanced approaches at an
individual DI subsidiary of an advanced
approaches bank may not be
appropriate. Therefore, the final rule
includes the proposed provision that
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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.
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B. U.S. Subsidiaries of Foreign Banks
Under the proposed rule, any U.S.chartered DI that is a subsidiary of a
foreign banking organization would be
subject to the U.S. regulatory capital
requirements for domestically-owned
U.S. DIs. Thus, if the U.S. DI subsidiary
of a foreign banking organization met
any of the threshold criteria, it would be
a core bank and would be subject to the
advanced approaches. If it did not meet
any of the criteria, the U.S. DI could
remain a general bank or could opt in
to the advanced approaches, subject to
the same qualification process and
requirements as a domestically-owned
U.S. DI.
The proposed rule also provided that
a top-tier U.S. BHC, and its subsidiary
DIs, that was owned by a foreign
banking organization would be subject
to the same threshold levels for core
bank determination as a top-tier BHC
that is not owned by a foreign banking
organization.24 The preamble noted that
a U.S. BHC that met the conditions in
Federal Reserve SR letter 01–01 25 and
that was a core bank would not be
required to meet the minimum capital
ratios in the Board’s capital adequacy
guidelines, although it would be
required to adopt the advanced
approaches, compute and report its
capital ratios in accordance with the
advanced approaches, and make the
required public and regulatory
disclosures. A DI subsidiary of such a
U.S. BHC also would be a core bank and
would be required to adopt the
advanced approaches and meet the
minimum capital ratio requirements.
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
24 The Board notes that it generally does not
apply regulatory capital requirements to subsidiary
BHCs of top-tier U.S. BHCs, regardless of whether
the top-tier U.S. BHC is itself a subsidiary of a
foreign banking organization.
25 SR 01–01, ‘‘Application of the Board’s Capital
Adequacy Guidelines to Bank Holding Companies
Owned by Foreign Banking Organizations,’’ January
5, 2001.
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unless otherwise required to do so by
the Board. In response to the potential
burden issues identified by commenters
and outlined above, the Board notes that
the final rule allows the Board to
exempt any BHC from mandatory
application of the advanced approaches.
The Board will make such a
determination in light of the BHC’s asset
size (including subsidiary DI asset size
relative to total BHC asset size), level of
complexity, risk profile, or scope of
operation. Similarly, the final rule
allows a primary Federal supervisor to
exempt any DI under its jurisdiction
from mandatory application of the
advanced approaches. A primary
Federal supervisor will consider the
same factors in making its
determination.
C. Reservation of Authority
The proposed rule restated the
authority of a bank’s primary Federal
supervisor to require a bank to hold an
overall amount of capital greater than
would otherwise be required under the
rule if the agency determined that the
bank’s risk-based capital requirements
were not commensurate with the bank’s
credit, market, operational, or other
risks. In addition, the preamble of the
proposed rule noted the agencies’
expectation that there may be instances
when the rule would generate a riskweighted 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 riskweighted 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 riskweighted 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
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of the other agencies of its
determination.
Several commenters raised concerns
with the scope of the reservation of
authority, particularly as it would apply
to operational risk. These commenters
asserted, for example, that the agencies
should address identified operational
risk-related capital deficiencies through
Pillar 2, rather than through requiring a
bank to adjust input variables or
techniques used for the calculation of
Pillar 1 operational risk capital
requirements. Commenters were
concerned that excessive agency Pillar 1
intervention on operational risk might
inhibit innovation.
While the agencies agree that
innovation is important and that general
supervisory oversight likely would be
sufficient in many cases to address riskrelated capital deficiencies, the agencies
also believe that it is important to retain
as much supervisory flexibility as
possible as they move forward with
implementation of the final rule. In
general, the proposed reservation of
authority represented a reaffirmation of
the current authority of a bank’s primary
Federal supervisor to require the bank to
hold an overall amount of regulatory
capital or maintain capital ratios greater
than would be required under the
general risk-based capital rules. There
may be cases where requiring a bank to
assign a different risk-weighted asset
amount for operational risk may not
sufficiently address problems associated
with underlying quantification practices
and may cause an ongoing misalignment
between the operational risk of a bank
and the risk-weighted asset amount for
operational risk generated by the bank’s
operational risk quantification system.
In view of this and the inherent
flexibility provided for operational risk
measurement under the AMA, the
agencies believe it is appropriate to
articulate the specific measures a
primary Federal supervisor may take if
it determines that a bank’s risk-weighted
asset amount for operational risk is not
commensurate with the operational
risks of the bank. Therefore, the final
rule retains the reservation of authority
as proposed. The agencies emphasize
that any decision to exercise this
authority would be made judiciously
and that a bank bears the primary
responsibility for maintaining the
integrity, reliability, and accuracy of its
risk management and measurement
systems.
D. Principle of Conservatism
Several commenters asked whether it
would be permissible not to apply an
aspect of the rule for cost or regulatory
burden reasons, if the result would be
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a more conservative capital
requirement. For example, for purposes
of the RBA for securitization exposures,
some commenters asked whether a bank
could choose not to track the seniority
of a securitization exposure and,
instead, assume that the exposure is not
a senior securitization exposure.
Similarly, some commenters asked if
risk-based capital requirements for
certain exposures could be calculated
ignoring the benefits of risk mitigants
such as collateral or guarantees.
The agencies believe that in some
cases it may be reasonable to allow a
bank to implement a simplified capital
calculation if the result is more
conservative than would result from a
comprehensive application of the rule.
Under a new section 1(d) of the final
rule, a bank may choose not to apply a
provision of the rule to one or more
exposures provided that (i) the bank can
demonstrate on an ongoing basis to the
satisfaction of its primary Federal
supervisor that not applying the
provision would, in all circumstances,
unambiguously generate a risk-based
capital requirement for each exposure
greater than that which would otherwise
be required under this final rule, (ii) the
bank appropriately manages the risk of
those exposures, (iii) the bank provides
written notification to its primary
Federal supervisor prior to applying this
principle to each exposure, and (iv) the
exposures to which the bank applies
this principle are not, in the aggregate,
material to the bank.
The agencies emphasize that a
conservative capital requirement for a
group of exposures does not reduce the
need for appropriate risk management of
those exposures. Moreover, the
principle of conservatism applies to the
determination of capital requirements
for specific exposures; it does not apply
to the qualification or disclosure
requirements in sections 22 and 71 of
the final rule. Sections V.A.1., V.A.3.,
and V.E.2. of this preamble contain
examples of the appropriate use of this
principle of conservatism.
III. Qualification
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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
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planning and governance process to
oversee the implementation efforts
described in the plan, demonstrate to its
primary Federal supervisor that it meets
the qualification requirements in section
22 of the final rule, and complete a
satisfactory ‘‘parallel run’’ (discussed
below) before it may use the advanced
approaches for risk-based capital
purposes. A bank’s primary Federal
supervisor is responsible, after
consultation with other relevant
supervisors, for evaluating the bank’s
initial and ongoing compliance with the
qualification requirements for the
advanced approaches.
Under the final rule, as under the
proposed rule, a bank preparing to
implement the advanced approaches
must adopt a written implementation
plan, approved by its board of directors,
describing in detail how the bank
complies, or intends to comply, with the
qualification requirements. A core bank
must adopt a plan no later than six
months after it meets a threshold
criterion in section 1(b)(1) of the final
rule. If a bank meets a threshold
criterion on the effective date of the
final rule, the bank would have to adopt
a plan within six months of the effective
date. Banks that do not meet a threshold
criterion, but are nearing any criterion
by internal growth or merger, are
expected to engage in ongoing dialogue
with their primary Federal supervisor
regarding implementation strategies to
ensure their readiness to adopt the
advanced approaches when a threshold
criterion is reached. An opt-in bank may
adopt an implementation plan at any
time. Under the final rule, each core and
opt-in bank must submit its
implementation plan, together with a
copy of the minutes of the board of
directors’ approval of the plan, to its
primary Federal supervisor at least 60
days before the bank proposes to begin
its parallel run, unless the bank’s
primary Federal supervisor waives this
prior notice provision. The submission
to the primary Federal supervisor
should indicate the date that the bank
proposes to begin its parallel run.
In developing an implementation
plan, a bank must assess its current state
of readiness relative to the qualification
requirements in this final rule. This
assessment must include a gap analysis
that identifies where additional work is
needed and a remediation or action plan
that clearly sets forth how the bank
intends to fill the gaps it has identified.
The implementation plan must
comprehensively address the
qualification requirements for the bank
and each of its consolidated subsidiaries
(U.S. and foreign-based) with respect to
all portfolios and exposures of the bank
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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, 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
26 The bank’s primary Federal supervisor may
extend the bank’s first transitional floor period start
date.
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implementation plan, including the gap
analysis and action plan, will provide a
basis for ongoing supervisory dialogue
and review during the qualification
process. The primary Federal supervisor
will assess a bank’s progress relative to
its implementation plan. To the extent
that adjustments to target dates are
needed, these adjustments should be
made subject to the ongoing supervisory
discussion between the bank and its
primary Federal supervisor.
2. Parallel Run and Transitional Floor
Periods
Under the proposed and final rules,
once a bank has adopted its
implementation plan, it must complete
a satisfactory parallel run before it may
use the advanced approaches to
calculate its risk-based capital
requirements. The proposed rule
defined a satisfactory parallel run as a
period of at least four consecutive
calendar quarters during which a bank
complied with all of the qualification
requirements to the satisfaction of its
primary Federal supervisor.
Many commenters objected to the
proposed requirement that the bank had
to meet all of the qualification
requirements before it could begin the
parallel run period. The agencies
recognize that certain qualification
requirements, such as outcomes
analysis, become more meaningful as a
bank gains experience employing the
advanced approaches. The agencies
therefore are modifying the definition of
a satisfactory parallel run in the final
rule. Under the final rule, a satisfactory
parallel run is a period of at least four
consecutive calendar quarters during
which the bank complies with the
qualification requirements to the
satisfaction of its primary Federal
supervisor. This revised definition,
which does not contain the word ‘‘all,’’
recognizes that the qualification of
banks for the advanced approaches
during the parallel run period will be an
iterative and ongoing process. The
agencies intend to assess individual
advanced approaches methodologies
through numerous discussions, reviews,
data collection and analysis, and
examination activities. The agencies
also emphasize the critical importance
of ongoing validation of advanced
approaches methodologies both before
and after initial qualification decisions.
A bank’s primary Federal supervisor
will review a bank’s validation process
and documentation for the advanced
approaches on an ongoing basis through
the supervisory process. The bank
should include in its implementation
plan the steps it will take to enhance
compliance with the qualification
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requirements during the parallel run
period.
Commenters also requested the
flexibility, permitted under the New
Accord, to apply the advanced
approaches to some portfolios and other
approaches (such as the standardized
approach in the New Accord) to other
portfolios during the transitional floor
periods. The agencies believe, however,
that banks applying the advanced
approaches should move expeditiously
to extend the robust risk measurement
and management practices required by
the advanced approaches to all material
exposures. To preserve these positive
risk measurement and management
incentives for banks and to prevent
‘‘cherry picking’’ of portfolios, the final
rule retains the provision in the
proposed rule that states that a bank
may enter the first transitional floor
period only if it fully complies with the
qualification requirements in section 22
of the rule. As described above, the final
rule allows a simplified approach for
portfolios that are, in the aggregate,
immaterial to the bank.
Another concern identified by
commenters regarding the parallel run
was the asymmetric treatment of
mergers and acquisitions consummated
before and after the date a bank
qualified to use the advanced
approaches. Under the proposed rule, a
bank qualified to use the advanced
approaches that merged with or
acquired a company would have up to
24 months following the calendar
quarter during which the merger or
acquisition was consummated to
integrate the merged or acquired
company into the bank’s advanced
approaches capital calculations. In
contrast, the proposed rule could be
read to provide that a bank that merged
with or acquired a company before the
bank qualified to use the advanced
approaches had to fully implement the
advanced approaches for the merged or
acquired company before the bank
could qualify to use the advanced
approaches. The agencies agree that this
asymmetric treatment is not
appropriate. Accordingly, the final rule
applies the merger and acquisition
transition provisions both before and
after a bank qualifies to use the
advanced approaches. The merger and
acquisition transition provisions are
described in section III.D. of this
preamble.
During the parallel run period, a bank
continues to be subject to the general
risk-based capital rules but
simultaneously calculates its risk-based
capital ratios under the advanced
approaches. During this period, a bank
will report its risk-based capital ratios
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under the general risk-based capital
rules and the advanced approaches to
its primary Federal supervisor through
the supervisory process on a quarterly
basis. The agencies will share this
information with each other.
As described above, a bank must
provide its board-approved
implementation plan to its primary
Federal supervisor at least 60 days
before the bank proposes to begin its
parallel run period. A bank also must
receive approval from its primary
Federal supervisor before beginning its
first transitional floor period. In
evaluating whether to grant approval to
a bank to begin using the advanced
approaches for risk-based capital
purposes, the bank’s primary Federal
supervisor must determine that the bank
fully complies with all the qualification
requirements, the bank has conducted a
satisfactory parallel run, and the bank
has an adequate process to ensure
ongoing compliance with the
qualification requirements.
To provide for a smooth transition to
the advanced approaches, the proposed
rule imposed temporary limits on the
amount by which a bank’s risk-based
capital requirements could decline over
a period of at least three years (that is,
at least four consecutive calendar
quarters in each of the three transitional
floor periods). Based on its assessment
of the bank’s ongoing compliance with
the qualification requirements, a bank’s
primary Federal supervisor would
determine when the bank is ready to
move from one transitional floor period
to the next period and, after the full
transition has been completed, to exit
the last transitional floor period and
move to stand-alone use of the advanced
approaches. Table A sets forth the
proposed transitional floor periods for
banks moving to the advanced
approaches:
TABLE A.—TRANSITIONAL FLOORS
Transitional floor period
First floor period .................
Second floor period ............
Third floor period ................
Transitional
floor percentage
95
90
85
During the proposed transitional floor
periods, a bank would calculate its riskweighted assets under the general riskbased 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 ‘‘flooradjusted’’ risk-weighted assets. Third,
the bank would calculate its tier 1 and
total risk-based capital ratios using the
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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 ‘‘flooradjusted 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 riskbased capital ratios during the
transitional floor periods would be set
equal to the lower of the respective
floor-adjusted risk-based capital ratio
and the advanced approaches risk-based
capital ratio.
During the proposed transitional floor
periods, a bank’s tier 1 capital and tier
2 capital for all non-risk-based-capital
supervisory and regulatory purposes (for
example, lending limits and Regulation
W quantitative limits) would be the
bank’s tier 1 capital and tier 2 capital as
calculated under the advanced
approaches.
Thus, for example, to be well
capitalized under PCA, a bank would
have to have a floor-adjusted tier 1 riskbased capital ratio and an advanced
approaches tier 1 risk-based capital ratio
of 6 percent or greater, a floor-adjusted
total risk-based capital ratio and an
advanced approaches total risk-based
capital ratio of 10 percent or greater, and
a tier 1 leverage ratio of 5 percent or
greater (with tier 1 capital calculated
under the advanced approaches).
Although the PCA rules do not apply to
BHCs, a BHC would be required to
report all five of these regulatory capital
ratios and would have to meet
applicable supervisory and regulatory
requirements using the lower of the
respective floor-adjusted risk-based
capital ratio and the advanced
approaches risk-based capital ratio.27
27 The Board notes that, under the applicable
leverage ratio rule, a BHC that is rated composite
‘‘1’’ or that has adopted the market risk rule has a
minimum leverage ratio requirement of 3 percent.
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Under the proposed rule, after a bank
completed its transitional floor periods
and its primary Federal supervisor
determined the bank could begin using
the advanced approaches with no
further transitional floor, the bank
would use its tier 1 and total risk-based
capital ratios as calculated under the
advanced approaches and its tier 1
leverage ratio calculated using the
advanced approaches definition of tier 1
capital for PCA and all other
supervisory and regulatory purposes.
Although one commenter supported
the proposed transitional provisions,
many commenters objected to these
transitional provisions. Commenters
urged the agencies to conform the
transitional provisions to those in the
New Accord. Specifically, they
requested that the three transitional
floor periods be reduced to two periods
and that the transitional floor
percentages be reduced from 95 percent,
90 percent, and 85 percent to 90 percent
and 80 percent. Commenters also
requested that the transitional floor
calculation methodology be conformed
to the generally less restrictive
methodology of the New Accord.
Moreover, they expressed concern about
the requirement that a bank obtain
supervisory approval to move from one
transitional floor period to the next,
which could potentially extend each
floor period beyond four calendar
quarters.
The agencies believe that the
prudential transitional safeguards are
necessary to address concerns identified
in the analysis of the results of QIS–4.28
Specifically, the transitional safeguards
will ensure that implementation of the
advanced approaches will not result in
a precipitous drop in risk-based capital
requirements, and will provide a
smooth transition process as banks
refine their advanced systems. Banks’
computation of risk-based capital
requirements under both the general
risk-based capital rules and the
advanced approaches during the
parallel run and transitional floor
periods will help the agencies assess the
impact of the advanced approaches on
overall capital requirements, including
whether the change in capital
requirements relative to the general riskbased capital rules is consistent with the
For other BHCs, the minimum leverge ratio
requirement is 4 percent.
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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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.
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 riskbased capital rules both during the
parallel run and as a basis for the
transitional floor calculations. Should
the agencies finalize a standardized riskbased capital rule, the agencies expect
that a bank that opts in after the earliest
possible date or becomes a core bank
after the effective date of the final rule
would use the risk-based capital regime
(the general risk-based capital rules or
the standardized risk-based capital
rules) used by the bank immediately
before the bank begins its parallel run
both during the parallel run and as a
basis for the transitional floor
calculations. Under the final rule, 2008
is the first possible year for a bank to
begin its parallel run and 2009 is the
first possible year for a bank to begin its
first of three transitional floor periods.
B. Qualification Requirements
Because the advanced approaches use
banks’ estimates of certain key risk
parameters to determine risk-based
capital requirements, they introduce
greater complexity to the regulatory
capital framework and require banks to
possess a high level of sophistication in
risk measurement and risk management
systems. As a result, the final rule
requires each core or opt-in bank to
meet the qualification requirements
described in section 22 of the final rule
to the satisfaction of its primary Federal
supervisor for a period of at least four
consecutive calendar quarters before
using the advanced approaches to
calculate its minimum risk-based capital
requirements (subject to the transitional
floor provisions for at least an
additional three years). The
qualification requirements are written
broadly to accommodate the many ways
a bank may design and implement
robust internal credit and operational
risk measurement and management
systems, and to permit industry practice
to evolve.
Many of the qualification
requirements relate to a bank’s
advanced IRB systems. A bank’s
advanced IRB systems must incorporate
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five interdependent components in a
framework for evaluating credit risk and
measuring regulatory capital:
(i) A risk rating and segmentation
system that assigns ratings to individual
wholesale obligors and exposures and
assigns individual retail exposures to
segments;
(ii) A quantification process that
translates the risk characteristics of
wholesale obligors and exposures and
segments of retail exposures into
numerical risk parameters that are used
as inputs to the IRB risk-based capital
formulas;
(iii) An ongoing process that validates
the accuracy of the rating assignments,
segmentations, and risk parameters;
(iv) A data management and
maintenance system that supports the
advanced IRB systems; and
(v) Oversight and control mechanisms
that ensure the advanced IRB systems
are functioning effectively and
producing accurate results.
1. Process and Systems Requirements
One of the objectives of the advanced
approaches framework is to provide
appropriate incentives for banks to
develop and use better techniques for
measuring and managing their risks and
to ensure that capital is adequate to
support those risks. Section 3 of the
final rule requires a bank to hold capital
commensurate with the level and nature
of all risks to which the bank is
exposed. Section 22 of the final rule
specifically requires a bank to have a
rigorous process for assessing its overall
capital adequacy in relation to its risk
profile and a comprehensive strategy for
maintaining appropriate capital levels
(known as the internal capital adequacy
assessment process or ICAAP). Another
objective of the advanced approaches
framework is to ensure comprehensive
supervisory review of capital adequacy.
On February 28, 2007, the agencies
issued proposed guidance setting forth
supervisory expectations for a bank’s
ICAAP and addressing the process for a
comprehensive supervisory assessment
of capital adequacy.29 As set forth in
that guidance, and consistent with
existing supervisory practice, a bank’s
primary Federal supervisor will
evaluate how well the bank is assessing
its capital needs relative to its risks. The
supervisor will assess the bank’s overall
capital adequacy and will take into
account a bank’s ICAAP, its compliance
with the minimum capital requirements
set forth in this rule, and all other
relevant information. The primary
Federal supervisor will require a bank to
increase its capital levels or ratios if the
29 72
FR 9189.
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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.
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
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must ensure that the risk parameters
(PD, LGD, EAD, and, for wholesale
exposures, M) and reference data used
to determine its risk-based capital
requirements are representative of its
own credit and operational risk
exposures.
The final rule also requires that the
systems and processes that an advanced
approaches bank uses for risk-based
capital purposes must be consistent
with the bank’s internal risk
management processes and management
information reporting systems. This
means, for example, that data from the
latter processes and systems can be used
to verify the reasonableness of the
inputs the bank uses for calculating riskbased capital ratios.
2. Risk Rating and Segmentation
Systems for Wholesale and Retail
Exposures
To implement the IRB approach, a
bank must have internal risk rating and
segmentation systems that accurately
and reliably differentiate between
degrees of credit risk for wholesale and
retail exposures. As described below,
wholesale exposures include most
credit exposures to companies,
sovereigns, and other governmental
entities, as well as some exposures to
individuals. Retail exposures include
most credit exposures to individuals
and small credit exposures to businesses
that are managed as part of a segment of
exposures with homogeneous risk
characteristics. Together, wholesale and
retail exposures cover most credit
exposures of banks.
To differentiate among degrees of
credit risk, a bank must be able to make
meaningful and consistent distinctions
among credit exposures along two
dimensions—default risk and loss
severity in the event of a default. In
addition, a bank must be able to assign
wholesale obligors to rating grades that
approximately reflect likelihood of
default and must be able to assign
wholesale exposures to loss severity
rating grades (or LGD estimates) that
approximately reflect the loss severity
expected in the event of default during
economic downturn conditions. As
discussed below, the final rule requires
banks to treat wholesale exposures
differently from retail exposures when
differentiating among degrees of credit
risk; specifically, risk parameters for
retail exposures are assigned at the
segment level.
Wholesale Exposures
Under the proposed rule, a bank
would be required to have an internal
risk rating system that indicates the
likelihood of default of each individual
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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 socalled double default effects, the
agencies appreciate the commenters’
concerns about burden in this context.
Accordingly, the final rule does not
require a bank to assign an internal risk
rating to an underlying obligor to whom
the bank extends credit based solely on
the financial strength of a guarantor,
provided that all of the bank’s exposures
to that obligor are fully covered by
eligible guarantees and the bank applies
the PD substitution approach to all of
those exposures. A bank in this
situation is only required to assign an
internal risk rating to the guarantor.
However, a bank must immediately
assign an internal risk rating to the
obligor if a guarantee can no longer be
recognized under this final rule.
In determining an obligor rating, a
bank should consider key obligor
attributes, including both quantitative
and qualitative factors that could affect
the obligor’s default risk. From a
quantitative perspective, this could
include an assessment of the obligor’s
historic and projected financial
performance, trends in key financial
performance ratios, financial
contingencies, industry risk, and the
obligor’s position in the industry. On
the qualitative side, this could include
an assessment of the quality of the
obligor’s financial reporting, nonfinancial contingencies (for example,
labor problems and environmental
issues), and the quality of the obligor’s
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management based on an evaluation of
management’s ability to make realistic
projections, management’s track record
in meeting projections, and
management’s ability to effectively
adapt to changes in the economy and
the competitive environment.
Under the proposed rule, a bank
would assign each legal entity
wholesale obligor to a single rating
grade. Accordingly, if a single wholesale
exposure of the bank to an obligor
triggered the proposed rule’s definition
of default, all of the bank’s wholesale
exposures to that obligor would be in
default for risk-based capital purposes.
In addition, under the proposed rule, a
bank would not be allowed to consider
the value of collateral pledged to
support a particular wholesale exposure
(or any other exposure-specific
characteristics) when assigning a rating
to the obligor of the exposure. A bank
would, however, consider all available
financial information about the
obligor—including, where applicable,
the total operating income or cash flows
from all of the obligor’s projects or
businesses—when assigning an obligor
rating.
While a few commenters expressly
supported the proposal’s requirement
for banks to assign each legal entity
wholesale obligor to a single rating
grade, a substantial number of
commenters expressed reservations
about this requirement. These
commenters observed that in certain
circumstances an exposure’s
transaction-specific characteristics affect
its likelihood of default. Commenters
asserted that the agencies should
provide greater flexibility and allow
banks to depart from the one-rating-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-ratingper-obligor requirement. The
commenters noted that the probability
that an obligor will default on any one
such facility depends primarily on the
cash flows from the individual property
securing the facility, not the overall
condition of the obligor. Similarly,
several commenters asserted that
exposures involving transfer risk and
non-recourse exposures should be
exempted from the one-rating-perobligor 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
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may have different default probabilities.
For example, a sovereign government
may impose prohibitive exchange
restrictions that make it impossible for
a borrower to transfer payments in one
particular currency.
In addition, the agencies agree that
certain income-producing real estate
exposures for which the bank, in
economic substance, does not have
recourse to the borrower beyond the real
estate serving as collateral for the
exposure, have default probabilities
distinct from that of the borrower. Such
situations would arise, for example,
where real estate collateral is located in
a state where a bank, under applicable
state law, effectively does not have
recourse to the borrower if the bank
pursues the real estate collateral in the
event of default (for example, in a ‘‘oneaction’’ state or a state with a similar
law). In one-action states such as
Arizona, California, Idaho, Montana,
Nevada, and Utah, or in a state with a
similar law, such as New York, the
applicable foreclosure laws materially
limit a bank’s ability to collect against
both the collateral and the borrower.
A third instance in which exposures
to the same borrower may have
significantly different default
probabilities is when a borrower enters
bankruptcy and the bank extends
additional credit to the borrower under
the auspices of the bankruptcy
proceedings. This so-called debtor in
possession (DIP) financing is unique
from other exposure types because it
typically has priority over existing debt,
equity, and other claims on the
borrower. The agencies believe that
because of this unique priority status, if
a bank has an exposure to a borrower
that declares bankruptcy and defaults
on that exposure, and the bank
subsequently provides DIP financing to
that obligor, it may not be appropriate
to require the bank to treat the DIP
financing exposure at inception as an
exposure to a defaulted borrower.
To address these circumstances and
clarify the application of the one-ratingper-obligor requirement, the agencies
added a definition of obligor in the final
rule. The final rule defines an obligor as
the legal entity or natural person
contractually obligated on a wholesale
exposure except that a bank may treat
three types of exposures to the same
legal entity or natural person as having
separate obligors. First, exposures to the
same legal entity or natural person
denominated in different currencies.
Second, (i) income-producing real estate
exposures for which all or substantially
all of the repayment of the exposure is
reliant on cash flows of the real estate
serving as collateral for the exposure;
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the bank, in economic substance, does
not have recourse to the borrower
beyond the real estate serving as
collateral for the exposure; and no crossdefault 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-inpossession 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 nondefaulted obligors and at least one
obligor grade for defaulted obligors. The
agencies believe that because the riskbased capital requirement of a
wholesale exposure is directly linked to
its obligor rating grade, a bank must
have at least seven non-overlapping
obligor grades to differentiate
sufficiently the creditworthiness of nondefaulted 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
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the risk parameters for wholesale
exposures are assigned at the individual
exposure level, whereas risk parameters
for retail exposures are assigned at the
segment level. Banks typically manage
retail exposures on a segment basis,
where each segment contains exposures
with similar risk characteristics.
Therefore, a key characteristic of the
final rule’s retail framework is that the
risk parameters for retail exposures are
assigned to segments of exposures rather
than to individual exposures. Under the
retail framework, a bank groups its retail
exposures into segments with
homogeneous risk characteristics and
estimates PD and LGD for each segment.
Some commenters stated that for
internal risk management purposes they
assign risk parameters at the individual
retail exposure level rather than at the
segment level. These commenters
requested confirmation that this practice
would be permissible for risk-based
capital purposes under the final rule.
The agencies believe that a bank may
use its advanced systems, including
exposure-level risk parameter estimates,
to group exposures into segments with
homogeneous risk characteristics. Such
exposure-level estimates must be
aggregated in order to assign segmentlevel 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 nondefaulted retail exposures and (ii) retail
eligible margin loans for which the bank
adjusts EAD rather than LGD to reflect
the risk mitigating effects of financial
collateral from other retail eligible
margin loans. Otherwise, the agencies
do not require that banks consider any
particular risk drivers or employ any
minimum number of segments in any of
the three retail subcategories.
In determining how to segment retail
exposures within each subcategory for
the purpose of assigning risk
parameters, a bank should use a
segmentation approach that is
consistent with its approach for internal
risk assessment purposes and that
classifies exposures according to
predominant risk characteristics or
drivers. Examples of risk drivers could
include loan-to-value ratios, credit
scores, loan terms and structure,
origination channel, geographical
location of the borrower, collateral type,
and bank internal estimates of
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likelihood of default and loss severity
given default. Regardless of the risk
drivers used, a bank must be able to
demonstrate to its primary Federal
supervisor that its system assigns
accurate and reliable PD and LGD
estimates for each retail segment on a
consistent basis.
Definition of Default
Wholesale default. In the ANPR, the
agencies proposed to define default for
a wholesale exposure as either or both
of the following events: (i) The bank
determines that the borrower is unlikely
to pay its obligations to the bank in full,
without recourse to actions by the bank
such as the realization of collateral; or
(ii) the borrower is more than 90 days
past due on principal or interest on any
material obligation to the bank. The
ANPR’s definition of default was
generally consistent with the New
Accord.
A number of commenters on the
ANPR encouraged the agencies to use a
wholesale definition of default that
varied from the New Accord but
conformed more closely to that used by
bank risk managers. Many of these
commenters recommended that the
agencies define default for wholesale
exposures as the entry into non-accrual
or charge-off status. In the proposed
rule, the agencies amended the ANPR
definition of default to respond to these
concerns. Under the proposed definition
of default, a bank’s wholesale obligor
would be in default if, for any wholesale
exposure of the bank to the obligor, the
bank had (i) placed the exposure on
non-accrual status consistent with the
Consolidated Report of Condition and
Income (Call Report) Instructions or the
Thrift Financial Report (TFR) and the
TFR Instruction Manual; (ii) taken a full
or partial charge-off or write-down on
the exposure due to the distressed
financial condition of the obligor; or (iii)
incurred a credit-related loss of 5
percent or more of the exposure’s initial
carrying value in connection with the
sale of the exposure or the transfer of
the exposure to the held-for-sale,
available-for-sale, trading account, or
other reporting category.
The agencies received extensive
comment on the proposed definition of
default for wholesale exposures.
Commenters observed that the proposed
definition of default was different from
and more prescriptive than the
definition in the New Accord and
employed in other major jurisdictions.
They asserted that the proposed
definition would impose unjustifiable
systems burden and expense on banks
operating across multiple jurisdictions.
Commenters also asserted that many
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banks’ data collection systems are based
on the New Accord’s definition of
default, and therefore historical data
relevant to the proposed definition of
default are limited. Moreover,
commenters expressed concern that risk
parameters estimated using the
proposed definition of default would
differ materially from those estimated
using the New Accord’s definition of
default, resulting in different capital
requirements for U.S. banks relative to
their foreign peers.
The 5 percent credit-related loss
trigger in the proposed definition of
default for wholesale obligors was the
focus of significant commenter concern.
Commenters asserted that the trigger
inappropriately imported LGD and
maturity-related considerations into the
definition of default, could hamper the
use of loan sales as a risk management
practice, and could cause obligors that
are performing on their obligations to be
considered defaulted. These
commenters also claimed that the 5
percent trigger would add significant
implementation burden by, for example,
requiring banks to distinguish between
credit-related and non-credit-related
losses on sale.
Many commenters requested that the
agencies conform the U.S. wholesale
definition of default to the New Accord.
Other commenters requested that banks
be allowed the option to apply either
the U.S. or the New Accord definition
of default.
The agencies agree that the proposed
definition of default for wholesale
obligors could have unintended
consequences for implementation
burden and international consistency.
Therefore, the final rule contains a
definition of default for wholesale
obligors that is similar to the definition
proposed in the ANPR and consistent
with the New Accord. Specifically,
under the final rule, a bank’s wholesale
obligor is in default if, for any wholesale
exposure of the bank to the obligor: (i)
The bank considers that the obligor is
unlikely to pay its credit obligations to
the bank in full, without recourse by the
bank to actions such as realizing
collateral (if held); or (ii) the obligor is
past due more than 90 days on any
material credit obligation to the bank.
The final rule also clarifies, consistent
with the New Accord, that an overdraft
is past due once the obligor has
breached an advised limit or has been
advised of a limit smaller than the
current outstanding balance.
Consistent with the New Accord, the
following elements may be indications
of unlikeliness to pay under this
definition:
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(i) The bank places the exposure on
non-accrual status consistent with the
Call Report Instructions or the TFR and
the TFR Instruction Manual;
(ii) The bank takes a full or partial
charge-off or write-down on the
exposure due to the distressed financial
condition of the obligor;
(iii) The bank incurs a material creditrelated loss in connection with the sale
of the exposure or the transfer of the
exposure to the held-for-sale, availablefor-sale, trading account, or other
reporting category;
(iv) The bank consents to a distressed
restructuring of the exposure that is
likely to result in a diminished financial
obligation caused by the material
forgiveness or postponement of
principal, interest or (where relevant)
fees;
(v) The bank has filed as a creditor of
the obligor for purposes of the obligor’s
bankruptcy under the U.S. Bankruptcy
Code (or a similar proceeding in a
foreign jurisdiction regarding the
obligor’s credit obligation to the bank);
or
(vi) The obligor has sought or has
been placed in bankruptcy or similar
protection that would avoid or delay
repayment of the exposure to the bank.
If a bank carries a wholesale exposure
at fair value for accounting purposes,
the bank’s practices for determining
unlikeliness to pay for purposes of the
definition of default should be
consistent with the bank’s practices for
determining credit-related declines in
the fair value of the exposure.
Like the proposed definition of
default for wholesale obligors, the final
rule states that a wholesale exposure to
an obligor remains in default until the
bank has reasonable assurance of
repayment and performance for all
contractual principal and interest
payments on all exposures of the bank
to the obligor (other than exposures that
have been fully written-down or
charged-off). The agencies expect a bank
to employ standards for determining
whether it has a reasonable assurance of
repayment and performance that are
similar to those for determining whether
to restore a loan from non-accrual to
accrual status.
Retail default. In response to
comments on the ANPR, the agencies
proposed to define default for retail
exposures according to the timeframes
for loss classification that banks
generally use for internal purposes.
These timeframes are embodied in the
FFIEC’s Uniform Retail Credit
Classification and Account Management
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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 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-pastdue 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 120and 180-days-past-due thresholds,
which are consistent with national
discretion provided by the New Accord,
reflect a point at which retail exposures
in the United States are unlikely to
return to performing status. Therefore,
the agencies are incorporating the
proposed retail definition of default
without substantive change in the final
rule. (Parallel to the full or partial
30 FFIEC, ‘‘Uniform Retail Credit Classification
and Account Management Policy,’’ 65 FR 36903,
June 12, 2000.
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charge-off or write-down trigger for
retail exposures not held at fair value,
the agencies added a material negative
fair value adjustment of principal for
credit-related reasons trigger for retail
exposures held at fair value.)
The New Accord provides discretion
for national supervisors to set the retail
default trigger at up to 180 days past
due for different products, as
appropriate to local conditions.
Accordingly, banks implementing the
IRB approach in multiple jurisdictions
may be subject to different retail
definitions of default in their home and
host jurisdictions. The agencies
recognize that it could be costly and
burdensome for a U.S. bank to track
default data and estimate risk
parameters based on both the U.S.
definition of default and the definitions
of default in non-U.S. jurisdictions
where subsidiaries of the U.S. bank
implement the IRB approach. The
agencies are therefore incorporating
flexibility into the retail definition of
default. Specifically, for a retail
exposure held by a U.S. bank’s non-U.S.
subsidiary subject to an internal ratingsbased approach to capital adequacy
consistent with the New Accord in a
non-U.S. jurisdiction, the final rule
allows the bank to elect to use the
definition of default of that jurisdiction,
subject to prior approval by the bank’s
primary Federal supervisor. The
primary Federal supervisor will revoke
approval for a bank to use this provision
if the supervisor finds that the bank uses
the provision to arbitrage differences in
national definitions of default.
The definition of default for retail
exposures differs from the definition for
the wholesale portfolio in that the retail
default definition applies on an
exposure-by-exposure basis rather than
on an obligor-by-obligor basis. In other
words, default on one retail exposure
does not require a bank to treat all other
retail obligations of the same borrower
to the bank as defaulted. This difference
reflects the fact that banks generally
manage retail credit risk based on
segments of similar exposures rather
than through the assignment of ratings
to particular borrowers. In addition, it is
quite common for retail borrowers that
default on some of their obligations to
continue payment on others.
Although the retail definition of
default does not explicitly include
credit-related losses in connection with
loan sales and the agencies have
replaced the 5 percent credit-related
loss threshold for wholesale exposures
with a less prescriptive treatment that is
consistent with the New Accord, the
agencies expect banks to ensure that
exposure sales do not bias or otherwise
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distort the estimated risk parameters
assigned by a bank to its wholesale
exposures and retail segments.
Rating Philosophy
A bank’s internal risk rating policy for
wholesale exposures must describe the
bank’s rating philosophy, which is how
the bank’s wholesale obligor rating
assignments are affected by the bank’s
choice of the range of economic,
business, and industry conditions that
are considered in the obligor rating
process. The philosophical basis of a
bank’s rating system is important
because, when combined with the credit
quality of individual obligors, it will
determine the frequency of obligor
rating changes in a changing economic
environment. Rating systems that rate
obligors based on their ability to
perform over a wide range of economic,
business, and industry conditions,
sometimes described as ‘‘through-thecycle’’ systems, tend to have ratings that
migrate more slowly as conditions
change. Banks that rate obligors based
on a more narrow range of likely
expected conditions (primarily on
recent conditions), sometimes called
‘‘point-in-time’’ systems, tend to have
ratings that migrate more frequently.
Many banks will rate obligors using an
approach that considers a combination
of the current conditions and a wider
range of other likely conditions. In any
case, the bank must specify the rating
philosophy used and establish a policy
for the migration of obligors from one
rating grade to another in response to
economic cycles. A bank should
understand the effects of ratings
migration on its risk-based capital
requirements and ensure that sufficient
capital is maintained during all phases
of the economic cycle.
Rating and Segmentation Reviews and
Updates
Each wholesale obligor rating and (if
applicable) wholesale exposure loss
severity rating must reflect current
information. A bank’s internal risk
rating system for wholesale exposures
must provide for the review and update
(as appropriate) of each obligor rating
and (if applicable) loss severity rating
whenever the bank receives new
material information, but no less
frequently than annually. Under the
proposed rule, a bank’s retail exposure
segmentation system would provide for
the review and update (as appropriate)
of assignments of retail exposures to
segments whenever the bank received
new material information. The proposed
rule specified that the review would be
required no less frequently than
quarterly.
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69307
One commenter noted that quarterly
reviews may not be appropriate for
high-quality retail portfolios, such as
retail exposures associated with a bank’s
wealth management or private banking
businesses. The commenter suggested
that banks should have the flexibility to
review and update segmentation
assignments for such portfolios on a less
frequent basis appropriate to the credit
quality of the portfolios.
The agencies agree that it may be
appropriate for a bank to review and
update segmentation assignments for
certain high-quality retail exposures on
a less frequent basis than quarterly,
provided a bank is following sound risk
management practices. Therefore, the
final rule generally requires a quarterly
review and update, as appropriate, of
retail exposure segmentation
assignments, allowing some flexibility
to accommodate sound internal risk
management practices.
3. Quantification of Risk Parameters for
Wholesale and Retail Exposures
A bank must have a comprehensive
risk parameter quantification process
that produces accurate, timely, and
reliable estimates of the risk
parameters—PD, LGD, EAD, and (for
wholesale exposures) M—for its
wholesale obligors and exposures and
retail exposures. Statistical methods and
models used to develop risk parameter
estimates, as well as any adjustments to
the estimates or empirical data, should
be transparent, well supported, and
documented. The following sections of
the preamble discuss the rule’s
definitions of the risk parameters for
wholesale exposures and retail
segments.
Probability of Default (PD)
As noted above, under the final rule,
a bank must assign each of its wholesale
obligors to an internal rating grade and
then must associate a PD with each
rating grade. PD for a wholesale
exposure to a non-defaulted obligor is
the bank’s empirically based best
estimate of the long-run average oneyear 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
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relatively low default rates in their first
year, rising default rates in the next few
years, and declining default rates for the
remainder of their terms. Because of the
one-year IRB horizon, the proposed rule
provided two different definitions of PD
for a segment of non-defaulted retail
exposures based on the materiality of
seasoning effects for the segment or for
the segment’s retail exposure
subcategory. Under the proposed rule,
PD for a segment of non-defaulted retail
exposures for which seasoning effects
were not material, or for a segment of
non-defaulted retail exposures in a retail
exposure subcategory for which
seasoning effects were not material,
would be the bank’s empirically based
best estimate of the long-run average of
one-year default rates for the exposures
in the segment, capturing the average
default experience for exposures in the
segment over a mix of economic
conditions (including economic
downturn conditions) sufficient to
provide a reasonable estimate of the
average one-year default rate over the
economic cycle for the segment. PD for
a segment of non-defaulted retail
exposures for which seasoning effects
were material would be the bank’s
empirically based best estimate of the
annualized cumulative default rate over
the expected remaining life of exposures
in the segment, capturing the average
default experience for exposures in the
segment over a mix of economic
conditions (including economic
downturn conditions) to provide a
reasonable estimate of the average
performance over the economic cycle
for the segment.
Commenters objected to this
treatment of retail exposures with
material seasoning effects. They asserted
that requiring banks to use an
annualized cumulative default rate to
recognize seasoning effects was too
prescriptive and would preclude other
reasonable approaches. The agencies
believe that commenters have presented
reasonable alternative approaches to
recognizing the effects of seasoning in
PD and are, therefore, providing
additional flexibility for recognizing
those effects in the final rule.
Based on comments and additional
consideration, the agencies also are
clarifying that a segment of retail
exposures has material seasoning effects
if there is a material relationship
between the time since origination of
exposures within the segment and the
bank’s best estimate of the long-run
average one-year default rate for the
exposures in the segment. Moreover,
because the agencies believe that the
IRB approach must, at a minimum,
require banks to hold appropriate
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amounts of risk-based capital to address
credit risks over a one-year horizon, the
final rule’s incorporation of seasoning
effects is explicitly one-directional.
Specifically, a bank must increase PDs
above the best estimate of the long-run
average one-year default rate for
segments of unseasoned retail
exposures, but may not decrease PD
below the best estimate of the long-run
average one-year default rate for a
segment of retail exposures that the
bank estimates will have lower PDs in
future years due to seasoning.
The final rule defines PD for a
segment of non-defaulted retail
exposures as the bank’s empirically
based best estimate of the long-run
average one-year default rate for the
exposures in the segment, capturing the
average default experience for exposures
in the segment over a mix of economic
conditions (including economic
downturn conditions) sufficient to
provide a reasonable estimate of the
average one-year default rate over the
economic cycle for the segment and
adjusted upward as appropriate for
segments for which seasoning effects are
material. If a bank does not adjust PD to
reflect seasoning effects for a segment of
exposures, it should be able to
demonstrate to its primary Federal
supervisor, using empirical analysis,
why seasoning effects are not material
or why adjustment is not relevant for
the segment.
For wholesale exposures to defaulted
obligors and for segments of defaulted
retail exposures, PD is 100 percent.
Loss Given Default (LGD)
Under the proposed rule, a bank
would directly estimate an ELGD and
LGD risk parameter for each wholesale
exposure or would assign each
wholesale exposure to an expected loss
severity grade and a downturn loss
severity grade, estimate an ELGD risk
parameter for each expected loss
severity grade, and estimate an LGD risk
parameter for each downturn loss
severity grade. In addition, a bank
would estimate an ELGD and LGD risk
parameter for each segment of retail
exposures.
Expected Loss Given Default (ELGD)
The proposed rule defined the ELGD
of a wholesale exposure as the bank’s
empirically based best estimate of the
default-weighted average economic loss
per dollar of EAD the bank expected to
incur in the event that the obligor of the
exposure (or a typical obligor in the loss
severity grade assigned by the bank to
the exposure) defaulted within a one-
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year horizon.31 The proposed rule
defined ELGD for a segment of retail
exposures as the bank’s empirically
based best estimate of the defaultweighted 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 riskbased 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 riskbased capital requirements for U.S.
banks compared to foreign banks using
the New Accord’s LGD-based ECL
definition.
The agencies have concluded that the
regulatory burden and potential
competitive inequities identified by
commenters outweigh the supervisory
benefits of the proposed ELGD risk
parameter, and are, therefore, not
including it in the final rule. Instead,
consistent with the New Accord, a bank
must use LGD for the calculation of ECL
and the EL component of the IRB riskbased 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
31 Under the proposal, ELGD was not the
statistical expected value of LGD.
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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.
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Economic Loss and Post-Default
Extensions of Credit
Commenters requested additional
clarity regarding the treatment of postdefault 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 amount must capture all material
credit-related losses on the exposure
(including accrued but unpaid interest
or fees, losses on the sale of repossessed
collateral, direct workout costs, and an
appropriate allocation of indirect
workout costs). Where positive or
negative cash flows on a wholesale
exposure to a defaulted obligor or on a
defaulted retail exposure (including
proceeds from the sale of collateral,
workout costs, and draw-downs of
unused credit lines) are expected to
occur after the date of default, the
estimated economic loss amount must
reflect the net present value of cash
flows as of the default date using a
discount rate appropriate to the risk of
the exposure. The possibility of 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.
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Economic Downturn Conditions
The expected loss severities of some
exposures may be substantially higher
during economic downturn conditions
than during other periods, while for
other types of exposures they may not.
Accordingly, the proposed rule required
banks to use an LGD estimate that
reflected economic downturn
conditions for purposes of calculating
the risk-based capital requirements for
wholesale exposures and retail
segments.
Several commenters objected to the
requirement that LGD estimates must
reflect economic downturn conditions.
Some of these commenters stated that
empirical evidence of correlation
between economic downturn and LGD
is inconclusive, except in certain cases.
A few noted that estimates of expected
LGD include conservative inputs, such
as a conservative estimate of potential
loss in the event of default or a
conservative discount rate or collateral
assumptions. One commenter suggested
that if a bank can demonstrate it has
been prudent in its LGD estimation and
it has no evidence of the cyclicality of
LGDs, it should not be required to
calculate downturn LGDs. Other
commenters remarked that the
requirement to incorporate downturn
conditions into LGD estimates should
not be used as a surrogate for proper
modeling of PD/LGD correlations.
Finally, a number of commenters
supported a pillar 2 approach for
addressing LGD estimation.
Consistent with the New Accord, the
final rule maintains the requirement for
a bank to use an LGD estimate that
reflects economic downturn conditions
for purposes of calculating the riskbased capital requirements for
wholesale exposures and retail
segments. More specifically, banks must
produce for each wholesale exposure (or
loss severity rating grade) and retail
segment an estimate of the economic
loss per dollar of EAD that the bank
would expect to incur if default were to
occur within a one-year horizon during
economic downturn conditions.
For the purpose of defining economic
downturn conditions, the proposed rule
identified two wholesale exposure
subcategories—high-volatility
commercial real estate (HVCRE)
wholesale exposures and non-HVCRE
wholesale exposures (that is, all
wholesale exposures that are not
HVCRE exposures)—and three retail
exposure subcategories—residential
mortgage exposures, QREs, and other
retail exposures. The proposed rule
defined economic downturn conditions
with respect to an exposure as those
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conditions in which the aggregate
default rates for the exposure’s entire
wholesale or retail subcategory held by
the bank (or subdivision of such
subcategory selected by the bank) in the
exposure’s national jurisdiction (or
subdivision of such jurisdiction selected
by the bank) were significantly higher
than average.
The agencies specifically sought
comment on whether to require banks to
determine economic downturn
conditions at a more granular level than
an entire wholesale or retail exposure
subcategory in a national jurisdiction.
Some commenters stated that the
proposed requirement is at a sufficiently
granular level. Others asserted that the
requirement should be eliminated or
made less granular. Those commenters
favoring less granularity stated that
aggregate default rates for different
product subcategories in different
countries are unlikely to peak at the
same time and that requiring economic
downturn analysis at the product
subcategory and national jurisdiction
level does not recognize potential
diversification effects across products
and national jurisdictions and is thus
overly conservative. Commenters also
maintained that the proposed
granularity requirement adds
complexity and implementation burden
relative to the New Accord.
The agencies believe that the
proposed definition of economic
downturn conditions incorporates an
appropriate level of granularity and are
incorporating it unchanged in the final
rule. The agencies understand that
downturns in particular geographical
subdivisions of national jurisdictions or
in particular industrial sectors may
result in significantly increased loss
rates in material subdivisions of a
bank’s exposures. The agencies also
recognize that diversification across
those subdivisions may mitigate risk for
the overall organization. However, the
agencies believe that the required
minimum level of granularity at the
subcategory and national jurisdiction
level provides a suitable balance
between allowing for the benefits of
diversification and appropriate
conservatism for risk-based capital
requirements.
Under the final rule, a bank must
consider economic downturn conditions
that appropriately reflect its actual
exposure profile. For example, a bank
with a geographical or industry sector
concentration in a subcategory of
exposures may find that information
relating to a downturn in that
geographical region or industry sector
may be more relevant for the bank than
a general downturn affecting many
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regions or industries. The final rule (like
the proposed rule) allows banks to
subdivide exposure subcategories or
national jurisdictions as they deem
appropriate given the exposures held by
the bank. Moreover, the agencies note
that the exposure subcategory/national
jurisdiction granularity requirement is
only a minimum granularity
requirement.
Supervisory Mapping Function
The proposed rule provided banks
two methods of generating LGD
estimates for wholesale exposures and
retail segments. First, a bank could use
its own estimates of LGD for a
subcategory of exposures if the bank had
prior written approval from its primary
Federal supervisor to use internal
estimates for that subcategory of
exposures. In approving a bank’s use of
internal estimates of LGD, a bank’s
primary Federal supervisor would
consider whether the bank’s internal
estimates of LGD were reliable and
sufficiently reflective of economic
downturn conditions. The supervisor
would also consider whether the bank
has rigorous and well-documented
policies and procedures for identifying
economic downturn conditions for the
exposure subcategory, identifying
material adverse correlations between
the relevant drivers of default rates and
loss rates given default, and
incorporating identified correlations
into internal LGD estimates. If a bank
had supervisory approval to use its own
estimates of LGD for an exposure
subcategory, it would use its own
estimates of LGD for all exposures
within that subcategory.
As an alternative to internal estimates
of LGD, the proposed rule provided a
supervisory mapping function for
converting ELGD into LGD for riskbased 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 × 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
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methodology for banks to use while
refining their LGD estimation
techniques.
In general, commenters viewed the
supervisory mapping function as a
significant deviation from the New
Accord that would add unwarranted
prescriptiveness and regulatory burden
to the U.S. rule. Commenters requested
more flexibility to address problems
with LGD estimation, including the
ability to apply appropriate margins of
conservatism as contemplated in the
New Accord. Commenters expressed
concern that U.S. supervisors would
employ an unreasonably high standard
for allowing own estimates of LGD,
forcing banks to use the supervisory
mapping function for an extended
period of time. Commenters also
expressed concern that supervisors
would view the output of the
supervisory mapping function as a floor
on internal estimates of LGD.
Commenters asserted that in both cases
risk-based capital requirements would
be increased at U.S. banks relative to
their foreign competitors, particularly
for high-quality assets, putting U.S.
banks at a competitive disadvantage to
foreign banks.
In particular, many commenters
viewed the supervisory mapping
function as overly punitive for exposure
categories with relatively low loss
severities, effectively imposing an 8
percent floor on LGD. Commenters also
objected to the proposed requirement
that a bank use the supervisory mapping
function for an entire subcategory of
exposures even if it had difficulty
estimating LGD only for a small subset
of those exposures.
The agencies continue to believe that
the supervisory mapping function is a
reasonable aid for dealing with
problems in LGD estimation. The
agencies recognize, however, that there
may be several valid methodologies for
addressing such problems. For example,
a relative scarcity of historical loss data
for a particular obligor or exposure type
may be addressed by increased reliance
on alternative data sources and 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.
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
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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 welldocumented 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 assetbased 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
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 predefault 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
32 To illustrate, suppose that for a particular assetbased lending exposure the EAD equaled $100 and
that for every $1 owed by the obligor at the time
of default the bank’s recovery would be $0.40.
Furthermore, suppose that in the event of default
within a one-year horizon, pre-default paydowns of
$20 would reduce the exposure amount to $80 at
the time of default. In this case, the bank’s
economic loss rate measured relative to the amount
owed at default (60 percent) would exceed the
economic loss rate measured relative to EAD (48
percent = .60 × ($100 ¥$20)/$100), because the
former does not reflect fully the impact of the predefault paydowns.
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reductions in exposure that could be
recognized, and generally contended
that the reductions should be
recognized for all exposures for which
a pattern of pre-default reductions can
be estimated reliably and accurately by
the bank.
Consistent with the New Accord, the
agencies have decided to maintain the
proposed treatment of pre-default
reductions in exposure in the final rule.
The final rule does not limit the
exposure types to which a bank may
apply this treatment. However, the
agencies have clarified their
requirement for quantification of LGD in
section 22(c)(4) of the final rule. This
section states that where the bank’s
quantification of LGD directly or
indirectly incorporates estimates of the
effectiveness of its credit risk
management practices in reducing its
exposure to troubled obligors prior to
default, the bank must support such
estimates with empirical analysis
showing that the estimates are
consistent with its historical experience
in dealing with such exposures during
economic downturn conditions.
A bank’s methods for reflecting
changes in exposure during the period
prior to default must be consistent with
other aspects of the final rule. For
example, a bank must use a default
horizon no longer than one year,
consistent with the one-year default
horizon incorporated in other aspects of
the final rule, such as the quantification
of PD. In addition, a pre-default
reduction in the outstanding amount on
one exposure that does not reflect a
reduction in the bank’s total exposure to
the obligor, such as a refinancing,
should not be reflected as a pre-default
recovery for LGD quantification
purposes.
The following simplified example
illustrates how a bank could approach
incorporating pre-default reductions in
exposure in LGD. Assume a bank has a
portfolio of asset-based loans fully
collateralized by receivables. The bank
maintains a database of such loans that
have defaulted, which records the
exposure at the time of default and the
losses incurred at and after the date of
default. After careful analysis of its
historical data, the bank finds that for
every $100 of exposure on a typical
asset-based loan at the time of default,
properly discounted average losses are
$80 under economic downturn
conditions. Thus, the bank may assign
an LGD estimate of 80 percent that is
based on such evidence.
However, assume that the bank
division responsible for collections
reports that the bank’s loan workout
practices generally result in exposures
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on the asset-based loans being
significantly reduced between the time
the loan is identified internally as a
problem exposure and the time when
the obligor is in default for risk-based
capital purposes. The bank studies the
pre-default paydown behavior of
obligors that default within the next
one-year horizon and during economic
downturn conditions. In particular, the
bank uses its internal historical data to
map exposure amounts for asset-based
loans at the time of default to exposure
amounts for the same loans at various
points in time prior to default and
confirms that the pattern of pre-default
paydowns corresponds to reductions in
the bank’s overall exposures to the
obligors, as opposed to refinancings.
Robust empirical analysis further
indicates that pre-default paydowns for
asset-based loans to obligors that default
within the next one-year horizon during
economic downturn conditions depend
on the length of time the loan has been
subject to workout. Specifically, the
bank finds that the prospects for further
pre-default paydowns diminish
markedly the longer the bank has
managed the loan as a problem credit
exposure. For loans that are not in
workout or that the bank has placed in
workout for fewer than 90 days, the
bank’s analysis indicates that predefault 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 predefault recoveries tend to be immaterial.
Thus, provided this analysis is suitable
for estimating LGDs according to section
22(c) of the final rule, the bank may
appropriately assign an LGD estimate of
40 percent to asset-based loans that are
not in workout or that have been in
workout for fewer than 90 days. For
asset-based loans that have been in
workout for at least 90 days, the bank
should assign an LGD of 80 percent.
Exposure at Default (EAD)
Under the proposed rule, EAD for the
on-balance sheet component of a
wholesale or retail exposure generally
was (i) the bank’s carrying value for the
exposure (including net accrued but
unpaid interest and fees) 33 less any
allocated transfer risk reserve for the
exposure, if the exposure was classified
as held-to-maturity or for trading; or (ii)
the bank’s carrying value for the
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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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 offbalance 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, repostyle transaction, or eligible margin
loan) in the form of a loan commitment
or line of credit, EAD under the
proposed rule was the bank’s best
estimate of net additions to the
outstanding amount owed the bank,
including estimated future additional
draws of principal and accrued but
unpaid interest and fees, that were
likely to occur over the remaining life of
the exposure assuming the exposure
were to go into default. This estimate of
net additions would reflect what would
be expected during a period of
economic downturn conditions. This
treatment is retained in the final rule.
Also, consistent with the New Accord,
the final rule extends this ‘‘own
estimates’’ treatment to trade-related
letters of credit and for transactionrelated contingencies. Trade-related
letters of credit are short-term selfliquidating instruments used to finance
the movement of goods and are
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collateralized by the underlying goods.
A transaction-related contingency
includes such items as a performance
bond or performance-based standby
letter of credit.
For the off-balance sheet component
of a wholesale or retail exposure other
than an OTC derivative contract, repostyle transaction, eligible margin loan,
loan commitment, or line of credit
issued by a bank, EAD was the notional
amount of the exposure. This treatment
is retained in the final rule.
One commenter asked the agencies to
permit banks to employ the New
Accord’s flexibility to reflect additional
draws on lines of credit in either LGD
or EAD. For the same reasons that the
agencies are requiring banks to include
net accrued but unpaid interest and fees
in EAD, the agencies have decided to
continue the requirement in the final
rule for banks to reflect estimates of
additional draws in EAD, consistent
with the proposed rule.
Another commenter noted that the
‘‘remaining life of the exposure’’
concept in the proposed definition of
EAD for off-balance sheet exposures is
ambiguous and inconsistent with
defining PD over a one-year horizon. To
address this commenter’s concern, the
agencies have modified the definition of
EAD. The final rule requires a bank to
estimate net additions to the
outstanding amount owed the bank in
the event of default over a one-year
horizon.
Other commenters noted that banks
may reduce their exposure to certain
sectors in periods of economic
downturn, and inquired as to the extent
to which such practices may be
reflected in EAD estimates. The agencies
believe that such practices may be
reflected in EAD estimates for loan
commitments, lines of credit, traderelated letters of credit, and transactionrelated 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 openend revolving credit line of $100, on
which the borrower had drawn $70 (the
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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% × $30). Additionally,
the bank’s analysis indicates that, on
average, during economic downturn
conditions, such a facility can be
expected to have accrued at the time of
default unpaid interest and commitment
fees equal to three months of interest
against the drawn amount and 0.5
percent against the undrawn amount,
which in this example is assumed to
equal $0.25. Thus, the EAD for
estimated future accrued but unpaid
interest and fees equals $0.25. In sum,
the EAD should be the drawn amount
plus estimated future accrued but
unpaid fees plus the estimated amount
of future draws = $76.25 ($70 + $0.25 +
$6).
Under the proposed rule, EAD for a
segment of retail exposures was the sum
of the EADs for each individual
exposure in the segment. The agencies
have changed this provision in the final
rule, recognizing that banks typically
estimate EAD for a segment of retail
exposures rather than on an individual
exposure basis.
Under the final and proposed rules,
for wholesale or retail exposures in
which only the drawn balance has been
securitized, the bank must reflect its
share of the exposures’ undrawn
balances in EAD. The undrawn balances
of revolving exposures for which the
drawn balances have been securitized
must be allocated between the seller’s
and investors’ interests on a pro rata
basis, based on the proportions of the
seller’s and investors’ shares of the
securitized drawn balances. For
example, if the EAD of a group of
securitized exposures’ undrawn
balances is $100, and the bank’s share
(seller’s interest) in the securitized
exposures is 25 percent, the bank must
reflect $25 in EAD for the undrawn
balances.
The final rule (like the proposed rule)
contains a separate treatment of EAD for
OTC derivative contracts, which is in
section 32 of the rule and discussed in
more detail in section V.C. of the
preamble. The final rule also clarifies
that a bank may use the treatment of
EAD in section 32 of the rule for repostyle transactions and eligible margin
loans, or the bank may use the general
definition of EAD described in this
section for such exposures.
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General Quantification Principles
The final rule, like the proposed rule,
requires data used by a bank to estimate
risk parameters to be relevant to the
bank’s actual wholesale and retail
exposures and of sufficient quality to
support the determination of risk-based
capital requirements for the exposures.
For wholesale exposures, estimation of
the risk parameters must be based on a
minimum of five years of default data to
estimate PD, seven years of loss severity
data to estimate LGD, and seven years
of exposure amount data to estimate
EAD. For segments of retail exposures,
estimation of risk parameters must be
based on a minimum of five years of
default data to estimate PD, five years of
loss severity data to estimate LGD, and
five years of exposure amount data to
estimate EAD. Default, loss severity, and
exposure amount data must include
periods of economic downturn
conditions or the bank must adjust its
estimates of risk parameters to
compensate for the lack of data from
such periods. Banks must base their
estimates of PD, LGD, and EAD on the
final rule’s definition of default, and
must review at least annually and
update (as appropriate) their risk
parameters and risk parameter
quantification process.
In all cases, banks are expected to use
the best available data for quantifying
the risk parameters. A bank could meet
the minimum data requirement by using
internal data, external data, or pooled
data combining internal data with
external data. Internal data refers to any
data on exposures held in a bank’s
existing or historical portfolios,
including data elements or information
provided by third parties regarding such
exposures. External data refers to
information on exposures held outside
of the bank’s portfolio or aggregate
information across an industry. For new
lines of business, where a bank lacks
sufficient internal data, a bank likely
will need to use external data to
supplement its internal data.
The agencies recognize that the
minimum sample period for reference
data provided in the final rule may not
provide the best available results. A
longer sample period usually captures
varying economic conditions better than
a shorter sample period. In addition, a
longer sample period will include more
default observations for LGD and EAD
estimation. Banks should consider using
a longer-than-minimum sample period
when possible. However, the potential
increase in precision afforded by a
larger sample size should be weighed
against the potential for diminished
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comparability of older data to the
existing portfolio.
Portfolios With Limited Data or Limited
Defaults
Many commenters requested further
clarity about the procedures that banks
should use to estimate risk parameters
for portfolios characterized by a lack of
internal data or with very little default
experience. In particular, the GAO
report recommended that the agencies
provide additional clarity on this issue.
Several commenters indicated that the
agencies should establish criteria for
identifying homogeneous portfolios of
low-risk exposures and allow banks to
apportion expected loss between LGD
and PD for those portfolios rather than
estimating each risk parameter
separately. Other commenters suggested
that the agencies consider whether
banks should be permitted to use the
New Accord’s standardized approach
for credit risk for such portfolios.
The final rule requires banks to meet
the qualification requirements in section
22 for all portfolios of exposures. The
agencies expect that banks
demonstrating appropriately rigorous
processes and sufficient degrees of
conservatism for portfolios with limited
data or limited defaults will be able to
meet the qualification requirements.
Section 22(c)(3) of the final rule
specifically states that a bank’s risk
parameter quantification process ‘‘must
produce appropriately conservative risk
parameter estimates where the bank has
limited relevant data.’’ The agencies
believe that this section provides
sufficient flexibility and incentives for
banks to develop and document sound
practices for applying the IRB approach
to portfolios lacking sufficient data.
The section of the preamble below
expands upon potential approaches to
portfolios with limited data. The BCBS
publication ‘‘Validation of low-default
portfolios in the Basel II Framework’’ 34
also provides a resource for banks facing
this issue. The agencies will work with
banks through the supervisory and
examination processes to address
particular situations.
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
34 BCBS, Basel Committee Newsletter No. 6,
‘‘Validation of low-default portfolios in the Base II
Framework,’’ September 2005.
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requirements of the rule. Alternatively,
a bank may be able to identify a set of
data-rich internal exposures that could
be used to inform the estimation of risk
parameters for the portfolio for which it
has insufficient data. The key
considerations for a bank in determining
whether to use alternative data sources
will be whether such data are
sufficiently accurate, complete,
representative and informative of the
bank’s existing exposures and whether
the bank’s quantification of risk
parameters is rigorously conducted and
well documented.
For instance, consider a bank that has
recently extended its credit card
operations to include a new market
segment for credit card loans and,
therefore, has limited internal data on
the performance of the exposures in this
new market segment. The bank could
acquire external data from various
vendors that would provide a broad,
market-wide picture of default and loss
experience in the new market segment.
This external data could then be
supplemented by the bank’s internal
data and experience with its existing
credit card operations. By comparing
the bank’s experience with its existing
customers to the market data, the bank
can refine the risk parameters estimated
from the external data on the new
market segment and make those
parameters more accurate for the bank’s
new market segment of exposures.
Using the combination of these data
sources, the bank may be able to
estimate appropriately conservative
estimates of risk parameters for its new
market segment of exposures. If the
bank is not able to do so, it must include
the new market segment of exposures in
its set of aggregate immaterial exposures
and apply a 100 percent risk weight.
Portfolios with limited defaults.
Commenters indicated that they had
experienced very few defaults for some
portfolios, most notably margin loans
and exposures to some sovereign
issuers, which made it difficult to
separately estimate PD and LGD. The
agencies recognize that some portfolios
have experienced very few defaults and
have very low loss experiences. The
absence of defaults or losses in
historical data does not, however,
preclude the potential for defaults or
large losses to arise in future
circumstances. Moreover, as discussed
previously, the ability to separate EL
into PD and LGD is a key component of
the IRB approach.
As with the cases described above in
which internal data are limited in all
dimensions, external data from some
related portfolios or for similar obligors
may be used to estimate risk parameters
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that are then mapped to the low default
portfolio or obligor. For example, banks
could consider instances of near default
or credit deterioration short of default in
these low default portfolios to inform
estimates of what might happen if a
default were to occur. Similarly,
scenario analysis that evaluates the
hypothetical impact of severe market
disruptions may help inform the bank’s
parameter estimates for margin loans.
For very low-risk wholesale obligors
that have publicly traded financial
instruments, banks may be able to glean
information about the relative values of
PD and LGD from different changes in
credit spreads on instruments of
different maturity or from different
moves in credit spreads and equity
prices. In all cases, risk parameter
estimates should incorporate a degree of
conservatism that is appropriate for the
overall rigor of the quantification
process.
Other quantification process
considerations. Both internal and
external reference data should not differ
systematically from a bank’s existing
portfolio in ways that seem likely to be
related to default risk, loss severity, or
exposure at default. Otherwise, the
derived PD, LGD, or EAD estimates may
not be applicable to the bank’s existing
portfolio. Accordingly, the bank must
conduct a comprehensive review and
analysis of reference data at least
annually to determine the relevance of
reference data to the bank’s exposures,
the quality of reference data to support
PD, LGD, and EAD estimates, and the
consistency of reference data to the
definition of default in the final rule.
Furthermore, a bank must have
adequate internal or external data to
estimate the risk parameters PD, LGD,
and EAD (each of which incorporates a
one-year time horizon) for all wholesale
exposure and retail segments, including
those originated for sale or that are in
the securitization pipeline.
As noted above, periods of economic
downturn conditions must be included
in the data sample (or adjustments to
risk parameters must be made). If the
reference data include data from beyond
the minimum number of years (to
capture a period of economic downturn
conditions or for other valid reasons),
the reference data need not cover all of
the intervening years. However, a bank
should justify the exclusion of available
data and, in particular, any temporal
discontinuities in data used. Including
periods of economic downturn
conditions increases the size and
potentially the breadth of the reference
data set. According to some empirical
studies, the average loss rate is higher
during periods of economic downturn
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conditions, such that exclusion of such
periods would bias LGD or EAD
estimates downward and unjustifiably
lower risk-based capital requirements.
Risk parameter estimates should take
into account the robustness of the
quantification process. The assumptions
and adjustments embedded in the
quantification process should reflect the
degree of uncertainty or potential error
inherent in the process. In practice, a
reasonable estimation approach likely
would result in a range of defensible
risk parameter estimates. The choices of
the particular assumptions and
adjustments that determine the final
estimate, within the defensible range,
should reflect the uncertainty in the
quantification process. More uncertainty
in the process should be reflected in the
assignment of final risk parameter
estimates that result in higher risk-based
capital requirements relative to a
quantification process with less
uncertainty. The degree of conservatism
applied to adjust for uncertainty should
be related to factors such as the
relevance of the reference data to a
bank’s existing exposures, the
robustness of the models, the precision
of the statistical estimates, and the
amount of judgment used throughout
the process. A bank is not required to
add a margin of conservatism at each
step if doing so would produce an
excessively conservative result. Instead,
the overall margin of conservatism
should adequately account for all
uncertainties and weaknesses in the
quantification process. Improvements in
the quantification process (including
use of more complete data and better
estimation techniques) may reduce the
appropriate degree of conservatism over
time.
Judgment will inevitably play a role
in the quantification process and may
materially affect the estimates of risk
parameters. Judgmental adjustments to
estimates are often necessary because of
limitations on available reference data
or because of inherent differences
between the reference data and the
bank’s existing exposures. The bank’s
risk parameter quantification process
must produce appropriately
conservative risk parameter estimates
when the bank has limited relevant
data, and any adjustments that are part
of the quantification process must not
result in a pattern of bias toward lower
risk parameter estimates. This does not
prohibit individual adjustments that
result in lower estimates of risk
parameters, as both upward and
downward adjustments are expected.
Individual adjustments are less
important than broad patterns;
consistent signs of judgmental decisions
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that materially lower risk parameter
estimates may be evidence of systematic
bias, which is not permitted.
In estimating relevant risk parameters,
banks should not rely on the possibility
of U.S. government financial assistance,
except for the financial assistance that
the U.S. government has a legally
binding commitment to provide.
4. Optional Approaches That Require
Prior Supervisory Approval
A bank that intends to apply the
internal models methodology to
counterparty credit risk, the double
default treatment for credit risk
mitigation, the IAA for securitization
exposures to ABCP programs, or the
IMA to equity exposures must receive
prior written approval from its primary
Federal supervisor. The criteria on
which approval will be based are
described in the respective sections
below.
5. Operational Risk
A bank must have operational risk
management processes, data and
assessment systems, and quantification
systems that meet the qualification
requirements in section 22(h) of the
final rule. A bank must have an
operational risk management function
that is independent of business line
management. The operational risk
management function is responsible for
the design, implementation, and
oversight of the bank’s operational risk
data and assessment systems,
operational risk quantification systems,
and related processes. The roles and
responsibilities of the operational risk
management function may vary between
banks, but should be clearly
documented. The operational risk
management function should have an
organizational stature commensurate
with the bank’s operational risk profile.
At a minimum, the bank’s operational
risk management function should
ensure the development of policies and
procedures for the explicit management
of operational risk as a distinct risk to
the bank’s safety and soundness.
A bank also must establish and
document a process to identify,
measure, monitor, and control
operational risk in bank products,
activities, processes, and systems. This
process should provide for the
consistent and comprehensive
collection of the data needed to estimate
the bank’s exposure to operational risk.
This process must capture business
environment and internal control factors
affecting the bank’s operational risk
profile. The process must also ensure
reporting of operational risk exposures,
operational loss events, and other
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relevant operational risk information to
business unit management, senior
management, and to the board of
directors (or a designated committee of
the board).
The final rule defines an operational
loss event as an event that results in loss
and is associated with any of the seven
operational loss event type categories.
Under the final rule, the agencies have
included definitions of the seven
operational loss event type categories,
consistent with the descriptions
outlined in the New Accord. The seven
operational loss event type categories
are: (i) Internal fraud, which is the
operational loss event type category that
comprises operational losses resulting
from an act involving at least one
internal party of a type intended to
defraud, misappropriate property or
circumvent regulations, the law or
company policy, excluding diversity
and discrimination-type events; (ii)
external fraud, which is the operational
loss event type category that comprises
operational losses resulting from an act
by a third party of a type intended to
defraud, misappropriate property or
circumvent the law; 35 (iii) employment
practices and workplace safety, which is
the operational loss event type category
that comprises operational losses
resulting from an act inconsistent with
employment, health, or safety laws or
agreements, payment of personal injury
claims, or payment arising from
diversity or discrimination events; (iv)
clients, products, and business
practices, which is the operational loss
event type category that comprises
operational losses resulting from the
nature or design of a product or from an
unintentional or negligent failure to
meet a professional obligation to
specific clients (including fiduciary and
suitability requirements); (v) damage to
physical assets, which is the operational
loss event type category that comprises
operational losses resulting from the
loss of or damage to physical assets from
natural disaster or other events; (vi)
business disruption and system failures,
which is the operational loss event type
category that comprises operational
losses resulting from disruption of
business or system failures; and (vii)
execution, delivery, and process
management, which is the operational
loss event type category that comprises
operational losses resulting from failed
transaction processing or process
management or losses arising from
35 Retail credit card losses arising from noncontractual, 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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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.
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
36 New
Accord, ¶ 673.
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operational risk—is an estimate of
aggregate operational losses generated
by the bank’s AMA process.
Many commenters supported the
agencies’ proposed definition of
operational loss and viewed it as
appropriate and consistent with general
use within the banking industry. Some
commenters, however, opposed the
inclusion of a specific definition of
operational loss and asserted that the
proposed treatment of operational loss
is too prescriptive. In addition, some
commenters maintained that including a
definition of operational loss is
inconsistent with the New Accord,
which does not explicitly define
operational loss. In response to a
specific question in the proposal, many
commenters asserted that the definition
of operational loss should relate to its
impact on regulatory capital rather than
economic capital concepts. One
commenter, however, recommended
using the replacement cost of any fixed
asset affected by an operational loss
event to reflect the actual financial
impact of the event.
Because operational losses are the
building blocks in a bank’s calculation
of its operational risk capital
requirement under the AMA, the
agencies continue to believe that it is
necessary to define what is meant by
operational loss to achieve
comparability and foster consistency
both across banks and across business
lines within a bank. Additionally, the
agencies agree with those commenters
who asserted that the definition of
operational loss should relate to its
impact on regulatory capital. Therefore,
the agencies have adopted the proposed
definition of operational loss
unchanged.
In the preamble to the proposed rule,
the agencies recognized that there was
a potential to double-count all or a
portion of the risk-based capital
requirement associated with fixed
assets. Under the proposed rule, the
credit-risk-weighted asset amount for a
bank’s premises would equal the
carrying value of the premises on the
financial statements of the bank,
determined in accordance with GAAP.
A bank’s operational risk exposure
estimate addressing bank premises
generally would be different than, and
in addition to, the risk-based capital
requirement generated under the
proposed rule and could, at least in part,
address the same risk exposure. The
majority of commenters on this issue
recommended removing the credit risk
capital requirement for premises and
other fixed assets and preserving only
the operational risk capital requirement.
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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
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.
37 New
38 New
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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 caseby-case basis, in which a shorter
observation period may be appropriate,
such as a bank’s initial implementation
of an AMA. Therefore, the final rule
retains the five-year historical
observation period requirements and the
transitional flexibility for internal
operational loss event data, as proposed.
In relation to the provision that
permits a bank to refrain from collecting
internal operational loss event data
below established thresholds, a few
commenters sought clarification of the
proposed requirement that the
thresholds must permit the bank to
capture ‘‘substantially all’’ of the dollar
value of a bank’s operational losses. In
particular, they questioned whether a
bank must collect all or a very high
percentage of operational losses or
whether smaller losses could be
modeled.
To demonstrate the appropriateness of
its threshold for internal operational
loss event data collection, a bank might
choose to collect all internal operational
loss event data, at least for a time, to
support a meaningful analysis around
the appropriateness of its chosen data
collection threshold. Alternatively, a
bank might be able to obtain data from
systems outside of its operational risk
data and assessment system (for
example, the bank’s general ledger
system) to demonstrate the impact of
choosing different thresholds on its
operational risk exposure estimates.
With respect to the commenters’
question regarding modeling smaller
losses, the agencies would consider
permitting such an approach based on
whether the approach meets the overall
qualification requirements outlined in
the final rule. In particular, the agencies
would consider whether the bank
satisfies those requirements pertaining
to a bank’s operational risk
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quantification system as well as its
control, oversight, and validation
mechanisms. Such modeling
considerations, however, would not
eliminate the requirement for a bank to
demonstrate the appropriateness of any
established internal operational loss
event data collection thresholds.
A bank also must establish a
systematic process to determine its
methodologies for incorporating
external operational loss event data into
its operational risk data and assessment
systems. The proposed and final rules
define external operational loss event
data for a bank as gross operational loss
amounts, dates, recoveries, and relevant
causal information for operational loss
events occurring at organizations other
than the bank. External operational loss
event data may serve a number of
different purposes in a bank’s
operational risk data and assessment
systems. For example, external
operational loss event data may be a
particularly useful input in determining
a bank’s level of exposure to operational
risk when internal operational loss
event data are limited. In addition,
external operational loss event data
provide a means for the bank to
understand industry experience and, in
turn, provide a means for the bank to
assess the adequacy of its internal
operational loss event data.
While internal and external
operational loss event data provide a
historical perspective on operational
risk, it is also important that a bank
incorporate forward-looking elements
into its operational risk data and
assessment systems. Accordingly, under
the final rule, as under the proposed
rule, a bank must incorporate business
environment and internal control factors
into its operational risk data and
assessment systems to assess fully its
exposure to operational risk. In
principle, a bank with strong internal
controls in a stable business
environment would have less exposure
to operational risk than a bank with
internal control weaknesses that is
growing rapidly or introducing new
products. In this regard, a bank should
identify and assess the level and trends
in operational risk and related control
structures at the bank. These
assessments should be current and
comprehensive across the bank, and
they should identify the operational
risks facing the bank. The framework
established by a bank to maintain these
risk assessments should be sufficiently
flexible to accommodate increasing
complexity, new activities, changes in
internal control systems, and an
increasing volume of information. A
bank must also periodically compare the
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results of its prior business environment
and internal control factor assessments
against the bank’s actual operational
losses incurred in the intervening
period.
A few commenters sought
clarification on the agencies’
expectations regarding a bank’s periodic
comparisons of its prior business
environment and internal control factor
assessments against its actual
operational losses. One commenter
expressed concern over the difficulty of
conducting an empirically robust
analysis to fulfill the requirement.
Under the final rule, a bank has
flexibility in the approach it uses to
conduct its business environment and
internal control factor assessments. As
such, the methods for conducting
comparisons of these assessments
against actual operational loss
experience may also vary and precise
modeling calibration may not be
practical. The agencies maintain,
however, that it is important for a bank
to perform such comparisons to ensure
that its assessments are current,
reasonable, and appropriately factored
into the bank’s AMA framework. In
addition, the comparisons could
highlight the need for potential
adjustments to the bank’s operational
risk management processes.
A bank also must have a systematic
process for determining its
methodologies for incorporating
scenario analysis into its operational
risk data and assessment systems. As an
input to a bank’s operational risk data
and assessment systems, scenario
analysis is especially relevant for
business lines or operational loss event
types where internal data, external data,
and assessments of the business
environment and internal control factors
do not provide a sufficiently robust
estimate of the bank’s exposure to
operational risk.
Similar to business environment and
internal control factor assessments, the
results of scenario analysis provide a
means for a bank to incorporate a
forward-looking element into its
operational risk data and assessment
systems. Under the proposed rule,
scenario analysis was defined as a
systematic process of obtaining expert
opinions from business managers and
risk management experts to derive
reasoned assessments of the likelihood
and loss impact of plausible highseverity 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
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include the well-reasoned evaluation
and use of external operational loss
event data, adjusted as appropriate to
ensure relevance to a bank’s operational
risk profile and control structure.
A bank’s operational risk data and
assessment systems must include
credible, transparent, systematic, and
verifiable processes that incorporate all
four operational risk elements (that is,
internal operational loss event data,
external operational loss event data,
scenario analysis, and business
environment and internal control
factors). The bank should have clear
standards for the collection and
modification of all elements. The bank
should combine these four elements in
a manner that most effectively enables
it to quantify its exposure to operational
risk.
Operational Risk Quantification System
A bank must have an operational risk
quantification system that generates
estimates of its operational risk
exposure using its operational risk data
and assessment systems. The final rule
defines operational risk exposure as the
99.9th percentile of the distribution of
potential aggregate operational losses, as
generated by the bank’s operational risk
quantification system over a one-year
horizon (and not incorporating eligible
operational risk offsets or qualifying
operational risk mitigants). The mean of
such a total loss distribution is the
bank’s EOL. The final rule defines EOL
as the expected value of the distribution
of potential aggregate operational losses,
as generated by the bank’s operational
risk quantification system using a oneyear 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
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combining the four required elements of
a bank’s operational risk data and
assessment system (internal operational
loss event data, external operational loss
event data, scenario analysis, and
assessments of the bank’s business
environment and internal control
factors) will also vary across banks.
Factors affecting the weighting include
a bank’s operational risk profile,
operational loss experience, internal
control environment, and relative
quality and content of the four elements.
These factors will influence the
emphasis placed on certain elements
relative to others. As such, the agencies
are not prescribing specific
requirements around the weighting of
each element, nor are they placing any
specific limitations on the use of the
elements. In view of this flexibility,
however, under the final rule a bank’s
operational risk quantification systems
must include a credible, transparent,
systematic, and verifiable approach for
weighting the use of the four elements.
As part of its operational risk
exposure estimate, a bank must use a
unit of measure that is appropriate for
the bank’s range of business activities
and the variety of operational loss
events to which it is exposed. The
proposed rule defined a unit of measure
as the level (for example, organizational
unit or operational loss event type) at
which the bank’s operational risk
quantification system generated a
separate distribution of potential
operational losses. Under the proposed
rule, a bank could not combine business
activities or operational loss events with
different risk profiles within the same
loss distribution.
Many commenters expressed concern
that the prohibition against combining
business activities or operational loss
events with different risk profiles within
the same loss distribution was an
impractical standard because some level
of combination was unavoidable.
Additionally, commenters noted that
data limitations made it difficult to
quantify risk profiles at a granular level.
Commenters also expressed concern
that the proposed rule appeared to
preclude the use of ‘‘top-down’’
approaches, given that under a firmwide approach business activities or
operational loss events with different
risk profiles would necessarily be
combined within the same loss
distribution. One commenter suggested
that, because of data limitations and the
potential for wide variations in risk
profiles within individual business lines
and/or types of operational loss events,
banks be afforded some latitude in
moving from a ‘‘top-down’’ approach to
a ‘‘bottom-up’’ approach.
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The agencies have retained the
proposed definition of unit of measure
in the final rule. The agencies recognize,
however, that there is a need for
flexibility in assessing whether a bank’s
chosen unit of measure is appropriate
for the bank’s range of business
activities and the variety of operational
loss events to which it is exposed. In
some instances, data limitations may
indeed prevent a bank’s operational risk
quantification systems from generating a
separate distribution of potential
operational losses for certain business
lines or operational loss event types.
Therefore, the agencies have modified
the final rule to provide a bank more
flexibility in devising an appropriate
unit of measure. Specifically, a bank
must employ a unit of measure that is
appropriate for its range of business
activities and the variety of operational
loss events to which it is exposed, and
that does not combine business
activities or operational loss events with
demonstrably different risk profiles
within the same loss distribution.
The agencies recognize that
operational losses across operational
loss event types and business lines may
be related. Under the final rule, as under
the proposed rule, a bank may use its
internal estimates of dependence among
operational losses within and across
business lines and operational loss
event types if the bank can demonstrate
to the satisfaction of its primary Federal
supervisor that its process for estimating
dependence is sound, robust to a variety
of scenarios, implemented with
integrity, and allows for the uncertainty
surrounding the estimates. The agencies
expect that a bank’s assumptions
regarding dependence will be
conservative given the uncertainties
surrounding dependence modeling for
operational risk. If a bank does not
satisfy the requirements surrounding
dependence, the bank must sum
operational risk exposure estimates
across units of measure to calculate its
total operational risk exposure.
Under the proposed rule, dependence
was defined as ‘‘a measure of the
association among operational losses
across and within business lines and
operational loss event types.’’ One
commenter recommended that the
agencies revise the definition of
dependence to ‘‘a measure of the
association among operational losses
across and within units of measure.’’
The agencies recognize that examples of
units of measure include, but are not
limited to, business lines and
operational loss event types, and that a
bank’s operational risk quantification
system could generate distributions of
potential operational losses that are
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separate from its business lines and
operational loss event types. Units of
measure can also encompass
correlations over time. Therefore, the
agencies have amended the final rule to
define dependence as a measure of the
association among operational losses
across and within units of measure.
As noted above, under the proposed
rule, a bank that did not satisfy the
requirements surrounding dependence
would sum operational risk exposure
estimates across units of measure to
calculate its total operational risk
exposure. Several commenters asserted
that the New Accord does not require a
bank to sum its operational risk
exposure estimates across units of
measure if the bank cannot demonstrate
adequate support of its dependence
assumptions. One commenter asked the
agencies to remove this requirement
from the final rule. Several commenters
suggested that if a bank cannot provide
sufficient support for its dependence
estimates, a conservative assumption of
positive dependence is warranted, but
not an assumption of perfect positive
dependence as implied by the
summation requirement. Another
commenter suggested that the
dependence assumption should be
based upon a conservative statistical
analysis of industry data.
The New Accord states that, absent a
satisfactory demonstration of a bank’s
‘‘systems for determining correlations’’
to its national supervisor, ‘‘risk
measures for different operational risk
estimates must be added for purposes of
calculating the regulatory minimum
capital requirement.’’ 39 The agencies
continue to believe that this treatment of
operational risk exposure estimates
across units of measure is prudent until
the relationships among operational
losses are better understood. Therefore,
the final rule retains the proposed rule’s
requirement regarding the summation of
operational risk exposure estimates.
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
39 New
Accord, ¶669.
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acceptable estimates of dependency are
available.
The agencies recognize that there may
be different ways to estimate the
relationship among operational losses
across and within units of measure.
Therefore, under the final rule, a bank
has flexibility to use different
methodologies to demonstrate
dependence across units of measure.
However, the bank must demonstrate to
the satisfaction of its primary Federal
supervisor that its process for estimating
dependence is sound, robust to a variety
of scenarios, implemented with
integrity, and allows for the uncertainty
surrounding the estimates.
A bank’s chosen unit of measure
affects how it should account for
dependence. Explicit assumptions
regarding dependence across units of
measure are always necessary to
estimate operational risk exposure at the
bank level. However, explicit
assumptions regarding dependence
within units of measure are not
necessary, and under many
circumstances models assume statistical
independence within each unit of
measure. The use of only a few units of
measure increases the need to ensure
that dependence within units of
measure is suitably reflected in the
operational risk exposure estimate.
In addition, the bank’s process for
estimating dependence should provide
for ongoing monitoring, recognizing that
dependence estimates can change. The
agencies expect that a bank’s approach
for developing explicit and objective
dependence determinations will
improve over time. As such, the bank
should develop a process for assessing
incremental improvements to the
approach (for example, through out-ofsample testing).
Under the final rule, as under the
proposed rule, a bank must review and
update (as appropriate) its operational
risk quantification system whenever the
bank becomes aware of information that
may have a material effect on the bank’s
estimate of operational risk exposure,
but no less frequently than annually.
The agencies recognize that, in
limited circumstances, there may not be
sufficient data available for a bank to
generate a credible estimate of its own
operational risk exposure at the 99.9
percent confidence level. In these
limited circumstances, under the
proposed rule, a bank could use an
alternative operational risk
quantification system, subject to prior
approval by the bank’s primary Federal
supervisor. The alternative approach
was not available at the BHC level.
One commenter asserted that, in line
with the New Accord’s continuum of
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operational risk measurement
approaches, all banks, including BHCs,
should be permitted to adopt an
alternative operational risk
quantification system, such as the New
Accord’s standardized approach or
allocation approach. The commenter
further noted that a bank’s use of an
allocation approach should not be
subject to more stringent terms and
conditions than those set forth in the
New Accord.
The agencies are maintaining the
alternative approach provision in the
final rule. The agencies are not
prescribing specific estimation
methodologies under this approach and
expect use of an alternative approach to
occur on a very limited basis. A bank
proposing to use an alternative
operational risk quantification system
must submit a proposal to its primary
Federal supervisor. In evaluating a
bank’s proposal, the primary Federal
supervisor will review the bank’s
justification for requesting use of an
alternative approach in light of the
bank’s size, complexity, and risk profile.
The bank’s primary Federal supervisor
will also consider whether the estimate
of operational risk under the alternative
approach is appropriate (for example,
whether the estimate results in capital
levels that are commensurate with the
bank’s operational risk profile and is
sensitive to changes in the bank’s risk
profile) and can be supported
empirically. Furthermore, the agencies
expect a bank using an alternative
operational risk quantification system to
adhere to the rule’s qualification
requirements, including establishment
and use of operational risk management
processes and data and assessment
systems. As under the proposed rule,
the alternative approach is not available
at the BHC level.
A bank proposing an alternative
approach to operational risk based on an
allocation methodology should be aware
of certain limitations associated with
the use of such an approach.
Specifically, the agencies will not
permit a DI to accept an allocation of
operational risk capital requirements
that includes non-DIs. Unlike the 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 commonly-controlled DI,
there are no statutory provisions
requiring cross-guarantees between a DI
and its non-DI affiliates. 40 Furthermore,
depositors and creditors of a DI
generally have no legal recourse to
40 12
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capital funds that are not held by the DI
or its affiliate DIs.
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6. Data Management and Maintenance
A bank must have data management
and maintenance systems that
adequately support all aspects of the
bank’s advanced IRB systems,
operational risk management processes,
operational risk data and assessment
systems, operational risk quantification
systems, and, to the extent the bank uses
the following systems, the internal
models methodology, the double default
excessive correlation detection process,
the IMA for equity exposures, and the
IAA for securitization exposures to
ABCP programs (collectively, advanced
systems).
The bank’s data management and
maintenance systems must adequately
support the timely and accurate
reporting of risk-based capital
requirements. Specifically, a bank must
retain sufficient data elements related to
key risk drivers to permit monitoring,
validation, and refinement of the bank’s
advanced systems. A bank’s data
management and maintenance systems
should generally support the rule’s
qualification requirements relating to
quantification, validation, and control
and oversight mechanisms, as well as
the bank’s broader risk management and
reporting needs. The precise data
elements to be collected are dictated by
the features and methodologies of the
risk measurement and management
systems employed by the bank. To meet
the significant data management
challenges presented by the
quantification, validation, and control
and oversight requirements of the
advanced approaches, a bank must
retain data in an electronic format that
allows timely retrieval for analysis,
reporting, and disclosure purposes. The
agencies did not receive any material
comments on these data management
requirements.
7. Control and Oversight Mechanisms
The consequences of an inaccurate or
unreliable advanced system can be
significant, particularly regarding the
calculation of risk-based capital
requirements. Accordingly, bank senior
management is responsible for ensuring
that all advanced systems function
effectively and comply with the
qualification requirements.
Under the proposed rule, a bank’s
board of directors (or a designated
committee of the board) would at least
annually evaluate the effectiveness of,
and approve, the bank’s advanced
systems. Multiple commenters objected
to this requirement. Commenters
suggested that a bank’s board of
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directors should have more narrowly
defined responsibilities, and that
evaluation of a bank’s advanced systems
would be more effectively and
appropriately accomplished by senior
management.
The agencies believe that a bank’s
board of directors has ultimate
accountability for the effectiveness of
the bank’s advanced systems. However,
the agencies agree that it is not
necessarily the responsibility of a bank’s
board of directors to conduct an
evaluation of the effectiveness of a
bank’s advanced systems. Evaluation
may include transaction testing,
validation, and audit activities more
appropriately the responsibility of
senior management. Accordingly, the
final rule requires a bank’s board of
directors to review the effectiveness of,
and approve, the bank’s advanced
systems at least annually.
To support senior management’s and
the board of directors’’ oversight
responsibilities, a bank must have an
effective system of controls and
oversight that ensures ongoing
compliance with the qualification
requirements; maintains the integrity,
reliability, and accuracy of the bank’s
advanced systems; and includes
adequate corporate governance and
project management processes. Banks
have flexibility to determine how to
achieve integrity in their risk
management systems. Banks are,
however, expected to follow standard
control principles in their systems such
as checks and balances, separation of
duties, appropriateness of incentives,
and data integrity assurance, including
that of information purchased from
third parties. Moreover, the oversight
process should be sufficiently
independent of the advanced systems’’
development, implementation, and
operation to ensure the integrity of the
component systems. The objective of
risk management system oversight is to
ensure that the various systems used in
determining risk-based capital
requirements are operating as intended.
The oversight process should draw
conclusions on the soundness of the
components of the risk management
system, identify errors and flaws, and
recommend corrective action as
appropriate.
Validation
A bank must validate its advanced
systems on an ongoing basis. Validation
is the set of activities designed to give
the greatest possible assurances of
accuracy of the advanced systems.
Validation includes three broad
components: (i) Evaluation of the
conceptual soundness of the advanced
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69319
systems; (ii) ongoing monitoring that
includes process verification and
comparison of the bank’s internal
estimates with relevant internal and
external data sources or results from
other estimation techniques
(benchmarking); and (iii) outcomes
analysis that includes back-testing.
Each of these three components of
validation must be applied to the bank’s
risk rating and segmentation systems,
risk parameter quantification processes,
and internal models that are part of the
bank’s advanced systems. A sound
validation process should take business
cycles into account, and any
adjustments for stages of the economic
cycle should be clearly specified in
advance and fully documented as part
of the validation policy. Senior
management of the bank should be
notified of the validation results and
should take corrective action where
appropriate.
A bank’s validation process must be
independent of the advanced systems’
development, implementation, and
operation, or be subject to independent
assessment of its adequacy and
effectiveness. A bank should ensure that
individuals who perform the review are
not biased in their assessment due to
their involvement in the development,
implementation, or operation of the
processes or products. For example,
reviews of the internal risk rating and
segmentation systems should be
performed by individuals who were not
part of the development,
implementation, or maintenance of
those systems. In addition, individuals
performing the reviews should possess
the requisite technical skills and
expertise to fulfill their mandate.
The first component of validation is
evaluating conceptual soundness, which
involves assessing the quality of the
design and construction of a risk
measurement or management system.
This evaluation of conceptual
soundness should include
documentation and empirical evidence
supporting the methods used and the
variables selected in the design and
quantification of the bank’s advanced
systems. The documentation should
also evidence an understanding of the
systems’ limitations. The development
of internal risk rating and segmentation
systems and their quantification
processes requires banks to exercise
judgment. Validation should ensure that
these judgments are well informed and
considered, and generally include a
body of expert opinion. A bank should
review developmental evidence
whenever the bank makes material
changes in its advanced systems.
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The second component of the
validation process for a bank’s advanced
systems is ongoing monitoring to
confirm that the systems were
implemented appropriately and
continue to perform as intended. Such
monitoring involves process verification
and benchmarking. Process verification
includes verifying that internal and
external data are accurate and complete,
as well as ensuring that: Internal risk
rating and segmentation systems are
being used, monitored, and updated as
designed; ratings are assigned to
wholesale obligors and exposures as
intended; and appropriate remediation
is undertaken if deficiencies exist.
Benchmarking means the comparison
of a bank’s internal estimates with
relevant internal and external data or
with estimates based on other
estimation techniques. Banks are
required to use alternative data sources
or risk assessment approaches to draw
inferences about the validity of their
internal risk ratings, segmentations, risk
parameter estimates, and model outputs
on an ongoing basis. For credit risk
ratings, examples of alternative data
sources include independent internal
raters (such as loan review), external
rating agencies, wholesale and retail
credit risk models developed
independently, or retail credit bureau
models. Because it may take
considerable time before outcomes with
which to conduct sufficiently robust
backtesting are available, benchmarking
will be a very important validation
device. Benchmarking applies to all
quantification processes and internal
risk rating and segmentation activities.
Benchmarking allows a bank to
compare its estimates with those of
other estimation techniques and data
sources. Results of benchmarking
exercises can be a valuable diagnostic
tool in identifying potential weaknesses
in a bank’s risk quantification system.
While benchmarking activities allow for
inferences about the appropriateness of
the quantification processes and
internal risk rating and segmentation
systems, they are not the same as
backtesting. Differences observed
between the bank’s risk estimates and
the benchmark do not necessarily
indicate that the internal risk ratings,
segmentation decisions, or risk
parameter estimates are in error. The
benchmark itself is an alternative
prediction, and the difference may be
due to different data or methods. As part
of the benchmarking exercise, the bank
should investigate the source of the
differences and whether the extent of
the differences is appropriate.
The third component of the validation
process is outcomes analysis, which is
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the comparison of the bank’s forecasts of
risk parameters and other model outputs
with actual outcomes. A bank’s
outcomes analysis must include
backtesting, which is the comparison of
the bank’s forecasts generated by its
internal models with actual outcomes
during a sample period not used in
model development. In this context,
backtesting is one form of out-of-sample
testing. The agencies note that in other
contexts backtesting may refer to insample 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-byyear realized default rates may be
expected to differ significantly from the
long-run one-year average. Also,
changes in economic conditions
between the historical data and current
period can lead to differences between
actual outcomes and estimates.
One commenter asserted that
requiring a bank to perform a
statistically robust form of backtesting
would be an impractically high standard
for AMA qualification given the nature
of operational risk. The commenter
further claimed that validating an
operational risk model must rely on the
robustness of the logical structure of the
model and the appropriateness of the
resultant operational risk exposure
when benchmarked against other
established reference points.
The agencies recognize that it may
take considerable time before actual
outcomes outside of the sample period
used in model development are
available that would allow a bank to
backtest its operational risk models by
comparing its internal estimates with
these outcomes. The agencies also
acknowledge that a bank may be unable
to backtest an operational risk model
with the same degree of statistical
precision that it is able to backtest an
internal market risk model. When a
bank’s backtesting process is not
sufficiently robust, a bank may need to
rely more heavily on benchmarking and
other alternative validation devices. The
agencies maintain, however, that
backtesting provides important feedback
on the accuracy of model outputs and
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that a bank should be able to assess how
actual losses compare with estimates
previously generated by its model.
Internal Audit
A bank must have an internal audit
function independent of business-line
management that at least annually
assesses the effectiveness of the controls
supporting the bank’s advanced
systems. Internal audit should review
the validation process, including
validation procedures, responsibilities,
results, timeliness, and responsiveness
to findings. Further, internal audit
should evaluate the depth, scope, and
quality of the risk management system
review process and conduct appropriate
testing to ensure that the conclusions of
these reviews are well founded. Internal
audit must report its findings at least
annually to the bank’s board of directors
(or a committee thereof).
Stress Testing
A bank must periodically stress test
its advanced systems. Stress testing
analysis is a means of understanding
how economic cycles, especially
downturns as described by stress
scenarios, affect risk-based capital
requirements, including migration
across rating grades or segments and the
credit risk mitigation benefits of double
default treatment. Stress testing analysis
consists of identifying stress scenarios
and then assessing the effects of the
scenarios on key performance measures,
including risk-based capital
requirements. Under the rule, changes
in borrower credit quality will lead to
changes in risk-based capital
requirements. Because credit quality
changes typically reflect changing
economic conditions, risk-based capital
requirements may also vary with the
economic cycle. During an economic
downturn, risk-based capital
requirements will increase if wholesale
obligors or retail exposures migrate
toward lower credit quality rating
grades or segments.
Supervisors expect banks to manage
their regulatory capital position so that
they remain at least adequately
capitalized during all phases of the
economic cycle. A bank that credibly
estimates regulatory capital levels
during a downturn can be more
confident of appropriately managing
regulatory capital.
Banks should use a range of plausible
but severe scenarios and methods when
stress testing to manage regulatory
capital. Scenarios may be historical,
hypothetical, or model-based. Key
variables specified in a scenario may
include, for example, interest rates,
transition matrices (ratings and score-
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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 subportfolios. The severity of the stress
scenarios should be consistent with the
periodic economic downturns
experienced in the bank’s market areas.
Such scenarios may be less severe than
those used for other purposes, such as
testing a bank’s solvency.
The scope of stress testing analysis
should be broad and include all material
portfolios. The time horizon of the
analysis should be consistent with the
specifics of the scenario and should be
long enough to measure the material
effects of the scenario on key
performance measures. For example, if
a scenario such as a historical recession
has material income and segment or
ratings migration effects over two years,
the appropriate time horizon is at least
two years.
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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
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makes any significant change to its
modeling assumptions.
If an agency determines that a bank
that uses the advanced approaches to
calculate its risk-based capital
requirements has fallen out of
compliance with one or more of the
qualification requirements, the agency
will notify the bank of its failure to
comply. After receiving such notice, a
bank must establish and submit a plan
satisfactory to its primary Federal
supervisor to return to compliance. If
the bank’s primary Federal supervisor
determines that the bank’s risk-based
capital requirements are not
commensurate with the bank’s credit,
market, operational, or other risks, it
may require the bank to calculate its
risk-based capital requirements using
the general risk-based capital rules or a
modified form of the advanced
approaches (for example, with fixed
supervisory risk parameters).
Under the proposed rule, a bank that
fell out of compliance with the
qualification requirements would also
be required to disclose publicly its
noncompliance with the qualification
requirements promptly after receiving
notice of noncompliance from its
primary Federal supervisor.
Commenters objected to this
requirement, noting that it is not one of
the public disclosure requirements of
the New Accord. The agencies have
determined that the public disclosure of
noncompliance is not always necessary,
because the disclosure may not reflect
the degree of noncompliance. Therefore,
the agencies are not including a general
noncompliance disclosure requirement
in the final rule. However, the agencies
acknowledge that a bank’s significant
noncompliance with the qualification
requirements is an important factor in
market participants’ assessments of the
bank’s risk profile and, thus, a primary
Federal supervisor may require public
disclosure of noncompliance with the
qualification requirements if such
noncompliance is significant.
D. Merger and Acquisition Transition
Provisions
Due to the advanced approaches’
rigorous systems requirements, a bank
that merges with or acquires another
company might not be able to quickly
integrate the merged or acquired
company’s exposures into its risk-based
capital calculations. The proposed rule
provided transition provisions that
would allow the acquiring bank time to
integrate the merged or acquired
company into its advanced approaches,
subject to an implementation plan
submitted to the bank’s primary Federal
supervisor. As proposed, the transition
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69321
provisions applied only to banks that
had already qualified to use the
advanced approaches. The agencies
recognize, however, that a bank in the
process of qualifying to use the
advanced approaches may merge with
or acquire a company and need time to
integrate the company into its advanced
approaches on an implementation
schedule distinct from its original
implementation plan. In the final rule,
the agencies are therefore allowing
banks to take advantage of the proposed
rule’s transition provisions for mergers
and acquisitions both before and after
they qualify to use the advanced
approaches.
Under the proposed rule, a bank
could use the transition provisions for
the merged or acquired company’s
exposures for up to 24 months following
the calendar quarter during which the
merger or acquisition consummates. A
bank’s primary Federal supervisor could
extend the transition period for up to an
additional 12 months. Commenters
generally supported this timeframe and
associated supervisory flexibility.
Therefore, the final rule adopts the
proposed rule’s merger and acquisition
transition timeframe without change.
To take advantage of the merger and
acquisition transition provisions, the
acquiring bank must submit to its
primary Federal supervisor an
implementation plan for using the
advanced approaches for the merged or
acquired company. The proposed rule
required a bank to submit such a plan
within 30 days of consummating the
merger or acquisition. Many
commenters asserted that the 30-day
timeframe for submission of an
implementation plan may be too short,
particularly given the many integration
activities that must take place
immediately following the
consummation of a merger or
acquisition. These commenters
generally suggested that banks instead
be given 90 or 180 days to submit the
implementation plan. The agencies
agree with these commenters that the
proposed timeframe for submitting an
implementation plan may be too short.
Accordingly, the final rule requires a
bank to submit an implementation plan
within 90 days of the consummation of
a merger or acquisition.
Under the final rule, if a bank that
uses the advanced approaches to
calculate risk-based capital
requirements merges with or acquires a
company that does not calculate riskbased capital requirements using the
advanced approaches, the acquiring
bank may use the general risk-based
capital rules to compute the riskweighted assets and associated capital
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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 credit-risk-weighted
assets but are included in the acquiring
bank’s total risk-weighted assets. If the
acquiring bank uses the general riskbased capital rules for acquired
exposures, it must disclose publicly the
amounts of risk-weighted assets and
qualifying capital calculated under the
general risk-based capital rules with
respect to the acquired company and
under this rule for the acquiring bank.
The primary Federal supervisor of the
bank will monitor the merger or
acquisition to determine whether the
acquiring bank’s application of the
general risk-based capital rules for the
acquired company produces appropriate
risk-based capital requirements for the
assets of the acquired company in light
of the overall risk profile of the
acquiring bank.
Similarly, a core or opt-in bank that
merges with or acquires another core or
opt-in bank might not be able to apply
its systems for the advanced approaches
immediately to the acquired bank’s
exposures. Accordingly, the final rule
permits a core or opt-in bank that
merges with or acquires another core or
opt-in bank to use the acquired bank’s
advanced approaches to determine the
risk-weighted asset amounts for, and
deductions from capital associated with,
the acquired bank’s exposures during
the merger and acquisition transition
timeframe.
A third potential merger or
acquisition scenario is a bank subject to
the general risk-based capital rules that
merges with or acquires a bank that uses
the advanced approaches. If, after the
merger or acquisition, the acquiring
bank is not a core bank, it could choose
to opt in to the advanced approaches or
to apply the general risk-based capital
rules to the consolidated bank. If the
acquiring bank chooses to remain on the
general risk-based capital rules, the
bank must immediately apply the
general risk-based capital rules to all its
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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exposures, including those of the
acquired bank.
If the acquiring bank chooses or is
required to move to the advanced
approaches, however, it could apply the
advanced approaches to the acquired
exposures (provided that it continues to
meet all of the qualification
requirements for those exposures) for up
to 24 months (with a potential 12-month
extension) while it completes the
process of qualifying to use the
advanced approaches for the entire
bank. If the acquiring bank has not
begun implementing the advanced
approaches at the time of the merger or
acquisition, it may instead use the
transition timeframes described in
section III.A. of the preamble and
section 21 of the final rule. In the latter
case, the bank must consult with its
primary Federal supervisor regarding
the appropriate risk-based capital
treatment of the acquired exposures. In
no case may a bank permanently apply
the advanced approaches only to an
acquired bank’s exposures and not to
the consolidated bank.
Because eligible credit reserves and
the ALLL are treated differently under
the general risk-based capital rules and
the advanced approaches, the final rule
specifies how the acquiring bank must
treat the general allowances associated
with the merged or acquired company’s
exposures during the period when the
general risk-based capital rules apply to
the acquiring bank. Specifically, ALLL
associated with the exposures of the
merged or acquired company may not
be directly included in the acquiring
bank’s tier 2 capital. Rather, any excess
eligible credit reserves (that is, eligible
credit reserves minus total expected
credit losses) associated with the
merged or acquired company’s
exposures may be included in the
acquiring bank’s tier 2 capital up to 0.6
percent of the credit-risk-weighted
assets associated with those exposures.
IV. Calculation of Tier 1 Capital and
Total Qualifying Capital
The final rule maintains the minimum
risk-based capital ratio requirements of
4.0 percent tier 1 capital to total riskweighted assets and 8.0 percent total
qualifying capital to total risk-weighted
assets. A bank’s total qualifying capital
is the sum of its tier 1 (core) capital
elements and tier 2 (supplemental)
capital elements, subject to various
limits and restrictions, minus certain
deductions (adjustments). The agencies
are not restating the elements of tier 1
and tier 2 capital in the final rule. Those
capital elements generally remain as
they are currently in the general risk-
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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 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
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.
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.
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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 working group
that is currently looking at issues related
to the definition of regulatory capital.
Accordingly, the agencies have not
modified the existing definition of
regulatory capital and related
deductions at this time, other than with
respect to implementation of the
advanced approaches.
Under the general risk-based capital
rules, a bank is allowed to include in
tier 2 capital its ALLL up to 1.25 percent
of risk-weighted assets (net of certain
deductions). Amounts of ALLL in
excess of this limit are deducted from
the gross amount of risk-weighted
assets.
Under the proposed rule, the ALLL
was treated differently. The proposed
rule included a methodology for
adjusting risk-based capital
requirements based on a comparison of
the bank’s eligible credit reserves to its
ECL. The proposed rule defined eligible
credit reserves as all general allowances,
including the ALLL, established through
46 By contrast, OTS rules require the deduction of
equity investments from total capital. 12 CFR
567.5(c)(2)(ii). ‘‘Equity investments’’ are defined to
include (i) investments in equity securities (other
than investments in subsidiaries, equity
investments that are permissible for national banks,
indirect ownership interests in certain pools of
assets (for example, mutual funds), Federal Home
Loan Bank stock and Federal Reserve Bank stock);
and (ii) investments in certain real property. 12 CFR
567.1. Savings associations applying the final rule
are not required to deduct investments in equity
securities. Instead, such investments are subject to
the equity treatment in part VI of the final rule.
Equity investments in real estate continue to be
deducted to the same extent as under the general
risk-based capital rules.
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a 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. 390447 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 non-defaulted
obligor or a non-defaulted retail segment
was equal to the product of PD, ELGD,
and EAD for the exposure or segment.
The ECL for non-defaulted exposures
thus reflected expected economic losses,
including the cost of carry and direct
and indirect workout expenses. The
bank’s ECL for a wholesale exposure to
a defaulted obligor or a defaulted retail
segment was equal to the bank’s
impairment estimate for allowance
purposes for the exposure or segment.
The ECL for defaulted exposures thus
was based on accounting measures of
credit loss incorporated into a bank’s
charge-off and reserving practices.
In the proposal, the agencies solicited
comment on a possible alternative
treatment for determining ECL for a
defaulted exposure that would be more
consistent with the proposed treatment
of ECL for non-defaulted exposures.
That alternative approach calculated
ECL as the bank’s current carrying value
of the exposure multiplied by the bank’s
best estimate of the expected economic
loss rate associated with the exposure
(measured relative to the current
carrying value). Commenters on this
issue generally supported the proposed
treatment and expressed some concern
about the added complexity of the
alternative treatment.
The agencies believe that, for
defaulted exposures, any difference
between a bank’s best estimate of
economic losses and its impairment
estimate for ALLL purposes is likely to
be small. The agencies also believe that
the proposed ALLL impairment
approach is less burdensome for banks
than the ‘‘best estimate of economic
loss’’ approach. As a result, the agencies
are retaining this aspect of the proposed
definition of ECL for defaulted
exposures. The agencies recognize that
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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this treatment requires a bank to specify
how much of its ALLL is attributable to
defaulted exposures, and emphasize
that a bank must capture all material
economic losses on defaulted exposures
when building its databases for
estimating LGDs for non-defaulted
exposures.
The agencies also sought comment on
the appropriate measure of ECL for
assets held at fair value with gains and
losses flowing through earnings.
Commenters expressed the view that
there should be no ECL for such assets
because expected losses on such assets
already have been removed from
regulatory capital. The agencies agree
with this position and, therefore, under
the final rule, a bank may assign an ECL
of zero to assets held at fair value with
gains and losses flowing through
earnings. The agencies are otherwise
maintaining the proposed definition of
ECL in the final rule, with the
substitution of LGD for ELGD noted
above.
Under the final rule, consistent with
the proposal, a bank must compare the
total dollar amount of its ECL to its
eligible credit reserves. If there is a
shortfall of eligible credit reserves
compared to total ECL, the bank must
deduct 50 percent of the shortfall from
tier 1 capital and 50 percent from tier 2
capital. If eligible credit reserves exceed
total ECL, the excess portion of eligible
credit reserves may be included in tier
2 capital up to 0.6 percent of credit-riskweighted assets.
A number of commenters objected to
the 0.6 percent limit on inclusion of
excess reserves in tier 2 capital and
suggested that there should be a higher
or no limit on the amount of excess
reserves that may be included in
regulatory capital. While the 0.6 percent
limit is part of the New Accord, some
commenters asserted that this limitation
would put U.S. banks at a competitive
disadvantage because U.S. accounting
practices (as compared to accounting
practices in many other countries) lead
to higher reserves that are more likely to
exceed the limitation. Another
commenter asserted that the proposed
limitation on excess reserves is more
restrictive than the current cap on ALLL
in the general risk-based capital rules.
Finally, several commenters suggested
that because ALLL is the first buffer
against credit losses, it should be
included without limit in tier 1 capital.
The agencies believe that the
proposed 0.6 percent limit on inclusion
of excess reserves in tier 2 capital is
roughly equivalent to the 1.25 percent
cap in the general risk-based capital
rules and serves to maintain general
consistency in the treatment of reserves
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domestically and internationally.
Accordingly, the agencies have included
the 0.6 percent cap in the final rule.
Under the proposed rule, a bank
would deduct from tier 1 capital any
after-tax gain-on-sale. Gain-on-sale was
defined as an increase in a bank’s equity
capital that resulted from a
securitization, other than an increase in
equity capital that resulted from the
bank’s receipt of cash in connection
with the securitization. The agencies
designed this deduction to offset
accounting treatments that produce an
increase in a bank’s equity capital and
tier 1 capital at the inception of a
securitization—for example, a gain
attributable to a CEIO that results from
Financial Accounting Standard (FAS)
140 accounting treatment for the sale of
underlying exposures to a securitization
special purpose entity (SPE). Over time,
as the bank, from an accounting
perspective, realizes the increase in
equity capital and tier 1 capital booked
at the inception of the securitization
through actual receipt of cash flows, the
amount of the required deduction
would shrink accordingly.
Under the general risk-based capital
rules,48 a bank must deduct CEIOs,
whether purchased or retained, from tier
1 capital to the extent that the CEIOs
exceed 25 percent of the bank’s tier 1
capital. Under the proposed rule, a bank
would deduct CEIOs from tier 1 capital
to the extent they represent gain-on-sale,
and would deduct any remaining CEIOs
50 percent from tier 1 capital and 50
percent from tier 2 capital.
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.
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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The agencies received a number of
comments on the proposed
securitization-linked deductions. In
particular, some commenters urged the
agencies to retain the general risk-based
capital rule for deducting only CEIOs
that exceed 25 percent of tier 1 capital.
Some of these commenters noted that
the ‘‘harsher’’ securitization-linked
deductions under the advanced
approaches could have a significant tier
1 capital impact and, accordingly, could
have an unwarranted effect on a bank’s
tier 1 leverage ratio calculation. A few
commenters encouraged the agencies to
permit a bank to replace the deduction
approach for certain securitization
exposures with a 1,250 percent risk
weight approach, in part to mitigate
potential tier 1 leverage ratio effects.
The agencies are retaining the
securitization-related deductions as
proposed. The proposed deductions are
part of the New Accord’s securitization
framework. The agencies believe that
they should be retained to foster
consistency among participants in the
international securitization markets.
The proposed rule also required a
bank to deduct the bank’s exposure on
certain unsettled and failed capital
markets transactions 50 percent from
tier 1 capital and 50 percent from tier 2
capital. The agencies are retaining this
deduction as proposed.
The agencies are also retaining, as
proposed, the deductions in the general
risk-based capital rules for investments
in unconsolidated banking and finance
subsidiaries and reciprocal holdings of
bank capital instruments. Further, the
agencies are retaining the current
treatment for national and state banks
that control or hold an interest in a
financial subsidiary. As required by the
Gramm-Leach-Bliley Act, assets and
liabilities of the financial subsidiary are
not consolidated with those of the bank
for risk-based capital purposes and the
bank must deduct its equity investment
(including retained earnings) in the
financial subsidiary from regulatory
capital—50 percent from tier 1 capital
and 50 percent from tier 2 capital.49 A
49 See Public Law 106–102 (November 12, 1999),
codified, among other places, at 12 U.S.C. 24a. See
also 12 CFR 5.39(h)(1) (national banks); 12 CFR
208.73(a) (state member banks); 12 CFR part 325,
Appendix A, § 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 nonincludable 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
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BHC generally does not deconsolidate
the assets and liabilities of the financial
subsidiaries of the BHC’s subsidiary
banks and does not deduct from its
regulatory capital the equity
investments of its subsidiary banks in
financial subsidiaries. Rather, a BHC
generally fully consolidates the
financial subsidiaries of its subsidiary
banks. These treatments continue under
the final rule.
For BHCs with consolidated
insurance underwriting subsidiaries that
are functionally regulated by a State
insurance regulator (or subject to
comparable supervision and regulatory
capital requirements in a non-U.S.
jurisdiction), the proposed rule set forth
the following treatment. The assets and
liabilities of the subsidiary would be
consolidated for purposes of
determining the BHC’s risk-weighted
assets. However, the BHC would deduct
from tier 1 capital an amount equal to
the insurance underwriting subsidiary’s
minimum regulatory capital
requirement as determined by its
functional (or equivalent) regulator. For
U.S. regulated insurance underwriting
subsidiaries, this amount generally
would be 200 percent of the subsidiary’s
Authorized Control Level as established
by the appropriate state insurance
regulator.
The proposal noted that its approach
with respect to functionally regulated
consolidated insurance underwriting
subsidiaries was different from the New
Accord, which broadly endorses a
deconsolidation and deduction
approach for insurance subsidiaries.
The proposal acknowledged the Board’s
concern that a full deconsolidation and
deduction approach does not capture
the credit risk in insurance
underwriting subsidiaries at the
consolidated BHC level.
Several commenters objected to the
proposed deduction from tier 1 capital
and instead supported a deduction 50
percent from tier 1 capital and 50
percent from tier 2 capital. Others
supported the full deduction and
deconsolidation approach endorsed by
the New Accord and maintained that, by
contrast, the proposed approach was
overly conservative and resulted in a
double-count of capital requirements for
insurance regulation and banking
regulation.
The Board continues to believe that a
consolidated BHC risk-based capital
measure should incorporate all credit,
market, and operational risks to which
the BHC is exposed, regardless of the
bank capital instruments are deducted from a
savings association’s total capital under 12 CFR
567.5(c)(2).
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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.
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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 riskweighted assets for operational risk,
minus the sum of its excess eligible
credit reserves (eligible credit reserves
in excess of its total ECL) not included
in tier 2 capital. Unlike under the
proposal, allocated transfer risk reserves
are not subtracted from total riskweighted 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 riskweighted asset amounts for exposures
that have been grouped into four general
categories: wholesale, retail,
securitization, and equity. It must also
identify and determine risk-weighted
asset amounts for assets not included in
an exposure category and any 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
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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 riskweighted assets, risk-weighted assets for
securitization exposures, and riskweighted assets for equity exposures.
1. Wholesale Exposures
Consistent with the proposed rule, the
final rule defines a wholesale exposure
as a credit exposure to a company,
individual, sovereign entity, or other
governmental entity (other than a
securitization exposure, retail exposure,
or equity exposure).50 The term
‘‘company’’ is broadly defined to mean
a corporation, partnership, limited
liability company, depository
institution, business trust, SPE,
association, or similar organization.
Examples of a wholesale exposure
include: (i) A non-tranched guarantee
issued by a bank on behalf of a
company; 51 (ii) a repo-style transaction
entered into by a bank with a company
and any other transaction in which a
bank posts collateral to a company and
faces counterparty credit risk; (iii) an
exposure that a bank treats as a covered
position under the market risk rule for
which there is a counterparty credit risk
capital requirement; (iv) a sale of
corporate loans by a bank to a third
party in which the bank retains full
recourse; (v) an OTC derivative contract
entered into by a bank with a company;
(vi) an exposure to an individual that is
not managed by the bank as part of a
segment of exposures with
homogeneous risk characteristics; and
(vii) a commercial lease.
The agencies proposed two
subcategories of wholesale exposures—
HVCRE exposures and non-HVCRE
exposures. Under the proposed rule,
HVCRE exposures would be subject to a
separate IRB risk-based capital formula
that would produce a higher risk-based
capital requirement for a given set of
risk parameters than the IRB risk-based
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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capital formula for non-HVCRE
wholesale exposures. Further, the
agencies proposed that once an
exposure was determined to be an
HVCRE exposure, it would remain an
HVCRE exposure until paid in full, sold,
or converted to permanent financing.
The proposed rule defined an HVCRE
exposure as a credit facility that
finances or has financed the acquisition,
development, or construction of real
property, excluding facilities that
finance (i) one-to four-family residential
properties or (ii) commercial real estate
projects that meet the following
conditions: (A) The exposure’s loan-tovalue (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 outof-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 riskweight function for HVCRE exposures is
unnecessary because the higher risk
associated with such exposures would
be reflected in higher PDs and LGDs.
Other commenters stated that tracking
the exception requirements for
acquisition, development, or
construction loans would be
burdensome and expressed concern that
all multifamily loans could be subject to
the HVCRE treatment. Yet other
commenters requested that the agencies
exclude from the definition of HVCRE
all multifamily acquisition,
development, or construction loans;
additional commercial real estate
exposures; and other exposures with
significant project equity and/or pre-sale
commitments. A few commenters
supported the proposed approach to
HVCRE exposures.
The agencies have determined that
the proposed definition of HVCRE
exposures strikes an appropriate balance
between risk-sensitivity and simplicity.
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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Thus, the final rule retains the
definition as proposed. If a bank does
not want to track compliance with the
definition for burden-related reasons,
the bank may choose to apply the
HVCRE risk-weight function to all credit
facilities that finance the acquisition,
construction, or development of
multifamily and commercial real
property. The agencies believe that this
treatment would be an appropriate
application of the principle of
conservatism discussed in section II.D.
of the preamble and set forth in section
1(d) of the final rule.
The New Accord identifies five subclasses of specialized lending for which
the primary source of repayment of the
obligation is the income generated by
the financed asset(s) rather than the
independent capacity of a broader
commercial enterprise. The sub-classes
are project finance, object finance,
commodities finance, income-producing
real estate, and HVCRE. The New
Accord provides a methodology to
accommodate banks that cannot meet
the requirements for the estimation of
PD for these exposure types. The
proposed rule did not include a separate
treatment for specialized lending
beyond the separate IRB risk-based
capital formula for HVCRE exposures
specified in the New Accord. The
agencies noted in the proposal that
sophisticated banks that would be
applying the advanced approaches in
the United States should be able to
estimate risk parameters for specialized
lending. The agencies continue to
believe that banks using the advanced
approaches in the United States should
be able to estimate risk parameters for
specialized lending and, therefore, have
not adopted a separate treatment for
specialized lending in the final rule.
In contrast to the New Accord, the
agencies did not propose a separate riskbased capital function for exposures to
small- and medium-size enterprises
(SMEs). The SME function in the New
Accord generates a lower risk-based
capital requirement for an exposure to
an SME than for an exposure to a larger
firm that has the same risk parameter
values. The agencies were not aware of
compelling evidence that smaller firms
are subject to less systematic risk than
is already reflected in the wholesale
exposure risk-based capital formula,
which specifies lower AVCs as PDs
increase.
A number of commenters objected to
this aspect of the proposal and urged the
agencies to include in the final rule the
SME risk-based capital function from
the New Accord. Several commenters
expressed concern about potential
competitive disparities in the market for
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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 individualexposure 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 fourfamily 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; (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 nonbusiness purposes (other than
residential mortgage exposures and
QREs) that are managed as part of a
segment of similar exposures are other
retail exposures. Such exposures may
include personal term loans, margin
loans, auto loans and leases, credit card
accounts with credit lines above
$100,000, and student loans. There is no
upper limit on the size of these types of
retail exposures to individuals. Second,
exposures to individuals or companies
for business purposes (other than
residential mortgage exposures and
QREs), up to a single-borrower exposure
threshold of $1 million, that are
managed as part of a segment of similar
exposures are other retail exposures. For
the purpose of assessing exposure to a
single borrower, the bank must
aggregate all business exposures to a
particular legal entity and its affiliates
that are consolidated under GAAP. If
that borrower is a natural person, any
consumer loans (for example, personal
credit card loans or mortgage loans) to
that borrower would not be part of the
aggregate. A bank could distinguish a
consumer loan from a business loan by
the loan department through which the
loan is made. Exposures to a borrower
for business purposes primarily secured
by residential property count toward the
$1 million single-borrower other retail
business exposure threshold.54
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
53 The proposed rule excluded from the definition
of a residential mortgage exposure certain pre-sold
one- to-four family residential construction loans
and certain multifamily residential loans. The
treatment of such loans under the final rule is
discussed below in section V.B.5. of the preamble.
54 The proposed rule excluded from the definition
of an other retail exposure certain pre-sold one-tofour 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.
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 riskweight function with a lower AVC for
SME exposures is not substantiated by
sufficient empirical evidence and may
give rise to a domestic competitive
inequity between banks subject to the
advanced approaches and banks subject
to the general risk-based capital rules.
2. Retail Exposures
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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 passthrough securities guaranteed by Fannie
Mae or Freddie Mac (whether or not
issued out of a structure that tranches
credit risk) as securitization exposures.
A synthetic securitization was defined
as a transaction in which (i) all or a
portion of the credit risk of one or more
underlying exposures is transferred to
one or more third parties through the
use of one or more credit derivatives or
guarantees (other than a guarantee that
transfers only the credit risk of an
individual retail exposure); (ii) the
credit risk associated with the
underlying exposures has been
separated into at least two tranches
reflecting different levels of seniority;
(iii) performance of the securitization
exposures depends on the performance
of the underlying exposures; and (iv) all
or substantially all of the underlying
exposures are financial exposures.
Accordingly, the proposed definition of
a securitization exposure included
tranched cover or guarantee
arrangements—that is, arrangements in
which an entity transfers a portion of
the credit risk of an underlying
exposure to one or more guarantors or
credit derivative providers but also
retains a portion of the credit risk,
where the risk transferred and the risk
retained are of different seniority levels.
The preamble to the proposal noted
that, provided there is a tranching of
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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; creditenhancing representations and
warranties; and CEIOs. Securitization
exposures also could include assets sold
with retained tranched recourse.
As explained in the proposal, if a
bank purchases an asset-backed security
issued by a securitization SPE and
purchases a credit derivative to protect
itself from credit losses associated with
the asset-backed security, the purchase
of the credit derivative by the investing
bank does not turn the traditional
securitization into a synthetic
securitization. Instead, the investing
bank would be viewed as having
purchased a traditional securitization
exposure and would reflect the CRM
benefits of the credit derivative through
the securitization CRM rules described
later in the preamble and in section 46
of the rule. Moreover, if a bank provides
a guarantee or a credit derivative on a
securitization exposure, that guarantee
or credit derivative would also be a
securitization exposure.
Commenters raised several objections
to the proposed definitions of
traditional and synthetic securitizations.
First, several commenters objected to
the requirement that all or substantially
all of the underlying exposures must be
financial exposures. These commenters
noted that the securitization market
rapidly evolves and expands to cover
new asset classes—such as intellectual
property rights, project finance
revenues, and entertainment royalties—
that may or may not be financial assets.
Commenters expressed particular
concern that the proposed definitions
may exclude from the securitization
framework leases that include a material
lease residual component.
The agencies believe that requiring all
or substantially all of the underlying
exposures for a securitization to be
financial exposures creates an important
boundary between the wholesale and
retail frameworks, on the one hand, and
the securitization framework, on the
other hand. Accordingly, the agencies
are maintaining this requirement in the
final rule. The securitization framework
was designed to address the tranching of
the credit risk of financial exposures
and was not designed, for example, to
apply to tranched credit exposures to
commercial or industrial companies or
nonfinancial assets. Accordingly, under
the final rule, a specialized loan to
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finance the construction or acquisition
of large-scale projects (for example,
airports and power plants), objects (for
example, ships, aircraft, or satellites), or
commodities (for example, reserves,
inventories, precious metals, oil, or
natural gas) generally is not a
securitization exposure because the
assets backing the loan typically are
nonfinancial assets (the facility, object,
or commodity being financed). In
addition, although some structured
transactions involving incomeproducing 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
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
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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single underlying financial asset in the
final rule. The agencies believe that
basing the applicability of the
securitization framework on the
presence of some minimum number of
underlying exposures would complicate
the rule and would create a divergence
from the New Accord, without any
material improvement in risk
sensitivity. The securitization
framework is designed specifically to
deal with tranched exposures to credit
risk. Moreover, the principal risk-based
capital approaches of the securitization
framework take into account the
effective number of underlying
exposures.
The agencies agree with commenters
that the proposed definition for
securitization exposures was quite
broad and captured some exposures that
would more appropriately be treated
under the wholesale or equity
frameworks. To limit the scope of the
IRB securitization framework, the
agencies have modified the definition of
traditional securitization in the final
rule to make clear that operating
companies are not traditional
securitizations (even if all or
substantially all of their assets are
financial exposures). For purposes of
the final rule’s definition of traditional
securitization, operating companies
generally are companies that produce
goods or provide services beyond the
business of investing, reinvesting,
holding, or trading in financial assets.
Examples of operating companies are
depository institutions, bank holding
companies, securities brokers and
dealers, insurance companies, and nonbank 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
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Federal supervisor of a bank with
discretion to exclude from the definition
of traditional securitization investment
firms that exercise substantially
unfettered control over the size and
composition of their assets, liabilities,
and off-balance sheet transactions. The
agencies will consider a number of
factors in the exercise of this discretion,
including an assessment of the
investment firm’s leverage, risk profile,
and economic substance. This
supervisory exclusion is intended to
provide discretion to a bank’s primary
Federal supervisor to distinguish
structured finance transactions, to
which the securitization framework was
designed to apply, from more flexible
investment firms such as many hedge
funds and private equity funds. Only
investment firms that can easily change
the size and composition of their capital
structure, as well as the size and
composition of their assets and offbalance 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
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appropriate IRB classification is made.
The agencies will consider a number of
factors when assessing the economic
substance of a transaction including, for
example, the amount of equity in the
structure, overall leverage (whether onor off-balance sheet), whether
redemption rights attach to the equity
investor, and the ability of the junior
tranches to absorb losses without
interrupting contractual payments to
more senior tranches.
One commenter asked whether a bank
could ignore the credit protection
provided by a tranched guarantee for
risk-based capital purposes and instead
calculate the risk-based capital
requirement for the guaranteed exposure
as if the guarantee did not exist. The
agencies believe that this treatment
would be an appropriate application of
the principle of conservatism discussed
in section II.D. of this preamble and set
forth in section 1(d) of the final rule.
As noted above, the proposed rule
defined mortgage-backed pass-through
securities guaranteed by Fannie Mae or
Freddie Mac (whether or not issued out
of a structure that tranches credit risk)
as securitization exposures. The
agencies have reconsidered this
proposal and have concluded that a
special treatment for these securities is
inconsistent with the New Accord and
would violate the fundamental credittranching-based nature of the definition
of securitization exposures. The final
rule therefore does not define all
mortgage-backed pass-through securities
guaranteed by Fannie Mae or Freddie
Mac to be securitization exposures. As
a result, those mortgage-backed
securities that involve tranching of
credit risk will be securitization
exposures; those mortgage-backed
securities that do not involve tranching
of credit risk will not be securitization
exposures.56
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
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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securitization SPE. The agencies are
addressing specific commenter concerns
about the burden of applying the
securitization framework to these
exposures in preamble section V.E.
below and section 42(a)(5) of the final
rule.
4. Equity Exposures
The proposed rule defined an equity
exposure to mean:
(i) A security or instrument whether
voting or non-voting that represents a
direct or indirect ownership interest in,
and a residual claim on, the assets and
income of a company, unless: (A) The
issuing company is consolidated with
the bank under GAAP; (B) the bank is
required to deduct the ownership
interest from tier 1 or tier 2 capital; (C)
the ownership interest is redeemable;
(D) the ownership interest incorporates
a payment or other similar obligation on
the part of the issuing company (such as
an obligation to pay periodic interest);
or (E) the ownership interest is a
securitization exposure.
(ii) A security or instrument that is
mandatorily convertible into a security
or instrument described in (i).
(iii) An option or warrant that is
exercisable for a security or instrument
described in (i).
(iv) Any other security or instrument
(other than a securitization exposure) to
the extent the return on the security or
instrument is based on the performance
of a security or instrument described in
(i). For example, a short position in an
equity security or a total return equity
swap would be characterized as an
equity exposure.
The proposal noted that
nonconvertible term or perpetual
preferred stock generally would be
considered wholesale exposures rather
than equity exposures. Financial
instruments that are convertible into an
equity exposure only at the option of the
holder or issuer also generally would be
considered wholesale exposures rather
than equity exposures provided that the
conversion terms do not expose the
bank to the risk of losses arising from
price movements in that equity
exposure. Upon conversion, the
instrument would be treated as an
equity exposure. In addition, the
agencies note that unfunded equity
commitments, which are commitments
to make equity investments at a future
date, meet the definition of an equity
exposure.
Many commenters expressed support
for the proposed definition of equity
exposure, except for the proposed
exclusion of equity investments in
hedge funds and other leveraged
investment vehicles, as discussed above.
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The agencies are adopting the proposed
definition for equity exposures with one
exception. They have eliminated in the
final rule the exclusion of a redeemable
ownership interest from the definition
of equity exposure. The agencies believe
that redeemable ownership interests,
such as those in mutual funds and
private equity funds, are most
appropriately treated as equity
exposures.
The agencies anticipate that, as a
general matter, each of a bank’s
exposures will fit in one and only one
exposure category. One exception to this
principle is that equity derivatives
generally will meet the definition of an
equity exposure (because of the bank’s
exposure to the underlying equity
security) and the definition of a
wholesale exposure (because of the
bank’s credit risk exposure to the
counterparty). In such cases, as
discussed in more detail below, the
bank’s risk-based capital requirement
for the equity derivative generally is the
sum of its risk-based capital
requirement for the derivative
counterparty credit risk and for the
underlying exposure.
5. Boundary Between Operational Risk
and Other Risks
With the introduction of an explicit
risk-based capital requirement for
operational risk, issues arise about the
proper treatment of operational losses
that also could be attributed to either
credit risk or market risk. The agencies
recognize that these boundary issues are
important and have significant
implications for how banks must
compile loss data sets and compute riskbased capital requirements under the
final rule. Consistent with the treatment
in the New Accord and the proposed
rule, banks must treat operational losses
that are related to market risk as
operational losses for purposes of
calculating risk-based capital
requirements under this final rule. For
example, losses incurred from a failure
of bank personnel to properly execute a
stop loss order, from trading fraud, or
from a bank selling a security when a
purchase was intended, must be treated
as operational losses.
Under the proposed rule, banks
would treat losses that are related to
both operational risk and credit risk as
credit losses for purposes of calculating
risk-based capital requirements. For
example, where a loan defaults (credit
risk) and the bank discovers that the
collateral for the loan was not properly
secured (operational risk), the bank’s
resulting loss would be attributed to
credit risk (not operational risk). This
general separation between credit and
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operational risk is supported by current
U.S. accounting standards for the
treatment of credit risk.
To be consistent with prevailing
practice in the credit card industry, the
proposed rule included an exception to
this standard for retail credit card fraud
losses. Specifically, retail credit card
losses arising from non-contractual,
third party-initiated fraud (for example,
identity theft) would be treated as
external fraud operational losses under
the proposed rule. All other third partyinitiated 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 riskbased capital requirements under the
advanced approaches, there should be
consistency across U.S. banks in how
they categorize losses that relate to both
credit risk and operational risk.
Moreover, the agencies believe that
international consistency on this issue
is an important objective. Therefore, the
final rule maintains the proposed
boundaries for losses that relate to both
credit risk and operational risk and does
not incorporate any additional
exemptions beyond that in the proposal.
6. Boundary Between the Final Rule and
the Market Risk Rule
For banks subject to the market risk
rule, the existing market risk rule
applies to all positions classified as
trading positions in regulatory reports.
The New Accord establishes additional
criteria for positions to be eligible for
application of the market risk rule. The
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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.
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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 riskweighted 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 fourphase concept as proposed. Where
applicable, the agencies have clarified
particular issues within the four-phase
process.
1. Phase 1—Categorization of Exposures
In phase 1, a bank must determine
which of its exposures fall into each of
the four principal IRB exposure
categories—wholesale exposures, retail
exposures, securitization exposures, and
equity exposures. In addition, a bank
must identify within the wholesale
exposure category certain exposures that
receive a special treatment under the
wholesale framework. These exposures
include HVCRE exposures, sovereign
exposures, eligible purchased wholesale
exposures, eligible margin loans, repostyle 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
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exposures and exposures to or directly
and unconditionally guaranteed by the
Bank for International Settlements, the
International Monetary Fund, the
European Commission, the European
Central Bank, and multilateral
development banks are exempt from the
0.03 percent floor on PD discussed in
the next section.
The proposed rule recognized as
multilateral development banks only
those multilateral lending institutions or
regional development banks in which
the U.S. government is a shareholder or
contributing member. The final rule
adopts a slightly expanded definition of
multilateral development bank.
Specifically, under the final rule,
multilateral development bank is
defined to include the International
Bank for Reconstruction and
Development, the International Finance
Corporation, the Inter-American
Development Bank, the Asian
Development Bank, the African
Development Bank, the European Bank
for Reconstruction and Development,
the European Investment Bank, the
European Investment Fund, the Nordic
Investment Bank, the Caribbean
Development Bank, the Islamic
Development Bank, the Council of
Europe Development Bank; any
multilateral lending institution or
regional development bank in which the
U.S. government is a shareholder or
contributing member; and any
multilateral lending institution that a
bank’s primary Federal supervisor
determines poses comparable credit
risk.
In phase 1, a bank also must
subcategorize its retail exposures as
residential mortgage exposures, QREs,
or other retail exposures. In addition, a
bank must identify any on-balance sheet
asset that does not meet the definition
of a wholesale, retail, securitization, or
equity exposure, as well as any nonmaterial 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
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part of the process of assigning
wholesale obligors to rating grades, a
bank must identify which of its
wholesale obligors are in default. In
addition, a bank must group its retail
exposures within each retail
subcategory into segments that have
homogeneous risk characteristics. 57
Segmentation is the grouping of
exposures within each subcategory
according to the predominant risk
characteristics of the borrower (for
example, credit score, debt-to-income
ratio, and delinquency) and the
exposure (for example, product type and
LTV ratio). In general, retail segments
should not cross national jurisdictions.
A bank has substantial flexibility to use
the retail portfolio segmentation it
believes is most appropriate for its
activities, subject to the following broad
principles:
• Differentiation of risk—
Segmentation should provide
meaningful differentiation of risk.
Accordingly, in developing its risk
segmentation system, a bank should
consider the chosen risk drivers’ ability
to separate risk consistently over time
and the overall robustness of the bank’s
approach to segmentation.
• Reliable risk characteristics—
Segmentation should use borrowerrelated risk characteristics and
exposure-related risk characteristics that
reliably and consistently over time
differentiate a segment’s risk from that
of other segments.
• Consistency—Risk drivers for
segmentation should be consistent with
the predominant risk characteristics
used by the bank for internal credit risk
measurement and management.
• Accuracy—The segmentation
system should generate segments that
separate exposures by realized
performance and should be designed so
that actual long-run outcomes closely
approximate the retail risk parameters
estimated by the bank.
A bank might choose to segment
exposures by common risk drivers that
are relevant and material in determining
the loss characteristics of a particular
retail product. For example, a bank may
segment mortgage loans by LTV band,
age from origination, geography,
origination channel, and credit score.
Statistical modeling, expert judgment,
or some combination of the two may
determine the most relevant risk drivers.
Alternatively, a bank might segment by
grouping exposures with similar loss
characteristics, such as loss rates or
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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default rates, as determined by
historical performance of segments with
similar risk characteristics.
A bank must segment defaulted retail
exposures separately from nondefaulted retail exposures and should
base the segmentation of defaulted retail
exposures on characteristics that are
most predictive of current loss and
recovery rates. This segmentation
should provide meaningful
differentiation so that individual
exposures within each defaulted
segment do not have material
differences in their expected loss
severity.
Banks commonly obtain tranched
credit protection, for example first-loss
or second-loss guarantees, on certain
retail exposures such as residential
mortgages. The proposal recognized that
the securitization framework, which
applies to tranched wholesale
exposures, is not appropriate for
individual retail exposures. Therefore,
the agencies proposed to exclude
tranched guarantees that apply only to
an individual retail exposure from the
securitization framework. The preamble
to the proposal noted that an important
result of this exclusion is that, in
contrast to the treatment of wholesale
exposures, a bank may recognize
recoveries from both a borrower and a
guarantor for purposes of estimating
LGD for certain retail exposures.
Most commenters who addressed the
agencies’ proposed treatment for
tranched retail guarantees supported the
proposed approach. One commenter
urged the agencies to extend the
treatment of tranched guarantees of
retail exposures to wholesale exposures.
Another commenter asserted that the
proposed treatment was inconsistent
with the New Accord.
The agencies have determined that
while the securitization framework is
the most appropriate risk-based capital
treatment for most tranched guarantees,
the regulatory burden associated with
applying it to tranched guarantees of
individual retail exposures exceeds the
supervisory benefit. The agencies are
therefore adopting the proposed
treatment in the final rule and excluding
tranched guarantees of individual retail
exposures from the securitization
framework.
Some banks expressed concern about
the treatment of eligible margin loans
under the New Accord. Due to the
highly collateralized nature and low
loss frequency of margin loans, banks
typically collect little customer-specific
information that they could use to
differentiate margin loans into
segments. The agencies believe that a
bank could appropriately segment its
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margin loan portfolio using only
product-specific risk drivers, such as
product type and origination channel. A
bank could then use the definition of
default to associate a PD and LGD with
each segment. As described in section
32 of the rule, a bank may adjust the
EAD of eligible margin loans to reflect
the risk-mitigating effect of financial
collateral. If a bank elects this option to
adjust the EAD of eligible margin loans,
it must associate an LGD with the
segment that does not reflect the
presence of collateral.
Under the proposal, if a bank was not
able to estimate PD and LGD for an
eligible margin loan, the bank could
apply a 300 percent risk weight to the
EAD of the loan. Commenters generally
objected to this approach. As discussed
in section III.B.3. of the preamble,
several commenters asserted that the
agencies should permit banks to treat
margin loans and other portfolios that
exhibit low loss frequency or for which
a bank has limited data on a portfolio
basis, by apportioning EL between PD
and LGD for portfolios rather than
estimating each risk parameter
separately. Other commenters suggested
that banks should be expected to
develop sound practices for applying
the IRB approach to such exposures and
adopt an appropriate degree of
conservatism to address the level of
uncertainty in the estimation process.
Several commenters added that if a bank
simply is unable to estimate PD and
LGD for eligible margin loans, they
would support the agencies’ proposal to
apply a flat risk weight to the EAD of
eligible margin loans. However, they
asserted that the risk weight should not
exceed 100 percent given the low levels
of loss associated with these types of
exposures.
As discussed in section III.B.3. of the
preamble, the final rule provides
flexibility and incentives for banks to
develop and document sound practices
for applying the IRB approach to
portfolios with limited data or default
history, which may include eligible
margin loans. However, the agencies
believe that for banks facing particular
challenges with respect to estimating PD
and LGD for eligible margin loans, the
proposed application of a 300 percent
risk weight to the EAD of an eligible
margin loan is a reasonable alternative.
The option balances pragmatism with
the provision of appropriate incentives
for banks to develop processes to apply
the IRB approach to such exposures.
Accordingly, the final rule continues to
provide banks with the option of
applying a 300 percent risk weight to
the EAD of an eligible margin loan for
which it cannot estimate PD and LGD.
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Purchased Wholesale Exposures
A bank may also elect to use a topdown approach, similar to the treatment
of retail exposures, for eligible
purchased wholesale exposures. Under
the final rule, as under the proposal,
this approach may be used for
exposures purchased directly by the
bank. In addition, the final rule clarifies
that this approach also may be used for
exposures purchased by a securitization
SPE in which the bank has invested and
for which the bank calculates the capital
requirement on the underlying
exposures (KIRB) for purposes of the
SFA (as defined in section V.E.4. of the
preamble). Under this approach, in
phase 2, a bank would group its eligible
purchased wholesale exposures into
segments that have homogeneous risk
characteristics. To be an eligible
purchased wholesale exposure, several
criteria must be met:
• The purchased wholesale exposure
must be purchased from an unaffiliated
seller and must not have been directly
or indirectly originated by the
purchasing bank or securitization SPE;
• The purchased wholesale exposure
must be generated on an arm’s-length
basis between the seller and the obligor
(intercompany accounts receivable and
receivables subject to contra-accounts
between firms that buy and sell to each
other would not satisfy this criterion);
• The purchasing bank must have a
claim on all proceeds from the exposure
or a pro rata interest in the proceeds;
• The purchased wholesale exposure
must have an effective remaining
maturity of less than one year; and
• The purchased wholesale exposure
must, when consolidated by obligor, not
represent a concentrated exposure
relative to the portfolio of purchased
wholesale exposures.
Wholesale Lease Residuals
The agencies proposed a treatment for
wholesale lease residuals that differs
from the New Accord. A wholesale lease
residual typically exposes a bank to the
risk of a decline in value of the leased
asset and to the credit risk of the lessee.
Although the New Accord provides for
a flat 100 percent risk weight for
wholesale lease residuals, the preamble
to the proposal noted that the agencies
believed this treatment was excessively
punitive for leases to highly
creditworthy lessees. Accordingly, the
proposed rule required a bank to treat
its net investment in a wholesale lease
as a single exposure to the lessee. As
proposed, there would not be a separate
capital calculation for the wholesale
lease residual. Commenters on this issue
broadly supported the agencies’
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proposed approach. The agencies
believe the proposed approach
appropriately reflects current bank risk
management practice and are adopting
the proposed approach in the final rule.
Commenters also requested this
treatment for retail lease residuals.
However, the agencies have determined
that the proposal to apply a flat 100
percent risk weight for retail lease
residuals, consistent with the New
Accord, appropriately balances risk
sensitivity and complexity and are
maintaining this treatment in the final
rule.
3. Phase 3—Assignment of Risk
Parameters to Wholesale Obligors and
Exposures and Retail Segments
In phase 3, a bank associates a PD
with each wholesale obligor rating
grade; associates an LGD with each
wholesale loss severity rating grade or
assigns an LGD to each wholesale
exposure; assigns an EAD and M to each
wholesale exposure; and assigns a PD,
LGD, and EAD to each segment of retail
exposures. In some cases it may be
reasonable to assign the same PD, LGD,
or EAD to multiple segments of retail
exposures. The quantification phase for
PD, LGD, and EAD can generally be
divided into four steps—obtaining
historical reference data, estimating the
risk parameters for the reference data,
mapping the historical reference data to
the bank’s current exposures, and
determining the risk parameters for the
bank’s current exposures. As discussed
in more detail below, quantification of
M is accomplished through direct
computation based on the contractual
characteristics of the exposure.
A bank should base its estimation of
the values assigned to PD, LGD, and
EAD 58 on historical reference data that
are a reasonable proxy for the bank’s
current exposures and that provide
meaningful predictions of the
performance of such exposures. A
‘‘reference data set’’ consists of a set of
exposures to defaulted wholesale
obligors and defaulted retail exposures
(in the case of LGD and EAD estimation)
or to both defaulted and non-defaulted
wholesale obligors and retail exposures
(in the case of PD estimation).
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
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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the reference data, borrower and loan
characteristics related to the risk
parameters (such as loan terms, LTV
ratio, credit score, income, debt-toincome ratio, or performance history), or
other factors that are related in some
way to the risk parameters. Banks may
use more than one reference data set to
improve the robustness or accuracy of
the parameter estimates.
A bank should then apply statistical
techniques to the reference data to
determine a relationship between risk
characteristics and the estimated risk
parameter. The result of this step is a
model that ties descriptive
characteristics to the risk parameter
estimates. In this context, the term
‘‘model’’ is used in the most general
sense; a model may use simple
concepts, such as the calculation of
averages, or more complex ones, such as
an approach based on rigorous
regression techniques. This step may
include adjustments for differences
between this final rule’s definition of
default and the default definition in the
reference data set, or adjustments for
data limitations. This step includes
adjustments for seasoning effects related
to retail exposures, if material.
A bank may use more than one
estimation technique to generate
estimates of the risk parameters,
especially if there are multiple sets of
reference data or multiple sample
periods. If multiple estimates are
generated, the bank should have a clear
and consistent policy on reconciling
and combining the different estimates.
Once a bank estimates PD, LGD, and
EAD for its reference data sets, it should
create a link between its portfolio data
and the reference data based on
corresponding characteristics. Variables
or characteristics that are available for
the existing portfolio should be mapped
or linked to the variables used in the
default, loss-severity, or exposure
amount model. In order to effectively
map the data, reference data
characteristics need to allow for the
construction of rating and segmentation
criteria that are consistent with those
used on the bank’s portfolio. An
important element of mapping is
making adjustments for differences
between reference data sets and the
bank’s exposures.
Finally, a bank must apply the risk
parameters estimated for the reference
data to the bank’s actual portfolio data.
As noted above, the bank must attribute
a PD to each wholesale obligor risk
grade, an LGD to each wholesale loss
severity grade or wholesale exposure, an
EAD and M to each wholesale exposure,
and a PD, LGD, and EAD to each
segment of retail exposures. If multiple
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data sets or estimation methods are
used, the bank must adopt a means of
combining the various estimates at this
stage.
The final rule, as noted above, permits
a bank to elect to segment its eligible
purchased wholesale exposures like
retail exposures. A bank that chooses to
apply this treatment must directly
assign a PD, LGD, EAD, and M to each
such segment. If a bank can estimate
ECL (but not PD or LGD) for a segment
of eligible purchased wholesale
exposures, the bank must assume that
the LGD of the segment equals 100
percent and that the PD of the segment
equals ECL divided by EAD. The bank
must estimate ECL for the eligible
purchased wholesale exposures without
regard to any assumption of recourse or
guarantees from the seller or other
parties. The bank must then use the
wholesale exposure formula in section
31(e) of the final rule to determine the
risk-based capital requirement for each
segment of eligible purchased wholesale
exposures.
A bank may recognize the credit risk
mitigation benefits of collateral that
secures a wholesale exposure by
adjusting its estimate of the LGD of the
exposure and may recognize the credit
risk mitigation benefits of collateral that
secures retail exposures by adjusting its
estimate of the PD and LGD of the
segment of retail exposures. In certain
cases, however, a bank may take
financial collateral into account in
estimating the EAD of repo-style
transactions, eligible margin loans, and
OTC derivative contracts (as provided in
section 32 of the final rule).
Consistent with the proposed rule, the
final rule also provides that a bank may
use an EAD of zero for (i) derivative
contracts that are publicly traded on an
exchange that requires the daily receipt
and payment of cash-variation margin;
(ii) derivative contracts and repo-style
transactions that are outstanding with a
qualifying central counterparty (defined
below), but not for those transactions
that the qualifying central counterparty
has rejected; and (iii) credit risk
exposures to a qualifying central
counterparty that arise from derivative
contracts and repo-style transactions in
the form of clearing deposits and posted
collateral. The final rule, like the
proposed rule, defines a qualifying
central counterparty as a counterparty
(for example, a clearing house) that: (i)
Facilitates trades between
counterparties in one or more financial
markets by either guaranteeing trades or
novating contracts; (ii) requires all
participants in its arrangements to be
fully collateralized on a daily basis; and
(iii) the bank demonstrates to the
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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 onand off-balance sheet exposures. A bank
that uses an EAD approach to measure
the exposure amount of such
transactions is not required to apply
separately a risk-based capital
requirement to an on-balance sheet
receivable from the counterparty
recorded in connection with that
transaction. Because any exposure
arising from the on-balance sheet
receivable is captured in the risk-based
capital requirement determined under
the EAD approach, a separate capital
requirement would double count the
exposure for regulatory capital
purposes.
A bank may take into account the risk
reducing effects of eligible guarantees
and eligible credit derivatives in
support of a wholesale exposure by
applying the PD substitution approach
or the LGD adjustment approach to the
exposure as provided in section 33 of
the final rule or, if applicable, applying
the double default treatment to the
exposure as provided in section 34 of
the final rule. A bank may decide
separately for each wholesale exposure
that qualifies for the double default
treatment whether to apply the PD
substitution approach, the LGD
adjustment approach, or the double
default treatment. A bank may take into
account the risk-reducing effects of
guarantees and credit derivatives in
support of retail exposures in a segment
when quantifying the PD and LGD of the
segment.
The proposed rule imposed several
supervisory limitations on risk
parameters assigned to wholesale
obligors and exposures and segments of
retail exposures. First, the PD for each
wholesale obligor or segment of retail
exposures could not be less than 0.03
percent, except for exposures to or
directly and unconditionally guaranteed
by a sovereign entity, the Bank for
International Settlements, the
International Monetary Fund, the
European Commission, the European
Central Bank, or a multilateral
development bank, to which the bank
assigns a rating grade associated with a
PD of less than 0.03 percent.
Second, the LGD of a segment of
residential mortgage exposures (other
than segments of residential mortgage
exposures for which all or substantially
all of the principal of the exposures is
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directly and unconditionally guaranteed
by the full faith and credit of a sovereign
entity) could not be less than 10
percent. These supervisory floors on PD
and LGD applied regardless of whether
the bank recognized an eligible
guarantee or eligible credit derivative as
provided in sections 33 and 34 of the
proposed rule.
Commenters did not object to the
floor on PD, and the agencies are
including it in the final rule. A number
of commenters, however, objected to the
10 percent floor on LGD for segments of
residential mortgage exposures. These
commenters asserted that the floor
would penalize low-risk mortgage
lending and would provide a
disincentive for obtaining high-quality
collateral. The agencies continue to
believe that the LGD floor is appropriate
at least until banks and the agencies
gain more experience with the advanced
approaches. Accordingly, the agencies
are maintaining the floor in the final
rule. As the agencies gain more
experience with the advanced
approaches they will reconsider the
need for the floor together with other
calibration issues identified during the
parallel run and transitional floor
periods. The agencies also intend to
address this issue and other calibration
issues with the BCBS and other
supervisory and regulatory authorities,
as appropriate.
The 10 percent LGD floor for
residential mortgage exposures applies
at the segment level. The agencies will
not allow a bank to artificially group
exposures into segments to avoid the
LGD floor for mortgage products. A bank
should use consistent risk drivers to
determine its retail exposure
segmentations and not artificially
segment low LGD loans with higher
LGD loans to avoid the floor.
A bank also must calculate M for each
wholesale exposure. Under the
proposed rule, for wholesale exposures
other than repo-style transactions,
eligible margin loans, and OTC
derivative contracts subject to a
qualifying master netting agreement
(defined in section V.C.2. of this
preamble), M was defined as the
weighted-average remaining maturity
(measured in whole or fractional years)
of the expected contractual cash flows
from the exposure, using the
undiscounted amounts of the cash flows
as weights. A bank could use its best
estimate of future interest rates to
compute expected contractual interest
payments on a floating-rate exposure,
but it could not consider expected but
noncontractually required returns of
principal, when estimating M. A bank
could, at its option, use the nominal
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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 weightedaverage remaining maturity (measured
in whole or fractional years) of the
individual transactions subject to the
qualifying master netting agreement,
with the weight of each individual
transaction set equal to the notional
amount of the transaction. The M for
netting sets for which the bank used the
internal models methodology was
calculated as described in section 32(c)
of the proposed rule.
Many commenters requested more
flexibility in the definition of M,
including the ability to estimate
noncontractually required prepayments
and the ability to use either discounted
or undiscounted cash flows. However,
the agencies believe that the proposed
definition of M, which is consistent
with the New Accord, is appropriately
conservative and provides for a
consistent definition of M across
internationally active banks. The final
rule therefore maintains the proposed
definition of M.
Under the final rule, as under the
proposal, for most exposures M may be
no greater than five years and no less
than one year. For exposures that have
an original maturity of less than one
year and are not part of a bank’s ongoing
financing of the obligor, however, a
bank may set M as low as one day,
consistent with the New Accord. An
exposure is not part of a bank’s ongoing
financing of the obligor if the bank (i)
has a legal and practical ability not to
renew or roll over the exposure in the
event of credit deterioration of the
obligor; (ii) makes an independent
credit decision at the inception of the
exposure and at every renewal or
rollover; and (iii) has no substantial
commercial incentive to continue its
credit relationship with the obligor in
the event of credit deterioration of the
obligor. Examples of transactions that
may qualify for the exemption from the
one-year maturity floor include amounts
due from other banks, including
deposits in other banks; bankers’’
acceptances; sovereign exposures; shortterm self-liquidating trade finance
exposures; repo-style transactions;
eligible margin loans; unsettled trades
and other exposures resulting from
payment and settlement processes; and
collateralized OTC derivative contracts
subject to daily remargining.
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4. Phase 4—Calculation of RiskWeighted Assets
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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
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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 riskbased capital formula specified in Table
B, and multiplying the output of the
formula (K) by the EAD of the exposure
or segment.59 Section 34 contains a
separate double default risk-based
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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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.
BILLING CODE 4810–33–P; 6210–01–P; 6714–01–P;
6720–01–P
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The sum of the dollar risk-based
capital requirements for wholesale
exposures to non-defaulted obligors
(including exposures subject to the
double default treatment described
below) and segments of non-defaulted
retail exposures equals the total dollar
risk-based capital requirement for those
exposures and segments. The total
dollar risk-based capital requirement
multiplied by 12.5 equals the riskweighted asset amount.
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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
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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
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EAD of the exposure. The reason for this
comparison was to ensure that a bank
did not receive a regulatory capital
benefit as a result of the exposure
moving from non-defaulted to defaulted
status.
The proposed rule provided a simpler
approach for segments of defaulted
retail exposures. The dollar risk-based
capital requirement for a segment of
defaulted retail exposures was 0.08
multiplied by the EAD of the segment.
Some commenters objected to the
proposed risk-based capital treatment of
defaulted wholesale exposures, which
differs from the approach in the New
Accord. These commenters contended
that it would be burdensome to track the
pre-default risk-based capital
requirements for purposes of the
proposed comparison. These
commenters also claimed that the cost
and burden of the proposed treatment of
defaulted wholesale exposures would
subject banks to a competitive
disadvantage relative to international
counterparts subject to an approach
similar to that in the New Accord.
In view of commenters’ concerns
about cost and regulatory burden, the
final rule treats defaulted wholesale
exposures the same as defaulted retail
exposures. The dollar risk-based capital
requirement of a wholesale exposure to
a defaulted obligor equals 0.08
multiplied by the EAD of the exposure.
The agencies will review banks’
practices to ensure that banks are not
moving exposures from non-defaulted to
defaulted status for the primary purpose
of obtaining a reduction in risk-based
capital requirements.
To convert the dollar risk-based
capital requirements for defaulted
exposures into a risk-weighted asset
amount, the bank must sum the dollar
risk-based capital requirements for all
wholesale exposures to defaulted
obligors and segments of defaulted retail
exposures and multiply the sum by
12.5.
A bank may assign a risk-weighted
asset amount of zero to cash owned and
held in all offices of the bank or in
transit, and for gold bullion held in the
bank’s own vaults or held in another
bank’s vaults on an allocated basis, to
the extent the gold bullion assets are
offset by gold bullion liabilities. The
risk-weighted asset amount for an onbalance 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 riskweighted asset amount for a portfolio of
exposures that the bank has
demonstrated to its primary Federal
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supervisor’s satisfaction is, when
combined with all other portfolios of
exposures that the bank seeks to treat as
immaterial for risk-based capital
purposes, not material to the bank
generally is its carrying value (for onbalance 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 riskweighted assets are defined as the sum
of risk-weighted assets for wholesale
exposures to non-defaulted obligors and
segments of non-defaulted retail
exposures, wholesale exposures to
defaulted obligors and segments of
defaulted retail exposures, assets not
included in an exposure category, nonmaterial portfolios of exposures (as
calculated under section 31 of the final
rule), and unsettled transactions (as
calculated under section 35 of the final
rule and described in section V.D. of the
preamble) minus the amounts deducted
from capital pursuant to the general
risk-based capital rules (excluding those
deductions reversed in section 12 of the
final rule).
5. Statutory Provisions on the
Regulatory Capital Treatment of Certain
Mortgage Loans
The general risk-based capital rules
assign 50 percent and 100 percent risk
weights to certain one-to four-family
residential pre-sold construction loans
and multifamily residential loans.60 The
agencies adopted these provisions as a
result of the Resolution Trust
Corporation Refinancing, Restructuring,
and Improvement Act of 1991 (RTCRRI
Act).61 The RTCRRI Act mandates that
each agency provide in its capital
regulations (i) A 50 percent risk weight
for certain one-to four-family residential
pre-sold construction loans and
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 a residence
consisting of more than 4 dwelling units if the loan
meets certain criteria outlined in the RTCRRI Act.
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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 fourfamily 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 risksensitive 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 riskbased 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 fourfamily residential construction loans if
the residences have been pre-sold under
firm contracts to purchasers who have
obtained firm commitments for
permanent qualifying mortgages and
have made substantial earnest money
deposits, and the loans meet the other
underwriting characteristics established
by the agencies in the general risk-based
capital rules; 63 (ii) a 50 percent risk
weight for multifamily residential loans
that meet certain statutory loan-to-value,
debt-to-income, amortization, and
performance requirements, and meet the
other underwriting characteristics
established by the agencies in the
general risk-based capital rules; 64 and
(iii) a 100 percent risk weight for oneto 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 riskbased 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
62 See
§§ 618(a) and (b) of the RTCRRI Act.
§ 618(a)(1)((B) of the RTCRRI Act.
64 See § 618(b)(1)(B) of the RTCRRI Act.
65 See § 618(a)(2) of the RTCRRI Act.
63 See
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intent of the New Accord and to its
implementation in other jurisdictions,
and would impose additional
compliance burdens on banks without
any associated benefit.
The agencies agree with these
concerns and have decided to adopt in
the final rule an alternative described in
the preamble to the proposed rule. The
proposed rule’s preamble noted the
tension between the statutory risk
weights provided by the RTCRRI Act
and the more risk-sensitive IRB
approaches to risk-based capital
requirements. The preamble observed
that the RTCRRI Act permits the
agencies to prescribe additional
underwriting characteristics for
identifying loans that are subject to the
50 percent statutory risk weights,
provided these underwriting
characteristics are ‘‘consistent with the
purposes of the minimum acceptable
capital requirements to maintain the
safety and soundness of financial
institutions.’’ The agencies asked
whether they should impose the
following additional underwriting
criteria as additional requirements for a
core or opt-in bank to qualify for the
statutory 50 percent risk weight for a
particular mortgage loan: (i) That the
bank has an IRB risk measurement and
management system in place that
assesses the PD and LGD of prospective
residential mortgage exposures; and (ii)
that the bank’s IRB system generates a
50 percent risk weight for the loan
under the IRB risk-based capital
formula. If the bank’s IRB system does
not generate a 50 percent risk weight for
a particular loan, the loan would not
qualify for the statutory risk weight and
would receive the risk weight generated
by the IRB system.
A few commenters opposed this
alternative approach and indicated that
the additional underwriting criteria
would increase operational burden.
Other commenters, however, observed
that compliance with the additional
underwriting criteria would not be
burdensome.
After careful consideration of the
comments and further analysis of the
text, spirit and legislative history of the
RTCRRI Act, the agencies have
concluded that they should impose the
additional underwriting criteria
described in the preamble to the
proposed rule as minimum
requirements for a core or opt-in bank
to use the statutory 50 percent risk
weight for particular loans. The agencies
believe that the imposition of these
criteria is consistent with the plain
language of the RTCRRI Act, which
allows a bank to use the 50 percent risk
weight only if it meets the additional
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underwriting characteristics established
by the agencies. The agencies have
concluded that the additional
underwriting characteristics imposed in
the final rule are ‘‘consistent with the
purposes of the minimum acceptable
capital requirements to maintain the
safety and soundness of financial
institution,’’ because the criteria will
make the risk-based capital requirement
for these loans a function of each bank’s
historical loss experience for the loans
and will therefore more accurately
reflect the performance and risk of loss
for these loans. The additional
underwriting characteristics are also
consistent with the purposes and
legislative history of RTCRRI Act, which
was designed to reflect the true level of
risk associated with these types of
mortgage loans and to do so in
accordance with the Basel Accord.66
A capital-related provision of the
Federal Deposit Insurance Corporation
Improvement Act of 1991 (‘‘FDICIA’’),
enacted by Congress just four days after
its adoption of the RTCRRI Act, also
supports the addition of the new
underwriting characteristics. Section
305(b)(1)(B) of FDICIA 67 directs each
agency to revise its risk-based capital
standards for insured depository
institutions to ensure that those
standards ‘‘reflect the actual
performance and expected risk of loss of
multifamily mortgages.’’ Although this
addresses only multifamily mortgage
loans (and not one-to four-family
residential pre-sold construction loans),
it provides the agencies with a
Congressional mandate—equal in force
and power to section 618 of the RTCRRI
Act—to enhance the risk sensitivity of
the regulatory capital treatment of
multifamily mortgage loans. Crucially,
the IRB approach required of core and
opt-in banks will produce capital
requirements that more accurately
reflect both performance and risk of loss
for multifamily mortgage loans than
either the Basel I risk weight or the
RTCRRI Act risk weight.
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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69337
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 riskbased capital purposes, a bank should
have in place operational procedures
and risk management processes that
ensure that all documentation used in
collateralizing or guaranteeing a
transaction is legal, valid, binding, and
enforceable under applicable law in the
relevant jurisdictions. The bank should
have conducted sufficient legal review
to reach a well-founded conclusion that
the documentation meets this standard
and should reconduct such a review as
necessary to ensure continuing
enforceability.
Although the use of CRM techniques
may reduce or transfer credit risk, it
simultaneously may increase other
risks, including operational, liquidity,
and market risks. Accordingly, it is
imperative that banks employ robust
procedures and processes to control
risks, including roll-off risk and
concentration of risks, arising from the
bank’s use of CRM techniques and to
monitor the implications of using CRM
techniques for the bank’s overall credit
risk profile.
1. Collateral
Under the final rule, a bank generally
recognizes collateral that secures a
wholesale exposure as part of the LGD
estimation process and generally
recognizes collateral that secures a retail
exposure as part of the PD and LGD
estimation process, as described above
in section V.B.3. of the preamble.
However, in certain limited
circumstances described in the next
section, a bank may adjust EAD to
reflect the risk mitigating effect of
financial collateral.
Although the final rule does not
contain specific regulatory requirements
about how a bank incorporates collateral
into PD or LGD estimates, a bank
should, when reflecting the credit risk
mitigation benefits of collateral in its
estimation of the risk parameters of a
wholesale or retail exposure:
(i) Conduct sufficient legal review to
ensure, at inception and on an ongoing
basis, that all documentation used in the
collateralized transaction is binding on
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all parties and legally enforceable in all
relevant jurisdictions;
(ii) Consider the correlation between
obligor risk and collateral risk in the
transaction;
(iii) Consider any currency and/or
maturity mismatch between the hedged
exposure and the collateral;
(iv) Ground its risk parameter
estimates for the transaction in
historical data, using historical recovery
rates where available; and
(v) Fully take into account the time
and cost needed to realize the
liquidation proceeds and the potential
for a decline in collateral value over this
time period.
The bank also should ensure that:
(i) The legal mechanism under which
the collateral is pledged or transferred
ensures that the bank has the right to
liquidate or take legal possession of the
collateral in a timely manner in the
event of the default, insolvency, or
bankruptcy (or other defined credit
event) of the obligor and, where
applicable, the custodian holding the
collateral;
(ii) The bank has taken all steps
necessary to fulfill legal requirements to
secure its interest in the collateral so
that it has and maintains an enforceable
security interest;
(iii) The bank has clear and robust
procedures to ensure observation of any
legal conditions required for declaring
the default of the borrower and prompt
liquidation of the collateral in the event
of default;
(iv) The bank has established
procedures and practices for (A)
conservatively estimating, on a regular
ongoing basis, the market value of the
collateral, taking into account factors
that could affect that value (for example,
the liquidity of the market for the
collateral and obsolescence or
deterioration of the collateral), and (B)
where applicable, periodically verifying
the collateral (for example, through
physical inspection of collateral such as
inventory and equipment); and
(v) The bank has in place systems for
promptly requesting and receiving
additional collateral for transactions
whose terms require maintenance of
collateral values at specified thresholds.
2. Counterparty Credit Risk of RepoStyle Transactions, Eligible Margin
Loans, and OTC Derivative Contracts
This section describes two EAD-based
methodologies—a collateral haircut
approach and an internal models
methodology—that a bank may use
instead of an LGD estimation
methodology to recognize the benefits of
financial collateral in mitigating the
counterparty credit risk associated with
repo-style transactions, eligible margin
loans, collateralized OTC derivative
contracts, and single product groups of
such transactions with a single
counterparty subject to a qualifying
master netting agreement (netting
sets).68 A third methodology, the simple
VaR methodology, is also available to
recognize financial collateral mitigating
the counterparty credit risk of single
product netting sets of repo-style
transactions and eligible margin loans.
These methodologies are substantially
the same as those in the proposal,
except for a few differences identified
below.
One difference from the proposal is
that, consistent with the New Accord,
under the final rule these three
methodologies may also be used to
recognize the benefits of any collateral
(not only financial collateral) mitigating
the counterparty credit risk of repo-style
transactions that are included in a
bank’s VaR-based measure under the
market risk rule. In response to
comments requesting broader
application of the EAD-based
methodologies for recognizing the riskmitigating effect of collateral, the
agencies added this flexibility to the
final rule to enhance international
consistency and reduce regulatory
burden.
A bank may use any combination of
the three methodologies for collateral
recognition; however, it must use the
same methodology for similar
exposures. This means that, as a general
matter, the agencies expect a bank to use
one of the three methodologies for all its
repo-style transactions, one of the three
methodologies for all its eligible margin
loans, and one of the three
methodologies for all its OTC derivative
contracts. A bank may, however, apply
a different methodology to subsets of
repo-style transactions, eligible margin
loans, or OTC derivatives by product
type or geographical location if its
application of different methodologies is
designed to separate transactions that do
not have similar risk profiles and is not
designed to arbitrage the rule. For
example, a bank may choose to use one
methodology for agency securities
lending transactions—that is, repo-style
transactions in which the bank, acting
as agent for a customer, lends the
customer’s securities and indemnifies
the customer against loss—and another
methodology for all other repo-style
transactions.
This section also describes the
methodology for calculating EAD for an
OTC derivative contract or set of OTC
derivative contracts subject to a
qualifying master netting agreement.
Table C illustrates which EAD
estimation methodologies may be
applied to particular types of exposure.
TABLE C
Models approach
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OTC derivative .................................................................................................
Recognition of collateral for OTC derivatives ..................................................
Repo-style transaction .....................................................................................
Eligible margin loan .........................................................................................
Cross-product netting set ................................................................................
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
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Current exposure methodology
Collateral haircut approach
X
........................
........................
........................
........................
........................
70 X
X
X
........................
counterparty that are subject to a qualifying crossproduct master netting agreement.
69 Only repo-style transactions and eligible
margin loans subject to a single-product qualifying
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Simple VaR 69
methodology
Internal models methodology
........................
........................
X
X
........................
X
X
X
X
X
master netting agreement are eligible for the simple
VaR methodology.
70 In conjunction with the current exposure
methodology.
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Qualifying Master Netting Agreement
Under the final rule, consistent with
the proposal, a qualifying master netting
agreement is defined to mean any
written, legally enforceable bilateral
agreement, provided that:
(i) The agreement creates a single
legal obligation for all individual
transactions covered by the agreement
upon an event of default, including
bankruptcy, insolvency, or similar
proceeding, of the counterparty;
(ii) The agreement provides the bank
the right to accelerate, terminate, and
close-out on a net basis all transactions
under the agreement and to liquidate or
set off collateral promptly upon an
event of default, including upon an
event of bankruptcy, insolvency, or
similar proceeding, of the counterparty,
provided that, in any such case, any
exercise of rights under the agreement
will not be stayed or avoided under
applicable law in the relevant
jurisdictions;
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69 Only repo-style transactions and eligible
margin loans subject to a single-product qualifying
master netting agreement are eligible for the simple
VaR methodology.
70 In conjunction with the current exposure
methodology.
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(iii) The bank has conducted
sufficient legal review to conclude with
a well-founded basis (and has
maintained sufficient written
documentation of that legal review) that
the agreement meets the requirements of
paragraph (ii) of this definition and that
in the event of a legal challenge
(including one resulting from default or
from bankruptcy, insolvency, or similar
proceeding) the relevant court and
administrative authorities would find
the agreement to be legal, valid, binding,
and enforceable under the law of the
relevant jurisdictions;
(iv) The bank establishes and
maintains procedures to monitor
possible changes in relevant law and to
ensure that the agreement continues to
satisfy the requirements of this
definition; and
(v) The agreement does not contain a
walkaway clause (that is, a provision
that permits a non-defaulting
counterparty to make lower payments
than it would make otherwise under the
agreement, or no payment at all, to a
defaulter or the estate of a defaulter,
even if the defaulter or the estate of the
defaulter is a net creditor under the
agreement).
The agencies consider the following
jurisdictions to be relevant for a
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69339
qualifying master netting agreement: the
jurisdiction in which each counterparty
is chartered or the equivalent location in
the case of non-corporate entities, and if
a branch of a counterparty is involved,
then also the jurisdiction in which the
branch is located; the jurisdiction that
governs the individual transactions
covered by the agreement; and the
jurisdiction that governs the agreement.
EAD for Repo-Style Transactions and
Eligible Margin Loans
Under the final rule, a bank may
recognize the risk-mitigating effect of
financial collateral that secures a repostyle 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.
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The proposed rule defined a repostyle 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 closeout the transaction on a net basis and to
liquidate or set off collateral promptly
upon an event of default (including
upon an event of bankruptcy,
insolvency, or similar proceeding) of the
counterparty, provided that, in any such
case, any exercise of rights under the
agreement will not be stayed or avoided
under applicable law in the relevant
jurisdictions;71 and
71 This
requirement is met where all transactions
under the agreement (i) are executed under U.S. law
and (ii) constitute ‘‘securities contracts’’ or
‘‘repurchase agreements’’ under section 555 or 559,
respectively, of the Bankruptcy Code (11 U.S.C. 555
or 559), qualified financial contracts under section
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(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 repo11(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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style transaction definition in
accordance with the 2006 interagency
securities borrowing rule.72 Under the
securities borrowing rule, the agencies
accorded preferential risk-based capital
treatment for cash-collateralized
securities borrowing transactions that
either met a bankruptcy standard such
as the standard in criterion (iii) above or
were overnight or unconditionally
cancelable at any time by the bank.
Commenters maintained that banks are
able to terminate promptly a repo-style
transaction with a counterparty whose
financial condition is deteriorating so
long as the transaction is done on an
overnight basis or is unconditionally
cancelable by the bank. As a result,
these commenters contended that events
of default and losses on such
transactions are very rare.
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
72 71
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definition for a material proportion of
their repo-style transactions. Consistent
with the 2006 securities borrowing rule,
a reasonably short notice period,
typically no more than the standard
settlement period associated with the
securities underlying the repo-style
transaction, would not detract from the
unconditionality of the bank’s
termination rights. With regard to
overnight transactions, the counterparty
generally should have no expectation,
either explicit or implicit, that the bank
will automatically roll over the
transaction. The agencies are
maintaining in substance all the other
components of the proposed definition
of repo-style transaction.
The proposed rule defined an eligible
margin loan as an extension of credit
where:
(i) The credit extension is
collateralized exclusively by debt or
equity securities that are liquid and
readily marketable;
(ii) The collateral is marked to market
daily and the transaction is subject to
daily margin maintenance requirements;
(iii) The extension of credit is
conducted under an agreement that
provides the bank the right to accelerate
and terminate the extension of credit
and to liquidate or set off collateral
promptly upon an event of default
(including upon an event of bankruptcy,
insolvency, or similar proceeding) of the
counterparty, provided that, in any such
case, any exercise of rights under the
agreement will not be stayed or avoided
under applicable law in the relevant
jurisdictions; 73 and
(iv) The bank has conducted and
documented sufficient legal review to
conclude with a well-founded basis that
the agreement meets the requirements of
paragraph (iii) of this definition and is
legal, valid, binding, and enforceable
under applicable law in the relevant
jurisdictions.
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
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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date far in the future is more
appropriately reflected as a discounted
positive cash flow in LGD estimation.
Criterion (iii) is satisfied when the bank
has conducted sufficient legal review to
conclude with a well-founded basis
(and has maintained sufficient written
documentation of that legal review) that
a margin loan would be exempt from the
bankruptcy auto-stay. The agencies are
therefore maintaining substantially the
same definition of eligible margin loan
in the final rule.
With the exception of repo-style
transactions that are included in a
bank’s VaR-based measure under the
market risk rule (as discussed above),
for purposes of determining EAD for
repo-style transactions, eligible margin
loans, and OTC derivatives, and
recognizing collateral mitigating the
counterparty credit risk of such
exposures, the final rule (consistent
with the proposed rule) allows banks to
take into account only financial
collateral. The proposed rule defined
financial collateral as collateral in the
form of any of the following instruments
in which the bank has a perfected, first
priority security interest or the legal
equivalent thereof: (i) Cash on deposit
with the bank (including cash held for
the bank by a third-party custodian or
trustee); (ii) gold bullion; (iii) long-term
debt securities that have an applicable
external rating of one category below
investment grade or higher (for example,
at least BB–); (iv) short-term debt
instruments that have an applicable
external rating of at least investment
grade (for example, at least A–3); (v)
equity securities that are publicly
traded; (vi) convertible bonds that are
publicly traded; and (vii) mutual fund
shares and money market mutual fund
shares if a price for the shares is
publicly quoted daily.
In connection with this definition, the
agencies asked for comment on the
appropriateness of requiring that a bank
have a perfected, first priority security
interest, or the legal equivalent thereof,
in the definition of financial collateral.
A couple of commenters supported this
requirement, but several other
commenters objected. The objecting
commenters acknowledged that the
requirement would generally be
consistent with current U.S. collateral
practices for repo-style transactions,
eligible margin loans, and OTC
derivatives, but they criticized the
requirement on the grounds that: (i)
Obtaining a perfected, first priority
security interest may not be the current
market practice outside the United
States; (ii) U.S. practices may evolve in
such a fashion as to not meet this
requirement; and (iii) the requirement is
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69341
not explicit in the New Accord. Other
commenters asked the agencies to
clarify that the requirement would be
met for all or certain forms of collateral
if the bank had possession and control
of the collateral and a reasonable basis
to believe it could promptly liquidate
the collateral.
The agencies believe that in order to
use the EAD adjustment approaches for
exposures within the United States, a
bank must have a perfected, first
priority security interest in collateral,
with the exception of cash on deposit
with the bank and certain custodial
arrangements. The agencies have
modified the proposed requirement to
address a concern raised by several
commenters that a bank could fail to
satisfy the first priority security interest
requirement because of the senior
security interest of a third-party
custodian involved as an intermediary
in the transaction. Under the final rule,
a bank meets the security interest
requirement so long as the bank has a
perfected, first priority security interest
in the collateral notwithstanding the
prior security interest of any custodial
agent. Outside of the United States, the
definition of financial collateral can be
satisfied as long as the bank has the
legal equivalent of a perfected, first
priority security interest. For example,
cash on deposit with the bank is an
example of the legal equivalent of a
perfected, first priority security interest.
The agencies intend to apply this ‘‘legal
equivalent’’ standard flexibly to deal
with non-U.S. collateral access regimes.
The agencies also invited comment on
the extent to which assets that do not
meet the definition of financial
collateral are the basis of repo-style
transactions engaged in by banks or are
taken by banks as collateral for eligible
margin loans or OTC derivatives. The
agencies also inquired as to whether the
definition of financial collateral should
be expanded to reflect any other asset
types.
A substantial number of commenters
asked the agencies to add asset types to
the list of financial collateral. The
principal recommended additions
included: (i) Non-investment-grade
externally rated bonds; (ii) bonds that
are not externally rated; (iii) all financial
instruments; (iv) letters of credit; (v)
mortgages loans; and (vi) certificates of
deposit. Some commenters that
advocated inclusion of a wider range of
bonds admitted that it may be
reasonable to impose some sort of
liquidity requirement on the additional
bonds and to impose a 25–50 percent
standard supervisory haircut for such
additional bonds. Some of the
commenters that advocated inclusion of
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a broader range of bonds and mortgages
asserted that such inclusion would be
warranted by the exemption from
bankruptcy auto-stay accorded to repostyle 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 repostyle transactions would be based on
collateral that is sufficiently liquid to
justify applying the EAD approach.
The agencies have included
conforming residential mortgages in the
definition of financial collateral and as
acceptable underlying instruments in
the definitions of repo-style transaction
and eligible margin loan based on the
liquidity of such mortgages and their
widespread use as collateral in repostyle transactions. However, because
this inclusion goes beyond the New
Accord’s recognition of financial
collateral, the agencies decided to take
a conservative approach and require
banks to use the standard supervisory
haircut approach, with a 25 percent
haircut and minimum ten-business-day
holding period, in order to recognize
conforming residential mortgage
collateral in EAD (other than for repostyle transactions that are included in a
bank’s VaR-based measure under the
market risk rule). Use of the standard
supervisory haircut approach for repostyle 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
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74 11
U.S.C. 559.
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collateralized by other types of financial
collateral. Due to concerns about both
competitive equity and the liquidity and
price availability of other types of
collateral, the agencies are not otherwise
expanding the proposed definition of
financial collateral in the final rule.
Collateral Haircut Approach
Under the collateral haircut approach
of the final rule, similar to the proposed
rule, a bank must set EAD equal to the
sum of three quantities: (i) The value of
the exposure less the value of the
collateral; (ii) the absolute value of the
net position in a given instrument or in
gold (where the net position in a given
instrument or in gold equals the sum of
the current market values of the
instrument or gold the bank has lent,
sold subject to repurchase, or posted as
collateral to the counterparty minus the
sum of the current market values of that
same instrument or gold the bank has
borrowed, purchased subject to resale,
or taken as collateral from the
counterparty) multiplied by the market
price volatility haircut appropriate to
the instrument or gold; and (iii) the sum
of the absolute values of the net position
of any cash or instruments in each
currency that is different from the
settlement currency multiplied by the
haircut appropriate to each currency
mismatch. To determine the appropriate
haircuts, a bank may choose to use
standard supervisory haircuts or, with
prior written approval from its primary
Federal supervisor, its own estimates of
haircuts.
In the preamble to the proposed rule,
for purposes of the collateral haircut
approach, the agencies clarified that a
given security would include, for
example, all securities with a single
Committee on Uniform Securities
Identification Procedures (CUSIP)
number and would not include
securities with different CUSIP
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numbers, even if issued by the same
issuer with the same maturity date. The
agencies sought comment on alternative
approaches for determining a given
security for purposes of the collateral
haircut approach. A few commenters
expressed support for the proposed
CUSIP approach to defining a given
security, but one commenter asked the
agencies to permit each bank the
flexibility to define given security. The
collateral haircut approach in the final
rule is based on a bank’s net position in
a ‘‘given instrument or gold’’ rather than
in a ‘‘given security’’ to more precisely
capture the positions to which a bank
must apply the haircuts. To enhance
safety and soundness and comparability
across banks, the agencies believe that it
is important to preserve the relatively
clear CUSIP approach to defining a
given instrument for purposes of the
collateral haircut approach.
Accordingly, the agencies are
maintaining the CUSIP approach as
appropriate for determining a given
instrument for instruments that are
securities.
Standard supervisory haircuts. Under
the final rule, as under the proposed
rule, if a bank chooses to use standard
supervisory haircuts, it must use an 8
percent haircut for each currency
mismatch and the haircut appropriate to
each security in Table D below. These
haircuts are based on the ten-businessday holding period for eligible margin
loans and must be multiplied by the
square root of 1⁄2 to convert the standard
supervisory haircuts to the fivebusiness-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.
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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.
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
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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calculate security type and currency
mismatch haircuts using its own
internal estimates of market price
volatility and foreign exchange
volatility. The bank’s primary Federal
supervisor would base approval to use
internally estimated haircuts on the
satisfaction of certain minimum
qualitative and quantitative standards.
These standards include: (i) The bank
must use a 99th percentile one-tailed
confidence interval and a minimum
five-business-day holding period for
repo-style transactions and a minimum
ten-business-day holding period for all
other transactions; (ii) the bank must
adjust holding periods upward where
and as appropriate to take into account
the illiquidity of an instrument; (iii) the
bank must select a historical observation
period for calculating haircuts of at least
one year; and (iv) the bank must update
its data sets and recompute haircuts no
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69343
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
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relevant categories, the bank must at a
minimum take into account (i) the type
of issuer of the security; (ii) the
applicable external rating of the
security; (iii) the maturity of the
security; and (iv) the interest rate
sensitivity of the security. A bank must
calculate a separate internally estimated
haircut for each individual debt security
that has an applicable external rating
below investment grade and for each
individual equity security. In addition,
a bank must internally estimate a
separate currency mismatch haircut for
each individual mismatch between each
net position in a currency that is
different from the settlement currency.
One commenter recommended that
the agencies permit banks to use
category-based internal estimate
haircuts for non-investment-grade bonds
and equity securities. The agencies have
decided to adopt the proposed rule’s
provisions on category-based haircuts
because they are consistent with the
New Accord and because the volatilities
of non-investment-grade bonds and of
equity securities are more dependent on
idiosyncratic, issuer-specific events
than the volatility of investment-grade
bonds.
Under the final rule, as under the
proposal, when a bank calculates an
internally estimated haircut on a TN-day
holding period, which is different from
the minimum holding period for the
transaction type, the bank must
calculate the applicable haircut (HM)
using the following square root of time
formula:
HM = HN
TM
,
TN
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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.
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Simple VaR Methodology
As noted above, under the final rule,
as under the proposal, a bank may use
one of two internal models approaches
to recognize the risk mitigating effects of
financial collateral that secures a repostyle 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, onetailed confidence interval for an
increase in the value of the exposures
minus the value of the collateral
(SE¥SC) over a five-business-day
holding period for repo-style
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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 includes, for example,
agency mortgage-backed securities
transactions conducted in the To-BeAnnounced market.
Figure 3 illustrates the treatment of
OTC derivative contracts.
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Current Exposure Methodology
The final rule’s current exposure
methodology for determining EAD for
single OTC derivative contracts is
similar to the methodology in the
general risk-based capital rules and is
the same as the current exposure
methodology in the proposal. Under the
current exposure methodology, the EAD
for an OTC derivative contract is equal
to the sum of the bank’s current credit
exposure and PFE on the derivative
contract. The current credit exposure for
a single OTC derivative contract is the
greater of the mark-to-market value of
the derivative contract or zero.
The final rule’s current exposure
methodology for OTC derivative
contracts subject to qualifying master
netting agreements is also similar to the
treatment in the agencies’ general riskbased 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
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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
76 This requirement was found in footnote 8 of the
proposed rule text (in section 32(b)(2)).
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69345
derivative products and reliance on
commissioned legal opinions as to the
enforceability of these contracts should
be a sufficient guarantor of
enforceability. These commenters added
that reliance on such commissioned
legal opinions is standard market
practice.
The agencies continue to believe that
the legal enforceability of netting
agreements is a necessary condition for
a bank to recognize netting effects in its
capital calculation. However, the
agencies have conducted additional
analysis and agree that a unique, written
legal opinion is not necessary in all
cases to ensure the enforceability of an
OTC derivative netting agreement.
Accordingly, the agencies have removed
the requirement that a bank obtain a
written and well reasoned legal opinion
for each of its qualifying master netting
agreements that cover OTC derivatives.
As a result, under the final rule, to
obtain netting treatment for multiple
OTC derivative contracts subject to a
qualifying master netting agreement, a
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bank must conduct sufficient legal
review to conclude with a well-founded
basis (and maintain sufficient written
documentation of that legal review) that
the agreement would provide
termination netting benefits and is legal,
valid, binding, and enforceable. In some
cases, this requirement could be met by
reasoned reliance on a commissioned
legal opinion or an in-house counsel
analysis. In other cases, however—for
example, involving certain new
derivative transactions or derivative
counterparties in unusual
jurisdictions—the bank would need to
obtain an explicit written legal opinion
from external or internal legal counsel
addressing the particular situation.
The proposed rule’s conversion factor
(CF) matrix used to compute PFE was
based on the matrices in the general
risk-based capital rules, with two
exceptions. First, under the proposed
rule, the CF for credit derivatives that
are not used to hedge the credit risk of
exposures subject to an IRB credit risk
capital requirement was specified to be
5.0 percent for contracts with
investment-grade reference obligors and
10.0 percent for contracts with noninvestment-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 riskreducing effects of the financial
collateral, the bank may either adjust
the LGD of the contract or, if the
transaction is subject to daily marking77 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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to-market and remargining, adjust the
EAD of the contract using the collateral
haircut approach for repo-style
transactions and eligible margin loans
described above and in section 32(b) of
the rule.
Under part VI of the final rule, and of
the proposed rule, a bank must treat an
equity derivative contract as an equity
exposure and compute a risk-weighted
asset amount for that exposure. If the
bank is using the internal models
approach for its equity exposures, it also
must compute a risk-weighted asset
amount for its counterparty credit risk
exposure on the equity derivative
contract. However, if the bank is using
the simple risk weight approach for its
equity exposures, it may choose not to
hold risk-based capital against the
counterparty credit risk of the equity
derivative contract. Likewise, a bank
that purchases a credit derivative that is
recognized under section 33 or 34 of the
rule as a credit risk mitigant for an
exposure that is not a covered position
under the market risk rule does not have
to compute a separate counterparty
credit risk capital requirement for the
credit derivative.78 If a bank chooses not
to hold risk-based capital against the
counterparty credit risk of such equity
or credit derivative contracts, it must do
so consistently for all such equity
derivative contracts or for all such credit
derivative contracts. Further, where the
contracts are subject to a qualifying
master netting agreement, the bank must
either include them all or exclude them
all from any measure used to determine
counterparty credit risk exposure to all
relevant counterparties for risk-based
capital purposes.
In addition, where a bank provides
protection through a credit derivative
that is not treated as a covered position
under the market risk rule, it must treat
the credit derivative as a wholesale
exposure to the reference obligor and
compute a risk-weighted asset amount
for the credit derivative under section
31 of the rule. The bank need not
compute a counterparty credit risk
capital requirement for the credit
derivative, so long as it does so
consistently for all such credit
derivatives and either includes all or
excludes all such credit derivatives that
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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are subject to a qualifying master netting
agreement from any measure used to
determine counterparty credit risk
exposure to all relevant counterparties
for risk-based capital purposes. Where
the bank provides protection through a
credit derivative treated as a covered
position under the market risk rule, it
must compute a counterparty credit risk
capital requirement for the credit
derivative under section 31 of the rule.
4. Internal Models Methodology
The final rule, like the proposed rule,
includes an internal models
methodology for the calculation of EAD
for the counterparty credit exposure of
OTC derivatives, eligible margin loans,
and repo-style transactions. The internal
models methodology requires a risk
model that estimates EAD at the level of
a netting set. A transaction not subject
to a qualifying master netting agreement
is considered to be its own netting set
and a bank must calculate EAD for each
such transaction individually.
A bank may use the internal models
methodology for OTC derivatives
(collateralized or uncollateralized) and
single-product netting sets thereof, for
eligible margin loans and single-product
netting sets thereof, or for repo-style
transactions and single-product netting
sets thereof. A bank that uses the
internal models methodology for a
particular transaction type (that is, OTC
derivative contracts, eligible margin
loans, or repo-style transactions) must
use the internal models methodology for
all transactions of that transaction type.
However, a bank may choose whether or
not to use the internal models
methodology for each transaction type.
A bank also may use the internal
models methodology for OTC
derivatives, eligible margin loans, and
repo-style transactions subject to a
qualifying cross-product master netting
agreement if (i) the bank effectively
integrates the risk mitigating effects of
cross-product netting into its risk
management and other information
technology systems; and (ii) the bank
obtains the prior written approval of its
primary Federal supervisor.
The final rule tracks the proposed rule
by defining a qualifying cross-product
master netting agreement as a qualifying
master netting agreement that provides
for termination and close-out netting
across multiple types of financial
transactions or qualifying master netting
agreements in the event of a
counterparty’s default, provided that:
(i) The underlying financial
transactions are OTC derivative
contracts, eligible margin loans, or repostyle transactions; and
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(ii) The bank obtains a written legal
opinion verifying the validity and
enforceability of the netting agreement
under applicable law of the relevant
jurisdictions if the counterparty fails to
perform upon an event of default,
including upon an event of bankruptcy,
insolvency, or similar proceeding.
As discussed in the proposal, banks
use several measures to manage their
exposure to the counterparty credit risk
of repo-style transactions, eligible
margin loans, and OTC derivatives,
including PFE, expected exposure (EE),
and expected positive exposure (EPE).
PFE is the maximum exposure
estimated to occur over a future horizon
at a high level of statistical confidence.
Banks often use PFE when measuring
counterparty credit risk exposure
against counterparty credit limits. EE is
the expected value of the probability
distribution of non-negative credit risk
exposures to a counterparty at any
specified future date, whereas EPE is the
time-weighted average of individual
expected exposures estimated for a
given forecasting horizon (one year in
the proposed rule). The final rule
clarifies that, when estimating EE, a
bank must set any negative market
values in the probability distribution of
market values to a counterparty at a
specified future date to zero to convert
the probability distribution of market
values to the probability distribution of
credit risk exposures. Banks typically
compute EPE, EE, and PFE using a
common stochastic model.
A paper published by the BCBS in
July 2005 titled ‘‘The Application of
Basel II to Trading Activities and the
Treatment of Double Default Effects’’
notes that EPE is an appropriate EAD
measure for determining risk-based
capital requirements for counterparty
credit risk because transactions with
counterparty credit risk ‘‘are given the
same standing as loans with the goal of
reducing the capital treatment’s
influence on a firm’s decision to extend
an on-balance sheet loan rather than
engage in an economically equivalent
transaction that involves exposure to
counterparty credit risk.’’ 79 An
adjustment to EPE, called ‘‘effective
EPE’’ and described below, is used in
the calculation of EAD under the
internal models methodology. EAD is
calculated as a multiple of effective EPE.
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
79 BCBS, ‘‘The Application of Basel II to Trading
Activities and the Treatment of Double Default
Effects,’’ July 2005, ¶ 15.
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risk) or may underestimate the
exposures of eligible margin loans, repostyle transactions, and OTC derivatives
with short maturities, the final rule, like
the proposed rule, uses a netting set’s
effective EPE as the basis for calculating
EAD for counterparty credit risk.
Consistent with the use of a one-year PD
horizon, effective EPE is the timeweighted average of effective EE over
one year where the weights are the
proportion that an individual effective
EE represents in a one-year time
interval. If all contracts in a netting set
mature before one year, effective EPE is
the average of effective EE until all
contracts in the netting set mature. For
example, if the longest maturity contract
in the netting set matures in six months,
effective EPE would be the average of
effective EE over six months.
Effective EE is defined as:
Effective EEtk = max(Effective EEtk-1,
EEtk)
where exposure is measured at future dates
t1, t2, t3, * * * and effective EEt0 equals
current exposure. Alternatively, a bank may
use a measure that is more conservative than
effective EPE for every counterparty (that is,
a measure based on peak exposure) with
prior approval of its primary Federal
supervisor.
The final rule clarifies that if a bank
hedges some or all of the counterparty
credit risk associated with a netting set
using an eligible credit derivative, the
bank may take the reduction in
exposure to the counterparty into
account when estimating EE. If the bank
recognizes this reduction in exposure to
the counterparty in its estimate of EE, it
must also use its internal model to
estimate a separate EAD for the bank’s
exposure to the protection provider of
the credit derivative.
The EAD for instruments with
counterparty credit risk must be
determined assuming economic
downturn conditions. To accomplish
this determination in a prudent manner,
the internal models methodology sets
EAD equal to EPE multiplied by a
scaling factor termed ‘‘alpha.’’ Alpha is
set at 1.4; a bank’s primary Federal
supervisor has the flexibility to raise
this value based on the bank’s specific
characteristics of counterparty credit
risk. In addition, with supervisory
approval, a bank may use its own
estimate of alpha, subject to a floor of
1.2.
In the proposal, the agencies
requested comment on all aspects of the
effective EPE approach to counterparty
credit risk and, in particular, on the
appropriateness of the monotonically
increasing effective EE function, the
alpha constant of 1.4, and the floor on
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69347
internal estimates of alpha of 1.2.
Commenters expressed a number of
objections to the proposed rule’s
internal models methodology.
Several commenters contended that
banks that use the internal models
methodology should be permitted to
calculate effective EPE at the
counterparty level and should not be
required to calculate effective EPE at the
netting set level. These commenters
indicated that while the New Accord
mandates calculation at the netting set
level, those banks that currently use an
EPE-style approach to measuring
counterparty credit risk for internal risk
management purposes typically use a
counterparty-by-counterparty EPE
approach. They asserted that forcing
banks to use a netting-set-by-netting-set
approach would be burdensome for
banks and would provide the agencies
no material regulatory benefits, as
netting effects are taken into account in
the calculation of EE.
The agencies have retained the netting
set focus of the calculation of effective
EPE to preserve international
consistency. The agencies will continue
to review the implications, particularly
with respect to the appropriate
recognition of netting benefits, of
allowing banks to calculate effective
EPE at the counterparty level.
One commenter objected to the
proposed rule’s requirement that a bank
use effective EE (as opposed to EE). This
commenter contended that effective EE
is an excessively conservative and
imprecise mechanism to address
rollover risk in a portfolio of short-term
transactions. The commenter
represented that rollover risk should be
addressed under Pillar 2 rather than
Pillar 1. The agencies continue to
believe that rollover risk is a core credit
risk that should be covered by explicit
risk-based capital requirements. The
agencies also remain concerned that EE
and EPE (as opposed to effective EE and
effective EPE) would not adequately
incorporate rollover risk and do not
believe that bank internal estimates of
rollover risk are sufficiently reliable at
this time to use for risk-based capital
purposes. To ensure consistency with
the New Accord and in light of the lack
of alternative prudent mechanisms to
incorporate rollover risk, the agencies
continue to include effective EE and
effective EPE in the final rule.
Several commenters criticized the
default alpha of 1.4 and the 1.2 floor on
internal estimates of alpha. These
commenters contended that these
supervisory alphas were too
conservative for many dealer banks with
large, diverse, and granular portfolios of
repo-style transactions, eligible margin
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loans, and OTC derivatives. Although
the agencies acknowledge the
possibility that certain banks with
certain types of portfolios at certain
times could warrant an alpha of less
than 1.2, the agencies believe it is
important to have a supervisory floor on
alpha. This floor will ensure
consistency with the New Accord,
comparability among the various banks
that use the internal models
methodology, and sufficient capital
through the economic cycle for
securities financing transactions and
OTC derivatives. Therefore, the agencies
are retaining the alpha floor as
proposed.
Similar to the proposal, under the
final rule a bank’s primary Federal
supervisor must determine that the bank
meets certain qualifying criteria before
the bank may use the internal models
methodology. These criteria consist of
the following operational requirements,
modeling standards, and model
validation requirements.
First, the bank must have the systems
capability to estimate EE on a daily
basis. While this requirement does not
require the bank to report EE daily, or
even estimate EE daily, the bank must
demonstrate that it is capable of
performing the estimation daily.
Second, the bank must estimate EE at
enough future time points to accurately
reflect all future cash flows of contracts
in the netting set. To accurately reflect
the exposure arising from a transaction,
the model should incorporate those
contractual provisions, such as reset
dates, that can materially affect the
timing, probability, or amount of any
payment. The requirement reflects the
need for an accurate estimate of EPE.
However, in order to balance the ability
to calculate exposures with the need for
information on timely basis, the number
of time points is not specified.
Third, the bank must have been using
an internal model that broadly meets the
minimum standards to calculate the
distributions of exposures upon which
the EAD calculation is based for a
period of at least one year prior to
approval. This requirement is to ensure
that the bank has integrated the
modeling into its counterparty credit
risk management process.
Fourth, the bank’s model must
account for the non-normality of
exposure distribution where
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appropriate. Non-normality of exposure
distribution means high loss events
occur more frequently than would be
expected on the basis of a normal
distribution, the statistical term for
which is leptokurtosis. In many
instances, there may not be a need to
account for this. Expected exposures are
much less likely to be affected by
leptokurtosis than peak exposures or
high percentile losses. However, the
bank must demonstrate that its EAD
measure is not affected by leptokurtosis
or must account for it within the model.
Fifth, the bank must measure,
monitor, and control the exposure to a
counterparty over the whole life of all
contracts in the netting set, in addition
to accurately measuring and actively
monitoring the current exposure to
counterparties. The bank should
exercise active management of both
existing exposure and exposure that
could change in the future due to
market moves.
Sixth, the bank must be able to
measure and manage current exposures
gross and net of collateral held, where
appropriate. The bank must estimate
expected exposures for OTC derivative
contracts both with and without the
effect of collateral agreements. By
contrast, under the proposed rule, a
bank would have to measure and
manage current exposure gross and net
of collateral held. Some commenters
criticized this requirement as
inconsistent with the New Accord and
bank internal risk management
practices. The agencies agree and have
revised the rule to only require a bank
to ‘‘be able to’’ measure and manage
current exposures gross and net of
collateral.
Seventh, the bank must have
procedures to identify, monitor, and
control specific wrong-way risk
throughout the life of an exposure. In
this context, wrong-way risk is the risk
that future exposure to a counterparty
will be high when the counterparty’s
probability of default is also high.
Wrong-way risk generally arises from
events specific to the counterparty,
rather than broad market downturns.
Eighth, the data used by the bank
should be adequate for the measurement
and modeling of the exposures. In
particular, the model must use current
market data to compute current
exposures. When a bank uses historical
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data to estimate model parameters, the
bank must use at least three years of
data that cover a wide range of
economic conditions. This requirement
reflects the longer horizon for
counterparty credit risk exposures
compared to market risk exposures. The
data must be updated at least quarterly
or more frequently if market conditions
warrant. Banks should consider using
model parameters based on forward
looking measures, where appropriate.
Ninth, the bank must subject its
models used in the calculation of EAD
to an initial validation and annual
model review process. The model
review should consider whether the
inputs and risk factors, as well as the
model outputs, are appropriate. The
review of outputs should include a
rigorous program of backtesting model
outputs against realized exposures.
Maturity Under the Internal Models
Methodology
Like corporate loan exposures,
counterparty exposure on netting sets is
susceptible to changes in economic
value that stem from deterioration in the
counterparty’s creditworthiness short of
default. The effective maturity
parameter (M) reflects the impact of
these changes on capital. The formula
used to compute M for netting sets with
maturities greater than one year must be
different than that generally applied to
wholesale exposures in order to reflect
how counterparty credit exposures
change over time. The final rule’s
definition of M under the internal
models methodology is identical to that
of the proposed rule and is based on a
weighted average of expected exposures
over the life of the transactions relative
to their one year exposures. Consistent
with the New Accord, the final rule
expands upon the proposal by providing
that a bank that uses an internal model
to calculate a one-sided credit valuation
adjustment may use the effective credit
duration estimated by the model as
M(EPE) in place of the formula in the
paragraph below.
If the remaining maturity of the
exposure or the longest-dated contract
contained in a netting set is greater than
one year, the bank must set M for the
exposure or netting set equal to the
lower of 5 years or M(EPE), where:
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Collateral Agreements Under the
Internal Models Methodology
The provisions of the final rule on
collateral agreements under the internal
models methodology are the same as
those of the proposed rule. Under the
final rule, if a bank has prior written
approval from its primary Federal
supervisor, it may capture within its
internal model the effect on EAD of a
collateral agreement that requires
receipt of collateral when exposure to
the counterparty increases. In no
circumstances, however, may a bank
take into account in EAD collateral
agreements triggered by deterioration of
counterparty credit quality. Several
commenters asked the agencies to
permit banks to incorporate in EAD
collateral agreements that are dependent
on a decline in the external rating of the
counterparty. The agencies do not
believe that banks are able to model the
necessary correlations with sufficient
reliability to accept these types of
collateral agreements under the internal
models methodology at this time.
In the context of the internal models
methodology, the rule defines a
collateral agreement as a legal contract
that: (i) Specifies the time when, and
circumstances under which, the
counterparty is required to exchange
collateral with the bank for a single
financial contract or for all financial
contracts covered under a qualifying
master netting agreement; and (ii)
confers upon the bank a perfected, first
priority security interest
(notwithstanding the prior security
interest of any custodial agent), or the
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legal equivalent thereof, in the collateral
posted by the counterparty under the
agreement. This security interest must
provide the bank with a right to close
out the financial positions and the
collateral upon an event of default of or
failure to perform by the counterparty
under the collateral agreement. A
contract would not satisfy this
requirement if the bank’s exercise of
rights under the agreement may be
stayed or avoided under applicable law
in the relevant jurisdictions.
If a bank’s internal model does not
capture the effects of collateral
agreements, the final rule provides a
‘‘shortcut’’ method to provide the bank
with some benefit, in the form of a
smaller EAD, for collateralized
counterparties. Under the shortcut
method, effective EPE is the lesser of a
threshold amount (linked to the
exposure amount at which a
counterparty must post collateral) plus
an add-on and effective EPE without a
collateral agreement. Although any bank
may use this ‘‘shortcut’’ method under
the internal models methodology, the
agencies expect banks that make
extensive use of collateral agreements to
develop the modeling capacity to
measure the impact of such agreements
on EAD. The shortcut method provided
in the final rule is identical to the
shortcut method provided in the
proposed rule.
Alternative Methods
Under the final rule, consistent with
the proposed rule, a bank using the
internal models methodology may use
an alternative method to determine EAD
for certain transactions, provided that
the bank can demonstrate to its primary
Federal supervisor that the method’s
output is more conservative than an
alpha of 1.4 (or higher) times effective
EPE.
Use of an alternative method may be
appropriate where a new product or
business line is being developed, where
a recent acquisition has occurred, or
where the bank believes that other more
conservative methods to measure
counterparty credit risk for a category of
transactions are prudent. The alternative
method should be applied to all similar
transactions. When an alternative
method is used, the bank should either
treat the particular transactions
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concerned as a separate netting set with
the counterparty or apply the alternative
model to the entire original netting set.
The agencies recognize that for new
OTC derivative products a bank may
need a transition period during which to
incorporate a new product into its
internal models methodology or to
demonstrate that an alternative method
is more conservative than an alpha of
1.4 (or higher) times effective EPE. The
final rule therefore provides that for
material portfolios of new OTC
derivative products, a bank may assume
that the current exposure methodology
in section 32(c) of the rule meets the
conservatism requirement for a period
not longer than 180 days. As a general
matter, the agencies expect that the
current exposure methodology in
section 32(c) of the rule would be an
acceptable, more conservative method
for immaterial portfolios of OTC
derivatives.
5. Guarantees and Credit Derivatives
That Cover Wholesale Exposures
The New Accord specifies that a bank
may adjust either the PD or the LGD of
a wholesale exposure to reflect the risk
mitigating effects of a guarantee or
credit derivative. Similarly, under the
final rule, as under the proposed rule,
a bank may choose either a PD
substitution or an LGD adjustment
approach to recognize the risk
mitigating effects of an eligible
guarantee or eligible credit derivative on
a wholesale exposure (or in certain
circumstances may choose to use a
double default treatment, as discussed
below). In all cases a bank must use the
same risk parameters for calculating
ECL for a wholesale exposure as it uses
for calculating the risk-based capital
requirement for the exposure. Moreover,
in all cases, a bank’s ultimate PD and
LGD for the hedged wholesale exposure
may not be lower than the PD and LGD
floors discussed above and described in
section 31(d) of the rule.
Eligible Guarantees and Eligible Credit
Derivatives
Under the proposed rule, guarantees
and credit derivatives had to meet
specific eligibility requirements to be
recognized as CRM for a wholesale
exposure. The proposed rule defined an
eligible guarantee as a guarantee that:
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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.
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(i) Is written and unconditional;
(ii) Covers all or a pro rata portion of
all contractual payments of the obligor
on the reference exposure;
(iii) Gives the beneficiary a direct
claim against the protection provider;
(iv) Is non-cancelable by the
protection provider for reasons other
than the breach of the contract by the
beneficiary;
(v) Is legally enforceable against the
protection provider in a jurisdiction
where the protection provider has
sufficient assets against which a
judgment may be attached and enforced;
and
(vi) Requires the protection provider
to make payment to the beneficiary on
the occurrence of a default (as defined
in the guarantee) of the obligor on the
reference exposure without first
requiring the beneficiary to demand
payment from the obligor.
Commenters suggested a number of
improvements to the proposed
definition of eligible guarantee. One
commenter asked the agencies to clarify
that the unconditionality requirement in
criterion (i) of the definition would be
interpreted consistently with the New
Accord’s requirement that ‘‘there should
be no clause in the protection contract
outside the direct control of the bank
that could prevent the protection
provider from being obliged to pay out
in a timely manner in the event that the
original counterparty fails to make the
payment(s) due.’’ 80 The agencies are not
providing the requested clarification.
The agencies have acquired
considerable experience in the intricate
issue of the conditionality of guarantees
under the general risk-based capital
rules and intend to address the meaning
of ‘‘unconditional’’ in the context of
eligible guarantees under this final rule
on a case-by-case basis going forward.
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
80 New
Accord, ¶189.
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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 principalonly 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 noncancelable by the protection provider
unilaterally.
One commenter asked the agencies to
modify the fifth criterion of the eligible
guarantee definition, which requires the
guarantee to be legally enforceable in a
jurisdiction where the protection
provider has sufficient assets, by
deleting the word ‘‘sufficient.’’ The
agencies have preserved the fifth
criterion of the proposed definition
intact. The agencies do not think that it
would be consistent with safety and
soundness to permit a bank to obtain
CRM benefits under the rule if the
guarantee were not legally enforceable
against the protection provider in a
jurisdiction where the protection
provider has sufficient available assets.
Finally, some commenters objected to
the sixth and final criterion of the
eligible guarantee definition, which
requires the protection provider to make
payments to the beneficiary upon
default of the obligor without first
requiring the beneficiary to demand
payment from the obligor. The agencies
have decided to modify this criterion to
make it more consistent with the New
Accord and actual market practice. The
final rule’s sixth criterion requires only
that the guarantee permit the bank to
obtain payment from the protection
provider in the event of an obligor
default in a timely manner and without
first having to take legal actions to
pursue the obligor for payment.
The agencies also have performed
additional analysis and review of the
definition of eligible guarantee and have
decided to add two additional criteria to
the definition. The first additional
criterion prevents guarantees from
certain affiliated companies from being
eligible guarantees. Under the final rule,
a guarantee will not be an eligible
guarantee if the protection provider is
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an affiliate of the bank (other than an
affiliated depository institution, bank,
securities broker or dealer, or insurance
company that does not control the bank
and that is subject to consolidated
supervision and regulation comparable
to that imposed on U.S. depository
institutions, securities broker-dealers, or
insurance companies). For purposes of
the definition, an affiliate of a bank is
defined as a company that controls, is
controlled by, or is under common
control with, the bank. Control of a
company is defined as (i) ownership,
control, or holding with power to vote
25 percent or more of a class of voting
securities of the company; or (ii)
consolidation of the company for
financial reporting purposes.
The strong correlations among the
financial conditions of affiliated parties
would typically render guarantees from
affiliates of the bank of little value
precisely when the bank would need
them most—when the bank itself is in
financial distress.81 For example, a
guarantee that a bank might receive
from its parent shell bank holding
company would provide little credit risk
mitigation to the bank as the bank
approached insolvency because the
financial condition of the holding
company would depend critically on
the financial health of the subsidiary
bank. Moreover, the holding company
typically would experience no increase
in its regulatory capital requirement for
issuing the guarantee because the
guarantee would be on behalf of a
consolidated subsidiary and would be
eliminated in the consolidation of the
holding company’s financial
statements.82
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
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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depository institution for this purpose
includes all subsidiaries of the
depository institution except financial
subsidiaries. The final rule recognizes
guarantees from these types of affiliates
because they are financial institutions
subject to prudential regulation by
national or state supervisory authorities.
The agencies expect that the prudential
regulation of the affiliate would help
prevent the affiliate from exposing itself
excessively to the credit exposures of
the bank. Similarly, these affiliates
would be subject to regulatory capital
requirements of their own and should
experience an increase in their
regulatory capital requirements for
issuing the guarantee.
The second additional criterion
precludes a guarantee from eligible
guarantee status if the guarantee
increases the beneficiary’s cost of credit
protection in response to deterioration
in the credit quality of the reference
exposure. This additional criterion is
consistent with the New Accord’s
treatment of guarantees and with the
proposed rule’s operational
requirements for synthetic
securitizations.
The proposed rule defined an eligible
credit derivative as a credit derivative in
the form of a credit default swap, nth-todefault swap, or total return swap
provided that:
(i) The contract meets the
requirements of an eligible guarantee
and has been confirmed by the
protection purchaser and the protection
provider;
(ii) Any assignment of the contract
has been confirmed by all relevant
parties;
(iii) If the credit derivative is a credit
default swap or nth-to-default swap, the
contract includes the following credit
events:
(A) Failure to pay any amount due
under the terms of the reference
exposure (with a grace period that is
closely in line with the grace period of
the reference exposure); and
(B) Bankruptcy, insolvency, or
inability of the obligor on the reference
exposure to pay its debts, or its failure
or admission in writing of its inability
generally to pay its debts as they
become due, and similar events;
(iv) The terms and conditions
dictating the manner in which the
contract is to be settled are incorporated
into the contract;
(v) If the contract allows for cash
settlement, the contract incorporates a
robust valuation process to estimate loss
reliably and specifies a reasonable
period for obtaining post-credit event
valuations of the reference exposure;
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(vi) If the contract requires the
protection purchaser to transfer an
exposure to the protection provider at
settlement, the terms of the exposure
provide that any required consent to
transfer may not be unreasonably
withheld;
(vii) If the credit derivative is a credit
default swap or nth-to-default swap, the
contract clearly identifies the parties
responsible for determining whether a
credit event has occurred, specifies that
this determination is not the sole
responsibility of the protection
provider, and gives the protection
purchaser the right to notify the
protection provider of the occurrence of
a credit event; and
(viii) If the credit derivative is a total
return swap and the bank records net
payments received on the swap as net
income, the bank records offsetting
deterioration in the value of the hedged
exposure (either through reductions in
fair value or by an addition to reserves).
Commenters generally supported the
proposed rule’s definition of eligible
credit derivative, but two commenters
asked for a series of changes. These
commenters asked that the final rule
specifically reference contingent credit
default swaps (CCDSs) in the list of
eligible forms of credit derivatives.
CCDS are a relatively new type of credit
derivative, and the agencies are still
considering their appropriate role
within the risk-based capital rules.
However, to enable the rule to adapt to
future market innovations, the agencies
have revised the definition of eligible
credit derivative to add to the list of
eligible credit derivative forms ‘‘any
other form of credit derivative approved
by’’ the bank’s primary Federal
supervisor.83
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
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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69351
the eligible credit derivative definition
to the current standard market practice.
Under the final rule, therefore, a credit
derivative will satisfy the definition of
an eligible credit derivative if the
protection provider’s obligation to make
default payments to the protection
purchaser is triggered only if the
reference obligor’s failure to pay
exceeds any applicable minimal
payment threshold that is consistent
with standard market practice.
Finally, a commenter asked for
clarification of the meaning of the sixth
criterion of the definition of eligible
credit derivative, which states that if the
contract requires the protection
purchaser to transfer an exposure to the
protection provider at settlement, the
terms of the exposure provide that any
required consent to transfer may not be
unreasonably withheld. To address any
potential ambiguity about which
exposure’s transferability must be
analyzed, the agencies have amended
the sixth component to read: ‘‘If the
contract requires the protection
purchaser to transfer an exposure to the
protection provider at settlement, the
terms of at least one of the exposures
that is permitted to be transferred under
the contract must provide that any
required consent to transfer may not be
unreasonably withheld.’’
The proposed rule also provided that
a bank may recognize an eligible credit
derivative that hedges an exposure that
is different from the credit derivative’s
reference exposure used for determining
the derivative’s cash settlement value,
deliverable obligation, or occurrence of
a credit event only if:
(i) The reference exposure ranks pari
passu (that is, equal) or junior to the
hedged exposure; and
(ii) The reference exposure and the
hedged exposure are exposures to the
same legal entity, and legally
enforceable cross-default or crossacceleration clauses are in place.
One commenter acknowledged that
the proposal’s pari passu ceiling is
consistent with the New Accord but
asked for clarification that the provision
only requires reference exposure
equality or subordination with respect
to priority of payments. Although the
agencies have concluded that it is not
necessary to amend the rule to provide
this clarification, the agencies agree that
the pari passu ceiling relates to priority
of payments only.
Two commenters also asked the
agencies to provide an exception to the
cross-default/cross-acceleration
requirement where the hedged exposure
is an OTC derivative contract or a
qualifying master netting agreement that
covers OTC derivative contracts.
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Although some parts of the debt markets
have incorporated obligations from OTC
derivative contracts in cross-default/
cross-acceleration clauses, the
commenter asserted that the practice is
not prevalent in many parts of the
market. In addition, the commenter
maintained that, unlike a failure to pay
on a loan or a bond, failure to pay on
an OTC derivative contract generally
would not trigger a credit event with
respect to the reference exposure of the
credit default swap. The agencies have
not made this change. The proposed
cross-default/cross-acceleration
requirement is consistent with the New
Accord. In addition, the agencies are
reluctant to permit a bank to obtain
CRM benefits for an exposure hedged by
a credit derivative whose reference
exposure is different than the hedged
exposure unless the hedged and
reference exposures would default
simultaneously. If the hedged exposure
could default prior to the default of the
reference exposure, the bank may suffer
losses on the hedged exposure and not
be able to collect default payments on
the credit derivative. The final rule
clarifies that, in order to recognize the
credit risk mitigation benefits of an
eligible credit derivative, cross-default/
cross-acceleration provisions must
assure payments under the credit
derivative are triggered if the obligor
fails to pay under the terms of the
hedged exposure.
PD Substitution Approach
Under the PD substitution approach
of the final rule, as under the proposal,
if the protection amount (as defined
below) of the eligible guarantee or
eligible credit derivative is greater than
or equal to the EAD of the hedged
exposure, a bank may substitute for the
PD of the hedged exposure the PD
associated with the rating grade of the
protection provider. If the bank
determines that full substitution leads to
an inappropriate degree of risk
mitigation, the bank may substitute a
higher PD for that of the protection
provider.
If the guarantee or credit derivative
provides the bank with the option to
receive immediate payout on triggering
the protection, then the bank must use
the lower of the LGD of the hedged
exposure (not adjusted to reflect the
guarantee or credit derivative) and the
LGD of the guarantee or credit
derivative. If the guarantee or credit
derivative does not provide the bank
with the option to receive immediate
payout on triggering the protection (and
instead provides for the guarantor to
assume the payment obligations of the
obligor over the remaining life of the
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hedged exposure), the bank must use
the LGD of the guarantee or credit
derivative.
If the protection amount of the
eligible guarantee or eligible credit
derivative is less than the EAD of the
hedged exposure, however, the bank
must treat the hedged exposure as two
separate exposures (protected and
unprotected) to recognize the credit risk
mitigation benefit of the guarantee or
credit derivative. The bank must
calculate its risk-based capital
requirement for the protected exposure
under section 31 of the rule (using a PD
equal to the protection provider’s PD, an
LGD determined as described above,
and an EAD equal to the protection
amount of the guarantee or credit
derivative). If the bank determines that
full substitution leads to an
inappropriate degree of risk mitigation,
the bank may use a higher PD than that
of the protection provider. The bank
must calculate its risk-based capital
requirement for the unprotected
exposure under section 31 of the rule
(using a PD equal to the obligor’s PD, an
LGD equal to the hedged exposure’s
LGD not adjusted to reflect the
guarantee or credit derivative, and an
EAD equal to the EAD of the original
hedged exposure minus the protection
amount of the guarantee or credit
derivative).
The protection amount of an eligible
guarantee or eligible credit derivative is
defined as the effective notional amount
of the guarantee or credit derivative
reduced by any applicable haircuts for
maturity mismatch, lack of
restructuring, and currency mismatch
(each described below). The effective
notional amount of a guarantee or credit
derivative is the lesser of the contractual
notional amount of the credit risk
mitigant and the EAD of the hedged
exposure, multiplied by the percentage
coverage of the credit risk mitigant. For
example, the effective notional amount
of a guarantee that covers, on a pro rata
basis, 40 percent of any losses on a $100
bond would be $40.
The agencies received no material
comments on the above-described
structure of the PD substitution
approach, and the final rule’s PD
substitution approach is substantially
the same as that of the proposed rule.
LGD Adjustment Approach
Under the LGD adjustment approach
of the final rule, as under the proposal,
if the protection amount of the eligible
guarantee or eligible credit derivative is
greater than or equal to the EAD of the
hedged exposure, the bank’s risk-based
capital requirement for the hedged
exposure is the greater of (i) the risk-
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based capital requirement for the
exposure as calculated under section 31
of the rule (with the LGD of the
exposure adjusted to reflect the
guarantee or credit derivative); or (ii) the
risk-based capital requirement for a
direct exposure to the protection
provider as calculated under section 31
of the rule (using the bank’s PD for the
protection provider, the bank’s LGD for
the guarantee or credit derivative, and
an EAD equal to the EAD of the hedged
exposure).
If the protection amount of the
eligible guarantee or eligible credit
derivative is less than the EAD of the
hedged exposure, however, the bank
must treat the hedged exposure as two
separate exposures (protected and
unprotected) in order to recognize the
credit risk mitigation benefit of the
guarantee or credit derivative. The
bank’s risk-based capital requirement
for the protected exposure would be the
greater of (i) the risk-based capital
requirement for the protected exposure
as calculated under section 31 of the
rule (with the LGD of the exposure
adjusted to reflect the guarantee or
credit derivative and EAD set equal to
the protection amount of the guarantee
or credit derivative); or (ii) the riskbased capital requirement for a direct
exposure to the protection provider as
calculated under section 31 of the rule
(using the bank’s PD for the protection
provider, the bank’s LGD for the
guarantee or credit derivative, and an
EAD set equal to the protection amount
of the guarantee or credit derivative).
The bank must calculate its risk-based
capital requirement for the unprotected
exposure under section 31 of the rule
using a PD set equal to the obligor’s PD,
an LGD set equal to the hedged
exposure’s LGD (not adjusted to reflect
the guarantee or credit derivative), and
an EAD set equal to the EAD of the
original hedged exposure minus the
protection amount of the guarantee or
credit derivative.
The agencies received no material
comments on the above-described
structure of the LGD adjustment
approach, and the final rule’s LGD
adjustment approach is substantially the
same as that of the proposed rule.
The PD substitution approach allows
a bank to effectively assess risk-based
capital against a hedged exposure as if
it were a direct exposure to the
protection provider, and the LGD
adjustment approach produces a riskbased capital requirement for a hedged
exposure that is never lower than that
of a direct exposure to the protection
provider. Accordingly, these approaches
do not fully reflect the risk mitigation
benefits certain types of guarantees and
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credit derivatives may provide because
the resulting risk-based capital
requirement does not consider the joint
probability of default of the obligor of
the hedged exposure and the protection
provider, sometimes referred to as the
‘‘double default’’ benefit. The agencies
have decided, consistent with the New
Accord and the proposed rule, to
recognize double default benefits in the
wholesale framework only for certain
hedged exposures covered by certain
guarantees and credit derivatives. A
later section of the preamble describes
which hedged exposures are eligible for
the double default treatment and
describes the double default treatment
that is available to those exposures.
Maturity Mismatch Haircut
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Under the final rule, a bank that seeks
to reduce the risk-based capital
requirement on a wholesale exposure by
recognizing an eligible guarantee or
eligible credit derivative must adjust the
effective notional amount of the credit
risk mitigant downward to reflect any
maturity mismatch between the hedged
exposure and the credit risk mitigant. A
maturity mismatch occurs when the
residual maturity of a credit risk
mitigant is less than that of the hedged
exposure(s).
The proposed rule provided,
consistent with the New Accord, that
when the hedged exposures have
different residual maturities, the longest
residual maturity of any of the hedged
exposures would be used as the residual
maturity of all hedged exposures. One
commenter criticized this provision as
excessively conservative. The agencies
agree and have decided to restrict the
application of this provision to
securitization CRM.84 Accordingly,
under the final rule, to calculate the
risk-based capital requirement for a
group of hedged wholesale exposures
that are covered by a single eligible
guarantee under which the protection
provider has agreed to backstop all
contractual payments associated with
each hedged exposure, a bank should
treat each hedged exposure as if it were
fully covered by a separate eligible
guarantee. To determine whether any of
the hedged wholesale exposures has a
maturity mismatch with the eligible
guarantee, the bank must assess whether
the residual maturity of the eligible
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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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 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 ×
(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
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69353
(iv) T = lesser of 5 or effective residual
maturity of the hedged exposure, expressed
in years.
Other than as discussed above with
respect to pools of hedged exposures
with different residual maturities, the
final rule’s provisions on maturity
mismatch do not differ from those of the
proposed rule.
Restructuring Haircut
Under the final rule, as under the
proposed rule, a bank that seeks to
recognize an eligible credit derivative
that does not include a distressed
restructuring as a credit event that
triggers payment under the derivative
must reduce the recognition of the
credit derivative by 40 percent. A
distressed restructuring is a
restructuring of the hedged exposure
involving forgiveness or postponement
of principal, interest, or fees that results
in a charge-off, specific provision, or
other similar debit to the profit and loss
account.
In other words, the effective notional
amount of the credit derivative adjusted
for lack of restructuring credit event
(and maturity mismatch, if applicable)
is: Pr = Pm × 0.60, where:
(i) Pr = effective notional amount of the
credit risk mitigant, adjusted for lack of
restructuring credit event (and maturity
mismatch, if applicable); and
(ii) Pm = effective notional amount of the
credit risk mitigant adjusted for maturity
mismatch (if applicable).
Two commenters opposed the 40
percent restructuring haircut. One
commenter contended that the 40
percent haircut is too punitive. The
other commenter contended that the 40
percent haircut should not apply when
the hedged exposure is an OTC
derivative contract or a qualifying
master netting agreement that covers
OTC derivative contracts. The 40
percent haircut is a rough estimate of
the reduced CRM benefits that accrue to
a bank that purchases a credit derivative
without restructuring coverage.
Nonetheless, the agencies recognize that
restructuring events could result in
substantial economic losses to a bank.
Moreover, the 40 percent haircut is
consistent with the New Accord and is
a reasonably prudent mechanism for
ensuring that banks do not receive
excessive CRM benefits for purchasing
credit protection that does not cover all
material sources of economic loss to the
bank on the hedged exposure.
The final rule’s provisions on lack of
restructuring as a credit event do not
differ from those of the proposed rule.
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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 × (1¥Hfx), where:
(i) Pc = effective notional amount of the
credit risk mitigant, adjusted for currency
mismatch (and maturity mismatch and lack
of restructuring credit event, if applicable);
(ii) Pr = effective notional amount of the
credit risk mitigant (adjusted for maturity
mismatch and lack of restructuring credit
event, if applicable); and
(iii) Hfx = haircut appropriate for the
currency mismatch between the credit risk
mitigant and the hedged exposure.
A bank may use a standard
supervisory haircut of 8 percent for Hfx
(based on a ten-business-day holding
period and daily marking-to-market and
remargining). Alternatively, a bank may
use internally estimated haircuts for Hfx
based on a ten-business-day holding
period and daily marking-to-market and
remargining if the bank qualifies to use
the own-estimates haircuts in paragraph
(b)(2)(iii) of section 32, the simple VaR
methodology in paragraph (b)(3) of
section 32, or the internal models
methodology in paragraph (d) of section
32 of the rule. The bank must scale
these haircuts up using a square root of
time formula if the bank revalues the
guarantee or credit derivative less
frequently than once every ten business
days.
The agencies received no comments
on the currency mismatch provisions
discussed above, and the final rule’s
provisions on currency mismatch do not
differ from those of the proposed rule.
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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
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amount to $100 × (3¥.25)÷(5¥.25) or $57.89.
The haircut for lack of restructuring would
reduce the protection amount to $57.89 × 0.6
or $34.74. So the bank would treat the $100
corporate exposure as two exposures: (i) An
exposure of $34.74 with the PD of the
protection provider, an LGD of 80 percent,
and an M of five; and (ii) an exposure of
$65.26 with the PD of the obligor, an LGD of
30 percent, and an M of five.
Multiple Credit Risk Mitigants
The New Accord provides that if
multiple credit risk mitigants (for
example, two eligible guarantees) cover
a single exposure, a bank must
disaggregate the exposure into portions
covered by each credit risk mitigant (for
example, the portion covered by each
guarantee) and must calculate separately
the risk-based capital requirement of
each portion.85 The New Accord also
indicates that when credit risk mitigants
provided by a single protection provider
have differing maturities, they should be
subdivided into separate layers of
protection.86 In the proposal, the
agencies invited comment on whether
and how the agencies should address
these and other similar situations in
which multiple credit risk mitigants
cover a single exposure.
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 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
85 New
Accord, ¶206.
86 Id.
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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 reinsurer) that is subject to supervision by
a state insurance regulator; a foreign
bank (as defined in section 211.2 of the
Federal Reserve Board’s Regulation K
(12 CFR 211.2)); a non-U.S. securities
firm; or a non-U.S. based insurance
company in the business of providing
credit protection. The proposal required
an eligible double default guarantor to
(i) have a bank-assigned PD that, at the
time the guarantor issued the guarantee
or credit derivative, was equal to or
lower than the PD associated with a
long-term external rating of at least the
third highest investment-grade rating
category; and (ii) have a current bankassigned PD that is equal to or lower
than the PD associated with a long-term
external rating of at least investment
grade. In addition, the proposal
permitted a non-U.S. based bank,
securities firm, or insurance company to
qualify as an eligible double default
guarantor only if the firm were subject
to consolidated supervision and
regulation comparable to that imposed
on U.S. depository institutions,
securities firms, or insurance companies
(as the case may be) or had issued an
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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outstanding and unsecured long-term
debt security without credit
enhancement that had a long-term
applicable external rating in one of the
three highest investment-grade rating
categories.
Commenters expressed two principal
criticisms of the proposed definition of
an eligible double default guarantor.
First, commenters asked the agencies to
conform the definition to the New
Accord by permitting a foreign financial
firm to qualify so long as it had an
outstanding long-term debt security
with an external rating of investment
grade or higher (for example, BBB¥ or
higher) instead of in one of the three
highest investment-grade rating
categories (for example, A¥ or higher).
In light of the other eligibility criteria,
the agencies have concluded that it
would be appropriate to conform this
provision of the definition to the New
Accord.
Commenters also requested that the
agencies conform the definition of
eligible double default guarantor to the
New Accord by permitting a financial
firm to qualify so long as it had a bankassigned PD, at the time the guarantor
issued the guarantee or credit derivative
or at any time thereafter, that was equal
to or lower than the PD associated with
a long-term external rating of at least the
third highest investment-grade rating
category. In light of the other eligibility
criteria, the agencies have concluded
that it would be appropriate to conform
this provision of the definition to the
New Accord.
Effectively, under the final rule, the
scope of an eligible double default
guarantor is limited to financial firms
whose normal business includes the
provision of credit protection, as well as
the management of a diversified
portfolio of credit risk. This restriction
arises from the agencies’ concern to
limit double default recognition to
financial institutions that have a high
level of credit risk management
expertise and that provide sufficient
market disclosure. The restriction is also
designed to limit the risk of excessive
correlation between the
creditworthiness of the guarantor and
the obligor of the hedged exposure due
to their performance depending on
common economic factors beyond the
systematic risk factor. As a result,
hedged exposures to potential credit
protection providers or affiliates of
credit protection providers are not
eligible for the double default treatment.
In addition, the agencies have excluded
hedged exposures to sovereign entities
from eligibility for double default
treatment because of the potential high
correlation between the
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creditworthiness of a sovereign and that
of a guarantor.
One commenter urged the agencies to
delete the requirement that the obligor
of a hedged exposure that qualifies for
double default treatment not be an
eligible double default guarantor or an
affiliate of such an entity. This
commenter represented that this
requirement significantly constrained
the scope of application of double
default treatment and assumed
inappropriately that there is an
excessive amount of correlation among
all financial firms. The agencies
acknowledge that this requirement is a
crude mechanism to prevent excessive
wrong-way risk, but the agencies have
decided to retain the requirement in
light of its consistency with the New
Accord and the limited ability of banks
to measure accurately correlations
among obligors.
In addition to limiting the types of
guarantees, credit derivatives,
guarantors, and hedged exposures
eligible for double default treatment, the
rule limits wrong-way risk further by
requiring a bank to implement a process
to detect excessive correlation between
the creditworthiness of the obligor of
the hedged exposure and the protection
provider. The bank must receive prior
written approval from its primary
Federal supervisor for this process in
order to recognize double default
benefits for risk-based capital purposes.
To apply double default treatment to a
particular hedged exposure, the bank
must determine that there is not
excessive correlation between the
creditworthiness of the obligor of the
hedged exposure and the protection
provider. For example, the
creditworthiness of an obligor and a
protection provider would be
excessively correlated if the obligor
derives a high proportion of its income
or revenue from transactions with the
protection provider. If excessive
correlation is present, the bank may not
use the double default treatment for the
hedged exposure.
The risk-based capital requirement for
a hedged exposure subject to double
default treatment is calculated by
multiplying a risk-based capital
requirement for the hedged exposure (as
if it were unhedged) by an adjustment
factor that considers the PD of the
protection provider (see section 34 of
the rule). Thus, the PDs of both the
obligor of the hedged exposure and the
protection provider are factored into the
hedged exposure’s risk-based capital
requirement. In addition, as under the
PD substitution treatment in section 33
of the rule, the bank is allowed to set
LGD equal to the lower of the LGD of
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69355
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-byexposure approach consistent with the
overall exposure-by-exposure approach
the rule takes to wholesale exposures.
The agencies believe that a different
treatment for guarantees that cover retail
exposures is necessary and appropriate
because of the rule’s segmentation
approach to retail exposures. The
approaches to retail guarantees
described in this section generally apply
only to guarantees of individual retail
exposures. Guarantees of multiple retail
exposures (such as pool private
mortgage insurance (PMI)) are typically
tranched (that is, they cover less than
the full amount of the hedged
exposures) and, therefore, are
securitization exposures under the final
rule.
The rule does not specify the ways in
which guarantees and credit derivatives
may be taken into account in the
segmentation of retail exposures.
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Likewise, the rule does not explicitly
limit the extent to which a bank may
take into account the credit risk
mitigation benefits of guarantees and
credit derivatives in its estimation of the
PD and LGD of retail segments, except
by the application of overall floors on
certain PD and LGD assignments. This
approach has the principal advantage of
being relatively easy for banks to
implement—the approach generally
would not disrupt the existing retail
segmentation practices of banks and
would not interfere with banks’
quantification of PD and LGD for retail
segments.
In the proposal, the agencies
expressed some concern, however, that
this approach would provide banks with
substantial discretion to incorporate
double default and double recovery
effects. To address these concerns, the
preamble to the proposed rule described
two possible alternative treatments for
guarantees of retail exposures. The first
alternative distinguished between
eligible retail guarantees and all other
(non-eligible) guarantees of retail
exposures. Under this alternative, an
eligible retail guarantee would be an
eligible guarantee that applies to a
single retail exposure and is (i) PMI
issued by a highly creditworthy
insurance company; or (ii) issued by a
sovereign entity or a political
subdivision of a sovereign entity.
Under this alternative, a bank would
be able to recognize the credit risk
mitigation benefits of eligible retail
guarantees that cover retail exposures in
a segment by adjusting its estimates of
LGD for the segment to reflect recoveries
from the guarantor. However, the bank
would have to estimate the PD of a
segment without reflecting the benefit of
guarantees. Specifically, a segment’s PD
would be an estimate of the stand-alone
probability of default for the retail
exposures in the segment, before taking
account of any guarantees. Accordingly,
for this limited set of traditional
guarantees of retail exposures by high
credit quality guarantors, a bank would
be allowed to recognize the benefit of
the guarantee when estimating LGD but
not when estimating PD.
This alternative approach would
provide a different treatment for noneligible retail guarantees. In short,
within the retail framework, a bank
would not be able to recognize noneligible 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
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recognize non-eligible retail guarantees
provided by a wholesale guarantor by
treating the hedged retail exposure as a
direct exposure to the guarantor and
applying the appropriate wholesale IRB
risk-based capital formula. In other
words, for retail exposures covered by
non-eligible retail guarantees, a bank
would be permitted to reflect the
guarantee by ‘‘desegmenting’’ the retail
exposures (which effectively would
convert the retail exposures into
wholesale exposures) and then applying
the rules set forth above for guarantees
that cover wholesale exposures. Thus,
under this approach, a bank would not
be allowed to recognize either double
default or double recovery effects for
non-eligible retail guarantees.
A second alternative that the agencies
described in the preamble to the
proposed rule would permit a bank to
recognize the credit risk mitigation
benefits of all eligible guarantees
(whether eligible retail guarantees or
not) that cover retail exposures by
adjusting its estimates of LGD for the
relevant segments, but would subject a
bank’s risk-based capital requirement
for a segment of retail exposures that are
covered by one or more non-eligible
retail guarantees to a floor. Under this
second alternative, the agencies could
impose a floor on risk-based capital
requirements of between 2 percent and
6 percent on such a segment of retail
exposures.
A substantial number of commenters
supported the flexible approach in the
text of the proposed rule. A few
commenters also supported the first
alternative approach in the preamble of
the proposed rule. Commenters
uniformly urged the agencies not to
adopt the second alternative approach.
The agencies have decided to adopt the
approach to retail guarantees in the text
of the proposed rule and not to adopt
either alternative approach described in
the proposed rule preamble. Although
the first alternative approach addresses
prudential concerns, the agencies have
concluded that it is excessively
conservative and prescriptive and
would not harmonize with banks’
internal risk measurement and
management practices. The agencies
also have determined that the second
alternative approach is insufficiently
risk sensitive and is not consistent with
the New Accord. In light of the final
rule’s flexible approach to retail
guarantees, the agencies expect banks to
limit their use of guarantees in the retail
segmentation process and retail risk
parameter estimation process to
situations where the bank has
particularly reliable data about the CRM
benefits of such guarantees.
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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 riskbased 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 systemwide failure of a settlement or clearing
system, the bank’s primary Federal
supervisor may waive risk-based capital
requirements for unsettled and failed
transactions until the situation is
rectified.
The final rule contains separate
treatments for delivery-versus-payment
(DvP) and payment-versus-payment
(PvP) transactions with a normal
settlement period, on the one hand, and
non-DvP/non-PvP transactions with a
normal settlement period, on the other
hand. The final rule provides the
following definitions of a DvP
transaction, a PvP transaction, and a
normal settlement period. A DvP
transaction is a securities or
commodities transaction in which the
buyer is obligated to make payment only
if the seller has made delivery of the
securities or commodities and the seller
is obligated to deliver the securities or
commodities only if the buyer has made
payment. A PvP transaction is a foreign
exchange transaction in which each
counterparty is obligated to make a final
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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external rating of any outstanding
unsecured long-term debt security
without credit enhancement issued by
the counterparty. A bank may estimate
a loss severity rating or LGD for the
exposure, or may use a 45 percent LGD
for the exposure provided the bank uses
the 45 percent LGD for all such
exposures (that is, for all non-DvP/nonPvP 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 riskbased 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
TABLE E.—RISK WEIGHTS FOR UNSET- sum of the risk-weighted asset amount
TLED DVP AND PVP TRANSACTIONS
for each DvP and PvP transaction with
a normal settlement period and the riskRisk weight to be
weighted asset amount for each nonNumber of business
applied to positive
days after contractual
DvP/non-PvP transaction with a normal
current
exposure
settlement date
settlement period.
(percent)
transfer of one or more currencies only
if the other counterparty has made a
final transfer of one or more currencies.
A transaction has a normal settlement
period if the contractual settlement
period for the transaction is equal to or
less than the market standard for the
instrument underlying the transaction
and equal to or less than five business
days.
A bank must hold risk-based capital
against a DvP or PvP transaction with a
normal settlement period if the bank’s
counterparty has not made delivery or
payment within five business days after
the settlement date. The bank must
determine its risk-weighted asset
amount for such a transaction by
multiplying the positive current
exposure of the transaction for the bank
by the appropriate risk weight in Table
E. The positive current exposure of a
transaction of a bank is the difference
between the transaction value at the
agreed settlement price and the current
market price of the transaction, if the
difference results in a credit exposure of
the bank to the counterparty.
mstockstill on PROD1PC66 with RULES2
From
From
From
46 or
5 to 15 ...............
16 to 30 .............
31 to 45 .............
more ..................
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
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E. Securitization Exposures
This section describes the framework
for calculating risk-based capital
requirements for securitization
exposures (the securitization
framework). In contrast to the
framework for wholesale and retail
exposures, the securitization framework
does not permit a bank to rely on its
internal assessments of the risk
parameters of a securitization
exposure.89 For securitization
exposures, which typically are tranched
exposures to a pool of underlying
exposures, such assessments would
require implicit or explicit estimates of
correlations among the losses on the
underlying exposures and estimates of
the credit risk-transfering consequences
of tranching. Such correlation and
tranching effects are difficult to estimate
and validate in an objective manner and
on a going-forward basis. Instead, the
securitization framework relies
principally on two sources of
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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69357
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).
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
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of CEIOs beyond a concentration
threshold is deducted from total capital
and there is no separate gain-on-sale
deduction.
The final rule retains the proposed
deduction of gains-on-sale and CEIOs.
These deductions are consistent with
the New Accord, and the agencies
believe they are warranted given
historical supervisory concerns with the
subjectivity involved in valuations of
gains-on-sale and CEIOs. Furthermore,
although the treatments of gains-on-sale
and CEIOs can increase an originating
bank’s risk-based capital requirement
following a securitization, the agencies
believe that such anomalies will be rare
where a securitization transfers
significant credit risk from the
originating bank to third parties.
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Ratings-Based Approach (RBA)
If a securitization exposure is not a
gain-on-sale or CEIO, a bank must apply
the RBA to a securitization exposure if
the exposure qualifies for the RBA. As
a general matter, an exposure qualifies
for the RBA if the exposure has an
external rating from an NRSRO or has
an inferred rating (that is, the exposure
is senior to another securitization
exposure in the transaction that has an
external rating from an NRSRO).90 For
example, a bank generally must use the
RBA approach to determine the riskbased capital requirement for an assetbacked 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
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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requirement for the underlying
exposures as if they were held directly
by the bank. A bank that qualifies for
and chooses to use the IAA must use the
IAA for all exposures that qualify for the
IAA.
A number of commenters asserted
that a bank should be permitted to use
the IAA for a securitization exposure to
an ABCP conduit even when the
exposure has an inferred rating,
provided all other IAA eligibility
criteria were met. The commenters
maintained that the RBA would produce
an excessive risk-based capital
requirement for an unrated
securitization exposure, such as a
liquidity facility, when the inferred
rating is based on a rated security that
is very junior to the unrated exposure.
Commenters suggested that allowing a
bank to use the IAA instead of the RBA
in such circumstances would lead to a
risk-based capital requirement that was
better aligned with the unrated
exposure’s actual risk.
Like the New Accord, the final rule
does not allow a bank to use the IAA for
securitization exposures that qualify for
the RBA based on an inferred rating.
While in some cases the IAA might
produce a more risk-sensitive capital
treatment relative to an inferred rating
under the RBA, the agencies—as well as
the majority of commenters—believe
that it is important to retain as much
consistency as possible with the New
Accord to provide a level international
playing field for financial services
providers in a competitive line of
business. The commenters’ concerns
relating to inferred ratings apply only to
a small proportion of outstanding ABCP
liquidity facilities. In many cases, a
bank may mitigate such concerns by
having the ABCP program issue an
additional, intermediate layer of
externally rated securities, which would
provide a more accurate reference for
inferring a rating on the unrated
liquidity facility. The agencies intend to
monitor developments in this area and,
as appropriate, will coordinate any
reassessment of the hierarchy of
securitization approaches with the
BCBS and other supervisory and
regulatory authorities.
Supervisory Formula Approach (SFA)
If a securitization exposure is not a
gain-on-sale or a CEIO, does not qualify
for the RBA, and is not an exposure to
an ABCP program for which the bank is
applying the IAA, the bank may apply
the SFA to the exposure if the bank is
able to calculate the SFA risk
parameters for the securitization. In
many cases, an originating bank would
use the SFA to determine its risk-based
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capital requirements for retained
securitization exposures.
Deduction
If a securitization exposure is not a
gain-on-sale or a CEIO and does not
qualify for the RBA, the IAA, or the
SFA, the bank must deduct the exposure
from total capital.
Numerous commenters requested an
alternative to deducting the
securitization exposure from capital.
Some of these commenters noted that if
a bank does not service the underlying
assets, the bank may not be able to
produce highly accurate estimates of a
key SFA risk parameter, KIRB, which is
the risk-based capital requirement as if
the underlying assets were held directly
by the bank. Commenters expressed
concern that, under the proposal, a bank
would be required to deduct from
capital some structured lending
products that have long histories of low
credit losses. Commenters maintained
that a bank should be allowed to
calculate the securitization exposure’s
risk-based capital requirement using the
rules for wholesale exposures or using
an IAA-like approach under which the
bank’s internal risk rating for the
exposure would be mapped into an
NRSRO’s rating category.
Like the proposal, the final rule
contains only those securitization
approaches in the New Accord. As
already noted, the agencies—and most
commenters—believe that it is
important to minimize substantive
differences between the final rule and
the New Accord to foster international
consistency. Furthermore, the agencies
believe that the hierarchy of
securitization approaches is sufficiently
comprehensive to accommodate
demonstrably low-risk structured
lending arrangements in a risk-sensitive
manner. As described in greater detail
below, for securitization exposures that
are not eligible for the RBA or the IAA,
a bank has flexibility under the SFA to
tailor its procedures for estimating KIRB
to the data that are available. The
agencies recognize that, in light of data
shortcomings, a bank may have to use
approaches to estimating KIRB that are
less sophisticated than what the bank
might use for similar assets that it
originates, services, and holds directly.
Supervisors generally will review the
reasonableness of KIRB estimates in the
context of available data, and will
expect estimates of KIRB to incorporate
appropriate conservatism to address any
data shortcomings.
Total risk-weighted assets for
securitization exposures equals the sum
of risk-weighted assets calculated under
the RBA, IAA, and SFA, plus any risk-
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weighted asset amounts calculated
under the early amortization provisions
in section 47 of the final rule.
Exceptions to the General Hierarchy of
Approaches
Consistent with the New Accord and
the proposed rule, the final rule
includes a mechanism that generally
prevents a bank’s effective risk-based
capital requirement from increasing as a
result of the bank securitizing its assets.
Specifically, the rule limits a bank’s
effective risk-based capital requirement
for all of its securitization exposures to
a single securitization to the applicable
risk-based capital requirement if the
underlying exposures were held directly
by the bank. Under the rule, unless one
or more of the underlying exposures
does not meet the definition of a
wholesale, retail, securitization, or
equity exposure, the total risk-based
capital requirement for all securitization
exposures held by a single bank
associated with a single securitization
(including any regulatory capital
requirement that relates to an early
amortization provision, but excluding
any capital requirements that relate to
the bank’s gain-on-sale or CEIOs
associated with the securitization)
cannot exceed the sum of (i) the bank’s
total risk-based capital requirement for
the underlying exposures as if the bank
directly held the underlying exposures;
and (ii) the bank’s total ECL for the
underlying exposures.
One commenter urged the agencies to
delete the reference to ECL in the capital
calculation. However, the agencies
believe it is appropriate to include the
ECL of the underlying exposures in this
calculation because ECL is included in
the New Accord’s limit, and because the
bank would have had to estimate the
ECL of the exposures and hold reserves
or capital against the ECL if the bank
held the underlying exposures on its
balance sheet.
This maximum risk-based capital
requirement is different from the general
risk-based capital rules. Under the
general risk-based capital rules, banks
generally are required to hold a dollar
in capital for every dollar in residual
interest, regardless of the effective riskbased 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 riskbased capital rules. Given the
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significantly heightened risk sensitivity
of the IRB approach, the agencies
believe that the maximum risk-based
capital requirement in the final rule is
appropriate.
The securitization framework also
includes provisions to limit the double
counting of risks in situations involving
overlapping securitization exposures.
While the proposal addressed only
those overlapping exposures arising in
the context of exposures to ABCP
programs and mortgage loan swaps with
recourse, the final rule addresses
overlapping exposures for
securitizations more generally. If a bank
has multiple securitization exposures
that provide duplicative coverage of the
underlying exposures of a securitization
(such as when a bank provides a
program-wide credit enhancement and
multiple pool-specific liquidity facilities
to an ABCP program), the bank is not
required to hold duplicative risk-based
capital against the overlapping position.
Instead, the bank would apply to the
overlapping position the applicable riskbased 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 rather than to the riskbased capital requirement for the
underlying exposures. The agencies
believe that this is a reasonable
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69359
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-onsale, not a CEIO, and not eligible for the
RBA, and all of the IAA qualification
criteria are met.
As described in section V.A.3. of this
preamble, a few commenters asserted
that OTC derivatives with a
securitization SPE as the counterparty
should be excluded from the definition
of securitization exposure. These
commenters objected to the burden of
using the securitization framework to
calculate a capital requirement for
counterparty credit risk for OTC
derivatives with a securitization SPE.
The agencies continue to believe that
the securitization framework is the most
appropriate way to assess the
counterparty credit risk of such
exposures, and that in many cases the
relatively simple RBA will apply to
such exposures. In response to
commenter concerns about burden, the
agencies have decided to add an
optional simple risk weight approach
for certain OTC derivatives. Under the
final rule, if a securitization exposure is
an OTC derivative contract (other than
a credit derivative) that has a first
priority claim on the cash flows from
the underlying exposures
(notwithstanding amounts due under
interest rate or currency derivative
contracts, fees due, or other similar
payments), a bank may choose to apply
an effective 100 percent risk weight to
the exposure rather than the general
securitization hierarchy of approaches.
This treatment is subject to supervisory
approval.
Like the proposed rule, the final rule
contains three additional exceptions to
the general hierarchy. Each exception
parallels the general risk-based capital
rules. First, an interest-only mortgagebacked 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-
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weighted assets.91 In such cases, the
bank must hold risk-based capital
against any securitization exposures of
the bank to the ABCP program. Third,
as required by Federal statute, a special
set of rules applies to transfers of small
business loans and leases with recourse
by well-capitalized depository
institutions.92
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Servicer Cash Advances
A traditional securitization typically
employs a servicing bank that—on a
day-to-day basis—collects principal,
interest, and other payments from the
underlying exposures of the
securitization and forwards such
payments to the securitization SPE or to
investors in the securitization. Such
servicing banks often provide to the
securitization a credit facility under
which the servicing bank may advance
cash to ensure an uninterrupted flow of
payments to investors in the
securitization (including advances made
to cover foreclosure costs or other
expenses to facilitate the timely
collection of the underlying exposures).
These servicer cash advance facilities
are securitization exposures.
Under the final rule, as under the
proposed rule, a servicing bank must
determine its risk-based capital
requirement for any advances under
such a facility using the hierarchy of
securitization approaches described
above. The treatment of the undrawn
portion of the facility depends on
whether the facility is an ‘‘eligible’’
servicer cash advance facility. An
eligible servicer cash advance facility is
a servicer cash advance facility in which
(i) the servicer is entitled to full
reimbursement of advances (except that
a servicer may be obligated to make
non-reimburseable advances for a
particular underlying exposure if any
such advance is limited to an
insignificant amount of the outstanding
principal balance of that exposure); (ii)
the servicer’s right to reimbursement is
senior in right of payment to all other
claims on the cash flows from the
underlying exposures of the
securitization; and (iii) the servicer has
no legal obligation to, and does not,
make advances to the securitization if
the servicer concludes the advances are
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-by-case basis because the agencies
may do this under the general reservation of
authority contained in section 1 of the rule.
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unlikely to be repaid. Consistent with
the general risk-based capital rules with
respect to residential mortgage servicer
cash advances, a servicing bank is not
required to hold risk-based capital
against the undrawn portion of an
eligible servicer cash advance facility. A
bank that provides a non-eligible
servicer cash advance facility must
determine its risk-based capital
requirement for the undrawn portion of
the facility in the same manner as the
bank would determine its risk-based
capital requirement for any other
undrawn securitization exposure.
Amount of a Securitization Exposure
Under the proposed rule, the amount
of an on-balance sheet securitization
exposure was the bank’s carrying value,
if the exposure was held-to-maturity or
for trading, or the bank’s carrying value
minus any unrealized gains and plus
any unrealized losses on the exposure,
if the exposure was available-for-sale. In
general, the amount of an off-balance
sheet securitization exposure was the
notional amount of the exposure. For an
OTC derivative contract that was not a
credit derivative, the notional amount
was the EAD of the derivative contract
(as calculated in section 32).
In the final rule the agencies are
maintaining the substance of the
proposed provision on the amount of a
securitization exposure with one
exception. The final rule provides that
the amount of a securitization exposure
that is a repo-style transaction, eligible
margin loan, or OTC derivative (other
than a credit derivative) is the EAD of
the exposure as calculated in section 32
of the final rule. The agencies believe
this change is consistent with the way
banks manage these exposures, more
appropriately reflects the collateral that
directly supports these exposures, and
recognizes the credit risk mitigation
benefits of netting where these
exposures are part of a cross-product
netting set. Because the collateral
associated with a repo-style transaction
or eligible margin loan is reflected in the
determination of exposure amount
under section 32 of the rule, these
transactions are not eligible for the
general securitization collateral
approach in section 46(b) of the final
rule. Similarly, if a bank chooses to
reflect collateral associated with an OTC
derivative contract in its determination
of exposure amount under section 32 of
the rule, it may not also apply the
general securitization collateral
approach in section 46(b) of the final
rule. Similar to the definition of EAD for
on-balance sheet exposures, the
agencies are clarifying that the amount
of an on-balance sheet securitization
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exposure is based on whether or not the
exposure is classified as an available for
sale security.
Under the proposal, when a
securitization exposure to an ABCP
program takes the form of a
commitment, such as a liquidity facility,
the notional amount could be reduced
to the maximum potential amount that
the bank currently would be required to
fund under the arrangement’s
documentation (the maximum potential
amount that could be drawn given the
assets currently held by the program).
Within some ABCP programs, however,
certain commitments, such as liquidity
facilities, may be dynamic in that the
maximum amount that can be drawn at
any moment depends on the current
credit quality of the program’s
underlying assets. That is, if the
underlying assets were to remain fixed,
but their credit quality deteriorated, the
maximum amount that could be drawn
against the liquidity facility could
increase.
The final rule clarifies that in such
circumstances the notional amount of
an off-balance sheet securitization
exposure to an ABCP program may be
reduced to the maximum potential
amount that the bank could be required
to fund given the program’s current
assets (calculated without regard to the
current credit quality of these assets).
Thus, if $100 is the maximum amount
that could be drawn given the current
volume and current credit quality of the
program’s assets, but the maximum
potential draw against these same assets
could increase to as much as $200 if
their credit quality were to deteriorate,
then the exposure amount is $200.
Some commenters recommended
capping the securitization amount for an
ABCP liquidity facility at the amount of
the outstanding commercial paper
covered by that facility. The agencies
believe, however, that this would be
inappropriate if the liquidity provider
could be required to advance a larger
amount. The agencies note that when
calculating the exposure amount of a
liquidity facility, a bank may take into
account any limits on advances—
including limits based on the amount of
commercial paper outstanding—that are
contained in the program’s
documentation.
Implicit Support
Like the proposed rule, the final rule
sets forth the regulatory capital
consequences if a bank provides support
to a securitization in excess of the
bank’s predetermined contractual
obligation to provide credit support to
the securitization. First, consistent with
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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 risk-weighted
assets only if each of the following
conditions is met: (i) The transfer is a
sale under GAAP; (ii) the originating
bank transfers to third parties credit risk
associated with the underlying
exposures; and (iii) any clean-up calls
relating to the securitization are eligible
clean-up calls (as discussed below).
Originating banks that meet these
conditions must hold regulatory capital
against any securitization exposures
they retain in connection with the
securitization. Originating banks that
fail to meet these conditions must hold
regulatory capital against the transferred
exposures as if they had not been
securitized and must deduct from tier 1
capital any gain-on-sale resulting from
the transaction. The operational
requirements for synthetic securitization
are described in preamble section
V.E.7., below.
Consistent with the general risk-based
capital rules, the above operational
requirements refer specifically to GAAP
for the purpose of determining whether
a securitization transaction should be
treated as an asset sale or a financing.
In contrast, the New Accord stipulates
guiding principles for use in
determining whether sale treatment is
warranted. One commenter requested
93 Interagency Guidance on Implicit Recourse in
Asset Securitizations, May 23, 2002.
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that the agencies conform the proposed
operational requirements for traditional
securitizations to those in the New
Accord. The agencies believe that the
current conditions to qualify for sale
treatment under GAAP are broadly
consistent with the guiding principles
enumerated in the New Accord.
However, if GAAP in this area were to
change materially in the future, the
agencies would reassess, and possibly
revise, the operational standards.
Clean-Up Calls
To satisfy the operational
requirements for securitizations and
enable an originating bank to exclude
the underlying exposures from the
calculation of its risk-based capital
requirements, any clean-up call
associated with a securitization must be
an eligible clean-up call. The proposal
defined a clean-up call as a contractual
provision that permits a servicer to call
securitization exposures (for example,
asset-backed securities) before the stated
(or contractual) maturity or call date.
The preamble to the proposed rule
explained that, in the case of a
traditional securitization, a clean-up call
is generally accomplished by
repurchasing the remaining
securitization exposures once the
amount of underlying exposures or
outstanding securitization exposures
falls below a specified level. In the case
of a synthetic securitization, the cleanup 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
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69361
and eligible clean-up call. One
commenter observed that prudential
concerns would also be satisfied if the
call were at the discretion of the
originator of the underlying exposures.
The agencies concur with this view and
have modified the final rule to state that
a clean-up call may permit the servicer
or originating bank to call the
securitization exposures before the
stated maturity or call date, and that an
eligible clean-up call must be
exercisable solely at the discretion of
the servicer or the originating bank.
Commenters also requested clarification
whether, for a securitization that
involves a master trust, the 10 percent
requirement described above in criteria
(iii)(A) and (iii)(B) would be interpreted
as applying to each series or tranche of
securities issued from the master trust.
The agencies believe this is a reasonable
interpretation. Thus, where a
securitization SPE is structured as a
master trust, a clean-up call with respect
to a particular series or tranche issued
by the master trust would meet criteria
(iii)(A) and (iii)(B) so long as the
outstanding principal amount in that
series was 10 percent or less of its
original amount at the inception of the
series.
Additional Supervisory Guidance
Over the last several years, the
agencies have published a significant
amount of supervisory guidance to
assist banks with assessing the extent to
which they have transferred credit risk
and, consequently, may recognize any
reduction in required regulatory capital
as a result of a securitization or other
form of credit risk transfer. 94 In general,
the agencies expect banks to continue to
use this guidance, most of which
remains applicable to the advanced
approaches securitization framework.
Banks are encouraged to consult with
their primary Federal supervisor about
transactions that require additional
guidance.
2. Ratings-Based Approach (RBA)
Under the final rule, as under the
proposal, a bank must determine the
risk-weighted asset amount for a
securitization exposure that is eligible
for the RBA by multiplying the amount
of the exposure by the appropriate riskweight provided in the tables in section
43 of the rule. Under the proposal,
whether a securitization exposure was
eligible for the RBA would depend on
whether the bank holding the
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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securitization exposure is an originating
bank or an investing bank. An
originating bank would be eligible to
use the RBA for a securitization
exposure if (i) the exposure had two or
more external ratings, or (ii) the
exposure had two or more inferred
ratings. In contrast, an investing bank
would be eligible to use the RBA for a
securitization exposure if the exposure
has one or more external or inferred
ratings. A bank would be an originating
bank if it (i) directly or indirectly
originated or securitized the underlying
exposures included in the
securitization, or (ii) serves as an ABCP
program sponsor to the securitization.
The proposed rule defined an external
rating as a credit rating assigned by a
NRSRO to an exposure, provided (i) the
credit rating fully reflects the entire
amount of credit risk with regard to all
payments owed to the holder of the
exposure, and (ii) the external rating is
published in an accessible form and is
included in the transition matrices
made publicly available by the NRSRO
that summarize the historical
performance of positions it has rated.
For example, if a holder is owed
principal and interest on an exposure,
the credit rating must fully reflect the
credit risk associated with timely
repayment of principal and interest.
Under the proposed rule, an exposure’s
applicable external rating was the
lowest external rating assigned to the
exposure by any NRSRO.
The proposed two-rating requirement
for originating banks was the only
material difference between the
treatment of originating banks and
investing banks under the proposed
securitization framework. Although the
two-rating requirement is not included
in the New Accord, it is generally
consistent with the treatment of
originating and investing banks in the
general risk-based capital rules. The
agencies sought comment on whether
this treatment was appropriate, and on
possible alternative mechanisms that
could be employed to ensure the
reliability of external and inferred
ratings on securitization exposures
retained by originating banks.
Commenters generally objected to the
two-rating requirement for originating
banks. Many asserted that since the
credit risk of a given securitization
exposure was the same regardless of the
holder, the risk-based capital treatments
also should be the same. Because
external ratings would be publicly
available, some commenters contended
that NRSROs will have strong
reputational reasons to give unbiased
ratings—even to non-traded
securitization exposures retained by
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originating banks. The agencies
continue to believe that external ratings
for securitization exposures retained by
an originating bank, which typically are
not traded, are subject to less market
discipline than ratings for exposures
sold to third parties. This disparity in
market discipline warrants more
stringent conditions on use of the
former for risk-based capital purposes.
Accordingly, the final rule retains the
two-rating requirement for originating
banks.
Consistent with the New Accord, the
final rule states that an unrated
securitization exposure has an inferred
rating if another securitization exposure
issued by the same issuer and secured
by the same underlying exposures has
an external rating and this rated
reference exposure (i) is subordinate in
all respects to the unrated securitization
exposure; (ii) does not benefit from any
credit enhancement that is not available
to the unrated securitization exposure;
and (iii) has an effective remaining
maturity that is equal to or longer than
the unrated securitization exposure.
Under the RBA, securitization
exposures with an inferred rating are
treated the same as securitization
exposures with an identical external
rating. This definition does not permit
a bank to assign an inferred rating based
on the ratings of the underlying
exposures in a securitization, even
when the unrated securitization
exposure is secured by a single,
externally rated security. In particular,
such a look-through approach would
fail to meet the requirements that the
rated reference exposure must be issued
by the same issuer, secured by the same
underlying assets, and subordinated in
all respects to the unrated securitization
exposure.
The agencies sought comment on
whether they should consider other
bases for inferring a rating for an
unrated securitization position, such as
using an applicable credit rating on
outstanding long-term debt of the issuer
or guarantor of the securitization
exposure. In situations where an
unrated securitization exposure
benefited from a guarantee that covered
all contractual payments associated
with the securitization exposure, several
commenters advocated allowing an
inferred rating to be assigned based on
the long-term rating of the guarantor. In
addition, some commenters
recommended that if a senior, unrated
securitization exposure is secured by a
single externally rated underlying
security, a bank should be permitted to
assign an inferred rating for the unrated
exposure using a look-through
approach.
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The agencies do not believe there is
a compelling need at this time to
supplement the New Accord’s methods
for determining an inferred rating.
However, if a need develops in the
future, the agencies will seek to revise
the New Accord in coordination with
the BCBS and other supervisory and
regulatory authorities. In the situations
cited above, the framework already
provides simplified methods for
calculating a securitization exposure’s
risk-based capital requirement. For
example, when a securitization
exposure benefits from a full guarantee,
such as from an externally rated
monoline insurance company, the
exposure’s external rating often will
reflect that guarantee. When the
guaranteed securitization exposure is
not externally rated, subject to the rules
for recognition of guarantees of
securitization exposures in section 46,
the unrated securitization exposure may
be treated as a direct (wholesale)
exposure to the guarantor. In addition,
when a securitization exposure to an
ABCP program is secured by a single,
externally rated asset, a look-through
approach may be possible under the
IAA provided that such a look-through
is no less conservative than the
applicable NRSRO rating
methodologies.
Under the proposal, if a securitization
exposure had multiple external ratings
or multiple inferred ratings, a bank
would be required to use the lowest
rating (the rating that would produce
the highest risk-based capital
requirement). Commenters objected that
this treatment was significantly more
conservative than required by the New
Accord, which permits use of the
second most favorable rating, and would
unfairly penalize banks in situations
where the lowest rating was unsolicited
or an outlier. The agencies recognize
commenters’ concerns regarding
unsolicited ratings, and note that the
New Accord states banks should use
solicited ratings. To maintain
consistency with the general risk-based
capital rules, the final rule defines the
applicable external rating of a
securitization exposure to be its lowest
solicited external rating and the
applicable inferred rating of a
securitization exposure to be the
inferred rating based on its lowest
solicited external rating.
For securitization exposures eligible
for the RBA, the risk-based capital
requirement per dollar of securitization
exposure depends on four factors: (i)
The applicable rating of the exposure;
(ii) whether the rating reflects a longterm or short-term assessment of the
exposure’s credit risk; (iii) whether the
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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
69363
senior. A bank must apply the risk
weights in column 3 of Table F to the
securitization exposure if N is less than
six.
In certain situations the rule provides
a simplified approach for determining
N. If the notional number of underlying
exposures of a securitization is 25 or
more or if all the underlying exposures
are retail exposures, a bank may assume
that N is six or more (unless the bank
knows or has reason to know that N is
less than six). However, if the notional
number of underlying exposures of a
securitization is less than 25 and one or
more of the underlying exposures is a
non-retail exposure, the bank must
compute N as described in the SFA
section below.
A few commenters wanted to
determine N only at the inception of a
securitization transaction, due to the
burden of tracking N over time. The
agencies believe that a bank must track
N over time to ensure an appropriate
risk-based capital requirement. The
number of underlying exposures in a
securitization typically changes over
time as some underlying exposures are
repaid or default. As the number of
underlying exposures changes, the risk
profile of the associated securitization
exposures changes, and a bank must
reflect this change in risk profile in its
risk-based capital requirement.
points. First, in the context of an ABCP
program, the final rule specifically
states that both the most senior
commercial paper issued by the
program and a liquidity facility
supporting the program may be ‘‘senior’’
exposures if the liquidity facility
provider’s right to reimbursement of any
drawn amounts is senior to all claims on
the cash flow from the underlying
exposures. Second, the final rule
clarifies that when determining whether
a securitization exposure is senior, a
bank is not required to consider any
amounts due under interest rate or
currency derivative contracts, fees due,
or other similar payments.
Consistent with the New Accord, a
bank must use Table F below when a
securitization exposure qualifies for the
RBA based on a long-term external
rating or an inferred rating based on a
long-term external rating. A bank may
apply the risk weights in column 1 of
Table F to the securitization exposure
only if the N is six or more and the
securitization exposure is a senior
securitization exposure. If N is six or
more but the securitization exposure is
not a senior securitization exposure, the
bank must apply the risk weights in
column 2 of Table F. Applying the
principle of conservatism, however, if N
is six or more a bank may use the risk
weights in column 2 of Table F without
determining whether the exposure is
TABLE F.—LONG-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA
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Applicable external or inferred rating
(illustrative rating example)
Column 1
Column 2
Column 3
Risk weights for
senior
securitization exposures backed
by granular pools
(percent)
Risk weights for
non-senior
securitization exposures backed
by granular pools
(percent)
Risk weights for
securitization exposures backed
by non-granular
pools
(percent)
Highest investment grade (for example, AAA) ..............................................
7
12
20
Second highest investment grade (for example, AA) ...................................
8
15
25
Third-highest investment grade—positive designation (for example, A+) ....
10
18
35
Third-highest investment grade (for example, A) ..........................................
12
20
Third-highest investment grade—negative designation (for example, A¥)
20
35
Lowest investment grade—positive designation (for example, BBB+) .........
35
50
Lowest investment grade (for example, BBB) ...............................................
60
75
Lowest investment grade—negative designation (for example, BBB¥) ......
100
One category below investment grade—positive designation (for example,
BB+) ...........................................................................................................
250
One category below investment grade (for example, BB) ............................
425
One category below investment grade—negative designation (for example,
BB¥) ..........................................................................................................
650
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TABLE F.—LONG-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA—Continued
Applicable external or inferred rating
(illustrative rating example)
Column 1
Column 2
Column 3
Risk weights for
senior
securitization exposures backed
by granular pools
(percent)
Risk weights for
non-senior
securitization exposures backed
by granular pools
(percent)
Risk weights for
securitization exposures backed
by non-granular
pools
(percent)
More than one category below investment grade .........................................
A bank must apply the risk weights in
Table G when the securitization
exposure qualifies for the RBA based on
Deduction from tier 1 and tier 2 capital.
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)
Column 1
Column 2
Column 3
Risk weights for
senior
securitization exposures backed
by granular pools
(percent)
Risk weights for
non-senior
securitization exposures backed
by granular pools
(percent)
Risk weights for
securitization exposures backed
by non-granular
pools
(percent)
Highest investment grade (for example, A1) .................................................
7
12
20
Second highest investment grade (for example, A2) ....................................
12
20
35
Third highest investment grade (for example, A3) ........................................
60
75
75
All other ratings ..............................................................................................
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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 investmentgrade rating to 650 percent for
exposures rated one category below
investment grade with a negative
designation. This pattern of risk weights
is broadly consistent with analyses
employing standard credit risk models
and a range of assumptions regarding
correlation effects and the types of
exposures being securitized.95 These
analyses imply that, compared with a
corporate bond having a given level of
stand-alone credit risk (for example, as
measured by its expected loss rate), a
securitization tranche having the same
level of stand-alone credit risk—but
backed by a reasonably granular and
diversified pool—will tend to exhibit
more systematic risk.96 This effect is
most pronounced for below-investmentgrade tranches and is the primary reason
why the RBA risk-weights increase
rapidly as ratings deteriorate over this
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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Deduction from tier 1 and tier 2 capital.
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 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
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discipline because these positions
generally are retained by the bank and
are not traded.
The most senior tranches of granular
securitizations with long-term
investment-grade external ratings
receive a more favorable risk weight as
compared to more subordinated
tranches of the same securitizations. To
be considered granular, a securitization
must have an N of at least six.
Consistent with the New Accord, the
lowest possible risk-weight, 7 percent,
applies only to senior securitization
exposures receiving the highest external
rating (for example, AAA) and backed
by a granular asset pool.
The agencies sought comment on how
well the risk weights in Tables G and H
capture the most important risk factors
for securitization exposures of varying
degrees of seniority and granularity. A
number of commenters contended that,
in the interest of competitive equity, the
risk weight for senior securitization
exposures having the highest rating and
backed by a granular asset pool should
be 6 percent, the level specified in the
European Union’s Capital Requirements
Directive (CRD). The agencies decided
against making this change. There is no
compelling empirical evidence to
support a 6 percent risk weight for all
exposures satisfying these conditions
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and, further, a 6 percent risk weight is
inconsistent with the New Accord.
Moreover, estimates of the credit risk
associated with such positions tend to
be highly sensitive to subjective
modeling assumptions and to the
specific types of underlying assets and
structure of the transaction, which
supports the use of the more
conservative approach in the New
Accord.
3. Internal Assessment Approach (IAA)
Under the final rule, as under the
proposal, a bank is permitted to
compute its risk-based capital
requirement for a securitization
exposure to an ABCP program (such as
a liquidity facility or credit
enhancement) using the bank’s internal
assessment of the credit quality of the
securitization exposure. The ABCP
program may be sponsored by the bank
itself or by a third party. To apply the
IAA, the bank’s internal assessment
process and the ABCP program must
meet certain qualification requirements
in section 44 of the final rule, and the
securitization exposure must initially be
internally rated at least equivalent to
investment grade. A bank that elects to
use the IAA for any securitization
exposure to an ABCP program must use
the IAA to compute risk-based capital
requirements for all securitization
exposures that qualify for the IAA.
Under the IAA, a bank maps its internal
credit assessment of a securitization
exposure to an equivalent external
credit rating from an NRSRO. The bank
must determine the risk-weighted asset
amount for a securitization exposure by
multiplying the amount of the exposure
(using the methodology set forth above
in the RBA section) by the appropriate
risk weight provided in Table F or G
above.
Under the proposal, a bank required
prior written approval from its primary
Federal supervisor before it could use
the IAA. Several commenters objected
to this requirement maintaining that
approval is not required under the New
Accord and would likely delay a bank
being authorized to use the IAA for new
ABCP programs. Instead, commenters
requested a submission and nonobjection 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
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opportunity to review a bank’s practices
relative to the final rule before allowing
a bank to use the optional approach. If
a bank chooses to implement the IAA at
the same time that it implements the
advanced approaches, the IAA review
and approval process will be part of the
overall qualification process. If a bank
chooses to implement the IAA after it
has qualified for the advanced
approaches, prior written approval is a
necessary safeguard for ensuring
appropriate application of the IAA.
Furthermore, the agencies believe this
requirement can be implemented
without impeding future innovations in
ABCP programs.
Similar to the proposed rule, under
the final rule a bank must demonstrate
that its internal credit assessment
process satisfies all the following
criteria in order to receive approval to
use the IAA.
The bank’s internal credit assessments
of securitization exposures to ABCP
programs must be based on publicly
available rating criteria used by an
NRSRO for evaluating the credit risk of
the underlying exposures. The
requirement that an NRSRO’s rating
criteria be publicly available does not
mean that these criteria must be
published formally by the NRSRO.
While the agencies expect banks to rely
on published rating criteria when these
criteria are available, an NRSRO often
delays publication of rating criteria for
securitizations involving new asset
types until the NRSRO builds sufficient
experience with such assets. Similarly,
as securitization structures evolve over
time, published criteria may be revised
with some lag. Especially for
securitizations involving new structures
or asset types, the requirement that
rating criteria be publicly available
should be interpreted broadly to
encompass not only published criteria,
but also criteria that are obtained
through written correspondence or other
communications with an NRSRO. In
such cases, these communications
should be documented and available for
review by the bank’s primary Federal
supervisor. The agencies believe this
flexibility is appropriate only for unique
situations when published rating
criteria are not generally applicable.
A commenter asked whether the
applicable NRSRO rating criteria must
cover all contractual payments owed to
the bank holding the exposure, or only
contractual principal and interest. For
example, liquidity facilities typically
obligate the seller to make certain future
fee and indemnity payments directly to
the liquidity bank. These ancillary
obligations, however, are not an
exposure to the ABCP program and
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69365
would not normally be covered by
NRSRO rating criteria, which focus on
the risks of the underlying assets and
the exposure’s vulnerability to those
risks. The agencies agree that such
ancillary obligations of the seller need
not be covered by the applicable NRSRO
rating criteria for an exposure to be
eligible for the IAA.
To be eligible for the IAA, a bank
must also demonstrate that its internal
credit assessments of securitization
exposures used for regulatory capital
purposes are consistent with those used
in its internal risk management process,
capital adequacy assessment process,
and management information reporting
systems. The bank must also
demonstrate that its internal credit
assessment process has sufficient
granularity to identify gradations of risk.
Each of the bank’s internal credit
assessment categories must correspond
to an external credit rating of an
NRSRO. In addition, the bank’s internal
credit assessment process, particularly
the stress test factors for determining
credit enhancement requirements, must
be at least as conservative as the most
conservative of the publicly available
rating criteria of the NRSROs that have
provided external credit ratings to the
commercial paper issued by the ABCP
program. In light of recent events in the
securitization market, the agencies
emphasize that if an NRSRO that
provides an external rating to an ABCP
program’s commercial paper changes its
methodology, the bank must evaluate
whether to revise its internal assessment
process.
Moreover, the bank must have an
effective system of controls and
oversight that ensures compliance with
these operational requirements and
maintains the integrity and accuracy of
the internal credit assessments. The
bank must also have an internal audit
function independent from the ABCP
program business line and internal
credit assessment process that assesses
at least annually whether the controls
over the internal credit assessment
process function as intended. The bank
must review and update each internal
credit assessment whenever new
material information is available, but no
less frequently than annually. The bank
must also validate its internal credit
assessment process on an ongoing basis,
but not less frequently than annually.
Under the proposed rule, in order for
a bank to use the IAA on a specific
exposure to an ABCP program, the
program had to satisfy the following
requirements:
(i) All commercial paper issued by the
ABCP program must have an external
rating.
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(ii) The ABCP program must have
robust credit and investment guidelines
(underwriting standards).
(iii) The ABCP program must perform
a detailed credit analysis of the asset
sellers’ risk profiles.
(iv) The ABCP program’s
underwriting policy must establish
minimum asset eligibility criteria that
include a prohibition of the purchase of
assets that are significantly past due or
defaulted, as well as limitations on
concentrations to an individual obligor
or geographic area and the tenor of the
assets to be purchased.
(v) The aggregate estimate of loss on
an asset pool that the ABCP program is
considering purchasing must consider
all sources of potential risk, such as
credit and dilution risk.
(vi) The ABCP program must
incorporate structural features into each
purchase of assets to mitigate potential
credit deterioration of the underlying
exposures. Such features may include
wind-down triggers specific to a pool of
underlying exposures.
Commenters suggested that the
program-level eligibility criteria should
apply only to those elements of the
ABCP program that are relevant to the
securitization exposure held by the bank
in order to prevent an ABCP program’s
purchase of a single asset pool that does
not meet the above criteria from
disallowing the IAA for securitization
exposures to that program that are
unrelated to the non-qualifying asset
pool. The agencies agree that this is a
reasonable approach. Accordingly, the
final rule applies criteria (ii) through
(vi) to the exposures underlying a
securitization exposure, rather than to
the entire ABCP program. For a
program-wide credit enhancement
facility, all of the separate seller-specific
arrangements benefiting from that
facility must meet the above
requirements for the facility to be
eligible for the IAA.
Several commenters objected to the
requirement that the ABCP program
prohibit purchases of significantly pastdue 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
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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-ofdays-past due criterion. In addition, the
term ‘defaulted assets’ in criterion (iv)
does not refer to the wholesale and
retail definitions of default in the final
rule, but rather may be interpreted as
referring to assets that have been
charged off or written down by the
seller prior to being placed into the
ABCP program or to assets that would
be charged off or written down under
the program’s governing contracts.
In addition, commenters asked the
agencies to clarify that a bank may
ignore one or more of the eligibility
requirements where the requirement is
not relevant to a particular exposure.
For example, in the case of a liquidity
facility supporting a static pool of term
loans, it may not be possible to
incorporate features into the transaction
that mitigate against a potential
deterioration in these assets, and there
may be no use for detailed credit
analyses of the seller following the
securitization if the seller has no further
involvement with the transaction. The
agencies have modified the final
criterion for determining whether an
exposure qualifies for the IAA, to
specify that where relevant, the ABCP
program must incorporate structural
features into each purchase of exposures
underlying the securitization exposure
to mitigate potential credit deterioration
of the underlying exposures.
4. Supervisory Formula Approach (SFA)
General Requirements
Under the proposed rule, a bank using
the SFA would determine the riskweighted asset amount for a
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securitization exposure by multiplying
the SFA risk-based capital requirement
for the exposure (as determined by the
supervisory formula set forth below) by
12.5. If the SFA risk weight for a
securitization exposure was 1,250
percent or greater, however, the bank
would deduct the exposure from total
capital rather than risk weight the
exposure. The agencies noted that
deduction is consistent with the
treatment of other high-risk
securitization exposures, such as CEIOs.
The SFA capital requirement for a
securitization exposure depends on the
following seven inputs:
(i) The amount of the underlying
exposures (UE);
(ii) The securitization exposure’s
proportion of the tranche that contains
the securitization exposure (TP);
(iii) The sum of the risk-based capital
requirement and ECL for the underlying
exposures (as determined under the
final rule as if the underlying exposures
were held directly on the bank’s balance
sheet) divided by the amount of the
underlying exposures (KIRB);
(iv) The tranche’s credit enhancement
level (L);
(v) The tranche’s thickness (T);
(vi) The securitization’s effective
number of underlying exposures (N);
and
(vii) The securitization’s exposureweighted 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:
E:\FR\FM\07DER2.SGM
07DER2
In these expressions, b[Y; a, b] refers
to the cumulative beta distribution with
parameters a and b evaluated at Y. In
the case where N = 1 and EWALGD =
100 percent, S[Y] in formula (1) must be
calculated with K[Y] set equal to the
product of KIRB and Y, and d set equal
to 1–KIRB. The major inputs to the SFA
formula (UE, TP, KIRB, L, T, EWALGD,
and N) are defined below and in section
45 of the final rule.
The agencies are modifying the SFA
treatment of certain high risk
securitization exposures in the final
rule. Under the proposed treatment
described above, a bank would have to
deduct from total capital any
securitization exposure with a SFA risk
weight equal to 1,250 percent. Under
certain circumstances, however, a slight
increase in the thickness of the tranche
that contains the securitization exposure
(T), holding other SFA risk parameters
fixed, could cause the exposure’s SFA
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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,
97 New
PO 00000
Accord, Annex 7.
Frm 00081
Fmt 4701
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69367
respectively. The bank must deduct
from total capital $5 (UE × TP × (KIRB
–L)), and the exposure’s risk-weighted
asset amount would be $125 (($15–$5)
× 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
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the bank may be required to deduct the
exposure.
The SFA formula effectively imposes
a 56 basis point minimum risk-based
capital requirement (8 percent of the 7
percent risk weight) per dollar of
securitization exposure. Although such
a floor may impose a capital
requirement that is too high for some
securitization exposures, the agencies
continue to believe that some minimum
prudential capital requirement is
appropriate in the securitization
context. This 7 percent risk-weight floor
is also consistent with the lowest capital
requirement available under the RBA
and, thus, should reduce incentives for
regulatory capital arbitrage.
The SFA formula is a blend of credit
risk modeling results and supervisory
judgment. The function S[Y]
incorporates two distinct features. The
first is a pure model-based estimate of
the pool’s aggregate systematic or nondiversifiable 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 modelbased percentage capital requirement
that could vary between zero and one,
depending on the number of effective
underlying exposures (N). The
supervisory add-on applies primarily to
positions just above KIRB, and its
quantitative effect diminishes rapidly as
the distance from KIRB widens.
Apart from the risk-weight floor and
other supervisory adjustments described
above, the supervisory formula attempts
to be as consistent as possible with the
parameters and assumptions of the IRB
approach that would apply to the
underlying exposures if held directly by
a bank.98 The specification of S[Y]
assumes that KIRB is an accurate
measure of the total systematic credit
risk of the pool of underlying exposures
and that a securitization merely
redistributes this systematic risk among
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.
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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
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
99 See Michael Pykhtin and Ashish Dev, ‘‘Coarsegrained CDOs,’’ Risk (January 2003), 16(1), 113–116.
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a reserve account (such as a cash
collateral account).
In practice, a bank’s ability to
calculate KIRB will often determine
whether it can use the SFA or whether
it must instead deduct an unrated
securitization exposure from total
capital. As noted above, there is a need
for flexibility when the estimation of
KIRB is constrained by data
shortcomings, such as when the bank
holding the securitization exposure is
not the servicer of the underlying assets.
The final rule clarifies that the
simplified approach for eligible
purchased wholesale exposures (Section
31) may be used for calculating KIRB.
To reduce the operational burden of
estimating KIRB, several commenters
urged the agencies to develop a simple
look-through approach such that when
all of the assets held by the SPE are
externally rated, KIRB could be
determined directly from the external
ratings of theses assets. The agencies
believe that a look-through approach for
estimating KIRB would be inconsistent
with the New Accord and would
increase the potential for capital
arbitrage. The agencies note that several
simplified methods for estimating 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 LookThrough 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 tranchespecific credit enhancements (such as
third-party guarantees that benefit only
a single tranche). Any after-tax gain-on-
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(100 + 1 + 1 + 1)
2
1002 + 12 + 12 + 12
=
10, 609
= 1.06
10, 003
ER07DE07.010</MATH>
As noted above, when calculating N
for a re-securitization, a bank must treat
each underlying securitization exposure
as an exposure to a single obligor. This
conservative treatment addresses the
concern that AVCs among securitization
exposures can be much greater than the
AVCs among the underlying individual
assets securing these securitization
exposures. Because the framework’s
simple approach to re-securitizations
may result in the differential treatment
of economically similar securitization
exposures, the agencies sought comment
on alternative approaches for
determining the N of a re-securitization.
While a number of commenters urged
that a bank be permitted to calculate N
for re-securitizations of asset-backed
securities by looking through to the
underlying pools of assets securing
these securities, none provided
theoretical or empirical evidence to
support this recommendation. Absent
such evidence, the final rule remains
consistent with New Accord’s
measurement of N for re-securitizations.
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
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 risksensitive 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:
ER07DE07.012</MATH>
N=
(vii) Exposure-weighted average loss
given default (EWALGD). The EWALGD
is calculated as:
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where EADi represents the EAD
associated with the ith instrument in the
pool of underlying exposures. For
purposes of computing N, multiple
exposures to one obligor must be treated
as a single underlying exposure. In the
case of a re-securitization (a
securitization in which some or all of
the underlying exposures are
themselves securitization exposures), a
bank must treat each underlying
securitization exposure as a single
exposure and must not look through to
the exposures that secure the underlying
securitization exposures.
N represents the granularity of a pool
of underlying exposures using an
‘‘effective’’ number of exposures
concept rather than a ‘‘gross’’ number of
exposures concept to appropriately
assess the diversification of pools that
have individual underlying exposures of
different sizes. An approach that simply
counts the gross number of underlying
exposures in a pool treats all exposures
in the pool equally. This simplifying
assumption could radically overestimate
the granularity of a pool with numerous
small exposures and one very large
exposure. The effective exposure
approach captures the notion that the
risk profile of such an unbalanced pool
is more like a pool of several mediumsized 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:
ER07DE07.011</GPH>
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:
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where Cm is the ratio of (i) the sum of
the amounts of the largest ‘‘m’’
underlying exposures of the
securitization; to (ii) UE. A bank may
select the level of ‘‘m’’ using its
discretion. For example, if the three
largest underlying exposures of a
securitization represent 15 percent of
the pool of underlying exposures, C3 for
the securitization is 0.15. As an
alternative simplification option, if only
C1 is available, and C1 is no more than
0.03, then the bank may set N=1/C1.
Under both simplification options a
bank may set EWALGD=0.50 unless one
or more of the underlying exposures is
a securitization exposure. If one or more
of the underlying exposures is a
securitization exposure, a bank using a
simplification option must set
EWALGD=1.
5. Eligible Market Disruption Liquidity
Facilities
Under the proposed SFA, there was
no special treatment provided for ABCP
liquidity facilities that could be drawn
upon only during periods of general
market disruption. In contrast, the New
Accord provides a more favorable
capital treatment within the SFA for
eligible market disruption liquidity
facilities than for other liquidity
facilities. Under the New Accord, an
eligible market disruption liquidity
facility is a liquidity facility that
supports an ABCP program and that (i)
is subject to an asset quality test that
precludes funding of underlying
exposures that are in default; (ii) can be
used to fund only those exposures that
have an investment-grade external
rating at the time of funding, if the
underlying exposures that the facility
must fund against are externally rated
exposures at the time that the exposures
are sold to the program; and (iii) may
only be drawn in the event of a general
market disruption.
The agencies sought comment on the
prevalence of eligible market disruption
liquidity facilities that might be subject
to the SFA and, by implication, whether
the final rule should incorporate the
treatment provided in the New Accord.
Commenters responded that eligible
market disruption liquidity facilities
currently are not a material product line
for U.S. banks, but urged international
consistency in this area. To limit
additional complexity in the final rule,
and because U.S. banks have limited
exposure to eligible market disruption
liquidity facilities, the agencies are not
including a separate treatment of
eligible market disruption liquidity
facilities in the final rule. The agencies
believe that the final rule provides
adequate flexibility to determine an
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appropriate capital requirement for
market disruption liquidity facilities.
6. CRM for Securitization Exposures
The treatment of CRM for
securitization exposures differs from
that applicable to wholesale and retail
exposures, and is largely unchanged
from the proposal. An originating bank
that has obtained a credit risk mitigant
to hedge its securitization exposure to a
synthetic or traditional securitization
that satisfies the operational criteria in
section 41 of the final rule may
recognize the credit risk mitigant, but
only as provided in section 46 of the
final rule. An investing bank that has
obtained a credit risk mitigant to hedge
a securitization exposure also may
recognize the credit risk mitigant, but
only as provided in section 46. A bank
that has used the RBA or IAA to
calculate its risk-based capital
requirement for a securitization
exposure whose external or inferred
rating (or equivalent internal rating
under the IAA) reflects the benefits of a
particular credit risk mitigant provided
to the associated securitization or that
supports some or all of the underlying
exposures, however, may not use the
securitization credit risk mitigation
rules to further reduce its risk-based
capital requirement for the exposure
based on that credit risk mitigant. For
example, a bank that owns a AAA-rated
asset-backed security that benefits from
an insurance wrap that is part of the
securitization transaction must calculate
its risk-based capital requirement for the
security strictly under the RBA. No
additional credit is given for the
presence of the insurance wrap. On the
other hand, if a bank owns a BBB-rated
asset-backed security and obtains a
credit default swap from a AAA-rated
counterparty to protect the bank from
losses on the security, the bank would
be able to apply the securitization CRM
rules to recognize the risk mitigating
effects of the credit default swap and
determine the risk-based capital
requirement for the position.
As under the proposal, the final rule
contains a treatment of CRM for
securitization exposures separate from
the treatment for wholesale and retail
exposures because the wholesale and
retail exposure CRM approaches rely on
substitutions of, or adjustments to, the
risk parameters of the hedged exposure.
Because the securitization framework
does not rely on risk parameters to
determine risk-based capital
requirements for securitization
exposures, a different treatment of CRM
for securitization exposures is
necessary.
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The securitization CRM rules, like the
wholesale and retail CRM rules, address
collateral separately from guarantees
and credit derivatives. A bank is not
permitted to recognize collateral other
than financial collateral as a credit risk
mitigant for securitization exposures. A
bank may recognize financial collateral
in determining the bank’s risk-based
capital requirement for a securitization
exposure that is not a repo-style
transaction, an eligible margin loan, or
an OTC derivative for which the bank
has reflected collateral in its
determination of exposure amount
under section 32 of the rule by using a
collateral haircut approach. The bank’s
risk-based capital requirement for a
collateralized securitization exposure is
equal to the risk-based capital
requirement for the securitization
exposure as calculated under the RBA
or the SFA multiplied by the ratio of
adjusted exposure amount (SE*) to
original exposure amount (SE),
Where:
(i) SE* = max {0, [SE¥C × (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 = ∑ a i Hi ,
i
where ai is the current market value of
the asset in the basket divided by the
current market value of all assets in the
basket and Hi is the haircut applicable
to that asset.
With the prior written approval of its
primary Federal supervisor, a bank may
calculate haircuts using its own internal
estimates of market price volatility and
foreign exchange volatility, subject to
the requirements for use of ownestimates haircuts contained in section
32 of the rule. Banks that use ownestimates 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
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reflect the longer-term nature of
securitization exposures as compared to
securities financing transactions,
however, these standard supervisory
haircuts (which are based on a tenbusiness-day holding period and daily
marking-to-market and remargining)
must be adjusted to a 65-business-day
holding period (the approximate
number of business days in a calendar
quarter) by multiplying them by the
square root of 6.5 (2.549510). A bank
also must adjust the standard
supervisory haircuts upward on the
basis of a holding period longer than 65
business days where and as appropriate
to take into account the illiquidity of the
collateral.
A bank may only recognize an eligible
guarantee or eligible credit derivative
provided by an eligible securitization
guarantor in determining the bank’s
risk-based capital requirement for a
securitization exposure. The definitions
of eligible guarantee and eligible credit
derivative apply to both the wholesale
and retail frameworks and the
securitization framework. An eligible
securitization guarantor is defined to
mean (i) a sovereign entity, the Bank for
International Settlements, the
International Monetary Fund, the
European Central Bank, the European
Commission, a Federal Home Loan
Bank, the Federal Agricultural Mortgage
Corporation (Farmer Mac), a multilateral
development bank, a depository
institution (as defined in section 3 of the
Federal Deposit Insurance Act (12
U.S.C. 1813)), a bank holding company
(as defined in section 2 of the Bank
Holding Company Act (12 U.S.C. 1841)),
a savings and loan holding company (as
defined in 12 U.S.C. 1467a) provided all
or substantially all of the holding
company’s activities are permissible for
a financial holding company under 12
U.S.C. 1843(k)), a foreign bank (as
defined in section 211.2 of the Federal
Reserve Board’s Regulation K (12 CFR
211.2)), or a securities firm; (ii) any
other entity (other than a securitization
SPE) that has issued and outstanding an
unsecured long-term debt security
without credit enhancement that has a
long-term applicable external rating in
one of the three highest investmentgrade rating categories; or (iii) any other
entity (other than a securitization SPE)
that has a PD assigned by the bank that
is lower than or equivalent to the PD
associated with a long-term external
rating in the third-highest investmentgrade 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
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determining the bank’s risk-based
capital requirement for a securitization
exposure. If the protection amount of
the eligible guarantee or eligible credit
derivative equals or exceeds the amount
of the securitization exposure, the bank
must set the risk-weighted asset amount
for the securitization exposure equal to
the risk-weighted asset amount for a
direct exposure to the eligible
securitization guarantor (as determined
in the wholesale risk weight function
described in section 31 of the final rule),
using the bank’s PD for the guarantor,
the bank’s LGD for the guarantee or
credit derivative, and an EAD equal to
the amount of the securitization
exposure (as determined in section 42(e)
of the final rule).
If the protection amount of the
eligible guarantee or eligible credit
derivative is less than the amount of the
securitization exposure, the bank must
divide the securitization exposure into
two exposures in order to recognize the
guarantee or credit derivative. The riskweighted asset amount for the
securitization exposure is equal to the
sum of the risk-weighted asset amount
for the covered portion and the riskweighted asset amount for the
uncovered portion. The risk-weighted
asset amount for the covered portion is
equal to the risk-weighted asset amount
for a direct exposure to the eligible
securitization guarantor (as determined
in the wholesale risk weight function
described in section 31 of the rule),
using the bank’s PD for the guarantor,
the bank’s LGD for the guarantee or
credit derivative, and an EAD equal to
the protection amount of the credit risk
mitigant. The risk-weighted asset
amount for the uncovered portion is
equal to the product of (i) 1.0 minus the
ratio of the protection amount of the
eligible guarantee or eligible credit
derivative divided by the amount of the
securitization exposure; and (ii) the riskweighted 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
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69371
exposures that have different residual
maturities, the bank must use the
longest residual maturity of any of the
hedged exposures as the residual
maturity of all the hedged exposures. If
the risk-weighted asset amount for a
guaranteed securitization exposure is
greater than the risk-weighted asset
amount for the securitization exposure
without the guarantee or credit
derivative, a bank may elect not to
recognize the guarantee or credit
derivative.
When a bank recognizes an eligible
guarantee or eligible credit derivative
provided by an eligible securitization
guarantor in determining the bank’s
risk-based capital requirement for a
securitization exposure, the bank also
must (i) calculate ECL for the protected
portion of the exposure using the same
risk parameters that it uses for
calculating the risk-weighted asset
amount of the exposure (that is, the PD
associated with the guarantor’s rating
grade, the LGD of the guarantee, and an
EAD equal to the protection amount of
the credit risk mitigant); and (ii) add
this ECL to the bank’s total ECL.
7. Synthetic Securitizations
Background
In a synthetic securitization, an
originating bank uses credit derivatives
or guarantees to transfer the credit risk,
in whole or in part, of one or more
underlying exposures to third-party
protection providers. The credit
derivative or guarantee may be either
collateralized or uncollateralized. In the
typical synthetic securitization, the
underlying exposures remain on the
balance sheet of the originating bank,
but a portion of the originating bank’s
credit exposure is transferred to the
protection provider or covered by
collateral pledged by the protection
provider.
In general, the final rule’s treatment of
synthetic securitizations is identical to
that of traditional securitizations and to
that described in the proposal. The
operational requirements for synthetic
securitizations are more detailed than
those for traditional securitizations and
are intended to ensure that the
originating bank has truly transferred
credit risk of the underlying exposures
to one or more third-party protection
providers.
Although synthetic securitizations
typically employ credit derivatives,
which might suggest that such
transactions would be subject to the
CRM rules in section 33 of the final rule,
banks must apply the securitization
framework when calculating risk-based
capital requirements for a synthetic
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securitization exposure. Banks may
ultimately be redirected to the
securitization CRM rules to adjust the
securitization framework capital
requirement for an exposure to reflect
the CRM technique used in the
transaction.
Operational Requirements for Synthetic
Securitizations
For synthetic securitizations, an
originating bank may recognize for riskbased capital purposes the use of CRM
to hedge, or transfer credit risk
associated with, underlying exposures
only if each of the following conditions
is satisfied:
(i) The credit risk mitigant is financial
collateral, an eligible credit derivative
from an eligible securitization guarantor
(defined above), or an eligible guarantee
from an eligible securitization
guarantor.
(ii) The bank transfers credit risk
associated with the underlying
exposures to third-party investors, and
the terms and conditions in the credit
risk mitigants employed do not include
provisions that:
(A) Allow for the termination of the
credit protection due to deterioration in
the credit quality of the underlying
exposures;
(B) Require the bank to alter or
replace the underlying exposures to
improve the credit quality of the
underlying exposures;
(C) Increase the bank’s cost of credit
protection in response to deterioration
in the credit quality of the underlying
exposures;
(D) Increase the yield payable to
parties other than the bank in response
to a deterioration in the credit quality of
the underlying exposures; or
(E) Provide for increases in a retained
first loss position or credit enhancement
provided by the bank after the inception
of the securitization.
(iii) The bank obtains a well-reasoned
opinion from legal counsel that
confirms the enforceability of the credit
risk mitigant in all relevant
jurisdictions.
(iv) Any clean-up calls relating to the
securitization are eligible clean-up calls
(as discussed above).
Failure to meet the above operational
requirements for a synthetic
securitization prevents the originating
bank from using the securitization
framework and requires the originating
bank to hold risk-based capital against
the underlying exposures as if they had
not been synthetically securitized. A
bank that provides credit protection to
a synthetic securitization must use the
securitization framework to compute
risk-based capital requirements for its
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exposures to the synthetic securitization
even if the originating bank failed to
meet one or more of the operational
requirements for a synthetic
securitization.
Consistent with the treatment of
traditional securitization exposures, a
bank must use the RBA for synthetic
securitization exposures that have an
appropriate number of external or
inferred ratings. For an originating bank,
the RBA will typically be used only for
the most senior tranche of the
securitization, which often has an
inferred rating. If a bank has a synthetic
securitization exposure that does not
have an external or inferred rating, the
bank must apply the SFA to the
exposure (if the bank and the exposure
qualify for use of the SFA) without
considering any CRM obtained as part of
the synthetic securitization. Then, if the
bank has obtained a credit risk mitigant
on the exposure as part of the synthetic
securitization, the bank may apply the
securitization CRM rules to reduce its
risk-based capital requirement for the
exposure. For example, if the credit risk
mitigant is financial collateral, the bank
may use the standard supervisory or
own-estimates haircuts to reduce its
risk-based capital requirement. If the
bank is a protection provider to a
synthetic securitization and has
obtained a credit risk mitigant on its
exposure, the bank may also apply the
securitization CRM rules in section 46
of the final rule to reduce its risk-based
capital requirement on the exposure. If
neither the RBA nor the SFA is
available, a bank must deduct the
exposure from regulatory capital.
First-Loss Tranches
If a bank has a first-loss position in a
pool of underlying exposures in
connection with a synthetic
securitization, the bank must deduct the
position from regulatory capital unless
(i) the position qualifies for use of the
RBA or (ii) the bank and the position
qualify for use of the SFA and KIRB is
greater than L.
Mezzanine Tranches
In a typical synthetic securitization,
an originating bank obtains credit
protection on a mezzanine, or secondloss, 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
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from an eligible securitization
guarantor, the bank generally will treat
the notional amount of the credit
derivative or guarantee (as adjusted to
reflect any maturity mismatch, lack of
restructuring coverage, or currency
mismatch) as a wholesale exposure to
the protection provider and use the IRB
approach for wholesale exposures to
determine the bank’s risk-based capital
requirement for the exposure. A bank
that creates the synthetic mezzanine
tranche by obtaining from a non-eligible
securitization guarantor a guarantee or
credit derivative that is collateralized by
financial collateral generally will (i) first
use the SFA to calculate the risk-based
capital requirement on the exposure
(ignoring the guarantee or credit
derivative and the associated collateral);
and (ii) then use the securitization CRM
rules to calculate any reductions to the
risk-based capital requirement resulting
from the associated collateral. The bank
may look only to the protection provider
from which it obtains the guarantee or
credit derivative when determining its
risk-based capital requirement for the
exposure (that is, if the protection
provider hedges the guarantee or credit
derivative with a guarantee or credit
derivative from a third party, the bank
may not look through the protection
provider to that third party when
calculating its risk-based capital
requirement for the exposure).
For a bank providing credit protection
on a mezzanine tranche of a synthetic
securitization, the bank must use the
RBA to determine the risk-based capital
requirement for the exposure if the
exposure has an external or inferred
rating. If the exposure does not have an
external or inferred rating and the
exposure qualifies for use of the SFA,
the bank may use the SFA to calculate
the risk-based capital requirement for
the exposure. If neither the RBA nor the
SFA are available, the bank must deduct
the exposure from regulatory capital. If
a bank providing credit protection on
the mezzanine tranche of a synthetic
securitization obtains a credit risk
mitigant to hedge its exposure, the bank
may apply the securitization CRM rules
to reflect the risk reduction achieved by
the credit risk mitigant.
Super-Senior Tranches
A bank that has the most senior
position in a pool of underlying
exposures in connection with a
synthetic securitization must use the
RBA to calculate its risk-based capital
requirement for the exposure if the
exposure has at least one external or
inferred rating (in the case of an
investing bank) or at least two external
or inferred ratings (in the case of an
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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-todefault 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-todefault credit derivative), it may only
recognize the credit protection for riskbased capital purposes either if it has
obtained credit protection on the same
underlying exposures in the form of
first-through-(n-1)-to-default credit
derivatives, or if n-1 of the underlying
exposures have already defaulted. In
such a case, the bank must again
determine its risk-based capital
requirement for the underlying
exposures as if the bank had only
synthetically securitized the n-1
underlying exposures with the lowest
capital requirement and had obtained
no credit risk mitigant on the other
underlying exposures.
A bank that provides credit protection
on a group of underlying exposures
through a first-to-default credit
derivative must determine its riskweighted 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
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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-todefault 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-todefault credit derivative on a basket of
five reference exposures. The derivative
is unrated and the protection amount of
the derivative is $100. The risk-based
capital requirements of the underlying
exposures are 2.5 percent, 5.0 percent,
10.0 percent, 15.0 percent, and 20
percent. The risk-weighted asset amount
of the derivative would be $100 × 12.5
× (.05 + .10 + .15 + .20) or $625. If the
derivative were externally rated in the
lowest investment-grade rating category
with a positive designation, the riskweighted asset amount would be $100 ×
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
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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sheet sources of funding. The payment
allocations used to distribute principal
and finance charge collections during
the amortization phase of these
transactions also can expose a bank to
greater risk of loss than in other
securitization transactions. The final
rule, consistent with the proposed rule,
assesses a risk-based capital
requirement that, in general, is linked to
the likelihood of an early amortization
event to address the risks that early
amortization of a securitization poses to
originating banks.
Consistent with the proposed rule, the
final rule defines an early amortization
provision as a provision in a
securitization’s governing
documentation that, when triggered,
causes investors in the securitization
exposures to be repaid before the
original stated maturity of the
securitization exposure, unless the
provision is solely triggered by events
not related to the performance of the
underlying exposures or the originating
bank (such as material changes in tax
laws or regulations).
Under the proposed rule, a bank
would not be required to hold
regulatory capital against the investors’
interest if early amortization is solely
triggered by events not related to the
performance of the underlying
exposures or the originating bank, such
as material changes in tax laws or
regulation. Under the New Accord, a
bank is also not required to hold
regulatory capital against the investors’
interest if (i) the securitization has a
replenishment structure in which the
individual underlying exposures do not
revolve and the early amortization ends
the ability of the originating bank to add
new underlying exposures to the
securitization; (ii) the securitization
involves revolving assets and contains
early amortization features that mimic
term structures; or (iii) investors in the
securitization remain fully exposed to
future draws by borrowers on the
underlying exposures even after the
occurrence of early amortization. The
agencies sought comment on the
appropriateness of these additional
exemptions in the U.S. markets for
revolving securitizations. Most
commenters asserted that the
exemptions provided in the New
Accord are prudent and should be
adopted by the agencies in order to
avoid placing U.S. banking
organizations at a competitive
disadvantage relative to foreign
competitors. The agencies generally
agree with this view of exemption (iii),
above, and the definition of early
amortization provision in the final rule
incorporates this exemption. The
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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 nonrevolving underlying exposures, only
the revolving underlying exposures give
rise to the risk of early amortization.
Under the final rule, consistent with
the proposal, the investors’ interest with
respect to a revolving securitization
captures both the drawn balances and
undrawn lines of the underlying
exposures that are allocated to the
investors in the securitization. The EAD
associated with the investors’ interest is
equal to the EAD of the underlying
exposures multiplied by the ratio of:
(i) The total amount of securitization
exposures issued by the securitization
SPE to investors; divided by
(ii) The outstanding principal amount
of underlying exposures.
In general, the applicable CF depends
on whether the early amortization
provision repays investors through a
controlled or non-controlled mechanism
and whether the underlying exposures
are revolving retail credit facilities that
are uncommitted (unconditionally
cancelable by the bank to the fullest
extent of Federal law, such as credit
card receivables) or are other revolving
credit facilities (for example, revolving
corporate credit facilities). Consistent
with the New Accord, under the
proposed rule a controlled early
amortization provision would meet each
of the following conditions:
(i) The originating bank has
appropriate policies and procedures to
ensure that it has sufficient capital and
liquidity available in the event of an
early amortization;
(ii) Throughout the duration of the
securitization (including the early
amortization period) there is the same
pro rata sharing of interest, principal,
expenses, losses, fees, recoveries, and
other cash flows from the underlying
exposures, based on the originating
bank’s and the investors’ relative shares
of the underlying exposures outstanding
measured on a consistent monthly basis;
(iii) The amortization period is
sufficient for at least 90 percent of the
total underlying exposures outstanding
at the beginning of the early
amortization period to have been repaid
or recognized as in default; and
(iv) The schedule for repayment of
investor principal is not more rapid
than would be allowed by straight-line
amortization over an 18-month period.
An early amortization provision that
does not meet any of the above criteria
is a non-controlled early amortization
provision.
The agencies solicited comment on
the distinction between controlled and
non-controlled early amortization
provisions and on the extent to which
banks use controlled early amortization
provisions. The agencies also invited
comment on the proposed definition of
a controlled early amortization
provision, including in particular the
18-month period set forth above.
Commenters generally believed that
very few, if any, revolving
securitizations would meet the criteria
needed to qualify for treatment as a
controlled early amortization structure.
One commenter maintained that a fixed
18-month straight-line amortization
period was too long for certain
exposures, such as prime credit cards.
The final rule is unchanged from the
proposal with respect to controlled and
non-controlled early amortization
provisions. The agencies believe that the
proposed eligibility criteria for a
controlled early amortization are
important indicators of the risks to
which an originating bank would be
exposed in the event of any early
amortization. While a fixed 18-month
straight-line amortization period is
unlikely to be the most appropriate
period in all cases, it is a reasonable
period for the vast majority of cases. The
lower operational burden of using a
single, fixed amortization period
warrants the potential diminution in
risk-sensitivity.
Controlled Early Amortization
Under the proposed rule, to calculate
the appropriate CF for a securitization of
uncommitted revolving retail exposures
that contains a controlled early
amortization provision, a bank would
compare the three-month average
annualized excess spread for the
securitization to the point at which the
bank is required to trap excess spread
under the securitization transaction. In
securitizations that do not require
excess spread to be trapped, or that
specify a trapping point based primarily
on performance measures other than the
three-month average annualized excess
spread, the excess spread trapping point
was 4.5 percent. The bank would divide
the three-month average annualized
excess spread level by the excess spread
trapping point and apply the
appropriate CF from Table H.
TABLE H.—CONTROLLED EARLY AMORTIZATION PROVISIONS
Uncommitted
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Retail Credit Lines .......................................
Non-retail Credit Lines ................................
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Committed
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.
90% CF ............................................................................................................................
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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.
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 nonretail credit lines because of the
demonstrated ability of banks to
monitor and, when appropriate, to
69375
Non-controlled Early Amortization
Under the proposed rule, to calculate
the appropriate CF for securitizations of
uncommitted revolving retail exposures
that contain a non-controlled early
amortization provision, a bank would
perform the excess spread calculations
described in the controlled early
amortization section above and then
apply the CFs in Table I.
TABLE I.—NON-CONTROLLED EARLY AMORTIZATION PROVISIONS
Uncommitted
Retail Credit Lines .......................................
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Non-retail Credit Lines ................................
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, 50% CF.
less than 50% of trapping point, 100% CF.
100% CF ..........................................................................................................................
A bank would use a 100 percent CF
for all other revolving underlying
exposures (committed exposures and
nonretail exposures) in securitizations
containing a non-controlled early
amortization provision. In other words,
no risk transference would be
recognized for these transactions; an
originating bank’s IRB capital
requirement would be the same as if the
underlying exposures had not been
securitized.
A few commenters asserted that the
proposed CFs were too high. The
agencies believe, however, that the
proposed CFs appropriately capture the
risk to the bank of a potential early
amortization event. The agencies also
believe that the proposed CFs, which
are consistent with the New Accord,
foster consistency across national
jurisdictions. Therefore, the agencies are
maintaining the proposed CFs in the
final rule with one exception, discussed
below.
In circumstances where a
securitization contains a mix of retail
and nonretail exposures or a mix of
committed and uncommitted exposures,
a bank may take a pro rata approach to
determining the CF for the
securitization’s early amortization
provision. If a pro rata approach is not
feasible, a bank must treat the
securitization as a securitization of
nonretail exposures if a single
underlying exposure is a nonretail
exposure and must treat the
securitization as a securitization of
committed exposures if a single
underlying exposure is a committed
exposure.
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Committed
Securitizations of Revolving Residential
Mortgage Exposures
The agencies sought comment on the
appropriateness of the proposed 4.5
percent excess spread trapping point
and on whether there were other types
and levels of early amortization triggers
used in securitizations of revolving
retail exposures that should be
addressed by the agencies. Although
some commenters believed the 4.5
percent trapping point assumption was
reasonable, others believed that it was
inappropriate for securitizations of
HELOCs. Unlike credit card
securitizations, U.S. HELOC
securitizations typically do not generate
material excess spread and typically are
structured with credit enhancements
and early amortization triggers based on
other factors, such as portfolio loss
rates. Under the proposed treatment,
banks would be required to hold capital
against the potential early amortization
of most U.S. HELOC securitizations at
their inception, rather than only if the
credit quality of the underlying
exposures deteriorated. Although the
New Accord does not provide an
alternative methodology, the agencies
concluded that the features of the U.S.
HELOC securitization market warrant an
alternative approach. Accordingly, the
final rule allows a bank the option of
applying either (i) the CFs in Tables I
and J, as appropriate, or (ii) a fixed CF
equal to 10 percent to its securitizations
for which all or substantially all of the
underlying exposures are revolving
residential mortgage exposures. If a
bank chooses the fixed CF of 10 percent,
it must use that CF for all securitizations
for which all or substantially all of the
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100% CF
100% CF
underlying exposures are revolving
residential mortgage exposures. The
agencies will monitor the
implementation of this alternative
approach to ensure that it is consistent
with safety and soundness.
F. Equity Exposures
1. Introduction and Exposure
Measurement
This section describes the final rule’s
risk-based capital treatment for equity
exposures. Consistent with the proposal,
under the final rule, a bank has the
option to use either a simple risk-weight
approach (SRWA) or an internal models
approach (IMA) for equity exposures
that are not exposures to an investment
fund. A bank must use a look-through
approach for equity exposures to an
investment fund.
Although the New Accord provides
national supervisors the option to
provide a grandfathering period for
equity exposures—whereby for a
maximum of ten years, supervisors
could permit banks to exempt from the
IRB treatment equity investments held
at the time of the publication of the New
Accord—the proposed rule did not
include such a grandfathering provision.
A number of commenters asserted that
the proposal was inconsistent with the
New Accord and would subject banks
using the agencies’ advanced
approaches to significant competitive
inequity.
The agencies continue to believe that
it is not appropriate or necessary to
incorporate the New Accord’s optional
ten-year grandfathering period for
equity exposures. The grandfathering
concept would reduce the risk
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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations
sensitivity of the SRWA and IMA.
Moreover, the IRB approach does not
provide grandfathering for other types of
exposures, and the agencies see no
compelling reason to do so for equity
exposures. Further, the agencies believe
that the overall final rule approach to
equity exposures sufficiently mitigates
potential competitive issues.
Accordingly, the final rule does not
provide a grandfathering period for
equity exposures.
Under the proposed SRWA, a bank
generally would assign a 300 percent
risk weight to publicly traded equity
exposures and a 400 percent risk weight
to non-publicly traded equity exposures.
Certain equity exposures to sovereigns,
multilateral institutions, and public
sector enterprises would have a risk
weight of 0 percent, 20 percent, or 100
percent; and certain community
development equity exposures, hedged
equity exposures, and, up to certain
limits, non-significant equity exposures
would receive a 100 percent risk weight.
Alternatively, under the proposed
rule, a bank that met certain minimum
quantitative and qualitative
requirements on an ongoing basis and
obtained the prior written approval of
its primary Federal supervisor could use
the IMA to determine its risk-based
capital requirement for all modeled
equity exposures. A bank that qualified
to use the IMA could apply the IMA to
its publicly traded and non-publicly
traded equity exposures, or could apply
the IMA only to its publicly traded
equity exposures. However, if the bank
applied the IMA to its publicly traded
equity exposures, it would be required
to apply the IMA to all such exposures.
Similarly, if a bank applied the IMA to
both publicly traded and non-publicly
traded equity exposures, it would be
required to apply the IMA to all such
exposures. If a bank did not qualify to
use the IMA, or elected not to use the
IMA, to compute its risk-based capital
requirements for equity exposures, the
bank would apply the SRWA to assign
risk weights to its equity exposures.
Several commenters objected to the
proposed restrictions on the use of the
IMA. Commenters asserted that banks
should be able to apply the SRWA and
the IMA for different portfolios or
subsets of equity exposures, provided
that banks’ choices are consistent with
internal risk management practices.
The agencies have not relaxed the
proposed restrictions regarding use of
the SRWA and IMA. The agencies
remain concerned that if banks are
permitted to employ either the SRWA or
IMA to different equity portfolios, banks
could choose one approach over the
other to manipulate their risk-based
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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 nonpublicly 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 nonU.S.-based securities exchange that is
registered with, or approved by, a
national securities regulatory authority
and that provides a liquid, two-way
market for the exposure (that is, there
are enough independent bona fide offers
to buy and sell so that a sales price
reasonably related to the last sales price
or current bona fide competitive bid and
offer quotations can be determined
promptly and a trade can be settled at
such a price within five business days).
Several commenters explicitly
supported the proposed definition of
publicly traded, noting that it is
reasonable and consistent with industry
practice. Other commenters requested
that the agencies revise the proposed
definition by eliminating the
requirement that a non-U.S.-based
securities exchange provide a liquid,
two-way market for the exposure.
Commenters asserted that this
requirement goes beyond the definition
in the New Accord, which defines a
publicly traded equity exposure as any
equity security traded on a recognized
security exchange. They asserted that
registration with or approval by the
national securities regulatory authority
should suffice, as registration or
approval generally would be predicated
on the existence of a two-way market.
The agencies have retained the
definition of publicly traded as
proposed. The agencies believe that the
liquid, two-way market requirement is
not in addition to the requirements of
the New Accord. Rather, this
requirement clarifies the intent of
‘‘traded’’ in the New Accord and helps
to ensure that a sales price reasonably
related to the last sales price or
competitive bid and offer quotations can
be determined promptly and settled
within five business days.
A bank using either the IMA or the
SRWA must determine the adjusted
carrying value for each equity exposure.
The proposed rule defined the adjusted
carrying value of an equity exposure as:
(i) For the on-balance sheet
component of an equity exposure, the
bank’s carrying value of the exposure
reduced by any unrealized gains on the
exposure that are reflected in such
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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 banks to measure the onbalance sheet equivalent of an offbalance 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.
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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Hedge Transactions
The agencies proposed specific rules
for recognizing hedged equity
exposures; they received no substantive
comment on these rules and are
adopting these rules as proposed. For
purposes of determining risk-weighted
assets under both the SRWA and the
IMA, a bank may identify hedge pairs,
which the final rule defines as two
equity exposures that form an effective
hedge provided each equity exposure is
publicly traded or has a return that is
primarily based on a publicly traded
equity exposure. A bank may risk
weight only the effective and ineffective
portions of a hedge pair rather than the
entire adjusted carrying value of each
exposure that makes up the pair. Two
equity exposures form an effective
hedge if the exposures either have the
same remaining maturity or each has a
remaining maturity of at least three
months; the hedge relationship is
documented formally before the bank
acquires at least one of the equity
exposures; the documentation specifies
the measure of effectiveness (E) (defined
below) the bank will use for the hedge
relationship throughout the life of the
transaction; and the hedge relationship
has an E greater than or equal to 0.8. A
bank must measure E at least quarterly
and must use one of three alternative
measures of E—the dollar-offset method,
The 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
Measures of Hedge Effectiveness
Under the dollar-offset method of
measuring effectiveness, the bank must
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
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:
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 riskweighted asset amount for an equity
exposure to an investment fund under
section 54 of the proposed rule.
If a bank exclusively uses the SRWA
for its equity exposures, the bank’s
aggregate risk-weighted asset amount for
its equity exposures (other than equity
exposures to investment funds) would
be equal to the sum of the risk-weighted
asset amounts for each of the bank’s
individual equity exposures.
TABLE J
Risk weight
Equity exposure
0 Percent ..........
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Xt = At ¥ Bt
At = the value at time t of the one exposure
in a hedge pair, and
Bt = the value at time t of the other exposure
in the hedge pair.
the 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 × $100 = $80
and the ineffective portion of the hedge
pair would be (1¥0.8) × $100 = $20.
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TABLE J—Continued
Risk weight
Equity exposure
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.
• 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.
A publicly traded equity exposure (including the ineffective portion of a hedge pair).
An equity exposure that is not publicly traded.
100 Percent ......
300 Percent ......
400 Percent ......
Several commenters addressed the
proposed risk weights under the SRWA.
A few commenters asserted that the 100
percent risk weight for the effective
portion of a hedge pair is too high.
These commenters suggested that the
risk weight for such exposures should
be zero or no more than 7 percent
because the effectively hedged portion
of a hedge pair involves negligible credit
risk. One commenter remarked that it
does not believe there is an economic
basis for the different risk weight for an
equity exposure to a Federal Home Loan
Bank depending on whether the equity
exposure is held as a condition of
membership.
The agencies do not agree with
commenters’ assertion that the effective
portion of a hedge pair entails negligible
credit risk. The agencies believe the 100
percent risk weight under the proposal
is an appropriate and prudential
safeguard; thus, it is maintained in the
final rule. Banks that seek to more
accurately account for equity hedging in
their risk-based capital requirements
should use the IMA.
The agencies agree that different risk
weights for an equity exposure to a
Federal Home Loan Bank or Farmer Mac
depending on whether the equity
exposure is held as a condition of
membership do not have an economic
justification, given the similar risk
profile of the exposures. Accordingly,
under the final rule SRWA, all equity
exposures to a Federal Home Loan Bank
or to Farmer Mac receive a 20 percent
risk weight.
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Non-significant Equity Exposures
Under the SRWA, a bank may apply
a 100 percent risk weight to nonsignificant 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.
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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 riskbased capital rules for nonfinancial
equity investments.
The agencies note that the applicable
general risk-based capital rules address
only nonfinancial equity investments;
that the 15 percent threshold is a
percentage only of tier 1 capital; and
that the 15 percent threshold was
designed for that particular rule. The
proposed materiality threshold of 10
percent of tier 1 plus tier 2 capital is
consistent with the New Accord and is
intended to identify non-significant
holdings of equity exposures under a
different type of capital framework.
Thus, the two threshold limits are not
directly comparable. The agencies
believe that the proposed 10 percent
threshold for determining nonsignificant 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 nonsignificant equity exposures is
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inappropriate for equity exposures to
investment firms with greater than
immaterial leverage.
Under the final rule, to compute the
aggregate adjusted carrying value of a
bank’s equity exposures for determining
non-significance, the bank may exclude
(i) equity exposures that receive less
than a 300 percent risk weight under the
SRWA (other than equity exposures
determined to be non-significant); (ii)
the equity exposure in a hedge pair with
the smaller adjusted carrying value; and
(iii) a proportion of each equity
exposure to an investment fund equal to
the proportion of the assets of the
investment fund that are not equity
exposures or that qualify as community
development equity exposures. If a bank
does not know the actual holdings of the
investment fund, the bank may calculate
the proportion of the assets of the fund
that are not equity exposures based on
the terms of the prospectus, partnership
agreement, or similar contract that
defines the fund’s permissible
investments. If the sum of the
investment limits for all exposure
classes within the fund exceeds 100
percent, the bank must assume that the
investment fund invests to the
maximum extent possible in equity
exposures.
When determining which of a bank’s
equity exposures qualify for a 100
percent risk weight based on nonsignificance, 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:
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69379
TABLE K
Risk weight
Equity exposure
0 Percent ..........
20 Percent ........
100 Percent ......
An equity exposure to an entity whose credit exposures are exempt from the 0.03 percent PD floor.
An equity exposure to a Federal Home Loan Bank or Farmer Mac.
• 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.
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).
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.
300 Percent ......
400 Percent ......
600 percent ......
102 The final rule generally defines these exposures as exposures that would qualify as community development investments under 12 U.S.C.
24(Eleventh), excluding equity exposures to an unconsolidated small business investment company and equity exposures held through a consolidated small business investment company described in section 302 of the Small Business Investment Act of 1958 (15 U.S.C. 682). For savings
associations, community development investments would be defined to mean equity investments that are designed primarily to promote community welfare, including the welfare of low- and moderate-income communities or families, such as by providing services or jobs, and excluding equity exposures to an unconsolidated small business investment company and equity exposures held through a consolidated small business investment company described in section 302 of the Small Business Investment Act of 1958 (15 U.S.C. 682).
3. Internal Models Approach (IMA)
The IMA is designed to provide banks
with a more sophisticated and 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.
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.
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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-
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term sample period. Banks with equity
portfolios containing equity exposures
with values that are highly nonlinear in
nature (for example, equity derivatives
or convertibles) must employ an
internal model designed to
appropriately capture the risks
associated with these instruments.
In addition, the number of risk factors
and exposures in the sample and the
data period used for quantification in
the bank’s models and benchmarking
exercise must be sufficient to provide
confidence in the accuracy and
robustness of the bank’s estimates. The
bank’s model and benchmarking
exercise also must incorporate data that
are relevant in representing the risk
profile of the bank’s modeled equity
exposures, and must include data from
at least one equity market cycle
containing adverse market movements
relevant to the risk profile of the bank’s
modeled equity exposures. In addition,
for the reasons described below, the
final rule adds that the bank’s
benchmarking exercise must be based
on daily market prices for the
benchmark portfolio. If the bank’s
model uses a scenario methodology, the
bank must demonstrate that the model
produces a conservative estimate of
potential losses on the bank’s modeled
equity exposures over a relevant longterm 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
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equity investments are more relevant
than public market proxies and should
be permitted even if they are only
available on a monthly basis. The
agencies agree with commenters on this
issue. Accordingly, under the final rule,
banks are not required to have daily
market prices for all modeled equity
exposures, either direct holdings or
proxies. However, to ensure sufficient
rigor in the modeling process, the final
rule requires that a bank’s
benchmarking exercise be based on
daily market prices for the benchmark
portfolio, as noted above.
Finally, the bank must be able to
demonstrate, using theoretical
arguments and empirical evidence, that
any proxies used in the modeling
process are comparable to the bank’s
modeled equity exposures, and that the
bank has made appropriate adjustments
for differences. The bank must derive
any proxies for its modeled equity
exposures or benchmark portfolio using
historical market data that are relevant
to the bank’s modeled equity exposures
or benchmark portfolio (or, where not,
must use appropriately adjusted data),
and such proxies must be robust
estimates of the risk of the bank’s
modeled equity exposures.
In evaluating whether a bank has met
the criteria described above, the bank’s
primary Federal supervisor may
consider, among other factors, (i) the
nature of the bank’s equity exposures,
including the number and types of
equity exposures (for example, publicly
traded, non-publicly traded, long,
short); (ii) the risk characteristics and
makeup of the bank’s equity exposures,
including the extent to which publicly
available price information is obtainable
on the exposures; and (iii) the level and
degree of concentration of, and
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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations
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 VaRbased model. The agencies recognize
that the type and sophistication of
internal models will vary across banks
due to differences in the nature, scope,
and complexity of business lines in
general and equity exposures in
particular. The agencies also recognize
that some banks employ models for
internal risk management and capital
allocation purposes that can be more
relevant to the bank’s equity exposures
than some VaR models. For example,
some banks employ rigorous historical
scenario analysis and other techniques
for assessing the risk of their equity
portfolios.
Banks that choose to use a VaR-based
internal model under the IMA should
use a historical observation period that
includes a sufficient amount of data
points to ensure statistically reliable and
robust loss estimates relevant to the
long-term risk profile of the bank’s
specific holdings. The data used to
represent return distributions should
reflect the longest sample period for
which data are available and should
meaningfully represent the risk profile
of the bank’s specific equity holdings.
The data sample should be long-term in
nature and, at a minimum, should
encompass at least one complete equity
market cycle containing adverse market
movements relevant to the risk profile of
the bank’s modeled exposures. The data
used should be sufficient to provide
conservative, statistically reliable, and
robust loss estimates that are not based
purely on subjective or judgmental
considerations.
The parameters and assumptions used
in a VaR model should be subject to a
rigorous and comprehensive regime of
stress-testing. Banks utilizing VaR
models should subject their internal
model and estimation procedures,
including volatility computations, to
either hypothetical or historical
scenarios that reflect worst-case losses
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given underlying positions in both
publicly traded and non-publicly traded
equities. At a minimum, banks that use
a VaR model should employ stress tests
to provide information about the effect
of tail events beyond the level of
confidence assumed in the IMA.
Banks using non-VaR internal models
that are based on stress tests or scenario
analyses should estimate losses under
worst-case modeled scenarios. These
scenarios should reflect the composition
of the bank’s equity portfolio and
should produce risk-based capital
requirements at least as large as those
that would be required to be held
against a representative market index or
other relevant benchmark portfolio
under a VaR approach. For example, for
a portfolio consisting primarily of
publicly held equity securities that are
actively traded, risk-based capital
requirements produced using historical
scenario analyses should be greater than
or equal to risk-based capital
requirements produced by a baseline
VaR approach for a major index or subindex that is representative of the bank’s
holdings.
The loss estimate derived from the
bank’s internal model constitutes the
risk-based capital requirement for the
modeled equity exposures (subject to
the supervisory floors described below).
The equity capital requirement is
incorporated into a bank’s risk-based
capital ratio through the calculation of
risk-weighted equivalent assets. To
convert the equity capital requirement
into risk-weighted equivalent assets, a
bank must multiply the capital
requirement by 12.5.
Risk-Weighted Assets Under the IMA
Under the proposed and final rules, as
noted above, a bank may apply the IMA
only to its publicly traded equity
exposures or may apply the IMA to its
publicly traded and non-publicly traded
equity exposures. In either case, a bank
is not allowed to apply the IMA to
equity exposures that receive a 0 or 20
percent risk weight under the SRWA,
community development equity
exposures, and equity exposures to
investment funds (collectively,
excluded equity exposures). Unlike the
SRWA, the IMA does not provide for a
10 percent materiality threshold for
non-significant equity exposures.
Several commenters objected to the
fact that the IMA does not provide a 100
percent risk weight for non-significant
equity exposures up to a 10 percent
materiality threshold. These
commenters maintained that the lack of
a materiality threshold under the IMA
will discourage use of this methodology
relative to the SRWA. Commenters
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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 riskbased capital requirements based on the
exposures it chooses to model and those
which it would deem immaterial (and to
which it would apply a 100 percent risk
weight). The agencies also believe that
a flat 100 percent risk weight is
inconsistent with the risk sensitivity of
the IMA.
Under the proposal, if a bank applied
the IMA to both publicly traded and
non-publicly traded equity exposures,
the bank’s aggregate risk-weighted asset
amount for its equity exposures would
be equal to the sum of the risk-weighted
asset amount of excluded equity
exposures (calculated outside of the
IMA) and the risk-weighted asset
amount of the non-excluded equity
exposures (calculated under the IMA).
The risk-weighted asset amount of the
non-excluded equity exposures
generally would be set equal to the
estimate of potential losses on the
bank’s non-excluded equity exposures
generated by the bank’s internal model
multiplied by 12.5. To ensure that a
bank holds a minimum amount of riskbased capital against its modeled equity
exposures, however, the proposed rule
contained a supervisory floor on the
risk-weighted asset amount of the nonexcluded equity exposures. As a result
of this floor, the risk-weighted asset
amount of the non-excluded equity
exposures could not fall below the sum
of (i) 200 percent multiplied by the
aggregate adjusted carrying value or
ineffective portion of hedge pairs, as
appropriate, of the bank’s non-excluded
publicly traded equity exposures; and
(ii) 300 percent multiplied by the
aggregate adjusted carrying value of the
bank’s non-excluded non-publicly
traded equity exposures.
Also under the proposal, if a bank
applied the IMA only to its publicly
traded equity exposures, the bank’s
aggregate risk-weighted asset amount for
its equity exposures would be equal to
the sum of (i) the risk-weighted asset
amount of excluded equity exposures
(calculated outside of the IMA); (ii) 400
percent multiplied by the aggregate
adjusted carrying value of the bank’s
non-excluded non-publicly traded
equity exposures; and (iii) the aggregate
risk-weighted asset amount of its nonexcluded 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
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bank’s non-excluded publicly traded
equity exposures generated by the
bank’s internal model multiplied by
12.5. Under the proposed rule, the riskweighted asset amount for the nonexcluded publicly traded equity
exposures would be subject to a floor of
200 percent multiplied by the aggregate
adjusted carrying value or ineffective
portion of hedge pairs, as appropriate, of
the bank’s non-excluded publicly traded
equity exposures.
Several commenters did not support
the concept of floors in a risk-sensitive
approach that requires a comparison to
estimates of potential losses produced
by a VaR methodology. If floors are
required in the final rule, however,
these commenters noted that the
calculation at the aggregate level would
not pose significant operational issues.
A few commenters, in contrast, objected
to the proposed aggregate floors,
asserting that it would be operationally
difficult to determine compliance with
such floors.
The agencies believe that it is prudent
to retain the floor requirements in the
IMA and, thus, are adopting the floor
requirements as described above. The
agencies note that the New Accord also
imposes a 200 percent and 300 percent
floor for publicly traded and nonpublicly 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.
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4. Equity Exposures to Investment
Funds
The proposed rule included a separate
treatment for equity exposures to
investment funds. As proposed, a bank
would determine the risk-weighted asset
amount for equity exposures to
investment funds using one of three
approaches: the full look-through
approach, the simple modified lookthrough 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
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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 riskbased capital requirements for certain
high-risk exposures and to ensure that
banks do not receive a punitive riskbased capital requirement for equity
exposures to investment funds that hold
only low-risk assets. Under the
proposal, the agencies defined an
investment fund as a company (i) all or
substantially all of the assets of which
are financial assets and (ii) that has no
material liabilities.
Generally, commenters supported the
separate treatment for equity exposures
to investment funds. However, several
commenters objected to the exclusion of
investment funds with material
liabilities from this separate treatment,
observing that it would exclude equity
exposures to hedge funds. Several
commenters suggested that investment
funds with material liabilities should be
eligible for the look-through approaches.
One commenter suggested that the
agencies should adopt the following
definition of investment fund: ‘‘A
company in which all or substantially
all of the assets are pooled financial
assets that are collectively managed in
order to generate a financial return,
including investment companies or
funds with material liabilities.’’ A few
commenters suggested that equity
exposures to investment funds with
material liabilities should be treated
under the SRWA or IMA as nonpublicly traded equity exposures rather
than the separate treatment developed
for equity exposures to investment
funds.
The agencies do not agree with
commenters that the look-through
approaches for investment funds should
apply to investment vehicles with
material liabilities. The look-through
treatment is designed to capture the
risks of an indirect holding of the
underlying assets of the investment
fund. Investment vehicles with material
liabilities provide a leveraged exposure
to the underlying financial assets and
have a risk profile that may not be
appropriately captured by a lookthrough approach.
Under the proposal, each of the
approaches to equity exposures to
investment funds imposed a 7 percent
minimum risk weight on such
exposures. This proposed minimum risk
weight was similar to the minimum 7
percent risk weight under the RBA for
securitization exposures and the
effective 56 basis point minimum risk-
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69381
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 riskbased capital requirement for exposures
not directly held by a bank. However,
the agencies believe the comments on
this issue have merit and recognize that
the floor would provide banks with an
incentive to invest in higher-risk
investment funds. Consistent with the
New Accord, the final rule does not
impose a 7 percent risk weight floor on
equity exposures to investment funds,
on either an individual or aggregate
basis.
Full Look-Through Approach
A bank may use the full look-through
approach only if the bank is able to
compute a risk-weighted asset amount
for each of the exposures held by the
investment fund. Under the proposed
rule, a bank would be required to
calculate the risk-weighted asset amount
for each of the exposures held by the
investment fund as if the exposures
were held directly by the bank.
Depending on whether the exposures
were wholesale, retail, securitization, or
equity exposures, a bank would apply
the appropriate IRB risk-based capital
treatment.
Several commenters suggested that
the agencies should allow a bank with
supervisory approval to use the IMA to
model the underlying assets of an
investment fund by including the bank’s
pro rata share of the investment fund’s
assets in its equities model. The
commenters believed there is no basis
for preventing a bank from using the
IMA, a sophisticated and risk-sensitive
approach, when a bank has full position
data for an investment fund.
The agencies agree with commenters’
views in this regard. If a bank has full
position data for an investment fund
and has been approved by its primary
Federal supervisor for use of the IMA,
it may include the underlying equity
exposures held by an investment fund,
after adjustment for proportional
ownership, in its equities model under
the IMA. Therefore, in the final rule,
under the full look-through approach, a
bank must either (i) set the riskweighted asset amount of the bank’s
equity exposure to the investment fund
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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 riskweighted asset amount for the equity
exposure to the investment fund is
determined together with the riskweighted asset amount for the bank’s
other non-excluded equity exposures
and is subject to the aggregate floors
under this approach.
Simple Modified Look-Through
Approach
Under the proposed simple modified
look-through approach, a bank would
set the risk-weighted asset amount for
its equity exposure to an investment
fund equal to the adjusted carrying
value of the equity exposure multiplied
by the highest risk weight in Table L
that applies to any exposure the fund is
permitted to hold under its prospectus,
partnership agreement, or similar
contract that defines the fund’s
permissible investments. The bank
could exclude derivative contracts that
are used for hedging, not speculative
purposes, and do not constitute a
material portion of the fund’s exposures.
Commenters generally supported the
simple modified look-through approach
as a low-burden yet moderately risksensitive way of treating equity
exposures to an investment fund.
However, several commenters objected
to the large jump in risk weights (from
a 400 percent to a 1,250 percent risk
weight) between investment funds
permitted to hold non-publicly traded
equity exposures and investment funds
permitted to hold OTC derivative
contracts and/or exposures that must be
deducted from regulatory capital or
receive a risk weight greater than 400
percent under the IRB approach. In
addition, one commenter objected to the
proposed 20 percent risk weight for the
most highly rated money market mutual
funds that are subject to SEC rule 2a-7
governing portfolio maturity, quality,
diversification and liquidity. This
commenter asserted that a 7 percent risk
weight for such exposures would be
appropriate.
The agencies agree that the proposed
risk-weighting for highly-rated money
market mutual funds subject to SEC rule
2a-7 is conservative, given the generally
low risk of such funds. Accordingly, the
agencies added a new investment fund
approach—the Money Market Fund
Approach—which applies a 7 percent
risk weight to a bank’s equity exposure
to a money market fund that is subject
to SEC rule 2a-7 and that has an
applicable external rating in the highest
investment-grade rating category.
The agencies have made no changes
to address commenters’ concerns about
a lack of intermediate risk weights
between 400 percent and 1,250 percent.
The agencies believe the range of risk
weights is sufficiently granular to
accommodate most equity exposures to
investment funds.
TABLE L.—MODIFIED LOOK-THROUGH APPROACHES FOR EQUITY EXPOSURES TO INVESTMENT FUNDS
Risk weight
Exposure class or investment fund type
0 Percent ...................
Sovereign exposures with a long-term external rating in the highest investment-grade rating category and sovereign exposures of the United States.
Exposures with a long-term external rating in the highest or second-highest investment-grade rating category; exposures
with a short-term external rating in the highest investment-grade rating category; and exposures to, or guaranteed by,
depository institutions, foreign banks (as defined in 12 CFR 211.2), or securities firms subject to consolidated supervision or regulation comparable to that imposed on U.S. securities broker-dealers that are repo-style transactions or
bankers’ acceptances.
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.
Exposures with a long-term or short-term external rating in the lowest investment-grade rating category.
Exposures with a long-term external rating one rating category below investment grade.
Publicly traded equity exposures.
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).
OTC derivative contracts and exposures that must be deducted from regulatory capital or receive a risk weight greater
than 400 percent under this appendix.
20 Percent .................
50 Percent .................
100
200
300
400
Percent
Percent
Percent
Percent
...............
...............
...............
...............
1,250 Percent ............
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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 riskweight categories in Table L based on
the investment limits in the fund’s
prospectus, partnership agreement, or
similar contract that defines the fund’s
permissible investments. If the sum of
the investment limits for all exposure
classes within the fund exceeds 100
percent, the bank must assume that the
fund invests to the maximum extent
permitted under its investment limits in
the exposure class with the highest risk
weight under Table L, and continues to
make investments in the order of the
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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.
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VI. Operational Risk
This section describes features of the
AMA framework for determining the
risk-based capital requirement for
operational risk. A bank meeting the
AMA qualifying criteria uses its internal
operational risk quantification system to
calculate its risk-based capital
requirement for operational risk.
Currently, the agencies’ general riskbased 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
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longer is an implicit capital buffer for
other risks.
The agencies recognize that
operational risk is a key risk in banks,
and evidence indicates that a number of
factors are driving increases in
operational risk. These factors include
greater use of automated technology,
proliferation of new and highly complex
products, growth of e-banking
transactions and related business
applications, large-scale acquisitions,
mergers, and consolidations, and greater
use of outsourcing arrangements.
Furthermore, the experience of a
number of high-profile, high-severity
operational losses across the banking
industry, including those resulting from
legal settlements, highlight operational
risk as a major source of unexpected
losses. Because the implicit regulatory
capital buffer for operational risk is
removed under the final rule, the
agencies are requiring banks using the
IRB approach for credit risk to use the
AMA to address operational risk when
computing their risk-based capital
requirement.
As discussed previously, operational
risk exposure is the 99.9th percentile of
the distribution of potential aggregate
operational losses as generated by the
bank’s operational risk quantification
system over a one-year horizon. EOL is
the expected value of the same
distribution of potential aggregate
operational losses. Under the proposal,
a bank’s risk-based capital requirement
for operational risk would be the sum of
EOL and UOL. A bank would be
allowed to recognize (i) certain offsets
for EOL (such as certain reserves and
other internal business practices), and
(ii) the effect of risk mitigants such as
insurance in calculating its regulatory
capital requirement for operational risk.
Under the proposed rule, the agencies
recognized that a bank’s risk-based
capital requirement for operational risk
could be based on UOL alone if the bank
could demonstrate it has offset EOL
with eligible operational risk offsets.
Eligible operational risk offsets were
defined as amounts, not to exceed EOL,
that (i) are generated by internal
business practices to absorb highly
predictable and reasonably stable
operational losses, including reserves
calculated in a manner consistent with
GAAP; and (ii) are available to cover
EOL with a high degree of certainty over
a one-year horizon. Eligible operational
risk offsets could only be used to offset
EOL, not UOL.
The preamble to the proposed rule
stated that in determining whether to
accept a proposed EOL offset, the
agencies would consider whether the
proposed offset would be available to
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cover EOL with a high degree of
certainty over a one-year horizon.
Supervisory recognition of EOL offsets
would be limited to those business lines
and event types with highly predictable,
routine losses. The preamble noted that
based on discussions with the industry
and supervisory experience, highly
predictable and routine losses appear to
be limited to those relating to securities
processing and to credit card fraud.
The majority of commenters on this
issue recommended that the agencies
should allow banks to present evidence
of additional areas with highly
predictable and reasonably stable losses
for which eligible operational risk
offsets could be considered. These
commenters identified fraud losses
pertaining to debit or ATM cards,
commercial or business credit cards,
HELOCs, and external checks in retail
banking as additional events that have
highly predictable and reasonably stable
losses. Commenters also identified legal
reserves set aside for small, predictable
legal loss events, budgeted funds, and
forecasted funds as other items that
should be considered eligible
operational risk offsets. Several
commenters also highlighted that the
proposed rule was inconsistent with the
New Accord regarding the ability of
budgeted funds to serve as EOL offsets.
One commenter proposed eliminating
EOL altogether because the commenter
already factors it into its pricing
practices.
The New Accord permits a supervisor
to accept expected loss offsets provided
a bank is ‘‘able to demonstrate to the
satisfaction of its national supervisor
that it has measured and accounted for
its EL exposure.’’ 103 To the extent a
bank is permitted to adjust its estimate
of operational risk exposure to reflect
potential operational risk offsets, it is
appropriate to consider the degree to
which such offsets meet U.S. accounting
standards and can be viewed as
regulatory capital substitutes. The final
rule retains the proposed definition
described above. The agencies believe
that this definition allows for the
supervisory consideration of EOL offsets
in a flexible and prudent manner.
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
103 103
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69383
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;
(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.
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
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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
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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.
104 New
Accord, footnote 110.
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The agencies view public disclosure
as an important complement to the
advanced approaches to calculating
minimum regulatory risk-based capital
requirements, which will be heavily
based on internal systems and
methodologies. With enhanced
transparency regarding banks’
experiences with the advanced
approaches, investors can better
evaluate a bank’s capital structure, risk
exposures, and capital adequacy. With
sufficient and relevant information,
market participants can better evaluate
a bank’s risk management performance,
earnings potential and financial
strength.
Improvements in public disclosures
come not only from regulatory
standards, but also through efforts by
bank management to improve
communications to public shareholders
and other market participants. In this
regard, improvements to risk
management processes and internal
reporting systems provide opportunities
to significantly improve public
disclosures over time. Accordingly, the
agencies strongly encourage the
management of each bank to regularly
review its public disclosures and
enhance these disclosures, where
appropriate, to clearly identify all
significant risk exposures—whether onor 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
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sufficient time to ensure usefulness of
the public disclosure requirements and
comparability across banks.
The agencies believe that it is
important to retain the vast majority of
the proposed disclosures, which are
consistent with the New Accord. These
disclosures will enable market
participants to gain key insights
regarding a bank’s capital structure, risk
exposures, risk assessment processes,
and ultimately, the capital adequacy of
the institution. The agencies also note
that many of the disclosure
requirements are already required by, or
are consistent with, existing GAAP, SEC
disclosure requirements, or regulatory
reporting requirements for banks. More
generally, the agencies view the public
disclosure requirements as an integral
part of the advanced approaches and the
New Accord and are continuing to
require their implementation beginning
with a bank’s first transitional floor
period.
The agencies are sympathetic,
however, to commenters’ concerns
about cross-border comparability. The
agencies believe that many of the
changes they have made to the final rule
(such as eliminating the ELGD risk
parameter and adopting the New
Accord’s definition of default for
wholesale exposures, as discussed
above) will address commenters’
concerns regarding comparability. In
addition, the agencies have made
several changes to the disclosure
requirements to make them more
consistent with the New Accord. These
changes should increase cross-border
comparability and reduce
implementation and compliance
burden. These changes are discussed in
the relevant sections below.
2. General Requirements
Under the proposed rule, the public
disclosure requirements would apply to
the top-tier legal entity that is a core or
opt-in bank within a consolidated
banking group—the top-tier U.S. BHC or
DI that is a core or opt-in bank.
Several commenters objected to this
proposal, noting that it is inconsistent
with the New Accord, which requires
such disclosures at the global top
consolidated level of a banking group to
which the framework applies.
Commenters asserted that public
disclosure at the U.S. BHC or DI level
for U.S. banking organizations owned by
a foreign banking organization is not
meaningful and could generate
confusion or misunderstanding in the
market.
The agencies agree that commenters’
concerns have merit and believe that it
is important to be consistent with the
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New Accord. Accordingly, under the
final rule, the public disclosure
requirements will generally be required
only at the top-tier global consolidated
level. Under exceptional circumstances,
a primary Federal supervisor may
require some or all of the public
disclosures at the top-tier U.S. level if
the primary Federal supervisor
determines that such disclosures are
important for market participants to
form appropriate insights regarding the
bank’s risk profile and associated level
of capital. A factor the agencies will
consider, for example, is whether a U.S.
subsidiary of a foreign banking
organization has debt or equity
registered and actively traded in the
United States.
In addition, the proposed rule stated
that, in general, a DI that is a subsidiary
of a BHC or another DI would not be
subject to the disclosure requirements
except that every DI would be required
to disclose total and tier 1 capital ratios
and their components, similar to current
requirements. Nonetheless, these
entities must file applicable bank
regulatory reports and thrift financial
reports. In addition, as described below
in the regulatory reporting section, the
agencies will require certain additional
regulatory reporting from banks
applying the advanced approaches, and
a limited amount of the reported
information will be publicly disclosed.
If a DI that is a core or opt-in bank and
is not a subsidiary of a BHC or another
DI that must make the full set of
disclosures, the DI would be required to
make the full set disclosures.
One commenter objected to the
supervisory flexibility provided to
require additional disclosures at the
subsidiary level. The commenter
maintained that in all cases DIs that are
a subsidiary of a BHC or another DI
should not be subject to the disclosure
requirements beyond disclosing their
total and tier 1 capital ratios and the
ratio components, as proposed. The
commenter suggested that the agencies
clarify this issue in the final rule.
The agencies do not believe, however,
that these changes are appropriate. The
agencies believe that it is important to
preserve some flexibility in the event
that the primary Federal supervisor
believes that disclosures from such a DI
are important for market participants to
form appropriate insights regarding the
bank’s risk profile and associated level
of capital.
The risks to which a bank is exposed,
and the techniques that it uses to
identify, measure, monitor, and control
those risks are important factors that
market participants consider in their
assessment of the bank. Accordingly,
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under the proposed and final rules, each
bank that is subject to the disclosure
requirements must have a formal
disclosure policy approved by its board
of directors that addresses the bank’s
approach for determining the
disclosures it should make. The policy
should address the associated internal
controls and disclosure controls and
procedures. The board of directors and
senior management must ensure that
appropriate review of the disclosures
takes place and that effective internal
controls and disclosure controls and
procedures are maintained.
A bank should decide which
disclosures are relevant for it based on
the materiality concept. Information
would be regarded as material if its
omission or misstatement could change
or influence the assessment or decision
of a user relying on that information for
the purpose of making investment
decisions.
To the extent applicable, a bank may
fulfill its disclosure requirements under
this final rule by relying on disclosures
made in accordance with accounting
standards or SEC mandates that are very
similar to the disclosure requirements in
this final rule. In these situations, a
bank must explain material differences
between the accounting or other
disclosure and the disclosures required
under this final rule.
Frequency/Timeliness
Under the proposed rule, the agencies
required that quantitative disclosures be
made quarterly. Several commenters
objected to this requirement. These
commenters asserted that banks subject
to the U.S. public disclosure
requirements would be placed at a
competitive disadvantage because the
New Accord requires banks to make
Pillar 3 public disclosures on a
semiannual basis.
The agencies believe that quarterly
public disclosure requirements are
important to ensure that the market has
access to timely and relevant
information and therefore have decided
to retain quarterly quantitative
disclosure requirements in the final
rule. This disclosure frequency is
consistent with longstanding
requirements in the United States for
robust quarterly disclosures in financial
and regulatory reports, and is
appropriate considering the potential for
rapid changes in risk profiles. Moreover,
many of the existing SEC, regulatory
reporting, and other disclosure
requirements that a bank may use to
help meet its public disclosure
requirements in the final rule are
already required on a quarterly basis.
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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 Web site) for each of the latest
three years (12 quarters) or such shorter
time period since the bank entered its
first transitional floor period. Except as
discussed below, management has
discretion to determine the appropriate
medium and location of the disclosures
required by this final rule. Furthermore,
banks have flexibility in formatting their
public disclosures. The agencies are not
specifying a fixed format for these
disclosures.
The agencies encourage management
to provide all of the required disclosures
in one place on the entity’s public Web
site. The public Web site addresses are
reported in the regulatory reports (for
example, the FR Y–9C).105
105 Alternatively, banks may provide the
disclosures in more than one place, as some of them
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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 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.
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Proprietary and Confidential
Information
The agencies stated in the preamble to
the proposed rule that they believed the
may be included in public financial reports (for
example, in Management’s Discussion and Analysis
included in SEC filings) or other regulatory reports
(for example, FR Y–9C Reports). Banks must
provide a summary table on their public Web site
that specifically indicates where all the disclosures
may be found (for example, regulatory report
schedules or page numbers in annual reports).
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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proposed requirements strike an
appropriate balance between the need
for meaningful disclosure and the
protection of proprietary and
confidential information.107 Many
commenters, however, expressed
concern that the required disclosures
would result in the release of
proprietary information. Commenters
expressed particular concerns about the
granularity of the credit loss history and
securitization disclosures, as well as
disclosures for portfolios subject to the
IRB risk-based capital formulas.
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,
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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and, hence, the capital adequacy of the
institution. The agencies are adopting
the tables as proposed, with the
exceptions noted below. Again, the
agencies note that the substantive
content of the tables is the focus of the
disclosure requirements, not the tables
themselves. The table numbers below
refer to the table numbers in the final
rule.
Table 11.1 disclosures (Scope of
Application) include a description of
the level in the organization to which
the disclosures apply and an outline of
any differences in consolidation for
accounting and regulatory capital
purposes, as well as a description of any
restrictions on the transfer of funds and
capital within the organization. These
disclosures provide the basic context
underlying regulatory capital
calculations.
One commenter questioned item (e) in
Table 11.1, which would require the
disclosure of the aggregate amount of
capital deficiencies in all subsidiaries
and the name(s) of such subsidiaries.
The commenter asserted that the scope
of this item should be limited to those
legal subsidiaries that are subject to
banking, securities, or insurance
regulators’ capital adequacy rules and
should not include unregulated entities
that are consolidated into the top
corporate entity or unconsolidated
affiliate and joint ventures.
As stated in a footnote to Table 11.1
in the proposed rule, the agencies
limited the proposed requirement to
legal subsidiaries that are subject to
banking, securities, or insurance
regulators’ capital adequacy rules. The
agencies are further clarifying this
disclosure in Table 11.1.
Table 11.2 disclosures (Capital
Structure) provide information on
various components of regulatory
capital available to absorb losses and
allow for an evaluation of the quality of
the capital available to absorb losses
within the bank.
Table 11.3 disclosures (Capital
Adequacy) provide information about
how a bank assesses the adequacy of its
capital and require that the bank
disclose its minimum capital
requirements for significant risk areas
and portfolios. The table also requires
disclosure of the regulatory capital
ratios of the consolidated group and
each DI subsidiary. Such disclosures
provide insight into the overall
adequacy of capital based on the risk
profile of the organization.
Tables 11.4, 11.5, and 11.7 disclosures
(Credit Risk) provide market
participants with insight into different
types and concentrations of credit risk
to which the bank is exposed and the
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techniques the bank uses to measure,
monitor, and mitigate those risks. These
disclosures are intended to enable
market participants to assess the credit
risk exposures under the IRB approach,
without revealing proprietary
information.
Several commenters made suggestions
related to Table 11.4. One commenter
addressed item (b), which requires the
disclosure of total and average gross
credit risk exposures over the period
broken down by major types of credit
exposure. The commenter asked the
agencies to clarify that methods used for
financial reporting purposes are allowed
for determining averages. Another
commenter requested that the agencies
clarify what is meant by ‘‘gross’’ in item
(b), given that a related footnote
describes net credit risk exposures in
accordance with GAAP.
As with most of the disclosure
requirements, the agencies are not
prescriptive regarding the
methodologies a bank must use for
determining averages. Rather, the bank
must choose whatever methodology it
believes to be most reflective of its risk
position. That methodology may be the
one the bank uses for financial reporting
purposes. The agencies have deleted
‘‘gross’’ and otherwise simplified the
wording of item (b) in Table 11.4 to
enhance clarity. Item (b) now reads
‘‘total credit risk exposures and average
credit risk exposures, after accounting
offsets in accordance with GAAP, and
without taking into account the effects
of credit risk mitigation techniques (for
example collateral and netting not
included in GAAP for disclosure), over
the period broken down by major types
of credit exposure.’’
In addition, a commenter noted that
the requirements in Table 11.4 regarding
the breakdown of disclosures by ‘‘major
types of credit exposure’’ in items (b)
through (e) and by ‘‘counterparty type’’
for items (d) and (f) are unclear.
Moreover, with respect to items (d), (e),
and (f), the commenter recommended
that disclosures should be provided on
an annual rather than quarterly basis.
The same commenter also asserted that
the disclosure of remaining contractual
maturity breakdown in item (e) should
be required annually. Finally, regarding
items (f) and (g), a few commenters
wanted clarification of the definition of
impaired and past due loans.
The agencies are not prescriptive with
regard to what is meant by ‘‘major types
of credit exposure,’’ disclosure by
counterparty type, or impaired and past
due loans. Bank management has the
discretion to determine the most
appropriate disclosure for the bank’s
risk profile consistent with internal
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practice, GAAP or regulatory reports
(such as the FR Y–9C). As noted in the
proposal, for major types of credit
exposure a bank could apply a
breakdown similar to that used for
accounting purposes, such as (a) loans,
off-balance sheet commitments, and
other non-derivative off-balance sheet
exposures, (b) debt securities, and (c)
OTC derivatives. The agencies do not
believe it is appropriate to make an
exception to the general quarterly
requirement for quantitative disclosures
for the disclosure in Table 11.4.
Commenters provided extensive
feedback on several aspects of Table
11.5 (Disclosures for Portfolios Subject
to IRB Risk-Based Capital Formulas).
Several commenters were concerned
that the required level of detail may
compel banks to disclose proprietary
information. With respect to item (c), a
couple of commenters noted that the
proposal differs from the New Accord in
requiring exposure-weighted average
capital requirements instead of risk
weight percentages for groups of
wholesale and retail exposures. One
commenter also suggested that the term
‘‘actual losses’’ required in item (d)
needs to be defined. Finally, several
commenters objected to the proposal in
item (e) to disclose backtesting results,
asserting that such results would not be
understood by the market. Commenters
suggested that disclosure of this item be
delayed beyond the proposed
commencement date of year-end 2010,
to commence instead ten years after a
bank exits from the parallel run period.
As discussed above, the agencies
believe that, in most cases, a bank can
make the required disclosures without
revealing proprietary information and
that the rule contains appropriate
provisions to deal with specific bank
concerns. With regard to item (c), the
agencies agree that there is no strong
policy reason to differ from the New
Accord and have changed item (c) to
require the specified disclosures in risk
weight percentages rather than
weighted-average capital requirements.
With respect to item (d), the agencies
are not imposing a prescriptive
definition of actual losses and believe
that banks should determine actual
losses consistent with internal practice.
Finally, regarding item (e), the agencies
believe that public disclosure of
backtesting results provides important
information to the market and should
not be delayed. However, the agencies
have slightly modified the requirement,
consistent with the New Accord, to
reinforce that disclosure of individual
risk parameter backtesting is not always
required.
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69387
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
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.
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The agencies have decided to clarify
that item (a) refers in part to the credit
rating downgrade of the bank making
the disclosure. This is consistent with
the intent of this disclosure requirement
in the New Accord. With respect to item
(b), the agencies recognize that this
proposed requirement may be
problematic for banks that have
implemented the internal models
methodology. Accordingly, the agencies
have decided to modify the rule to note
that this disclosure item is only required
for banks not using the internal models
methodology in section 32(d).
Table 11.8 disclosures (Securitization)
provide information to market
participants on the amount of credit risk
transferred and retained by the
organization through securitization
transactions and the types of products
securitized by the organization. These
disclosures provide users a better
understanding of how securitization
transactions impact the credit risk of the
bank.
One commenter asked the agencies to
explicitly acknowledge that they will
accept the definitions and
interpretations of the components of
securitization exposures that a bank
uses for financial reporting purposes
(FAS 140 reporting disclosures).
Generally, as noted above, the
agencies expect that a bank will be able
to fulfill some of its disclosure
requirements by relying on disclosures
made in accordance with accounting
standards, SEC mandates, or regulatory
reports. In these situations, a bank must
explain any material differences
between the accounting or other
disclosure and the disclosures required
under the final rule. The agencies do not
believe any changes to the rule are
necessary to accommodate the
commenter’s concern.
Table 11.9 disclosures (Operational
Risk) provide insight into the bank’s
application of the AMA for operational
risk and what internal and external
factors are considered in determining
the amount of capital allocated to
operational risk.
Table 11.10 disclosures (Equities Not
Subject to Market Risk Rule) provide
market participants with an
understanding of the types of equity
securities held by the bank and how
they are valued. The table also provides
information on the capital allocated to
different equity products and the
amount of unrealized gains and losses.
Table 11.11 disclosures (Interest Rate
Risk in Non-Trading Activities) provide
information about the potential risk of
loss that may result from changes in
interest rates and how the bank
measures such risk.
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4. Regulatory Reporting
In addition to the public disclosures
required by the consolidated banking
organization subject to the advanced
approaches, the agencies will require
certain additional regulatory reporting
from BHCs, their subsidiary DIs, and DIs
applying the advanced approaches that
are not subsidiaries of BHCs. The
agencies believe that the reporting of
key risk parameter estimates by each DI
applying the advanced approaches will
provide the primary Federal supervisor
and other relevant supervisors with data
important for assessing the
reasonableness and accuracy of the
bank’s calculation of its minimum
capital requirements under this final
rule and the adequacy of the
institution’s capital in relation to its
risks. This information will be collected
through regulatory reports. The agencies
believe that requiring certain common
reporting across banks will facilitate
comparable application of the final rule.
The agencies will publish in the
Federal Register reporting schedules
based on the reporting templates issued
for comment in September 2006.
Consistent with the proposed reporting
schedules, these reporting schedules
will include a summary schedule with
aggregate data that will be available to
the general public. It also will include
supporting schedules that will be
viewed as confidential supervisory
information. These schedules will be
broken out by exposure category and
will collect risk parameter and other
pertinent data in a systematic manner.
Under the final rule, banks must begin
reporting this information during their
parallel run on a confidential basis. The
agencies will share this information
with each other for calibration and other
analytical purposes.
One commenter expressed concerns
that some of the confidential
information requested in the proposed
reporting templates was also contained
in the public disclosure requirements
under the proposal. As a result, some
information would be classified as
confidential in the reporting templates
and public under the disclosure
requirements in the final rule.
The agencies recognize that there may
be some overlap between confidential
information required in the regulatory
reports and public information required
in the disclosure requirements of the
final rule. The agencies will address
specific comments on the reporting
templates separately. In general, the
agencies believe that given the different
purposes of the regulatory reporting and
public disclosure requirements under
the final rule, there may be some
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instances where the same or similar
disclosures may be required by both sets
of requirements. Many of the public
disclosures cover only a subset of the
information sought in the proposed
regulatory reporting templates. For
instance, banks are required only to
disclose publicly information ‘‘across a
sufficient number of PD grades to allow
a meaningful differentiation of credit
risk,’’ whereas the proposed reporting
templates contemplate a much more
granular collection of data by specified
PD bands. Such aggregation of data so
as to mask the confidential nature of
more granular information that is
reported to regulators is not unique to
the advanced approaches reporting. In
addition, the agencies believe that a
bank may be able to comply with some
of the public disclosure requirements
under this final rule by publicly
disclosing, at the bank’s discretion and
judgment, certain information found in
the reporting templates that otherwise
would be held confidential by the
agencies. A bank could disclose this
information on its Web site (as
described in ‘‘location and audit
requirements’’ above) if it believes that
such disclosures will meet the public
disclosure requirements required by the
rule.
List of Acronyms
ABCP Asset-Backed Commercial Paper
ALLL Allowance for Loan and Lease Losses
AMA Advanced Measurement Approaches
ANPR Advance Notice of Proposed
Rulemaking
AVC Asset Value Correlation
BCBS Basel Committee on Banking
Supervision
BHC Bank Holding Company
CCDS Contingent Credit Default Swap
CF Conversion Factor
CEIO Credit-Enhancing Interest-Only Strip
CRM Credit Risk Mitigation
CUSIP Committee on Uniform Securities
Identification Procedures
DI Depository Institution
DvP Delivery versus Payment
E Measure of Effectiveness
EAD Exposure at Default
ECL Expected Credit Loss
EE Expected Exposure
EL Expected Loss
ELGD Expected Loss Given Default
EOL Expected Operational Loss
EPE Expected Positive Exposure
EWALGD Exposure-Weighted Average Loss
Given Default
FAS Financial Accounting Standard
FDIC Federal Deposit Insurance
Corporation
FFIEC Federal Financial Institutions
Examination Council
GAAP Generally Accepted Accounting
Principles
GAO Government Accountability Office
HELOC Home Equity Line of Credit
HOLA Home Owners’ Loan Act
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HVCRE High-Volatility Commercial Real
Estate
IAA Internal Assessment Approach
ICAAP Internal Capital Adequacy
Assessment Process
IMA Internal Models Approach
IRB Internal Ratings-Based
KIRB Capital Requirement for Underlying
Pool of Exposures (securitizations)
LGD Loss Given Default
LTV Loan-to-Value Ratio
M Effective Maturity
NRSRO Nationally Recognized Statistical
Rating Organization
OCC Office of the Comptroller of the
Currency
OTC Over-the-Counter
OTS Office of Thrift Supervision
PCA Prompt Corrective Action
PD Probability of Default
PFE Potential Future Exposure
PMI Private Mortgage Insurance
PvP Payment versus Payment
QIS–3 Quantitative Impact Study 3
QIS–4 Quantitative Impact Study 4
QIS–5 Quantitative Impact Study 5
QRE Qualifying Revolving Exposure
RBA Ratings-Based Approach
RVC Ratio of Value Change
SEC Securities and Exchange Commission
SFA Supervisory Formula Approach
SME Small- and Medium-Size Enterprise
SPE Special Purpose Entity
SRWA Simple Risk-Weight Approach
TFR Thrift Financial Report
UL Unexpected Loss
UOL Unexpected Operational Loss
VaR Value-at-Risk
Regulatory Flexibility Act Analysis
The Regulatory Flexibility Act (RFA)
requires an agency that is issuing a final
rule to prepare and make available a
regulatory flexibility analysis that
describes the impact of the final rule on
small entities. 5 U.S.C. 603(a). The RFA
provides that an agency is not required
to prepare and publish a regulatory
flexibility analysis if the agency certifies
that the final rule will not have a
significant economic impact on a
substantial number of small entities. 5
U.S.C. 605(b).
Pursuant to section 605(b) of the RFA
(5 U.S.C. 605(b)), the agencies certify
that this final rule will not have a
significant economic impact on a
substantial number of small entities.
Pursuant to regulations issued by the
Small Business Administration (13 CFR
121.201), a ‘‘small entity’’ includes a
bank holding company, commercial
bank, or savings association with assets
of $165 million or less (collectively,
small banking organizations). The final
rule requires a bank holding company,
national bank, state member bank, state
nonmember bank, or savings association
to calculate its risk-based capital
requirements according to certain
internal-ratings-based and internal
model approaches if the bank holding
company, bank, or savings association
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(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 onbalance sheet foreign exposures at the
most recent year-end equal to $10
billion or more; or (iii) is a subsidiary
of a bank holding company, bank, or
savings association that would be
required to use the proposed rule to
calculate its risk-based capital
requirements.
The agencies estimate that zero small
bank holding companies (out of a total
of approximately 2,919 small bank
holding companies), 16 small national
banks (out of a total of approximately
948 small national banks), one small
state member bank (out of a total of
approximately 468 small state member
banks), one small state nonmember bank
(out of a total of approximately 3,242
small state nonmember banks), and zero
small savings associations (out of a total
of approximately 419 small savings
associations) would be subject to the
final rule on a mandatory basis. In
addition, each of the small banking
organizations subject to the final rule on
a mandatory basis is a subsidiary of a
bank holding company with over $250
billion in consolidated total assets or
over $10 billion in consolidated total
on-balance sheet foreign exposure.
Therefore, the agencies believe that the
final rule will not result in a significant
economic impact on a substantial
number of small entities.
Paperwork Reduction Act
In accordance with the requirements
of the Paperwork Reduction Act of 1995,
the agencies may not conduct or
sponsor, and respondents are not
required to respond to, an information
collection unless it displays a currently
valid Office of Management and Budget
(OMB) control number. OMB assigned
the following control numbers to the
collections of information: 1557–0234
(OCC), 3064–0153 (FDIC), and 1550–
0115 (OTS). The Board assigned control
number 7100–0313.
In September 2006 the OCC, FDIC,
and OTS submitted the information
collections contained in this rule to
OMB for review and approval once the
proposed rule was published. The
Board, under authority delegated to it by
OMB, also submitted the proposed
information collection to OMB.
The agencies (OCC, FDIC, the Board,
and OTS) determined that sections 21–
24, 42, 44, 53, and 71 of the final rule
contain collections of information. The
final rule sets forth a new risk-based
capital adequacy framework that would
require some banks and allow other
qualifying banks to use an internal
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ratings-based approach to calculate
regulatory credit risk capital
requirements and advanced
measurement approaches to calculate
regulatory operational risk capital
requirements. The collections of
information are necessary in order to
implement the proposed advanced
capital adequacy framework. The
agencies received approximately ninety
public comments. None of the comment
letters specifically addressed the
proposed burden estimates; therefore,
the burden estimates will remain
unchanged, as published in the notice of
proposed rulemaking (71 FR 55830).
The affected public are: national
banks and Federal branches and
agencies of foreign banks (OCC); state
member banks, bank holding
companies, affiliates and certain nonbank subsidiaries of bank holding
companies, uninsured state agencies
and branches of foreign banks,
commercial lending companies owned
or controlled by foreign banks, and Edge
and agreement corporations (Board);
insured nonmember banks, insured state
branches of foreign banks, and certain
subsidiaries of these entities (FDIC); and
savings associations and certain of their
subsidiaries (OTS).
Comment Request
The agencies have an ongoing interest
in your comments. They should be sent
to [Agency] Desk Officer, [OMB No.], by
mail to U.S. Office of Management and
Budget, 725 17th Street, NW., #10235,
Washington, DC 20503, or by fax to
(202) 395–6974.
Comments submitted in response to
this notice will be shared among the
agencies. All comments will become a
matter of public record. Written
comments should address the accuracy
of the burden estimates and ways to
minimize burden including the use of
automated collection techniques or the
use of other forms of information
technology as well as other relevant
aspects of the information collection
request.
OCC Executive Order 12866
Executive Order 12866 requires
Federal agencies to prepare a regulatory
impact analysis for agency actions that
are found to be ‘‘significant regulatory
actions.’’ ‘‘Significant regulatory
actions’’ include, among other things,
rulemakings that ‘‘have an annual effect
on the economy of $100 million or more
or adversely affect in a material way the
economy, a sector of the economy,
productivity, competition, jobs, the
environment, public health or safety, or
State, local, or tribal governments or
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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;
• 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
108 108 Executive Order 12866 (September 30,
1993), 58 FR 51735 (October 4, 1993), as amended
by Executive Order 13258 (February 26, 2002), 67
FR 9385 (February 28, 2002) and by Executive
Order 13422 (January 18, 2007), 72 FR 2763
(January 23, 2007). For the complete text of the
definition of ‘‘significant regulatory action,’’ see
E.O. 12866 at § 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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environment), together with, to the
extent feasible, a quantification of those
costs; and
• An assessment, including the
underlying analysis, of costs and
benefits of potentially effective and
reasonably feasible alternatives to the
planned regulation, identified by the
agencies or the public (including
improving the current regulation and
reasonably viable nonregulatory
actions), and an explanation why the
planned regulatory action is preferable
to the identified potential alternatives.
Set forth below is a summary of the
OCC’s regulatory impact analysis, which
can be found in its entirety at http://
www.occ.treas.gov/law/basel.htm under
the link of ‘‘Regulatory Impact Analysis
for Risk-Based Capital Standards:
Revised Capital Adequacy Guidelines
(Basel II: Advanced Approach) 2007’’.
I. The Need for the Regulatory Action
Federal banking law directs Federal
banking agencies including the Office of
the Comptroller of the Currency (OCC)
to require banking organizations to hold
adequate capital. The law authorizes
Federal banking agencies to set
minimum capital levels to ensure that
banking organizations maintain
adequate capital. The law also gives
Federal banking agencies broad
discretion with respect to capital
regulation by authorizing them to also
use any other methods that they deem
appropriate to ensure capital adequacy.
Capital regulation seeks to address
market failures that stem from several
sources. Asymmetric information about
the risk in a bank’s portfolio creates a
market failure by hindering the ability
of creditors and outside monitors to
discern a bank’s actual risk and capital
adequacy. Moral hazard creates market
failure in which the bank’s creditors fail
to restrain the bank from taking
excessive risks because deposit
insurance either fully or partially
protects them from losses. Public policy
addresses these market failures because
individual banks fail to adequately
consider the positive externality or
public benefit that adequate capital
brings to financial markets and the
economy as a whole.
Capital regulations cannot be static.
Innovation in and transformation of
financial markets require periodic
reassessments of what may count as
capital and what amount of capital is
adequate. Continuing changes in
financial markets create both a need and
an opportunity to refine capital
standards in banking. The Basel
Committee on Banking Supervision’s
‘‘International Convergence of Capital
Measurement and Capital Standards: A
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Revised Framework’’ (New Accord), and
its implementation in the United States,
reflects an appropriate step forward in
addressing these changes.
II. Regulatory Background
The capital regulation examined in
this analysis will apply to commercial
banks and savings associations
(collectively, banks). Three banking
agencies, the OCC, the Board of
Governors of the Federal Reserve
System (Board), and the FDIC regulate
commercial banks, while the Office of
Thrift Supervision (OTS) regulates all
federally chartered and many statechartered 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 riskweighting framework of the 1988
Accord. The other two approaches are
variations on an internal ratings-based
(IRB) approach that leverages banks’
internal credit-rating systems: a
‘‘foundation’’ methodology in which
banks estimate the probability of
borrower or obligor default, and an
‘‘advanced’’ approach in which banks
also supply other inputs needed for the
capital calculation. In addition, the new
framework uses more risk-sensitive
methods for dealing with collateral,
guarantees, credit derivatives,
securitizations, and receivables.
The New Accord also introduces an
explicit capital requirement for
operational risk.109 The New Accord
offers banks a choice of three
methodologies for calculating their
capital charge for operational risk. The
first method, called the Basic Indicator
Approach, requires banks to hold
capital for operational risk equal to 15
percent of annual gross income
(averaged over the most recent three
years). The second option, called the
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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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 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.
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3. Market Discipline (Pillar 3)
The third pillar of the New Accord
sets minimum disclosure requirements
for banks. The disclosures, covering the
composition and structure of the bank’s
capital, the nature of its risk exposures,
its risk management and internal control
processes, and its capital adequacy, are
intended to improve transparency and
strengthen market discipline. By
establishing a common set of disclosure
requirements, Pillar 3 seeks to provide
a consistent and understandable
disclosure framework that market
participants can use to assess key pieces
of information on the risks and capital
adequacy of a bank.
4. U.S. Implementation
The rule for implementing the New
Accord’s advanced approaches in the
United States will apply the new
framework to the largest and most
internationally active banks. All banks
will fall into one of three regulatory
categories. The first category, called
‘‘mandatory’’ banks, consists of banks
with consolidated assets of at least $250
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billion or consolidated on-balance-sheet
foreign exposures of $10 billion or more.
Mandatory banks will have to use the
New Accord’s most advanced methods
only: the Advanced IRB approach to
determine capital for credit risk and the
AMA to determine capital for
operational risk. A second category of
banks, called ‘‘opt-in’’ banks, includes
banks that do not meet either size
criteria of a mandatory bank but choose
voluntarily to comply with the
advanced approaches specified under
the New Accord. The third category,
called ‘‘general’’ banks, encompasses all
other banks, and these will continue to
operate under existing risk-based capital
rules, subject to any amendments.
Various changes to the rules that
apply to non-mandatory banks are
under consideration. The Federal
banking agencies have decided to issue
for comment a proposal that would
allow the voluntary adoption of the
standardized approach for credit risk
and the basic indicator approach for
operational risk for non-mandatory
banks (referred to hereafter as the
Standardized Option). Because the
Standardized Option would be a
separate rulemaking, our analysis will
focus just on the implementation of the
Advanced Approaches. However, we
will note how the Standardized Option
might affect the outcome of our analysis
if we anticipate the possibility that its
adoption could lead to a significantly
different outcome.
While introducing many significant
changes, the U.S. implementation of the
New Accord retains many components
of the capital rules currently in effect.
For example, it preserves existing
Prompt Corrective Action provisions for
all banks. The U.S. implementation of
the New Accord also keeps intact most
elements of the definition of what
comprises regulatory capital.
III. Costs and Benefits of the Rule
This analysis considers the costs and
benefits of the fully phased-in rule.
Under the rule, current capital rules will
remain in effect in 2008 during a
parallel run using both old and new
capital rules. For three years following
the parallel run, the final rule will apply
limits on the amount by which
minimum required capital may
decrease. This analysis, however,
considers the costs and benefits of the
rule as fully phased in.
Cost and benefit analysis of changes
in minimum capital requirements entail
considerable measurement problems.
On the cost side, it can be difficult to
attribute particular expenditures
incurred by banks to the costs of
implementation because banks would
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likely incur some of these costs as part
of their ongoing efforts to improve risk
measurement and management systems.
On the benefits side, measurement
problems are even greater because the
benefits of the rule are more qualitative
than quantitative. Measurement
problems exist even with an apparently
measurable effect such as lower
minimum capital because lower
minimum requirements do not
necessarily mean lower capital levels
held by banks. Healthy banks generally
hold capital well above regulatory
minimums for a variety of reasons, and
the effect of reducing the regulatory
minimum is uncertain and may vary
across regulated banks.
Benefits of the Rule
1. Better allocation of capital and
reduced impact of moral hazard
through reduction in the scope for
regulatory arbitrage: By assessing the
amount of capital required for each
exposure or pool of exposures, the
advanced approaches do away with the
simplistic risk buckets of current capital
rules. Getting rid of categorical risk
weighting and assigning capital based
on measured risk instead greatly curtails
or eliminates the ability of troubled
banks to ‘‘game’’ regulatory capital
requirements by finding ways to comply
technically with the requirements while
evading their intent and spirit.
2. Improved signal quality of capital
as an indicator of solvency: The
advanced approaches are designed to
more accurately align regulatory capital
with risk, which should improve the
signal quality of capital as an indicator
of solvency. The improved signaling
quality of capital will enhance banking
supervision and market discipline.
3. Encourages banks to improve credit
risk management: One of the principal
objectives of the rule is to more closely
align capital charges and risk. For any
type of credit, risk increases as either
the probability of default or the loss
given default increases. Under the final
rule, the capital charge for credit risk
depends on these risk parameter
measures and consequently capital
requirements will more closely reflect
risk. This enhanced link between capital
requirements and risk will encourage
banks to improve credit risk
management.
4. More efficient use of required bank
capital: Increased risk sensitivity and
improvements in risk measurement will
allow prudential objectives to be
achieved more efficiently. If capital
rules can better align capital with risk
across the system, a given level of
capital will be able to support a higher
level of banking activity while
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maintaining the same degree of
confidence regarding the safety and
soundness of the banking system. Social
welfare is enhanced by either the
stronger condition of the banking
system or the increased economic
activity the additional banking services
facilitate.
5. Incorporates and encourages
advances in risk measurement and risk
management: The rule seeks to improve
upon existing capital regulations by
incorporating advances in risk
measurement and risk management
made over the past 15 years. An
objective of the rule is to speed adoption
of new risk management techniques and
to promote the further development of
risk measurement and management
through the regulatory process.
6. Recognizes new developments and
accommodates continuing innovation in
financial products by focusing on risk:
The rule also has the benefit of
facilitating recognition of new
developments in financial products by
focusing on the fundamentals behind
risk rather than on static product
categories.
7. Better aligns capital and
operational risk and encourages banks
to mitigate operational risk: Introducing
an explicit capital calculation for
operational risk eliminates the implicit
and imprecise ‘‘buffer’’ that covers
operational risk under current capital
rules. Introducing an explicit capital
requirement for operational risk
improves assessments of the protection
capital provides, particularly at banks
where operational risk dominates other
risks. The explicit treatment also
increases the transparency of
operational risk, which could encourage
banks to take further steps to mitigate
operational risk.
8. Enhanced supervisory feedback:
Although U.S. banks have long been
subject to close supervision, aspects of
all three pillars of the rule aim to
enhance supervisory feedback from
Federal banking agencies to managers of
banks. Enhanced feedback could further
strengthen the safety and soundness of
the banking system.
9. Enhanced disclosure promotes
market discipline: The rule seeks to aid
market discipline through the regulatory
framework by requiring specific
disclosures relating to risk measurement
and risk management. Market discipline
could complement regulatory
supervision to bolster safety and
soundness.
10. Preserves the benefits of
international consistency and
coordination achieved with the 1988
Basel Accord: An important objective of
the 1988 Accord was competitive
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consistency of capital requirements for
banks competing in global markets. The
New Accord continues to pursue this
objective. Because achieving this
objective depends on the consistency of
implementation in the United States
and abroad, the Basel Committee on
Banking Supervision (BCBS) has
established an Accord Implementation
Group to promote consistency in the
implementation of the New Accord.
11. Ability to opt in offers long-term
flexibility to nonmandatory banks: The
U.S. implementation of the New Accord
allows non-mandatory banks to
individually judge when the benefits
they expect to realize from adopting the
advanced approaches outweigh their
costs. Even though the cost and
complexity of adopting the advanced
methods may present non-mandatory
banks with a substantial hurdle to
opting in at present, the potential longterm benefits of allowing nonmandatory 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
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
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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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 onetime expenditures to adopt this final
rule primarily involve money for system
development and software purchases.
4. Implicit costs: In addition to
explicit setup and recurring costs, banks
may also face implicit costs arising from
the time and inconvenience of having to
adapt to new capital regulations. At a
minimum this involves the increased
time and attention required of senior
bank management to introduce new
programs and procedures and the need
to closely monitor the new activities
during the inevitable rough patches
when the rule first takes effect.
5. Government Administrative Costs:
OCC expenditures fall into three broad
categories: training, guidance, and
supervision. Training includes expenses
for AMA and IRB workshops, and other
training courses and seminars for
examiners. Guidance expenses reflect
expenditures on the development of IRB
and AMA guidance. Supervision
expenses reflect bank-specific
supervisory activities related to the
development and implementation of the
New Accord. The largest OCC
expenditures have been on the
development of IRB and AMA policy
guidance. The $5.4 million spent on
guidance represents 54 percent of the
estimated total OCC advanced
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approaches-related expenditure of $10.0
million through the 2006 fiscal year. In
part, this large share reflects the absence
of data for training and supervision
costs for several years, but it also is
indicative of the large guidance
expenses in 2002 and 2003 when the
New Accord was in development. To
date, New Accord expenditures have
not been a large part of overall OCC
expenditures. The $3 million spent on
the advanced approaches in fiscal year
2006 represents less than one percent of
the OCC’s $579 million budget for the
year.
6. Total Cost: The OCC’s estimate of
the total cost of the rule includes
expenditures by banks and the OCC
from the present through 2011, the final
year of the transition period. Combining
expenditures by mandatory banks and
the OCC provides a present value
estimate of $498.9 million for the total
cost of the rule.
7. Procyclicality: Procyclicality refers
to the possibility that banks may reduce
lending during economic downturns
and increase lending during economic
expansions as a consequence of
minimum capital requirements. There is
some concern that the risk-sensitivity of
the Advanced IRB approach may cause
capital requirements for credit risk to
increase during an economic downturn.
Although procyclicality may be inherent
in banking to some extent, elements of
the advanced approaches could reduce
inherent procyclicality. Risk
management and information systems
may provide bank managers with more
forward-looking information about risk
that will allow them to adjust portfolios
gradually and with more foresight as the
economic outlook changes over the
business cycle. Regulatory stress-testing
requirements included in the rule also
will help ensure that banks anticipate
cyclicality in capital requirements to the
greatest extent possible, reducing the
potential economic impact of changes in
capital requirements.
IV. Competition Among Providers of
Financial Services
One potential concern with any
regulatory change is the possibility that
it might create a competitive advantage
for some banks relative to others, a
possibility that certainly applies to a
change with the scope of this final rule.
However, measurement difficulties
described in the preceding discussion of
costs and benefits also extend to any
consideration of the impact on
competition. Despite the inherent
difficulty of drawing definitive
conclusions, this section considers
various ways in which competitive
effects might be manifest, as well as
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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.
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 creditrisk-related reductions, overall capital
requirements for residential mortgages
could decline under the rule. Studies by
Calem and Follain112 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
111 Patrick de Fontnouvelle, Victoria Garrity,
Scott Chu, and Eric Rosengren, ‘‘The Potential
Impact of Explicit Basel II Operational Risk Capital
Charges on the Competitive Environment of
Processing Banks in the United States,’’ manuscript,
Federal Reserve Bank of Boston, January 12, 2005.
Available at http://www.federalreserve.gov/
generalinfo/basel2/whitepapers.htm.
112 Paul S. Calem and James R. Follain,
‘‘Regulatory Capital Arbitrage and the Potential
Competitive Impact of Basel II in the Market for
Residential Mortgages’’, The Journal of Real Estate
Finance and Economics, Vol. 35, pp. 197–219,
August 2007.
113 Diana Hancock, Andreas Lennert, Wayne
Passmore, and Shane M. Sherlund, ‘‘An Analysis of
the Potential Competitive Impact of Basel II Capital
Standards on U.S. Mortgage Rates and Mortgage
Securitization’’, manuscript, Federal Reserve Board,
April 2005. Available at http://
www.federalreserve.gov/generalinfo/basel2/
whitepapers.htm.
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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 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 Berger114 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 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,
114 Allen N. Berger, ‘‘Potential Competitive Effects
of Basel II on Banks in SME Credit Markets in the
United States,’’ Journal of Financial Services
Research, 29:1, pp. 5–36, 2006. Also available at
http://www.federalreserve.gov/generalinfo/basel2/
whitepapers.htm.
115 Timothy H. Hannan and Steven J. Pilloff,
‘‘Will the Proposed Application of Basel II in the
United States Encourage Increased Bank Merger
Activity? Evidence from Past Merger Activity,’’
Federal Reserve Board Finance and Economics
Discussion Series, 2004–13, February 2004.
Available at http://www.federalreserve.gov/
generalinfo/basel2/whitepapers.htm.
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and Vermilyea116 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 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
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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
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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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 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
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.
119 Cost estimates for adopting a rule that might
result from the Standardized Option are not
currently available.
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the final rule. Banks that are not
prepared for the adoption of the
advanced approach to credit risk under
the final rule could choose to use the
Foundation IRB methodology or even
the Standardized Approach. How
Alternative A might affect benefits
depends entirely on how many banks
select each of the three available
options. The most significant drawback
to Alternative A is the increased cost of
applying a new set of capital rules to all
U.S. banks. The vast majority of banks
in the United States would incur no
direct costs from new capital rules.
Under Alternative A, direct costs would
increase for every U.S. bank that would
have continued with current capital
rules. Although it is not clear how high
these costs might be, general banks
would face higher costs because they
would be changing capital rules
regardless of which option they choose
under Alternative A.
3. Alternative B: Permit U.S. banks to
choose among all three New Accord
operational risk approaches: The
operational risk approach that banks
ultimately selected would determine
how the overall benefits of the new
capital regulations would change under
Alternative B. Just as Alternative A
increases the flexibility of credit risk
rules for mandatory banks, Alternative B
is more flexible with respect to
operational risk. Because the
Standardized Approach tries to be more
sensitive to variations in operational
risk than the Basic Indicator Approach
and AMA is more sensitive than the
Standardized Approach, the effect of
implementing Alternative B depends on
how many banks select the more risk
sensitive approaches. As was the case
with Alternative A, the most significant
drawback to Alternative B is the
increased cost of applying a new set of
capital rules to all U.S. banks.
Under Alternative B, direct costs
would increase for every U.S. bank that
would have continued with current
capital rules. It is not clear how much
it might cost banks to adopt these
capital measures for operational risk,
but general banks would face higher
costs because they would be changing
capital rules regardless of which option
they choose under Alternative B.
4. Alternative C: Use a different asset
amount to determine a mandatory bank:
The number of mandatory banks
decreases slowly as the size thresholds
increase, and the number of banks
grows more quickly as the thresholds
decrease. Under Alternative C, the
framework of the final rule would
remain the same and only the number
of mandatory banks would change.
Because the structure of the
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implementation would remain intact,
Alternative C would capture all of the
benefits of the final rule. However,
because these benefits derive from
applying the final rule to individual
banks, changing the number of banks
affected by the rule will change the
cumulative level of the benefits
achieved. Generally, the benefits
associated with the rule will rise and
fall with the number of mandatory
banks. Because Alternative C would
change the number of mandatory banks
subject to the rule, aggregate costs will
also rise or fall with the number of
mandatory banks.
Overall Comparison of the Rule With
Baselines and Alternatives
The New Accord and its U.S.
implementation seek to incorporate risk
measurement and risk management
advances into capital requirements.
Risk-sensitive capital requirements are
integral to ensuring an adequate capital
cushion to absorb financial losses at
large complex financial banks. In
implementing the New Accord’s
advanced approaches in the United
States, the agencies’ intent is to achieve
risk-sensitivity while maintaining a
regulatory capital regime that is as
rigorous as the current system. Total
capital requirements under the
advanced approaches, including capital
for operational risk, will better allocate
capital in the system. This will occur
regardless of whether the minimum
required capital at a particular bank is
greater or less than it would be under
current capital rules. In order to ensure
that we achieve our goal of increased
risk sensitivity without loss of rigor, the
final rule provides a means for the
agencies to identify and address
deficiencies in the capital requirements
that may become apparent during the
transition period.
Although the anticipated benefits of
the final rule are difficult to quantify in
dollar terms because of measurement
problems, the OCC is confident that the
anticipated benefits well exceed the
anticipated costs of this regulation. On
the basis of our analysis, we believe that
the benefits of the final rule are
significant, durable, and hold the
potential to increase with time. The
offsetting costs of implementing the
final rule are also significant, but appear
to be largely because of considerable
start-up costs. However, much of the
apparent start-up costs reflect activities
that the banks would undertake as part
of their ongoing efforts to improve the
quality of their internal risk
measurement and management, even in
the absence of the New Accord and this
final rule. The advanced approaches
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seem to have fairly modest ongoing
expenses. Against these costs, the
significant benefits of the New Accord
suggest that the final rule offers an
improvement over the baseline scenario.
With regard to the three alternative
approaches we consider, the final rule
offers an important degree of flexibility
while significantly restricting costs by
limiting its application to large,
internationally active banks.
Alternatives A and B introduce more
flexibility from the perspective of the
large mandatory banks, but each is less
flexible with respect to other banks.
Either Alternative A or B would compel
these non-mandatory banks to select a
new set of capital rules and require
them to undertake the time and expense
of adjusting to this final rule.
Alternative C would change the number
of mandatory banks. If the number of
mandatory banks increases, then the
new rule would lose some of the
flexibility it achieves with the opt-in
option. Furthermore, costs would
increase as the final rule would compel
more banks to incur the expense of
adopting the advanced approaches.
Decreasing the number of mandatory
banks would decrease the aggregate
social good of each benefit achieved
with the final rule. The final rule offers
a better balance between costs and
benefits than any of the three
alternatives.
OTS Executive Order 12866
Determination
OTS commented on the development
of, and concurs with, OCC’s RIA. Rather
than replicate that analysis, OTS drafted
an RIA incorporating OCC’s analysis by
reference and adding appropriate
material reflecting the unique aspects of
the thrift industry. The full text of OTS’s
RIA is available at the locations for
viewing the OTS docket indicated in the
ADDRESSES section above. OTS believes
that its analysis meets the requirements
of Executive Order 12866.
The following discussion
supplements OCC’s summary of its RIA.
The final rule will apply to
approximately six mandatory and
potential opt-in savings associations
representing approximately 52 percent
of total thrift industry assets.
Approximately 76 percent of the total
assets in these six institutions are
concentrated in residential mortgagerelated 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
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associations will differ in important
ways from OCC-regulated national
banks. These differences are the focus of
OTS’s analysis.
Benefits. Among the benefits of the
final rule, OCC cites: (i) Better allocation
of capital and reduced impact of moral
hazard through reduction in the scope
for regulatory arbitrage; (ii) improved
signal quality of capital as an indicator
of institution solvency; and (iii) more
efficient use of required bank capital.
From OTS’s perspective, however, the
final rule may not provide the degree of
benefits anticipated by OCC from these
sources.
Because of the typically low credit
risk associated with residential
mortgage-related assets, OTS believes
that the risk-insensitive leverage ratio,
rather than the risk-based capital ratio,
may be more binding on savings
association institutions.120 As a result,
these institutions may be required to
hold more capital than would be
required under Basel II risk-based
standards alone. Therefore, the final
rule may cause these institutions to
incur much the same implementation
costs as banks with riskier assets, but
with reduced benefits.
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
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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and training. To date, Basel II
expenditures have not been a large part
of overall expenditures.
Competition. OTS agrees with OCC’s
analysis of competition among
providers of financial services. OTS
adds, however, that some institutions
with low credit risk portfolios face an
existing competitive disadvantage
because they are bound by a non-riskbased capital requirement—the leverage
ratio. Thus, the agencies regulate a class
of institutions that currently receive
fewer capital benefits from risk-based
capital rules because they are bound by
the risk-insensitive leverage ratio. This
anomaly will likely continue under the
final rule.
In addition, the results from QIS–3
and QIS–4 suggest that the largest
reductions in regulatory credit-risk
capital requirements from the
application of revised rules would occur
in the residential mortgage loan area.
Thus, to the extent regulatory credit-risk
capital requirements affect pricing of
such loans, it is possible that core and
opt-in institutions who are not
constrained by the leverage ratio may
experience an improvement in their
competitive standing vis-à-vis nonadopters 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 Sherlund122
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 nonadopters. 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 riskbased 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
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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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 twoyear period articulated in the
international Basel II framework,
providing a disincentive for core
institutions to hold the least risky
residential mortgages. This may have
the effect of reducing the core banks’’
advantage vis-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 prepared in
conjunction with the Executive Order
12866 analysis document titled
Regulatory Impact Analysis for RiskBased Capital Standards: Revised
Capital Adequacy Guidelines. The
analysis is available on the Internet at
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http://www.occ.treas.gov/law/basel.htm
under the link of ‘‘Regulatory Impact
Analysis for Risk-Based Capital
Standards: Revised Capital Adequacy
Guidelines (Basel II: Advanced
Approach) 2007’’.
OTS Unfunded Mandates Reform Act of
1995 Determination
The Unfunded Mandates Reform Act
of 1995 (Pub. L. 104–4) (UMRA)
requires cost-benefit and other analyses
for a rule that would include any
Federal mandate that may result in the
expenditure by State, local, and tribal
governments, in the aggregate, or by the
private sector of $100 million or more
(adjusted annually for inflation) in any
one year. The current inflation-adjusted
expenditure threshold is $119.6 million.
The requirements of the UMRA include
assessing a rule’s effects on future
compliance costs; particular regions or
State, local, or tribal governments;
communities; segments of the private
sector; productivity; economic growth;
full employment; creation of productive
jobs; and the international
competitiveness of U.S. goods and
services. The final rule qualifies as a
significant regulatory action under the
UMRA because its Federal mandates
may result in the expenditure by the
private sector of $119.6 or more in any
one year. As permitted by section 202(c)
of the UMRA, the required analyses
have been prepared in conjunction with
the Executive Order 12866 analysis
document titled Regulatory Impact
Analysis for Risk-Based Capital
Standards: Revised Capital Adequacy
Guidelines. The analysis is available at
the locations for viewing the OTS
docket indicated in the ADDRESSES
section above.
Text of Common Appendix (All
Agencies)
The text of the agencies’’ common
appendix appears below:
[Appendix l to Part l]—Capital Adequacy
Guidelines for [Banks]: Internal-RatingsBased and Advanced Measurement
Approaches
Part I General Provisions
Section 1 Purpose, Applicability,
Reservation of Authority, and Principle
of Conservatism
Section 2 Definitions
Section 3 Minimum Risk-Based Capital
Requirements
Part II Qualifying Capital
Section 11 Additional Deductions
Section 12 Deductions and Limitations
Not Required
Section 13 Eligible Credit Reserves
Part III Qualification
Section 21 Qualification Process
Section 22 Qualification Requirements
Section 23 Ongoing Qualification
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Section 24 Merger and Acquisition
Transitional Arrangements
Part IV Risk-Weighted Assets for General
Credit Risk
Section 31 Mechanics for Calculating
Total Wholesale and Retail 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)
Section 45 Supervisory Formula
Approach (SFA)
Section 46 Recognition of Credit Risk
Mitigants for Securitization Exposures
Section 47 Risk-Based Capital
Requirement for Early Amortization
Provisions
Part VI Risk-Weighted Assets for Equity
Exposures
Section 51 Introduction and Exposure
Measurement
Section 52 Simple Risk Weight Approach
(SRWA)
Section 53 Internal Models Approach
(IMA)
Section 54 Equity Exposures to
Investment Funds
Section 55 Equity Derivative Contracts
Part VII Risk-Weighted Assets for
Operational Risk
Section 61 Qualification Requirements
for Incorporation of Operational Risk
Mitigants
Section 62 Mechanics of Risk-Weighted
Asset Calculation
Part VIII Disclosure
Section 71 Disclosure Requirements
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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
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Income (Call Report) or Thrift Financial
Report (TFR), equal to $250 billion or more;
(ii) Has consolidated total on-balance sheet
foreign exposure at the most recent year-end
equal to $10 billion or more (where total onbalance sheet foreign exposure equals total
cross-border claims less claims with head
office or guarantor located in another country
plus redistributed guaranteed amounts to the
country of head office or guarantor plus local
country claims on local residents plus
revaluation gains on foreign exchange and
derivative products, calculated in accordance
with the Federal Financial Institutions
Examination Council (FFIEC) 009 Country
Exposure Report);
(iii) Is a subsidiary of a depository
institution that uses 12 CFR part 3, Appendix
C, 12 CFR part 208, Appendix F, 12 CFR part
325, Appendix D, or 12 CFR part 567,
Appendix C, to calculate its risk-based
capital requirements; or
(iv) Is a subsidiary of a bank holding
company that uses 12 CFR part 225,
Appendix G, to calculate its risk-based
capital requirements.
(2) Any [bank] may elect to use this
appendix to calculate its risk-based capital
requirements.
(3) A [bank] that is subject to this appendix
must use this appendix unless the [AGENCY]
determines in writing that application of this
appendix is not appropriate in light of the
[bank]’s asset size, level of complexity, risk
profile, or scope of operations. In making a
determination under this paragraph, the
[AGENCY] will apply notice and response
procedures in the same manner and to the
same extent as the notice and response
procedures in 12 CFR 3.12 (for national
banks), 12 CFR 263.202 (for bank holding
companies and state member banks), 12 CFR
325.6(c) (for state nonmember banks), and 12
CFR 567.3(d) (for savings associations).
(c) Reservation of authority—(1) Additional
capital in the aggregate. The [AGENCY] may
require a [bank] to hold an amount of capital
greater than otherwise required under this
appendix if the [AGENCY] determines that
the [bank]’s risk-based capital requirement
under this appendix is not commensurate
with the [bank]’s credit, market, operational,
or other risks. In making a determination
under this paragraph, the [AGENCY] will
apply notice and response procedures in the
same manner and to the same extent as the
notice and response procedures in 12 CFR
3.12 (for national banks), 12 CFR 263.202 (for
bank holding companies and state member
banks), 12 CFR 325.6(c) (for state nonmember
banks), and 12 CFR 567.3(d) (for savings
associations).
(2) Specific risk-weighted asset amounts. (i)
If the [AGENCY] determines that the riskweighted 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].
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(ii) If the [AGENCY] determines that the
risk-weighted asset amount for operational
risk produced by the [bank] under this
appendix is not commensurate with the
operational risks of the [bank], the [AGENCY]
may require the [bank] to assign a different
risk-weighted asset amount for operational
risk, to change elements of its operational
risk analytical framework, including
distributional and dependence assumptions,
or to make other changes to the [bank]’s
operational risk management processes, data
and assessment systems, or quantification
systems, all as specified by the [AGENCY].
(3) Other supervisory authority. Nothing in
this appendix limits the authority of the
[AGENCY] under any other provision of law
or regulation to take supervisory or
enforcement action, including action to
address unsafe or unsound practices or
conditions, deficient capital levels, or
violations of law.
(d) Principle of conservatism.
Notwithstanding the requirements of this
appendix, a [bank] may choose not to apply
a provision of this appendix to one or more
exposures, provided that:
(1) The [bank] can demonstrate on an
ongoing basis to the satisfaction of the
[AGENCY] that not applying the provision
would, in all circumstances, unambiguously
generate a risk-based capital requirement for
each such exposure greater than that which
would otherwise be required under this
appendix;
(2) The [bank] appropriately manages the
risk of each such exposure;
(3) The [bank] notifies the [AGENCY] in
writing prior to applying this principle to
each such exposure; and
(4) The exposures to which the [bank]
applies this principle are not, in the
aggregate, material to the [bank].
Section 2. Definitions
Advanced internal ratings-based (IRB)
systems means a [bank]’s internal risk rating
and segmentation system; risk parameter
quantification system; data management and
maintenance system; and control, oversight,
and validation system for credit risk of
wholesale and retail exposures.
Advanced systems means a [bank]’s
advanced IRB systems, operational risk
management processes, operational risk data
and assessment systems, operational risk
quantification systems, and, to the extent the
[bank] uses the following systems, the
internal models methodology, double default
excessive correlation detection process, IMA
for equity exposures, and IAA for
securitization exposures to ABCP programs.
Affiliate with respect to a company means
any company that controls, is controlled by,
or is under common control with, the
company.
Applicable external rating means:
(1) With respect to an exposure that has
multiple external ratings assigned by
NRSROs, the lowest solicited external rating
assigned to the exposure by any NRSRO; and
(2) With respect to an exposure that has a
single external rating assigned by an NRSRO,
the external rating assigned to the exposure
by the NRSRO.
Applicable inferred rating means:
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(1) With respect to an exposure that has
multiple inferred ratings, the lowest inferred
rating based on a solicited external rating;
and
(2) With respect to an exposure that has a
single inferred rating, the inferred rating.
Asset-backed commercial paper (ABCP)
program means a program that primarily
issues commercial paper that:
(1) Has an external rating; and
(2) Is backed by underlying exposures held
in a bankruptcy-remote SPE.
Asset-backed commercial paper (ABCP)
program sponsor means a [bank] that:
(1) Establishes an ABCP program;
(2) Approves the sellers permitted to
participate in an ABCP program;
(3) Approves the exposures to be
purchased by an ABCP program; or
(4) Administers the ABCP program by
monitoring the underlying exposures,
underwriting or otherwise arranging for the
placement of debt or other obligations issued
by the program, compiling monthly reports,
or ensuring compliance with the program
documents and with the program’s credit and
investment policy.
Backtesting means the comparison of a
[bank]’s internal estimates with actual
outcomes during a sample period not used in
model development. In this context,
backtesting is one form of out-of-sample
testing.
Bank holding company is defined in
section 2 of the Bank Holding Company Act
(12 U.S.C. 1841).
Benchmarking means the comparison of a
[bank]’s internal estimates with relevant
internal and external data or with estimates
based on other estimation techniques.
Business environment and internal control
factors means the indicators of a [bank]’s
operational risk profile that reflect a current
and forward-looking assessment of the
[bank]’s underlying business risk factors and
internal control environment.
Carrying value means, with respect to an
asset, the value of the asset on the balance
sheet of the [bank], determined in accordance
with GAAP.
Clean-up call means a contractual
provision that permits an originating [bank]
or servicer to call securitization exposures
before their stated maturity or call date. See
also eligible clean-up call.
Commodity derivative contract means a
commodity-linked swap, purchased
commodity-linked option, forward
commodity-linked contract, or any other
instrument linked to commodities that gives
rise to similar counterparty credit risks.
Company means a corporation,
partnership, limited liability company,
depository institution, business trust, special
purpose entity, association, or similar
organization.
Control. A person or company controls a
company if it:
(1) Owns, controls, or holds with power to
vote 25 percent or more of a class of voting
securities of the company; or
(2) Consolidates the company for financial
reporting purposes.
Controlled early amortization provision
means an early amortization provision that
meets all the following conditions:
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(1) The originating [bank] has appropriate
policies and procedures to ensure that it has
sufficient capital and liquidity available in
the event of an early amortization;
(2) Throughout the duration of the
securitization (including the early
amortization period), there is the same pro
rata sharing of interest, principal, expenses,
losses, fees, recoveries, and other cash flows
from the underlying exposures based on the
originating [bank]’s and the investors’
relative shares of the underlying exposures
outstanding measured on a consistent
monthly basis;
(3) The amortization period is sufficient for
at least 90 percent of the total underlying
exposures outstanding at the beginning of the
early amortization period to be repaid or
recognized as in default; and
(4) The schedule for repayment of investor
principal is not more rapid than would be
allowed by straight-line amortization over an
18-month period.
Credit derivative means a financial contract
executed under standard industry credit
derivative documentation that allows one
party (the protection purchaser) to transfer
the credit risk of one or more exposures
(reference exposure) to another party (the
protection provider). See also eligible credit
derivative.
Credit-enhancing interest-only strip (CEIO)
means an on-balance sheet asset that, in form
or in substance:
(1) Represents a contractual right to receive
some or all of the interest and no more than
a minimal amount of principal due on the
underlying exposures of a securitization; and
(2) Exposes the holder to credit risk
directly or indirectly associated with the
underlying exposures that exceeds a pro rata
share of the holder’s claim on the underlying
exposures, whether through subordination
provisions or other credit-enhancement
techniques.
Credit-enhancing representations and
warranties means representations and
warranties that are made or assumed in
connection with a transfer of underlying
exposures (including loan servicing assets)
and that obligate a [bank] to protect another
party from losses arising from the credit risk
of the underlying exposures. 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. Creditenhancing representations and warranties do
not include:
(1) Early default clauses and similar
warranties that permit the return of, or
premium refund clauses that cover, first-lien
residential mortgage exposures for a period
not to exceed 120 days from the date of
transfer, provided that the date of transfer is
within one year of origination of the
residential mortgage exposure;
(2) Premium refund clauses that cover
underlying exposures guaranteed, in whole
or in part, by the U.S. government, a U.S.
government agency, or a U.S. government
sponsored enterprise, provided that the
clauses are for a period not to exceed 120
days from the date of transfer; or
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(3) Warranties that permit the return of
underlying exposures in instances of
misrepresentation, fraud, or incomplete
documentation.
Credit risk mitigant means collateral, a
credit derivative, or a guarantee.
Credit-risk-weighted assets means 1.06
multiplied by the sum of:
(1) Total wholesale and retail risk-weighted
assets;
(2) Risk-weighted assets for securitization
exposures; and
(3) Risk-weighted assets for equity
exposures.
Current exposure means, with respect to a
netting set, the larger of zero or the market
value of a transaction or portfolio of
transactions within the netting set that would
be lost upon default of the counterparty,
assuming no recovery on the value of the
transactions. Current exposure is also called
replacement cost.
Default—(1) Retail. (i) A retail exposure of
a [bank] is in default if:
(A) The exposure is 180 days past due, in
the case of a residential mortgage exposure or
revolving exposure;
(B) The exposure is 120 days past due, in
the case of all other retail exposures; or
(C) The [bank] has taken a full or partial
charge-off, write-down of principal, or
material negative fair value adjustment of
principal on the exposure for credit-related
reasons.
(ii) Notwithstanding paragraph (1)(i) of this
definition, for a retail exposure held by a
non-U.S. subsidiary of the [bank] that is
subject to an internal ratings-based approach
to capital adequacy consistent with the Basel
Committee on Banking Supervision’s
‘‘International Convergence of Capital
Measurement and Capital Standards: A
Revised Framework’’ in a non-U.S.
jurisdiction, the [bank] may elect to use the
definition of default that is used in that
jurisdiction, provided that the [bank] has
obtained prior approval from the [AGENCY]
to use the definition of default in that
jurisdiction.
(iii) A retail exposure in default remains in
default until the [bank] has reasonable
assurance of repayment and performance for
all contractual principal and interest
payments on the exposure.
(2) Wholesale. (i) A [bank]’s wholesale
obligor is in default if:
(A) The [bank] determines that the obligor
is unlikely to pay its credit obligations to the
[bank] in full, without recourse by the [bank]
to actions such as realizing collateral (if
held); or
(B) The obligor is past due more than 90
days on any material credit obligation(s) to
the [bank].1
(ii) An obligor in default remains in default
until the [bank] has reasonable assurance of
repayment and performance for all
contractual principal and interest payments
on all exposures of the [bank] to the obligor
(other than exposures that have been fully
written-down or charged-off).
1 Overdrafts are past due once the obligor has
breached an advised limit or been advised of a limit
smaller than the current outstanding balance.
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Dependence means a measure of the
association among operational losses across
and within units of measure.
Depository institution is defined in section
3 of the Federal Deposit Insurance Act (12
U.S.C. 1813).
Derivative contract means a financial
contract whose value is derived from the
values of one or more underlying assets,
reference rates, or indices of asset values or
reference rates. Derivative contracts include
interest rate derivative contracts, exchange
rate derivative contracts, equity derivative
contracts, commodity derivative contracts,
credit derivatives, and any other instrument
that poses similar counterparty credit risks.
Derivative contracts also include unsettled
securities, commodities, and foreign
exchange transactions with a contractual
settlement or delivery lag that is longer than
the lesser of the market standard for the
particular instrument or five business days.
Early amortization provision means a
provision in the documentation governing a
securitization that, when triggered, causes
investors in the securitization exposures to
be repaid before the original stated maturity
of the securitization exposures, unless the
provision:
(1) Is triggered solely by events not directly
related to the performance of the underlying
exposures or the originating [bank] (such as
material changes in tax laws or regulations);
or
(2) Leaves investors fully exposed to future
draws by obligors on the underlying
exposures even after the provision is
triggered.
Economic downturn conditions means,
with respect to an exposure held by the
[bank], those conditions in which the
aggregate default rates for that exposure’s
wholesale or retail exposure subcategory (or
subdivision of such subcategory selected by
the [bank]) in the exposure’s national
jurisdiction (or subdivision of such
jurisdiction selected by the [bank]) are
significantly higher than average.
Effective maturity (M) of a wholesale
exposure means:
(1) For wholesale exposures other than
repo-style transactions, eligible margin loans,
and OTC derivative contracts described in
paragraph (2) or (3) of this definition:
(i) The weighted-average remaining
maturity (measured in years, whole or
fractional) of the expected contractual cash
flows from the exposure, using the
undiscounted amounts of the cash flows as
weights; or
(ii) The nominal remaining maturity
(measured in years, whole or fractional) of
the exposure.
(2) For repo-style transactions, eligible
margin loans, and OTC derivative contracts
subject to a qualifying master netting
agreement for which the [bank] does not
apply the internal models approach in
paragraph (d) of section 32 of this appendix,
the weighted-average remaining maturity
(measured in years, whole or fractional) of
the individual transactions subject to the
qualifying master netting agreement, with the
weight of each individual transaction set
equal to the notional amount of the
transaction.
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(3) For repo-style transactions, eligible
margin loans, and OTC derivative contracts
for which the [bank] applies the internal
models approach in paragraph (d) of section
32 of this appendix, the value determined in
paragraph (d)(4) of section 32 of this
appendix.
Effective notional amount means, for an
eligible guarantee or eligible credit
derivative, the lesser of the contractual
notional amount of the credit risk mitigant
and the EAD of the hedged exposure,
multiplied by the percentage coverage of the
credit risk mitigant. For example, the
effective notional amount of an eligible
guarantee that covers, on a pro rata basis, 40
percent of any losses on a $100 bond would
be $40.
Eligible clean-up call means a clean-up call
that:
(1) Is exercisable solely at the discretion of
the originating [bank] or servicer;
(2) Is not structured to avoid allocating
losses to securitization exposures held by
investors or otherwise structured to provide
credit enhancement to the securitization; and
(3) (i) For a traditional securitization, is
only exercisable when 10 percent or less of
the principal amount of the underlying
exposures or securitization exposures
(determined as of the inception of the
securitization) is outstanding; or
(ii) For a synthetic securitization, is only
exercisable when 10 percent or less of the
principal amount of the reference portfolio of
underlying exposures (determined as of the
inception of the securitization) is
outstanding.
Eligible credit derivative means a credit
derivative in the form of a credit default
swap, 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:
(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
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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 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 longterm external rating in the third-highest
investment-grade rating category; and
(ii) The [bank] currently assigns a PD to the
guarantor’s rating grade that is equal to or
lower than the PD associated with a longterm external rating in the lowest investmentgrade rating category; or
(2) Non-U.S.-based entities. A foreign bank
(as defined in § 211.2 of the Federal Reserve
Board’s Regulation K (12 CFR 211.2)), a nonU.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;
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(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 longterm 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 longterm external rating in the lowest investmentgrade rating category.
Eligible guarantee means a guarantee that:
(1) Is written and unconditional;
(2) Covers all or a pro rata portion of all
contractual payments of the obligor on the
reference exposure;
(3) Gives the beneficiary a direct claim
against the protection provider;
(4) Is not unilaterally cancelable by the
protection provider for reasons other than the
breach of the contract by the beneficiary;
(5) Is legally enforceable against the
protection provider in a jurisdiction where
the protection provider has sufficient assets
against which a judgment may be attached
and enforced;
(6) Requires the protection provider to
make payment to the beneficiary on the
occurrence of a default (as defined in the
guarantee) of the obligor on the reference
exposure in a timely manner without the
beneficiary first having to take legal actions
to pursue the obligor for payment;
(7) Does not increase the beneficiary’s cost
of credit protection on the guarantee in
response to deterioration in the credit quality
of the reference exposure; and
(8) Is not provided by an affiliate of the
[bank], unless the affiliate is an insured
depository institution, bank, securities broker
or dealer, or insurance company that:
(i) Does not control the [bank]; and
(ii) Is subject to consolidated supervision
and regulation comparable to that imposed
on U.S. depository institutions, securities
broker-dealers, or insurance companies (as
the case may be).
Eligible margin loan means an extension of
credit where:
(1) The extension of credit is collateralized
exclusively by liquid and readily marketable
debt or equity securities, gold, or conforming
residential mortgages;
(2) The collateral is marked to market
daily, and the transaction is subject to daily
margin maintenance requirements;
(3) The extension of credit is conducted
under an agreement that provides the [bank]
the right to accelerate and terminate the
extension of credit and to liquidate or set off
collateral promptly upon an event of default
(including upon an event of bankruptcy,
insolvency, or similar proceeding) of the
counterparty, provided that, in any such
case, any exercise of rights under the
agreement will not be stayed or avoided
under applicable law in the relevant
jurisdictions; 2 and
2 This requirement is met where all transactions
under the agreement are (i) executed under U.S. law
and (ii) constitute ‘‘securities contracts’’ under
section 555 of the Bankruptcy Code (11 U.S.C. 555),
qualified financial contracts under section 11(e)(8)
of the Federal Deposit Insurance Act (12 U.S.C.
1821(e)(8)), or netting contracts between or among
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(4) The [bank] has conducted sufficient
legal review to conclude with a well-founded
basis (and maintains sufficient written
documentation of that legal review) that the
agreement meets the requirements of
paragraph (3) of this definition and is legal,
valid, binding, and enforceable under
applicable law in the relevant jurisdictions.
Eligible operational risk offsets means
amounts, not to exceed expected operational
loss, that:
(1) Are generated by internal business
practices to absorb highly predictable and
reasonably stable operational losses,
including reserves calculated consistent with
GAAP; and
(2) Are available to cover expected
operational losses with a high degree of
certainty over a one-year horizon.
Eligible purchased wholesale exposure
means a purchased wholesale exposure that:
(1) The [bank] or securitization SPE
purchased from an unaffiliated seller and did
not directly or indirectly originate;
(2) Was generated on an arm’s-length basis
between the seller and the obligor
(intercompany accounts receivable and
receivables subject to contra-accounts
between firms that buy and sell to each other
do not satisfy this criterion);
(3) Provides the [bank] or securitization
SPE with a claim on all proceeds from the
exposure or a pro rata interest in the
proceeds from the exposure;
(4) Has an M of less than one year; and
(5) When consolidated by obligor, does not
represent a concentrated exposure relative to
the portfolio of purchased wholesale
exposures.
Eligible securitization guarantor means:
(1) A sovereign entity, the Bank for
International Settlements, the International
Monetary Fund, the European Central Bank,
the European Commission, a Federal Home
Loan Bank, Federal Agricultural Mortgage
Corporation (Farmer Mac), a multilateral
development bank, a depository institution, a
bank holding company, a savings and loan
holding company (as defined in 12 U.S.C.
1467a) provided all or substantially all of the
holding company’s activities are permissible
for a financial holding company under 12
U.S.C. 1843(k), a foreign bank (as defined in
§ 211.2 of the Federal Reserve Board’s
Regulation K (12 CFR 211.2)), or a securities
firm;
(2) Any other entity (other than a
securitization SPE) that has issued and
outstanding an unsecured long-term debt
security without credit enhancement that has
a long-term applicable external rating in one
of the three highest investment-grade rating
categories; or
(3) Any other entity (other than a
securitization SPE) that has a PD assigned by
the [bank] that is lower than or equal to the
PD associated with a long-term external
rating in the third highest investment-grade
rating category.
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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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 nonreimbursable 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 equitylinked swap, purchased equity-linked option,
forward equity-linked contract, or any other
instrument linked to equities that gives rise
to similar counterparty credit risks.
Equity exposure means:
(1) A security or instrument (whether
voting or non-voting) that represents a direct
or indirect ownership interest in, and is a
residual claim on, the assets and income of
a company, unless:
(i) The issuing company is consolidated
with the [bank] under GAAP;
(ii) The [bank] is required to deduct the
ownership interest from tier 1 or tier 2 capital
under this appendix;
(iii) The ownership interest incorporates a
payment or other similar obligation on the
part of the issuing company (such as an
obligation to make periodic payments); or
(iv) The ownership interest is a
securitization exposure;
(2) A security or instrument that is
mandatorily convertible into a security or
instrument described in paragraph (1) of this
definition;
(3) An option or warrant that is exercisable
for a security or instrument described in
paragraph (1) of this definition; or
(4) Any other security or instrument (other
than a securitization exposure) to the extent
the return on the security or instrument is
based on the performance of a security or
instrument described in paragraph (1) of this
definition.
Excess spread for a period means:
(1) Gross finance charge collections and
other income received by a securitization
SPE (including market interchange fees) over
a period minus interest paid to the holders
of the securitization exposures, servicing
fees, charge-offs, and other senior trust or
similar expenses of the SPE over the period;
divided by
(2) The principal balance of the underlying
exposures at the end of the period.
Exchange rate derivative contract means a
cross-currency interest rate swap, forward
foreign-exchange contract, currency option
purchased, or any other instrument linked to
exchange rates that gives rise to similar
counterparty credit risks.
Excluded mortgage exposure means any
one-to four-family residential pre-sold
construction loan for a residence for which
the purchase contract is cancelled that would
receive a 100 percent risk weight under
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section 618(a)(2) of the Resolution Trust
Corporation Refinancing, Restructuring, and
Improvement Act and under 12 CFR part 3,
Appendix A, section 3(a)(3)(iii) (for national
banks), 12 CFR part 208, Appendix A, section
III.C.3. (for state member banks), 12 CFR part
225, Appendix A, section III.C.3. (for bank
holding companies), 12 CFR part 325,
Appendix A, section II.C.a. (for state
nonmember banks), or 12 CFR 567.1
(definition of ‘‘qualifying residential
construction loan’’) and 12 CFR
567.6(a)(1)(iv) (for savings associations).
Expected credit loss (ECL) means:
(1) For a wholesale exposure to a nondefaulted obligor or segment of non-defaulted
retail exposures that is carried at fair value
with gains and losses flowing through
earnings or that is classified as held-for-sale
and is carried at the lower of cost or fair
value with losses flowing through earnings,
zero.
(2) For all other wholesale exposures to
non-defaulted obligors or segments of nondefaulted retail exposures, the product of PD
times LGD times EAD for the exposure or
segment.
(3) For a wholesale exposure to a defaulted
obligor or segment of defaulted retail
exposures, the [bank]’s impairment estimate
for allowance purposes for the exposure or
segment.
(4) Total ECL is the sum of expected credit
losses for all wholesale and retail exposures
other than exposures for which the [bank]
has applied the double default treatment in
section 34 of this appendix.
Expected exposure (EE) means the
expected value of the probability distribution
of non-negative credit risk exposures to a
counterparty at any specified future date
before the maturity date of the longest term
transaction in the netting set. Any negative
market values in the probability distribution
of market values to a counterparty at a
specified future date are set to zero to convert
the probability distribution of market values
to the probability distribution of credit risk
exposures.
Expected operational loss (EOL) means the
expected value of the distribution of
potential aggregate operational losses, as
generated by the [bank]’s operational risk
quantification system using a one-year
horizon.
Expected positive exposure (EPE) means
the weighted average over time of expected
(non-negative) exposures to a counterparty
where the weights are the proportion of the
time interval that an individual expected
exposure represents. When calculating riskbased capital requirements, the average is
taken over a one-year horizon.
Exposure at default (EAD). (1) For the onbalance sheet component of a wholesale
exposure or segment of retail exposures
(other than an OTC derivative contract, or a
repo-style transaction or eligible margin loan
for which the [bank] determines EAD under
section 32 of this appendix), EAD means:
(i) If the exposure or segment is a security
classified as available-for-sale, the [bank]’s
carrying value (including net accrued but
unpaid interest and fees) for the exposure or
segment less any allocated transfer risk
reserve for the exposure or segment, less any
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unrealized gains on the exposure or segment,
and plus any unrealized losses on the
exposure or segment; or
(ii) If the exposure or segment is not a
security classified as available-for-sale, the
[bank]’s carrying value (including net
accrued but unpaid interest and fees) for the
exposure or segment less any allocated
transfer risk reserve for the exposure or
segment.
(2) For the off-balance sheet component of
a wholesale exposure or segment of retail
exposures (other than an OTC derivative
contract, or a repo-style transaction or
eligible margin loan for which the [bank]
determines EAD under section 32 of this
appendix) in the form of a loan commitment,
line of credit, trade-related letter of credit, or
transaction-related contingency, EAD means
the [bank]’s best estimate of net additions to
the outstanding amount owed the [bank],
including estimated future additional draws
of principal and accrued but unpaid interest
and fees, that are likely to occur over a oneyear horizon assuming the wholesale
exposure or the retail exposures in the
segment were to go into default. This
estimate of net additions must reflect what
would be expected during economic
downturn conditions. Trade-related letters of
credit are short-term, self-liquidating
instruments that are used to finance the
movement of goods and are collateralized by
the underlying goods. Transaction-related
contingencies relate to a particular
transaction and include, among other things,
performance bonds and performance-based
letters of credit.
(3) For the off-balance sheet component of
a wholesale exposure or segment of retail
exposures (other than an OTC derivative
contract, or a repo-style transaction or
eligible margin loan for which the [bank]
determines EAD under section 32 of this
appendix) in the form of anything other than
a loan commitment, line of credit, traderelated letter of credit, or transaction-related
contingency, EAD means the notional
amount of the exposure or segment.
(4) EAD for OTC derivative contracts is
calculated as described in section 32 of this
appendix. A [bank] also may determine EAD
for repo-style transactions and eligible
margin loans as described in section 32 of
this appendix.
(5) For wholesale or retail exposures in
which only the drawn balance has been
securitized, the [bank] must reflect its share
of the exposures’ undrawn balances in EAD.
Undrawn balances of revolving exposures for
which the drawn balances have been
securitized must be allocated between the
seller’s and investors’ interests on a pro rata
basis, based on the proportions of the seller’s
and investors’ shares of the securitized
drawn balances.
Exposure category means any of the
wholesale, retail, securitization, or equity
exposure categories.
External operational loss event data
means, with respect to a [bank], gross
operational loss amounts, dates, recoveries,
and relevant causal information for
operational loss events occurring at
organizations other than the [bank].
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External rating means a credit rating that
is assigned by an NRSRO to an exposure,
provided:
(1) The credit rating fully reflects the entire
amount of credit risk with regard to all
payments owed to the holder of the exposure.
If a holder is owed principal and interest on
an exposure, the credit rating must fully
reflect the credit risk associated with timely
repayment of principal and interest. If a
holder is owed only principal on an
exposure, the credit rating must fully reflect
only the credit risk associated with timely
repayment of principal; and
(2) The credit rating is published in an
accessible form and is or will be included in
the transition matrices made publicly
available by the NRSRO that summarize the
historical performance of positions rated by
the NRSRO.
Financial collateral means collateral:
(1) In the form of:
(i) Cash on deposit with the [bank]
(including cash held for the [bank] by a 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).
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
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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 provided the
ADC facility as long as the permanent
financing is subject to the [bank]’s
underwriting criteria for long-term mortgage
loans.
Inferred rating. A securitization exposure
has an inferred rating equal to the external
rating referenced in paragraph (2)(i) of this
definition if:
(1) The securitization exposure does not
have an external rating; and
(2) Another securitization exposure issued
by the same issuer and secured by the same
underlying exposures:
(i) Has an external rating;
(ii) Is subordinated in all respects to the
unrated securitization exposure;
(iii) Does not benefit from any credit
enhancement that is not available to the
unrated securitization exposure; and
(iv) Has an effective remaining maturity
that is equal to or longer than that of the
unrated securitization exposure.
Interest rate derivative contract means a
single-currency interest rate swap, basis
swap, forward rate agreement, purchased
interest rate option, when-issued securities,
or any other instrument linked to interest
rates that gives rise to similar counterparty
credit risks.
Internal operational loss event data means,
with respect to a [bank], gross operational
loss amounts, dates, recoveries, and relevant
causal information for operational loss events
occurring at the [bank].
Investing [bank] means, with respect to a
securitization, a [bank] that assumes the
credit risk of a securitization exposure (other
than an originating [bank] of the
securitization). In the typical synthetic
securitization, the investing [bank] sells
credit protection on a pool of underlying
exposures to the originating [bank].
Investment fund means a company:
(1) All or substantially all of the assets of
which are financial assets; and
(2) That has no material liabilities.
Investors’ interest EAD means, with respect
to a securitization, the EAD of the underlying
exposures multiplied by the ratio of:
(1) The total amount of securitization
exposures issued by the securitization SPE to
investors; divided by
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(2) The outstanding principal amount of
underlying exposures.
Loss given default (LGD) means:
(1) For a wholesale exposure, the greatest
of:
(i) Zero;
(ii) The [bank]’s empirically based best
estimate of the long-run default-weighted
average economic loss, per dollar of EAD, the
[bank] would expect to incur if the obligor (or
a typical obligor in the loss severity grade
assigned by the [bank] to the exposure) were
to default within a one-year horizon over a
mix of economic conditions, including
economic downturn conditions; or
(iii) The [bank]’s empirically based best
estimate of the economic loss, per dollar of
EAD, the [bank] would expect to incur if the
obligor (or a typical obligor in the loss
severity grade assigned by the [bank] to the
exposure) were to default within a one-year
horizon during economic downturn
conditions.
(2) For a segment of retail exposures, the
greatest of:
(i) Zero;
(ii) The [bank]’s empirically based best
estimate of the long-run default-weighted
average economic loss, per dollar of EAD, the
[bank] would expect to incur if the exposures
in the segment were to default within a oneyear 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.
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
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Nordic Investment Bank, the Caribbean
Development Bank, the Islamic Development
Bank, the Council of Europe Development
Bank, and any other multilateral lending
institution or regional development bank in
which the U.S. government is a shareholder
or contributing member or which the
[AGENCY] determines poses comparable
credit risk.
Nationally recognized statistical rating
organization (NRSRO) means an entity
registered with the SEC as a nationally
recognized statistical rating organization
under section 15E of the Securities Exchange
Act of 1934 (15 U.S.C. 78o–7).
Netting set means a group of transactions
with a single counterparty that are subject to
a qualifying master netting agreement or
qualifying cross-product master netting
agreement. For purposes of the internal
models methodology in paragraph (d) of
section 32 of this appendix, each transaction
that is not subject to such a master netting
agreement is its own netting set.
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:
(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 crossacceleration clauses are in place other than
clauses obtained solely out of an abundance
of caution; and
(ii) Other credit exposures to the same legal
entity or natural person; and
(3) (i) A wholesale exposure authorized
under section 364 of the U.S. Bankruptcy
Code (11 U.S.C. 364) to a legal entity or
natural person who is a debtor-in-possession
for purposes of Chapter 11 of the Bankruptcy
Code; and
(ii) Other credit exposures to the same legal
entity or natural person.
Operational loss means a loss (excluding
insurance or tax effects) resulting from an
operational loss event. Operational loss
includes all expenses associated with an
operational loss event except for opportunity
costs, forgone revenue, and costs related to
risk management and control enhancements
implemented to prevent future operational
losses.
Operational loss event means an event that
results in loss and is associated with any of
the following seven operational loss event
type categories:
(1) Internal fraud, which means the
operational loss event type category that
comprises operational losses resulting from
an act involving at least one internal party of
a type intended to defraud, misappropriate
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property, or circumvent regulations, the law,
or company policy, excluding diversity- and
discrimination-type events.
(2) External fraud, which means the
operational loss event type category that
comprises operational losses resulting from
an act by a third party of a type intended to
defraud, misappropriate property, or
circumvent the law. Retail credit card losses
arising from non-contractual, third-party
initiated fraud (for example, identity theft)
are external fraud operational losses. All
other third-party initiated credit losses are to
be treated as credit risk losses.
(3) Employment practices and workplace
safety, which means the operational loss
event type category that comprises
operational losses resulting from an act
inconsistent with employment, health, or
safety laws or agreements, payment of
personal injury claims, or payment arising
from diversity- and discrimination-type
events.
(4) Clients, products, and business
practices, which means the operational loss
event type category that comprises
operational losses resulting from the nature
or design of a product or from an
unintentional or negligent failure to meet a
professional obligation to specific clients
(including fiduciary and suitability
requirements).
(5) Damage to physical assets, which
means the operational loss event type
category that comprises operational losses
resulting from the loss of or damage to
physical assets from natural disaster or other
events.
(6) Business disruption and system
failures, which means the operational loss
event type category that comprises
operational losses resulting from disruption
of business or system failures.
(7) Execution, delivery, and process
management, which means the operational
loss event type category that comprises
operational losses resulting from failed
transaction processing or process
management or losses arising from relations
with trade counterparties and vendors.
Operational risk means the risk of loss
resulting from inadequate or failed internal
processes, people, and systems or from
external events (including legal risk but
excluding strategic and reputational risk).
Operational risk exposure means the 99.9th
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
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with homogeneous risk characteristics, not
on an individual-exposure basis, and is
either:
(1) An exposure to an individual for nonbusiness purposes; or
(2) An exposure to an individual or
company for business purposes if the [bank]’s
consolidated business credit exposure to the
individual or company is $1 million or less.
Over-the-counter (OTC) derivative contract
means a derivative contract that is not traded
on an exchange that requires the daily receipt
and payment of cash-variation margin.
Probability of default (PD) means:
(1) For a wholesale exposure to a nondefaulted obligor, the [bank]’s empirically
based best estimate of the long-run average
one-year default rate for the rating grade
assigned by the [bank] to the obligor,
capturing the average default experience for
obligors in the rating grade over a mix of
economic conditions (including economic
downturn conditions) sufficient to provide a
reasonable estimate of the average one-year
default rate over the economic cycle for the
rating grade.
(2) For a segment of non-defaulted retail
exposures, the [bank]’s empirically based
best estimate of the long-run average one-year
default rate for the exposures in the segment,
capturing the average default experience for
exposures in the segment over a mix of
economic conditions (including economic
downturn conditions) sufficient to provide a
reasonable estimate of the average one-year
default rate over the economic cycle for the
segment and adjusted upward as appropriate
for segments for which seasoning effects are
material. For purposes of this definition, a
segment for which seasoning effects are
material is a segment where there is a
material relationship between the time since
origination of exposures within the segment
and the [bank]’s best estimate of the long-run
average one-year default rate for the
exposures in the segment.
(3) For a wholesale exposure to a defaulted
obligor or segment of defaulted retail
exposures, 100 percent.
Protection amount (P) means, with respect
to an exposure hedged by an eligible
guarantee or eligible credit derivative, the
effective notional amount of the guarantee or
credit derivative, reduced to reflect any
currency mismatch, maturity mismatch, or
lack of restructuring coverage (as provided in
section 33 of this appendix).
Publicly traded means traded on:
(1) Any exchange registered with the SEC
as a national securities exchange under
section 6 of the Securities Exchange Act of
1934 (15 U.S.C. 78f); or
(2) Any non-U.S.-based securities exchange
that:
(i) Is registered with, or approved by, a
national securities regulatory authority; and
(ii) Provides a liquid, two-way market for
the instrument in question, meaning that
there are enough independent bona fide
offers to buy and sell so that a sales price
reasonably related to the last sales price or
current bona fide competitive bid and offer
quotations can be determined promptly and
a trade can be settled at such a price within
five business days.
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Qualifying central counterparty means a
counterparty (for example, a clearinghouse)
that:
(1) Facilitates trades between
counterparties in one or more financial
markets by either guaranteeing trades or
novating contracts;
(2) Requires all participants in its
arrangements to be fully collateralized on a
daily basis; and
(3) The [bank] demonstrates to the
satisfaction of the [AGENCY] is in sound
financial condition and is subject to effective
oversight by a national supervisory authority.
Qualifying cross-product master netting
agreement means a qualifying master netting
agreement that provides for termination and
close-out netting across multiple types of
financial transactions or qualifying master
netting agreements in the event of a
counterparty’s default, provided that:
(1) The underlying financial transactions
are OTC derivative contracts, eligible margin
loans, or repo-style transactions; and
(2) The [bank] obtains a written legal
opinion verifying the validity and
enforceability of the agreement under
applicable law of the relevant jurisdictions if
the counterparty fails to perform upon an
event of default, including upon an event of
bankruptcy, insolvency, or similar
proceeding.
Qualifying master netting agreement means
any written, legally enforceable bilateral
agreement, provided that:
(1) The agreement creates a single legal
obligation for all individual transactions
covered by the agreement upon an event of
default, including bankruptcy, insolvency, or
similar proceeding, of the counterparty;
(2) The agreement provides the [bank] the
right to accelerate, terminate, and close-out
on a net basis all transactions under the
agreement and to liquidate or set off
collateral promptly upon an event of default,
including upon an event of bankruptcy,
insolvency, or similar proceeding, of the
counterparty, provided that, in any such
case, any exercise of rights under the
agreement will not be stayed or avoided
under applicable law in the relevant
jurisdictions;
(3) The [bank] has conducted sufficient
legal review to conclude with a well-founded
basis (and maintains sufficient written
documentation of that legal review) that:
(i) The agreement meets the requirements
of paragraph (2) of this definition; and
(ii) In the event of a legal challenge
(including one resulting from default or from
bankruptcy, insolvency, or similar
proceeding) the relevant court and
administrative authorities would find the
agreement to be legal, valid, binding, and
enforceable under the law of the relevant
jurisdictions;
(4) The [bank] establishes and maintains
procedures to monitor possible changes in
relevant law and to ensure that the agreement
continues to satisfy the requirements of this
definition; and
(5) The agreement does not contain a
walkaway clause (that is, a provision that
permits a non-defaulting counterparty to
make a lower payment than it would make
otherwise under the agreement, or no
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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);
(2) Is unsecured and unconditionally
cancelable by the [bank] to the fullest extent
permitted by Federal law; and
(3) Has a maximum exposure amount
(drawn plus undrawn) of up to $100,000.
Repo-style transaction means a repurchase
or reverse repurchase transaction, or a
securities borrowing or securities lending
transaction, including a transaction in which
the [bank] acts as agent for a customer and
indemnifies the customer against loss,
provided that:
(1) The transaction is based solely on
liquid and readily marketable securities,
cash, gold, or conforming residential
mortgages;
(2) The transaction is marked-to-market
daily and subject to daily margin
maintenance requirements;
(3)(i) The transaction is a ‘‘securities
contract’’ or ‘‘repurchase agreement’’ under
section 555 or 559, respectively, of the
Bankruptcy Code (11 U.S.C. 555 or 559), a
qualified financial contract under section
11(e)(8) of the Federal Deposit Insurance Act
(12 U.S.C. 1821(e)(8)), or a netting contract
between or among financial institutions
under sections 401–407 of the Federal
Deposit Insurance Corporation Improvement
Act of 1991 (12 U.S.C. 4401–4407) or the
Federal Reserve Board’s Regulation EE (12
CFR part 231); or
(ii) If the transaction does not meet the
criteria set forth in paragraph (3)(i) of this
definition, then either:
(A) The transaction is executed under an
agreement that provides the [bank] the right
to accelerate, terminate, and close-out the
transaction on a net basis and to liquidate or
set off collateral promptly upon an event of
default (including upon an event of
bankruptcy, insolvency, or similar
proceeding) of the counterparty, provided
that, in any such case, any exercise of rights
under the agreement will not be stayed or
avoided under applicable law in the relevant
jurisdictions; or
(B) The transaction is:
(1) Either overnight or unconditionally
cancelable at any time by the [bank]; and
(2) Executed under an agreement that
provides the [bank] the right to accelerate,
terminate, and close-out the transaction on a
net basis and to liquidate or set off collateral
promptly upon an event of counterparty
default; and
(4) The [bank] has conducted sufficient
legal review to conclude with a well-founded
basis (and maintains sufficient written
documentation of that legal review) that the
agreement meets the requirements of
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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 fourfamily residential property; or
(2) An exposure with an original and
outstanding amount of $1 million or less that
is primarily secured by a first or subsequent
lien on residential property that is not one to
four family.
Retail exposure means a residential
mortgage exposure, a qualifying revolving
exposure, or an other retail exposure.
Retail exposure subcategory means the
residential mortgage exposure, qualifying
revolving exposure, or other retail exposure
subcategory.
Risk parameter means a variable used in
determining risk-based capital requirements
for wholesale and retail exposures,
specifically probability of default (PD), loss
given default (LGD), exposure at default
(EAD), or effective maturity (M).
Scenario analysis means a systematic
process of obtaining expert opinions from
business managers and risk management
experts to derive reasoned assessments of the
likelihood and loss impact of plausible highseverity 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 onbalance 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.
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
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facility provider’s right to reimbursement of
the drawn amounts is senior to all claims on
the cash flows from the underlying exposures
except amounts due under interest rate or
currency derivative contracts, fees due, or
other similar payments.
Servicer cash advance facility means a
facility under which the servicer of the
underlying exposures of a securitization may
advance cash to ensure an uninterrupted
flow of payments to investors in the
securitization, including advances made to
cover foreclosure costs or other expenses to
facilitate the timely collection of the
underlying exposures. See also eligible
servicer cash advance facility.
Sovereign entity means a central
government (including the U.S. government)
or an agency, department, ministry, or central
bank of a central government.
Sovereign exposure means:
(1) A direct exposure to a sovereign entity;
or
(2) An exposure directly and
unconditionally backed by the full faith and
credit of a sovereign entity.
Subsidiary means, with respect to a
company, a company controlled by that
company.
Synthetic securitization means a
transaction in which:
(1) All or a portion of the credit risk of one
or more underlying exposures is transferred
to one or more third parties through the use
of one or more credit derivatives or
guarantees (other than a guarantee that
transfers only the credit risk of an individual
retail exposure);
(2) The credit risk associated with the
underlying exposures has been separated into
at least two tranches reflecting different
levels of seniority;
(3) Performance of the securitization
exposures depends upon the performance of
the underlying exposures; and
(4) All or substantially all of the underlying
exposures are financial exposures (such as
loans, commitments, credit derivatives,
guarantees, receivables, asset-backed
securities, mortgage-backed securities, other
debt securities, or equity securities).
Tier 1 capital is defined in [the general
risk-based capital rules], as modified in part
II of this appendix.
Tier 2 capital is defined in [the general
risk-based capital rules], as modified in part
II of this appendix.
Total qualifying capital means the sum of
tier 1 capital and tier 2 capital, after all
deductions required in this appendix.
Total risk-weighted assets means:
(1) The sum of:
(i) Credit risk-weighted assets; and
(ii) Risk-weighted assets for operational
risk; minus
(2) Excess eligible credit reserves not
included in tier 2 capital.
Total wholesale and retail risk-weighted
assets means the sum of risk-weighted assets
for wholesale exposures to non-defaulted
obligors and segments of non-defaulted retail
exposures; risk-weighted assets for wholesale
exposures to defaulted obligors and segments
of defaulted retail exposures; risk-weighted
assets for assets not defined by an exposure
category; and risk-weighted assets for non-
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material portfolios of exposures (all as
determined in section 31 of this appendix)
and risk-weighted assets for unsettled
transactions (as determined in section 35 of
this appendix) minus the amounts deducted
from capital pursuant to [the general riskbased capital rules] (excluding those
deductions reversed in section 12 of this
appendix).
Traditional securitization means a
transaction in which:
(1) All or a portion of the credit risk of one
or more underlying exposures is transferred
to one or more third parties other than
through the use of credit derivatives or
guarantees;
(2) The credit risk associated with the
underlying exposures has been separated into
at least two tranches reflecting different
levels of seniority;
(3) Performance of the securitization
exposures depends upon the performance of
the underlying exposures;
(4) All or substantially all of the underlying
exposures are financial exposures (such as
loans, commitments, credit derivatives,
guarantees, receivables, asset-backed
securities, mortgage-backed securities, other
debt securities, or equity securities);
(5) The underlying exposures are not
owned by an operating company;
(6) The underlying exposures are not
owned by a small business investment
company described in section 302 of the
Small Business Investment Act of 1958 (15
U.S.C. 682); and
(7) The underlying exposures are not
owned by a firm an investment in which
qualifies as a community development
investment under 12 U.S.C. 24(Eleventh).
(8) The [AGENCY] may determine that a
transaction in which the underlying
exposures are owned by an investment firm
that exercises substantially unfettered control
over the size and composition of its assets,
liabilities, and off-balance sheet exposures is
not a traditional securitization based on the
transaction’s leverage, risk profile, or
economic substance.
(9) The [AGENCY] may deem a transaction
that meets the definition of a traditional
securitization, notwithstanding paragraph
(5), (6), or (7) of this definition, to be a
traditional securitization based on the
transaction’s leverage, risk profile, or
economic substance.
Tranche means all securitization exposures
associated with a securitization that have the
same seniority level.
Underlying exposures means one or more
exposures that have been securitized in a
securitization transaction.
Unexpected operational loss (UOL) means
the difference between the [bank]’s
operational risk exposure and the [bank]’s
expected operational loss.
Unit of measure means the level (for
example, organizational unit or operational
loss event type) at which the [bank]’s
operational risk quantification system
generates a separate distribution of potential
operational losses.
Value-at-Risk (VaR) means the estimate of
the maximum amount that the value of one
or more exposures could decline due to
market price or rate movements during a
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fixed holding period within a stated
confidence interval.
Wholesale exposure means a credit
exposure to a company, natural person,
sovereign entity, or governmental entity
(other than a securitization exposure, retail
exposure, excluded mortgage exposure, or
equity exposure). Examples of a wholesale
exposure include:
(1) A non-tranched guarantee issued by a
[bank] on behalf of a company;
(2) A repo-style transaction entered into by
a [bank] with a company and any other
transaction in which a [bank] posts collateral
to a company and faces counterparty credit
risk;
(3) An exposure that a [bank] treats as a
covered position under [the market risk rule]
for which there is a counterparty credit risk
capital requirement;
(4) A sale of corporate loans by a [bank] to
a third party in which the [bank] retains full
recourse;
(5) An OTC derivative contract entered into
by a [bank] with a company;
(6) An exposure to an individual that is not
managed by a [bank] as part of a segment of
exposures with homogeneous risk
characteristics; and
(7) A commercial lease.
Wholesale exposure subcategory means the
HVCRE or non-HVCRE wholesale exposure
subcategory.
Section 3. Minimum Risk-Based Capital
Requirements
(a) Except as modified by paragraph (c) of
this section or by section 23 of this appendix,
each [bank] must meet a minimum ratio of:
(1) Total qualifying capital to total riskweighted assets of 8.0 percent; and
(2) Tier 1 capital to total risk-weighted
assets of 4.0 percent.
(b) Each [bank] must hold capital
commensurate with the level and nature of
all risks to which the [bank] is exposed.
(c) When a [bank] subject to [the market
risk rule] calculates its risk-based capital
requirements under this appendix, the [bank]
must also refer to [the market risk rule] for
supplemental rules to calculate risk-based
capital requirements adjusted for market risk.
Part II. Qualifying Capital
Section 11. Additional Deductions
(a) General. A [bank] that uses this
appendix must make the same deductions
from its tier 1 capital and tier 2 capital
required in [the general risk-based capital
rules], except that:
(1) A [bank] is not required to deduct
certain equity investments and CEIOs (as
provided in section 12 of this appendix); and
(2) A [bank] also must make the deductions
from capital required by paragraphs (b) and
(c) of this section.
(b) Deductions from tier 1 capital. A [bank]
must deduct from tier 1 capital any gain-onsale associated with a securitization exposure
as provided in paragraph (a) of section 41
and paragraphs (a)(1), (c), (g)(1), and (h)(1) of
section 42 of this appendix.
(c) Deductions from tier 1 and tier 2
capital. A [bank] must deduct the exposures
specified in paragraphs (c)(1) through (c)(7)
in this section 50 percent from tier 1 capital
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69405
and 50 percent from tier 2 capital. If the
amount deductible from tier 2 capital
exceeds the [bank]’s actual tier 2 capital,
however, the [bank] must deduct the excess
from tier 1 capital.
(1) Credit-enhancing interest-only strips
(CEIOs). In accordance with paragraphs (a)(1)
and (c) of section 42 of this appendix, any
CEIO that does not constitute gain-on-sale.
(2) Non-qualifying securitization
exposures. In accordance with paragraphs
(a)(4) and (c) of section 42 of this appendix,
any securitization exposure that does not
qualify for the Ratings-Based Approach, the
Internal Assessment Approach, or the
Supervisory Formula Approach under
sections 43, 44, and 45 of this appendix,
respectively.
(3) Securitizations of non-IRB exposures. In
accordance with paragraphs (c) and (g)(4) of
section 42 of this appendix, certain
exposures to a securitization any underlying
exposure of which is not a wholesale
exposure, retail exposure, securitization
exposure, or equity exposure.
(4) Low-rated securitization exposures. In
accordance with section 43 and paragraph (c)
of section 42 of this appendix, any
securitization exposure that qualifies for and
must be deducted under the Ratings-Based
Approach.
(5) High-risk securitization exposures
subject to the Supervisory Formula
Approach. In accordance with paragraphs (b)
and (c) of section 45 of this appendix and
paragraph (c) of section 42 of this appendix,
certain high-risk securitization exposures (or
portions thereof) that qualify for the
Supervisory Formula Approach.
(6) Eligible credit reserves shortfall. In
accordance with paragraph (a)(1) of section
13 of this appendix, any eligible credit
reserves shortfall.
(7) Certain failed capital markets
transactions. In accordance with paragraph
(e)(3) of section 35 of this appendix, the
[bank]’s exposure on certain failed capital
markets transactions.
Section 12. Deductions and Limitations Not
Required
(a) Deduction of CEIOs. A [bank] is not
required to make the deductions from capital
for CEIOs in 12 CFR part 3, Appendix A,
section 2(c) (for national banks), 12 CFR part
208, Appendix A, section II.B.1.e. (for state
member banks), 12 CFR part 225, Appendix
A, section II.B.1.e. (for bank holding
companies), 12 CFR part 325, Appendix A,
section II.B.5. (for state nonmember banks),
and 12 CFR 567.5(a)(2)(iii) and 567.12(e) (for
savings associations).
(b) Deduction of certain equity
investments. A [bank] is not required to make
the deductions from capital for nonfinancial
equity investments in 12 CFR part 3,
Appendix A, section 2(c) (for national banks),
12 CFR part 208, Appendix A, section II.B.5.
(for state member banks), 12 CFR part 225,
Appendix A, section II.B.5. (for bank holding
companies), and 12 CFR part 325, Appendix
A, section II.B. (for state nonmember banks).
Section 13. Eligible Credit Reserves
(a) Comparison of eligible credit reserves to
expected credit losses—(1) Shortfall of
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eligible credit reserves. If a [bank]’s eligible
credit reserves are less than the [bank]’s total
expected credit losses, the [bank] must
deduct the shortfall amount 50 percent from
tier 1 capital and 50 percent from tier 2
capital. If the amount deductible from tier 2
capital exceeds the [bank]’s actual tier 2
capital, the [bank] must deduct the excess
amount from tier 1 capital.
(2) Excess eligible credit reserves. If a
[bank]’s eligible credit reserves exceed the
[bank]’s total expected credit losses, the
[bank] may include the excess amount in tier
2 capital to the extent that the excess amount
does not exceed 0.6 percent of the [bank]’s
credit-risk-weighted assets.
(b) Treatment of allowance for loan and
lease losses. Regardless of any provision in
[the general risk-based capital rules], the
ALLL is included in tier 2 capital only to the
extent provided in paragraph (a)(2) of this
section and in section 24 of this appendix.
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Part III. Qualification
Section 21. Qualification Process
(a) Timing. (1) A [bank] that is described
in paragraph (b)(1) of section 1 of this
appendix must adopt a written
implementation plan no later than six
months after the later of April 1, 2008, or the
date the [bank] meets a criterion in that
section. The implementation plan must
incorporate an explicit first floor period start
date no later than 36 months after the later
of April 1, 2008, or the date the [bank] meets
at least one criterion under paragraph (b)(1)
of section 1 of this appendix. The [AGENCY]
may extend the first floor period start date.
(2) A [bank] that elects to be subject to this
appendix under paragraph (b)(2) of section 1
of this appendix must adopt a written
implementation plan.
(b) Implementation plan. (1) The [bank]’s
implementation plan must address in detail
how the [bank] complies, or plans to comply,
with the qualification requirements in
section 22 of this appendix. The [bank] also
must maintain a comprehensive and sound
planning and governance process to oversee
the implementation efforts described in the
plan. At a minimum, the plan must:
(i) Comprehensively address the
qualification requirements in section 22 of
this appendix for the [bank] and each
consolidated subsidiary (U.S. and foreignbased) of the [bank] with respect to all
portfolios and exposures of the [bank] and
each of its consolidated subsidiaries;
(ii) Justify and support any proposed
temporary or permanent exclusion of
business lines, portfolios, or exposures from
application of the advanced approaches in
this appendix (which business lines,
portfolios, and exposures must be, in the
aggregate, immaterial to the [bank]);
(iii) Include the [bank]’s self-assessment of:
(A) The [bank]’s current status in meeting
the qualification requirements in section 22
of this appendix; and
(B) The consistency of the [bank]’s current
practices with the [AGENCY]’s supervisory
guidance on the qualification requirements;
(iv) Based on the [bank]’s self-assessment,
identify and describe the areas in which the
[bank] proposes to undertake additional work
to comply with the qualification
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requirements in section 22 of this appendix
or to improve the consistency of the [bank]’s
current practices with the [AGENCY]’s
supervisory guidance on the qualification
requirements (gap analysis);
(v) Describe what specific actions the
[bank] will take to address the areas
identified in the gap analysis required by
paragraph (b)(1)(iv) of this section;
(vi) Identify objective, measurable
milestones, including delivery dates and a
date when the [bank]’s implementation of the
methodologies described in this appendix
will be fully operational;
(vii) Describe resources that have been
budgeted and are available to implement the
plan; and
(viii) Receive approval of the [bank]’s
board of directors.
(2) The [bank] must submit the
implementation plan, together with a copy of
the minutes of the board of directors’
approval, to the [AGENCY] at least 60 days
before the [bank] proposes to begin its
parallel run, unless the [AGENCY] waives
prior notice.
(c) Parallel run. Before determining its riskbased capital requirements under this
appendix and following adoption of the
implementation plan, the [bank] must
conduct a satisfactory parallel run. A
satisfactory parallel run is a period of no less
than four consecutive calendar quarters
during which the [bank] complies with the
qualification requirements in section 22 of
this appendix to the satisfaction of the
[AGENCY]. During the parallel run, the
[bank] must report to the [AGENCY] on a
calendar quarterly basis its risk-based capital
ratios using [the general risk-based capital
rules] and the risk-based capital requirements
described in this appendix. During this
period, the [bank] is subject to [the general
risk-based capital rules].
(d) Approval to calculate risk-based capital
requirements under this appendix. The
[AGENCY] will notify the [bank] of the date
that the [bank] may begin its first floor period
if the [AGENCY] determines that:
(1) The [bank] fully complies with all the
qualification requirements in section 22 of
this appendix;
(2) The [bank] has conducted a satisfactory
parallel run under paragraph (c) of this
section; and
(3) The [bank] has an adequate process to
ensure ongoing compliance with the
qualification requirements in section 22 of
this appendix.
(e) Transitional floor periods. Following a
satisfactory parallel run, a [bank] is subject to
three transitional floor periods.
(1) Risk-based capital ratios during the
transitional floor periods—(i) Tier 1 riskbased capital ratio. During a [bank]’s
transitional floor periods, the [bank]’s tier 1
risk-based capital ratio is equal to the lower
of:
(A) The [bank]’s floor-adjusted tier 1 riskbased 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:
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(A) The [bank]’s floor-adjusted total riskbased capital ratio; or
(B) The [bank]’s advanced approaches total
risk-based capital ratio.
(2) Floor-adjusted risk-based capital ratios.
(i) A [bank]’s floor-adjusted tier 1 risk-based
capital ratio during a transitional floor period
is equal to the [bank]’s tier 1 capital as
calculated under [the general risk-based
capital rules], divided by the product of:
(A) The [bank]’s total risk-weighted assets
as calculated under [the general risk-based
capital rules]; and
(B) The appropriate transitional floor
percentage in Table 1.
(ii) A [bank]’s floor-adjusted total riskbased capital ratio during a transitional floor
period is equal to the sum of the [bank]’s tier
1 and tier 2 capital as calculated under [the
general risk-based capital rules], divided by
the product of:
(A) The [bank]’s total risk-weighted assets
as calculated under [the general risk-based
capital rules]; and
(B) The appropriate transitional floor
percentage in Table 1.
(iii) A [bank] that meets the criteria in
paragraph (b)(1) or (b)(2) of section 1 of this
appendix as of April 1, 2008, must use [the
general risk-based capital rules] during the
parallel run and as the basis for its
transitional floors.
TABLE 1.—TRANSITIONAL FLOORS
Transitional floor period
First floor period ........
Second floor period ...
Third floor period .......
Transitional floor percentage
95 percent.
90 percent.
85 percent.
(3) Advanced approaches risk-based
capital ratios. (i) A [bank]’s advanced
approaches tier 1 risk-based capital ratio
equals the [bank]’s tier 1 risk-based capital
ratio as calculated under this appendix (other
than this section on transitional floor
periods).
(ii) A [bank]’s advanced approaches total
risk-based capital ratio equals the [bank]’s
total risk-based capital ratio as calculated
under this appendix (other than this section
on transitional floor periods).
(4) Reporting. During the transitional floor
periods, a [bank] must report to the
[AGENCY] on a calendar quarterly basis both
floor-adjusted risk-based capital ratios and
both advanced approaches risk-based capital
ratios.
(5) Exiting a transitional floor period. A
[bank] may not exit a transitional floor period
until the [bank] has spent a minimum of four
consecutive calendar quarters in the period
and the [AGENCY] has determined that the
[bank] may exit the floor period. The
[AGENCY]’s determination will be based on
an assessment of the [bank]’s ongoing
compliance with the qualification
requirements in section 22 of this appendix.
(6) Interagency study. After the end of the
second transition year (2010), the Federal
banking agencies will publish a study that
evaluates the advanced approaches to
determine if there are any material
deficiencies. For any primary Federal
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supervisor to authorize any institution to exit
the third transitional floor period, the study
must determine that there are no such
material deficiencies that cannot be
addressed by then-existing tools, or, if such
deficiencies are found, they are first
remedied by changes to this appendix.
Notwithstanding the preceding sentence, a
primary Federal supervisor that disagrees
with the finding of material deficiency may
not authorize any institution under its
jurisdiction to exit the third transitional floor
period unless it provides a public report
explaining its reasoning.
Section 22. Qualification Requirements
(a) Process and systems requirements. (1) A
[bank] must have a rigorous process for
assessing its overall capital adequacy in
relation to its risk profile and a
comprehensive strategy for maintaining an
appropriate level of capital.
(2) The systems and processes used by a
[bank] for risk-based capital purposes under
this appendix must be consistent with the
[bank]’s internal risk management processes
and management information reporting
systems.
(3) Each [bank] must have an appropriate
infrastructure with risk measurement and
management processes that meet the
qualification requirements of this section and
are appropriate given the [bank]’s size and
level of complexity. Regardless of whether
the systems and models that generate the risk
parameters necessary for calculating a
[bank]’s risk-based capital requirements are
located at any affiliate of the [bank], the
[bank] itself must ensure that the risk
parameters and reference data used to
determine its risk-based capital requirements
are representative of its own credit risk and
operational risk exposures.
(b) Risk rating and segmentation systems
for wholesale and retail exposures. (1) A
[bank] must have an internal risk rating and
segmentation system that accurately and
reliably differentiates among degrees of credit
risk for the [bank]’s wholesale and retail
exposures.
(2) For wholesale exposures:
(i) A [bank] must have an internal risk
rating system that accurately and reliably
assigns each obligor to a single rating grade
(reflecting the obligor’s likelihood of default).
A [bank] may elect, however, not to assign to
a rating grade an obligor to whom the [bank]
extends credit based solely on the financial
strength of a guarantor, provided that all of
the [bank]’s exposures to the obligor are fully
covered by eligible guarantees, the [bank]
applies the PD substitution approach in
paragraph (c)(1) of section 33 of this
appendix to all exposures to that obligor, and
the [bank] immediately assigns the obligor to
a rating grade if a guarantee can no longer be
recognized under this appendix. The [bank]’s
wholesale obligor rating system must have at
least seven discrete rating grades for nondefaulted 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
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severity rating grade (reflecting the [bank]’s
estimate of the LGD of the exposure). A
[bank] employing loss severity rating grades
must have a sufficiently granular loss
severity grading system to avoid grouping
together exposures with widely ranging
LGDs.
(3) For retail exposures, a [bank] must have
an internal system that groups retail
exposures into the appropriate retail
exposure subcategory, groups the retail
exposures in each retail exposure
subcategory into separate segments with
homogeneous risk characteristics, and
assigns accurate and reliable PD and LGD
estimates for each segment on a consistent
basis. The [bank]’s system must identify and
group in separate segments by subcategories
exposures identified in paragraphs (c)(2)(ii)
and (iii) of section 31 of this appendix.
(4) The [bank]’s internal risk rating policy
for wholesale exposures must describe the
[bank]’s rating philosophy (that is, must
describe how wholesale obligor rating
assignments are affected by the [bank]’s
choice of the range of economic, business,
and industry conditions that are considered
in the obligor rating process).
(5) The [bank]’s internal risk rating system
for wholesale exposures must provide for the
review and update (as appropriate) of each
obligor rating and (if applicable) each loss
severity rating whenever the [bank] receives
new material information, but no less
frequently than annually. The [bank]’s retail
exposure segmentation system must provide
for the review and update (as appropriate) of
assignments of retail exposures to segments
whenever the [bank] receives new material
information, but generally no less frequently
than quarterly.
(c) Quantification of risk parameters for
wholesale and retail exposures. (1) The
[bank] must have a comprehensive risk
parameter quantification process that
produces accurate, timely, and reliable
estimates of the risk parameters for the
[bank]’s wholesale and retail exposures.
(2) Data used to estimate the risk
parameters must be relevant to the [bank]’s
actual wholesale and retail exposures, and of
sufficient quality to support the
determination of risk-based capital
requirements for the exposures.
(3) The [bank]’s risk parameter
quantification process must produce
appropriately conservative risk parameter
estimates where the [bank] has limited
relevant data, and any adjustments that are
part of the quantification process must not
result in a pattern of bias toward lower risk
parameter estimates.
(4) The [bank]’s risk parameter estimation
process should not rely on the possibility of
U.S. government financial assistance, except
for the financial assistance that the U.S.
government has a legally binding
commitment to provide.
(5) Where the [bank]’s quantifications of
LGD directly or indirectly incorporate
estimates of the effectiveness of its credit risk
management practices in reducing its
exposure to troubled obligors prior to default,
the [bank] must support such estimates with
empirical analysis showing that the estimates
are consistent with its historical experience
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in dealing with such exposures during
economic downturn conditions.
(6) PD estimates for wholesale obligors and
retail segments must be based on at least five
years of default data. LGD estimates for
wholesale exposures must be based on at
least seven years of loss severity data, and
LGD estimates for retail segments must be
based on at least five years of loss severity
data. EAD estimates for wholesale exposures
must be based on at least seven years of
exposure amount data, and EAD estimates for
retail segments must be based on at least five
years of exposure amount data.
(7) Default, loss severity, and exposure
amount data must include periods of
economic downturn conditions, or the [bank]
must adjust its estimates of risk parameters
to compensate for the lack of data from
periods of economic downturn conditions.
(8) The [bank]’s PD, LGD, and EAD
estimates must be based on the definition of
default in this appendix.
(9) The [bank] must review and update (as
appropriate) its risk parameters and its risk
parameter quantification process at least
annually.
(10) The [bank] must at least annually
conduct a comprehensive review and
analysis of reference data to determine
relevance of reference data to the [bank]’s
exposures, quality of reference data to
support PD, LGD, and EAD estimates, and
consistency of reference data to the definition
of default contained in this appendix.
(d) Counterparty credit risk model. A
[bank] must obtain the prior written approval
of the [AGENCY] under section 32 of this
appendix to use the internal models
methodology for counterparty credit risk.
(e) Double default treatment. A [bank] must
obtain the prior written approval of the
[AGENCY] under section 34 of this appendix
to use the double default treatment.
(f) Securitization exposures. A [bank] must
obtain the prior written approval of the
[AGENCY] under section 44 of this appendix
to use the Internal Assessment Approach for
securitization exposures to ABCP programs.
(g) Equity exposures model. A [bank] must
obtain the prior written approval of the
[AGENCY] under section 53 of this appendix
to use the Internal Models Approach for
equity exposures.
(h) Operational risk—(1) Operational risk
management processes. A [bank] must:
(i) Have an operational risk management
function that:
(A) Is independent of business line
management; and
(B) Is responsible for designing,
implementing, and overseeing the [bank]’s
operational risk data and assessment systems,
operational risk quantification systems, and
related processes;
(ii) Have and document a process (which
must capture business environment and
internal control factors affecting the [bank]’s
operational risk profile) to identify, measure,
monitor, and control operational risk in
[bank] products, activities, processes, and
systems; and
(iii) Report operational risk exposures,
operational loss events, and other relevant
operational risk information to business unit
management, senior management, and the
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board of directors (or a designated committee
of the board).
(2) Operational risk data and assessment
systems. A [bank] must have operational risk
data and assessment systems that capture
operational risks to which the [bank] is
exposed. The [bank]’s operational risk data
and assessment systems must:
(i) Be structured in a manner consistent
with the [bank]’s current business activities,
risk profile, technological processes, and risk
management processes; and
(ii) Include credible, transparent,
systematic, and verifiable processes that
incorporate the following elements on an
ongoing basis:
(A) Internal operational loss event data.
The [bank] must have a systematic process
for capturing and using internal operational
loss event data in its operational risk data
and assessment systems.
(1) The [bank]’s operational risk data and
assessment systems must include a historical
observation period of at least five years for
internal operational loss event data (or such
shorter period approved by the [AGENCY] to
address transitional situations, such as
integrating a new business line).
(2) The [bank] must be able to map its
internal operational loss event data into the
seven operational loss event type categories.
(3) The [bank] may refrain from collecting
internal operational loss event data for
individual operational losses below
established dollar threshold amounts if the
[bank] can demonstrate to the satisfaction of
the [AGENCY] that the thresholds are
reasonable, do not exclude important internal
operational loss event data, and permit the
[bank] to capture substantially all the dollar
value of the [bank]’s operational losses.
(B) External operational loss event data.
The [bank] must have a systematic process
for determining its methodologies for
incorporating external operational loss event
data into its operational risk data and
assessment systems.
(C) Scenario analysis. The [bank] must
have a systematic process for determining its
methodologies for incorporating scenario
analysis into its operational risk data and
assessment systems.
(D) Business environment and internal
control factors. The [bank] must incorporate
business environment and internal control
factors into its operational risk data and
assessment systems. The [bank] must also
periodically compare the results of its prior
business environment and internal control
factor assessments against its actual
operational losses incurred in the intervening
period.
(3) Operational risk quantification systems.
(i) The [bank]’s operational risk
quantification systems:
(A) Must generate estimates of the [bank]’s
operational risk exposure using its
operational risk data and assessment systems;
(B) Must employ a unit of measure that is
appropriate for the [bank]’s range of business
activities and the variety of operational loss
events to which it is exposed, and that does
not combine business activities or
operational loss events with demonstrably
different risk profiles within the same loss
distribution;
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(C) Must include a credible, transparent,
systematic, and verifiable approach for
weighting each of the four elements,
described in paragraph (h)(2)(ii) of this
section, that a [bank] is required to
incorporate into its operational risk data and
assessment systems;
(D) May use internal estimates of
dependence among operational losses across
and within units of measure if the [bank] can
demonstrate to the satisfaction of the
[AGENCY] that its process for estimating
dependence is sound, robust to a variety of
scenarios, and implemented with integrity,
and allows for the uncertainty surrounding
the estimates. If the [bank] has not made such
a demonstration, it must sum operational risk
exposure estimates across units of measure to
calculate its total operational risk exposure;
and
(E) Must be reviewed and updated (as
appropriate) whenever the [bank] becomes
aware of information that may have a
material effect on the [bank]’s estimate of
operational risk exposure, but the review and
update must occur no less frequently than
annually.
(ii) With the prior written approval of the
[AGENCY], a [bank] may generate an estimate
of its operational risk exposure using an
alternative approach to that specified in
paragraph (h)(3)(i) of this section. A [bank]
proposing to use such an alternative
operational risk quantification system must
submit a proposal to the [AGENCY]. In
determining whether to approve a [bank]’s
proposal to use an alternative operational
risk quantification system, the [AGENCY]
will consider the following principles:
(A) Use of the alternative operational risk
quantification system will be allowed only
on an exception basis, considering the size,
complexity, and risk profile of the [bank];
(B) The [bank] must demonstrate that its
estimate of its operational risk exposure
generated under the alternative operational
risk quantification system is appropriate and
can be supported empirically; and
(C) A [bank] must not use an allocation of
operational risk capital requirements that
includes entities other than depository
institutions or the benefits of diversification
across entities.
(i) Data management and maintenance. (1)
A [bank] must have data management and
maintenance systems that adequately support
all aspects of its advanced systems and the
timely and accurate reporting of risk-based
capital requirements.
(2) A [bank] must retain data using an
electronic format that allows timely retrieval
of data for analysis, validation, reporting, and
disclosure purposes.
(3) A [bank] must retain sufficient data
elements related to key risk drivers to permit
adequate monitoring, validation, and
refinement of its advanced systems.
(j) Control, oversight, and validation
mechanisms. (1) The [bank]’s senior
management must ensure that all
components of the [bank]’s advanced systems
function effectively and comply with the
qualification requirements in this section.
(2) The [bank]’s board of directors (or a
designated committee of the board) must at
least annually review the effectiveness of,
and approve, the [bank]’s advanced systems.
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(3) A [bank] must have an effective system
of controls and oversight that:
(i) Ensures ongoing compliance with the
qualification requirements in this section;
(ii) Maintains the integrity, reliability, and
accuracy of the [bank]’s advanced systems;
and
(iii) Includes adequate governance and
project management processes.
(4) The [bank] must validate, on an ongoing
basis, its advanced systems. The [bank]’s
validation process must be independent of
the advanced systems’ development,
implementation, and operation, or the
validation process must be subjected to an
independent review of its adequacy and
effectiveness. Validation must include:
(i) An evaluation of the conceptual
soundness of (including developmental
evidence supporting) the advanced systems;
(ii) An ongoing monitoring process that
includes verification of processes and
benchmarking; and
(iii) An outcomes analysis process that
includes back-testing.
(5) The [bank] must have an internal audit
function independent of business-line
management that at least annually assesses
the effectiveness of the controls supporting
the [bank]’s advanced systems and reports its
findings to the [bank]’s board of directors (or
a committee thereof).
(6) The [bank] must periodically stress test
its advanced systems. The stress testing must
include a consideration of how economic
cycles, especially downturns, affect riskbased capital requirements (including
migration across rating grades and segments
and the credit risk mitigation benefits of
double default treatment).
(k) Documentation. The [bank] must
adequately document all material aspects of
its advanced systems.
Section 23. Ongoing Qualification
(a) Changes to advanced systems. A [bank]
must meet all the qualification requirements
in section 22 of this appendix on an ongoing
basis. A [bank] must notify the [AGENCY]
when the [bank] makes any change to an
advanced system that would result in a
material change in the [bank]’s risk-weighted
asset amount for an exposure type, or when
the [bank] makes any significant change to its
modeling assumptions.
(b) Failure to comply with qualification
requirements. (1) If the [AGENCY]
determines that a [bank] that uses this
appendix and has conducted a satisfactory
parallel run fails to comply with the
qualification requirements in section 22 of
this appendix, the [AGENCY] will notify the
[bank] in writing of the [bank]’s failure to
comply.
(2) The [bank] must establish and submit
a plan satisfactory to the [AGENCY] to return
to compliance with the qualification
requirements.
(3) In addition, if the [AGENCY]
determines that the [bank]’s risk-based
capital requirements are not commensurate
with the [bank]’s credit, market, operational,
or other risks, the [AGENCY] may require
such a [bank] to calculate its risk-based
capital requirements:
(i) Under [the general risk-based capital
rules]; or
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(ii) Under this appendix with any
modifications provided by the [AGENCY].
Part IV. Risk-Weighted Assets for General
Credit Risk
Section 24. Merger and Acquisition
Transitional Arrangements
(a) Mergers and acquisitions of companies
without advanced systems. If a [bank] merges
with or acquires a company that does not
calculate its risk-based capital requirements
using advanced systems, the [bank] may use
[the general risk-based capital rules] to
determine the risk-weighted asset amounts
for, and deductions from capital associated
with, the merged or acquired company’s
exposures for up to 24 months after the
calendar quarter during which the merger or
acquisition consummates. The [AGENCY]
may extend this transition period for up to
an additional 12 months. Within 90 days of
consummating the merger or acquisition, the
[bank] must submit to the [AGENCY] an
implementation plan for using its advanced
systems for the acquired company. During
the period when [the general risk-based
capital rules] apply to the merged or acquired
company, any ALLL, net of allocated transfer
risk reserves established pursuant to 12
U.S.C. 3904, associated with the merged or
acquired company’s exposures may be
included in the acquiring [bank]’s tier 2
capital up to 1.25 percent of the acquired
company’s risk-weighted assets. All general
allowances of the merged or acquired
company must be excluded from the [bank]’s
eligible credit reserves. In addition, the riskweighted assets of the merged or acquired
company are not included in the [bank]’s
credit-risk-weighted assets but are included
in total risk-weighted assets. If a [bank] relies
on this paragraph, the [bank] must disclose
publicly the amounts of risk-weighted assets
and qualifying capital calculated under this
appendix for the acquiring [bank] and under
[the general risk-based capital rules] for the
acquired company.
(b) Mergers and acquisitions of companies
with advanced systems—(1) If a [bank]
merges with or acquires a company that
calculates its risk-based capital requirements
using advanced systems, the [bank] may use
the acquired company’s advanced systems to
determine the risk-weighted asset amounts
for, and deductions from capital associated
with, the merged or acquired company’s
exposures for up to 24 months after the
calendar quarter during which the
acquisition or merger consummates. The
[AGENCY] may extend this transition period
for up to an additional 12 months. Within 90
days of consummating the merger or
acquisition, the [bank] must submit to the
[AGENCY] an implementation plan for using
its advanced systems for the merged or
acquired company.
(2) If the acquiring [bank] is not subject to
the advanced approaches in this appendix at
the time of acquisition or merger, during the
period when [the general risk-based capital
rules] apply to the acquiring [bank], the
ALLL associated with the exposures of the
merged or acquired company may not be
directly included in tier 2 capital. Rather, any
excess eligible credit reserves associated with
the merged or acquired company’s exposures
may be included in the [bank]’s tier 2 capital
up to 0.6 percent of the credit-risk-weighted
assets associated with those exposures.
Section 31. Mechanics for Calculating Total
Wholesale and Retail Risk-Weighted Assets
(a) Overview. A [bank] must calculate its
total wholesale and retail risk-weighted asset
amount in four distinct phases:
(1) Phase 1—categorization of exposures;
(2) Phase 2—assignment of wholesale
obligors and exposures to rating grades and
segmentation of retail exposures;
(3) Phase 3—assignment of risk parameters
to wholesale exposures and segments of retail
exposures; and
(4) Phase 4—calculation of risk-weighted
asset amounts.
(b) Phase 1—Categorization. The [bank]
must determine which of its exposures are
wholesale exposures, retail exposures,
securitization exposures, or equity exposures.
The [bank] must categorize each retail
exposure as a residential mortgage exposure,
a QRE, or an other retail exposure. The [bank]
must identify which wholesale exposures are
HVCRE exposures, sovereign exposures, OTC
derivative contracts, repo-style transactions,
eligible margin loans, eligible purchased
wholesale exposures, unsettled transactions
to which section 35 of this appendix applies,
and eligible guarantees or eligible credit
derivatives that are used as credit risk
mitigants. The [bank] must identify any onbalance sheet asset that does not meet the
definition of a wholesale, retail, equity, or
securitization exposure, as well as any nonmaterial portfolio of exposures described in
paragraph (e)(4) of this section.
(c) Phase 2—Assignment of wholesale
obligors and exposures to rating grades and
retail exposures to segments—(1) Assignment
of wholesale obligors and exposures to rating
grades.
(i) The [bank] must assign each obligor of
a wholesale exposure to a single obligor
rating grade and must assign each wholesale
exposure to which it does not directly assign
an LGD estimate to a loss severity rating
grade.
(ii) The [bank] must identify which of its
wholesale obligors are in default.
(2) Segmentation of retail exposures. (i)
The [bank] must group the retail exposures
in each retail subcategory into segments that
have homogeneous risk characteristics.
(ii) The [bank] must identify which of its
retail exposures are in default. The [bank]
must segment defaulted retail exposures
separately from non-defaulted retail
exposures.
(iii) If the [bank] determines the EAD for
eligible margin loans using the approach in
paragraph (b) of section 32 of this appendix,
the [bank] must identify which of its retail
exposures are eligible margin loans for which
the [bank] uses this EAD approach and must
segment such eligible margin loans
separately from other retail exposures.
(3) Eligible purchased wholesale
exposures. A [bank] may group its eligible
purchased wholesale exposures into
segments that have homogeneous risk
characteristics. A [bank] must use the
wholesale exposure formula in Table 2 in
this section to determine the risk-based
capital requirement for each segment of
eligible purchased wholesale exposures.
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(d) Phase 3—Assignment of risk
parameters to wholesale exposures and
segments of retail exposures—(1)
Quantification process. Subject to the
limitations in this paragraph (d), the [bank]
must:
(i) Associate a PD with each wholesale
obligor rating grade;
(ii) Associate an LGD with each wholesale
loss severity rating grade or assign an LGD to
each wholesale exposure;
(iii) Assign an EAD and M to each
wholesale exposure; and
(iv) Assign a PD, LGD, and EAD to each
segment of retail exposures.
(2) Floor on PD assignment. The PD for
each wholesale obligor or retail segment may
not be less than 0.03 percent, except for
exposures to or directly and unconditionally
guaranteed by a sovereign entity, the Bank for
International Settlements, the International
Monetary Fund, the European Commission,
the European Central Bank, or a multilateral
development bank, to which the [bank]
assigns a rating grade associated with a PD
of less than 0.03 percent.
(3) Floor on LGD estimation. The LGD for
each segment of residential mortgage
exposures (other than segments of residential
mortgage exposures for which all or
substantially all of the principal of each
exposure is directly and unconditionally
guaranteed by the full faith and credit of a
sovereign entity) may not be less than 10
percent.
(4) Eligible purchased wholesale
exposures. A [bank] must assign a PD, LGD,
EAD, and M to each segment of eligible
purchased wholesale exposures. If the [bank]
can estimate ECL (but not PD or LGD) for a
segment of eligible purchased wholesale
exposures, the [bank] must assume that the
LGD of the segment equals 100 percent and
that the PD of the segment equals ECL
divided by EAD. The estimated ECL must be
calculated for the exposures without regard
to any assumption of recourse or guarantees
from the seller or other parties.
(5) Credit risk mitigation—credit
derivatives, guarantees, and collateral. (i) A
[bank] may take into account the risk
reducing effects of eligible guarantees and
eligible credit derivatives in support of a
wholesale exposure by applying the PD
substitution or LGD adjustment treatment to
the exposure as provided in section 33 of this
appendix or, if applicable, applying double
default treatment to the exposure as provided
in section 34 of this appendix. A [bank] may
decide separately for each wholesale
exposure that qualifies for the double default
treatment under section 34 of this appendix
whether to apply the double default
treatment or to use the PD substitution or
LGD adjustment treatment without
recognizing double default effects.
(ii) A [bank] may take into account the risk
reducing effects of guarantees and credit
derivatives in support of retail exposures in
a segment when quantifying the PD and LGD
of the segment.
(iii) Except as provided in paragraph (d)(6)
of this section, a [bank] may take into
account the risk reducing effects of collateral
in support of a wholesale exposure when
quantifying the LGD of the exposure and may
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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, repostyle transactions, and eligible margin loans.
(i) A [bank] must calculate its EAD for an
OTC derivative contract as provided in
paragraphs (c) and (d) of section 32 of this
appendix. A [bank] may take into account the
risk-reducing effects of financial collateral in
support of a repo-style transaction or eligible
margin loan and of any collateral in support
of a repo-style transaction that is included in
the [bank]’s VaR-based measure under [the
market risk rule] through an adjustment to
EAD as provided in paragraphs (b) and (d) of
section 32 of this appendix. A [bank] that
takes collateral into account through such an
adjustment to EAD under section 32 of this
appendix may not reflect such collateral in
LGD.
(ii) A [bank] may attribute an EAD of zero
to:
(A) Derivative contracts that are publicly
traded on an exchange that requires the daily
receipt and payment of cash-variation
margin;
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(B) Derivative contracts and repo-style
transactions that are outstanding with a
qualifying central counterparty (but not for
those transactions that a qualifying central
counterparty has rejected); and
(C) Credit risk exposures to a qualifying
central counterparty in the form of clearing
deposits and posted collateral that arise from
transactions described in paragraph
(d)(6)(ii)(B) of this section.
(7) Effective maturity. An exposure’s M
must be no greater than five years and no less
than one year, except that an exposure’s M
must be no less than one day if the exposure
has an original maturity of less than one year
and is not part of a [bank]’s ongoing
financing of the obligor. An exposure is not
part of a [bank]’s ongoing financing of the
obligor if the [bank]:
(i) Has a legal and practical ability not to
renew or roll over the exposure in the event
of credit deterioration of the obligor;
(ii) Makes an independent credit decision
at the inception of the exposure and at every
renewal or roll over; and
(iii) Has no substantial commercial
incentive to continue its credit relationship
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with the obligor in the event of credit
deterioration of the obligor.
(e) Phase 4—Calculation of risk-weighted
assets—(1) Non-defaulted exposures. (i) A
[bank] must calculate the dollar risk-based
capital requirement for each of its wholesale
exposures to a non-defaulted obligor (except
eligible guarantees and eligible credit
derivatives that hedge another wholesale
exposure and exposures to which the [bank]
applies the double default treatment in
section 34 of this appendix) and segments of
non-defaulted retail exposures by inserting
the assigned risk parameters for the
wholesale obligor and exposure or retail
segment into the appropriate risk-based
capital formula specified in Table 2 and
multiplying the output of the formula (K) by
the EAD of the exposure or segment.
Alternatively, a [bank] may apply a 300
percent risk weight to the EAD of an eligible
margin loan if the [bank] is not able to meet
the agencies’’ requirements for estimation of
PD and LGD for the margin loan.
BILLING CODE 4810–33–P; 6210–01–P; 6714–01–P;
6720–01–P
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BILLING CODE 4810–33–C; 6210–01–C; 6714–01–C;
6720–01–C
(ii) The sum of all the dollar risk-based
capital requirements for each wholesale
exposure to a non-defaulted obligor and
segment of non-defaulted retail exposures
calculated in paragraph (e)(1)(i) of this
section and in paragraph (e) of section 34 of
this appendix equals the total dollar riskbased capital requirement for those
exposures and segments.
(iii) The aggregate risk-weighted asset
amount for wholesale exposures to nondefaulted obligors and segments of nondefaulted retail exposures equals the total
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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
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69411
exposure to a defaulted obligor calculated in
paragraph (e)(2)(i) of this section plus the
dollar risk-based capital requirements for
each segment of defaulted retail exposures
calculated in paragraph (e)(2)(ii) of this
section equals the total dollar risk-based
capital requirement for those exposures and
segments.
(iv) The aggregate risk-weighted asset
amount for wholesale exposures to defaulted
obligors and segments of defaulted retail
exposures equals the total dollar risk-based
capital requirement calculated in paragraph
(e)(2)(iii) of this section multiplied by 12.5.
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(3) Assets not included in a defined
exposure category. (i) A [bank] may assign a
risk-weighted asset amount of zero to cash
owned and held in all offices of the [bank]
or in transit and for gold bullion held in the
[bank]’s own vaults, or held in another
[bank]’s vaults on an allocated basis, to the
extent the gold bullion assets are offset by
gold bullion liabilities.
(ii) The risk-weighted asset amount for the
residual value of a retail lease exposure
equals such residual value.
(iii) The risk-weighted asset amount for
any other on-balance-sheet asset that does
not meet the definition of a wholesale, retail,
securitization, or equity exposure equals the
carrying value of the asset.
(4) Non-material portfolios of exposures.
The risk-weighted asset amount of a portfolio
of exposures for which the [bank] has
demonstrated to the [AGENCY]’s satisfaction
that the portfolio (when combined with all
other portfolios of exposures that the [bank]
seeks to treat under this paragraph) is not
material to the [bank] is the sum of the
carrying values of on-balance sheet exposures
plus the notional amounts of off-balance
sheet exposures in the portfolio. For
purposes of this paragraph (e)(4), the notional
amount of an OTC derivative contract that is
not a credit derivative is the EAD of the
derivative as calculated in section 32 of this
appendix.
Section 32. Counterparty Credit Risk of RepoStyle Transactions, Eligible Margin Loans,
and OTC Derivative Contracts
(a) In General. (1) This section describes
two methodologies—a collateral haircut
approach and an internal models
methodology—that a [bank] may use instead
of an LGD estimation methodology to
recognize the benefits of financial collateral
in mitigating the counterparty credit risk of
repo-style transactions, eligible margin loans,
collateralized OTC derivative contracts, and
single product netting sets of such
transactions and to recognize the benefits of
any collateral in mitigating the counterparty
credit risk of repo-style transactions that are
included in a [bank]’s VaR-based measure
under [the market risk rule]. A third
methodology, the simple VaR methodology,
is available for single product netting sets of
repo-style transactions and eligible margin
loans.
(2) This section also describes the
methodology for calculating EAD for an OTC
derivative contract or a set of OTC derivative
contracts subject to a qualifying master
netting agreement. A [bank] also may use the
internal models methodology to estimate
EAD for qualifying cross-product master
netting agreements.
(3) A [bank] may only use the standard
supervisory haircut approach with a
minimum 10-business-day holding period to
recognize in EAD the benefits of conforming
residential mortgage collateral that secures
repo-style transactions (other than repo-style
transactions included in the [bank]’s VaRbased 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 repostyle 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 singleproduct netting set of such transactions by
factoring the collateral into its LGD estimates
for the exposure. Alternatively, a [bank] may
estimate an unsecured LGD for the exposure,
as well as for any repo-style transaction that
is included in the [bank]’s VaR-based
measure under [the market risk rule], and
determine the EAD of the exposure using:
(i) The collateral haircut approach
described in paragraph (b)(2) of this section;
(ii) For netting sets only, the simple VaR
methodology described in paragraph (b)(3) of
this section; or
(iii) The internal models methodology
described in paragraph (d) of this section.
(2) Collateral haircut approach—(i) EAD
equation. A [bank] may determine EAD for
an eligible margin loan, repo-style
transaction, or netting set by setting EAD
equal to max {0, [(SE¥SC) + S(Es × Hs) +
S(Efx × Hfx)]}, where:
(A) SE 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) SC equals the value of the collateral
(the sum of the current market values of all
instruments, gold, and cash the [bank] has
borrowed, purchased subject to resale, or
taken as collateral from the counterparty
under the transaction (or netting set));
(C) Es equals the absolute value of the net
position in a given instrument or in gold
(where the net position in a given instrument
or in gold equals the sum of the current
market values of the instrument or gold the
[bank] has lent, sold subject to repurchase, or
posted as collateral to the counterparty
minus the sum of the current market values
of that same instrument or gold the [bank]
has borrowed, purchased subject to resale, or
taken as collateral from the counterparty);
(D) Hs equals the market price volatility
haircut appropriate to the instrument or gold
referenced in Es;
(E) Efx equals the absolute value of the net
position of instruments and cash in a
currency that is different from the settlement
currency (where the net position in a given
currency equals the sum of the current
market values of any instruments or cash in
the currency the [bank] has lent, sold subject
to repurchase, or posted as collateral to the
counterparty minus the sum of the current
market values of any instruments or cash in
the currency the [bank] has borrowed,
purchased subject to resale, or taken as
collateral from the counterparty); and
(F) Hfx equals the haircut appropriate to
the mismatch between the currency
referenced in Efx and the settlement
currency.
(ii) Standard supervisory haircuts. (A)
Under the standard supervisory haircuts
approach:
(1) A [bank] must use the haircuts for
market price volatility (Hs) in Table 3, as
adjusted in certain circumstances as
provided in paragraph (b)(2)(ii)(A)(3) and (4)
of this section;
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TABLE 3.—STANDARD SUPERVISORY MARKET PRICE VOLATILITY HAIRCUTS 1
Issuers exempt
from the 3 basis
point floor
Applicable external rating grade category for debt securities
Residual maturity for debt
securities
Two highest investment-grade rating categories for long-term ratings/highest investment-grade rating category for short-term ratings.
≤ 1 year ............................
>1 year, ≤ 5 years ............
> 5 years ..........................
0.005
0.02
0.04
0.01
0.04
0.08
Two lowest investment-grade rating categories for both short- and longterm ratings.
≤ 1 year ............................
> 1 year, ≤ 5 years ...........
> 5 years ..........................
0.01
0.03
0.06
0.02
0.06
0.12
One rating category below investment grade ..............................................
All ......................................
0.15
0.25
Other issuers
Main index equities (including convertible bonds) and gold .......................................................................
0.15
Other publicly traded equities (including convertible bonds), conforming residential mortgages, and
nonfinancial collateral.
0.25
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69413
TABLE 3.—STANDARD SUPERVISORY MARKET PRICE VOLATILITY HAIRCUTS 1—Continued
Applicable external rating grade category for debt securities
Issuers exempt
from the 3 basis
point floor
Other issuers
Mutual funds ................................................................................................................................................
Highest haircut applicable to any
security in which the fund can invest.
Cash on deposit with the [bank] (including a certificate of deposit issued by the [bank]) .........................
0
market price volatility haircuts in Table 3 are based on a ten-business-day holding period.
(2) For currency mismatches, a [bank] must
use a haircut for foreign exchange rate
volatility (Hfx) of 8 percent, as adjusted in
certain circumstances as provided in
paragraph (b)(2)(ii)(A)(3) and (4) of this
section.
(3) For repo-style transactions, a [bank]
may multiply the supervisory haircuts
provided in paragraphs (b)(2)(ii)(A)(1) and (2)
of this section by the square root of 1⁄2 (which
equals 0.707107).
(4) A [bank] must adjust the supervisory
haircuts upward on the basis of a holding
period longer than ten business days (for
eligible margin loans) or five business days
(for repo-style transactions) where and as
appropriate to take into account the
illiquidity of an instrument.
(iii) Own internal estimates for haircuts.
With the prior written approval of the
[AGENCY], a [bank] may calculate haircuts
(Hs and Hfx) using its own internal estimates
of the volatilities of market prices and foreign
exchange rates.
(A) To receive [AGENCY] approval to use
its own internal estimates, a [bank] must
satisfy the following minimum quantitative
standards:
(1) A [bank] must use a 99th percentile
one-tailed confidence interval.
(2) The minimum holding period for a
repo-style transaction is five business days
and for an eligible margin loan is ten
business days. When a [bank] calculates an
own-estimates haircut on a TN-day holding
period, which is different from the minimum
holding period for the transaction type, the
applicable haircut (HM) is calculated using
the following square root of time formula:
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.
(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
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haircuts for categories of securities. For a
category of securities, the [bank] must
calculate the haircut on the basis of internal
volatility estimates for securities in that
category that are representative of the
securities in that category that the [bank] has
lent, sold subject to repurchase, posted as
collateral, borrowed, purchased subject to
resale, or taken as collateral. In determining
relevant categories, the [bank] must at a
minimum take into account:
(1) The type of issuer of the security;
(2) The applicable external rating of the
security;
(3) The maturity of the security; and
(4) The interest rate sensitivity of the
security.
(C) With respect to debt securities that
have an applicable external rating of below
investment grade and equity securities, a
[bank] must calculate a separate haircut for
each individual security.
(D) Where an exposure or collateral
(whether in the form of cash or securities) is
denominated in a currency that differs from
the settlement currency, the [bank] must
calculate a separate currency mismatch
haircut for its net position in each
mismatched currency based on estimated
volatilities of foreign exchange rates between
the mismatched currency and the settlement
currency.
(E) A [bank]’s own estimates of market
price and foreign exchange rate volatilities
may not take into account the correlations
among securities and foreign exchange rates
on either the exposure or collateral side of a
transaction (or netting set) or the correlations
among securities and foreign exchange rates
between the exposure and collateral sides of
the transaction (or netting set).
(3) Simple VaR methodology. With the
prior written approval of the [AGENCY], a
[bank] may estimate EAD for a netting set
using a VaR model that meets the
requirements in paragraph (b)(3)(iii) of this
section. In such event, the [bank] must set
EAD equal to max {0, [(SE—SC) + PFE]},
where:
(i) SE equals the value of the exposure (the
sum of the current market values of all
instruments, gold, and cash the [bank] has
lent, sold subject to repurchase, or posted as
collateral to the counterparty under the
netting set);
(ii) SC equals the value of the collateral
(the sum of the current market values of all
instruments, gold, and cash the [bank] has
borrowed, purchased subject to resale, or
taken as collateral from the counterparty
under the netting set); and
(iii) PFE (potential future exposure) equals
the [bank]’s empirically based best estimate
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of the 99th percentile, one-tailed confidence
interval for an increase in the value of (SE—
SC) over a five-business-day holding period
for repo-style transactions or over a tenbusiness-day holding period for eligible
margin loans using a minimum one-year
historical observation period of price
data representing the instruments that the
[bank] has lent, sold subject to
repurchase, posted as collateral,
borrowed, purchased subject to resale, or
taken as collateral. The [bank] must
validate its VaR model, including by
establishing and maintaining a rigorous and
regular back-testing regime.
(c) EAD for OTC derivative contracts. (1) A
[bank] must determine the EAD for an OTC
derivative contract that is not subject to a
qualifying master netting agreement using the
current exposure methodology in paragraph
(c)(5) of this section or using the internal
models methodology described in paragraph
(d) of this section.
(2) A [bank] must determine the EAD for
multiple OTC derivative contracts that are
subject to a qualifying master netting
agreement using the current exposure
methodology in paragraph (c)(6) of this
section or using the internal models
methodology described in paragraph (d) of
this section.
(3) Counterparty credit risk for credit
derivatives. Notwithstanding the above, (i) A
[bank] that purchases a credit derivative that
is recognized under section 33 or 34 of this
appendix as a credit risk mitigant for an
exposure that is not a covered position under
[the market risk rule] need not compute a
separate counterparty credit risk capital
requirement under this section so long as the
[bank] does so consistently for all such credit
derivatives and either includes all or
excludes all such credit derivatives that are
subject to a master netting agreement from
any measure used to determine counterparty
credit risk exposure to all relevant
counterparties for risk-based capital
purposes.
(ii) A [bank] that is the protection provider
in a credit derivative must treat the credit
derivative as a wholesale exposure to the
reference obligor and need not compute a
counterparty credit risk capital requirement
for the credit derivative under this section, so
long as it does so consistently for all such
credit derivatives and either includes all or
excludes all such credit derivatives that are
subject to a master netting agreement from
any measure used to determine counterparty
credit risk exposure to all relevant
counterparties for risk-based capital purposes
(unless the [bank] is treating the credit
derivative as a covered position under [the
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1 The
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securities
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market risk rule], in which case the [bank]
must compute a supplemental counterparty
credit risk capital requirement under this
section).
(4) Counterparty credit risk for equity
derivatives. A [bank] must treat an equity
derivative contract as an equity exposure and
compute a risk-weighted asset amount for the
equity derivative contract under part VI
(unless the [bank] is treating the contract as
a covered position under [the market risk
rule]). In addition, if the [bank] is treating the
contract as a covered position under [the
market risk rule] and in certain other cases
described in section 55 of this appendix, the
[bank] must also calculate a risk-based
capital requirement for the counterparty
credit risk of an equity derivative contract
under this part.
(5) Single OTC derivative contract. Except
as modified by paragraph (c)(7) of this
section, the EAD for a single OTC derivative
contract that is not subject to a qualifying
master netting agreement is equal to the sum
of the [bank]’s current credit exposure and
potential future credit exposure (PFE) on the
derivative contract.
(i) Current credit exposure. The current
credit exposure for a single OTC derivative
contract is the greater of the mark-to-market
value of the derivative contract or zero.
(ii) PFE. The PFE for a single OTC
derivative contract, including an OTC
derivative contract with a negative mark-tomarket value, is calculated by multiplying
the notional principal amount of the
derivative contract by the appropriate
conversion factor in Table 4. For purposes of
calculating either the PFE under this
paragraph or the gross PFE under paragraph
(c)(6) of this section for exchange rate
contracts and other similar contracts in
which the notional principal amount is
equivalent to the cash flows, notional
principal amount is the net receipts to each
party falling due on each value date in each
currency. For any OTC derivative contract
that does not fall within one of the specified
categories in Table 4, the PFE must be
calculated using the ‘‘other’’ conversion
factors. A [bank] must use an OTC derivative
contract’s effective notional principal amount
(that is, its apparent or stated notional
principal amount multiplied by any
multiplier in the OTC derivative contract)
rather than its apparent or stated notional
principal amount in calculating PFE. PFE of
the protection provider of a credit derivative
is capped at the net present value of the
amount of unpaid premiums.
TABLE 4.—CONVERSION FACTOR MATRIX FOR OTC DERIVATIVE CONTRACTS 1
Remaining maturity 2
Interest rate
One year or less ......
Over one to five
years .....................
Over five years .........
Foreign exchange rate
and gold
Credit (investment-grade
reference obligor)3
Credit (non-investmentgrade reference obligor)
Precious metals (except
gold)
Equity
Other
0.00
0.01
0.05
0.10
0.06
0.07
0.10
0.005
0.015
0.05
0.075
0.05
0.05
0.10
0.10
0.08
0.10
0.07
0.08
0.12
0.15
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1 For an OTC derivative contract with multiple exchanges of principal, the conversion factor is multiplied by the number of remaining payments
in the derivative contract.
2 For an OTC derivative contract that is structured such that on specified dates any outstanding exposure is settled and the terms are reset so
that the market value of the contract is zero, the remaining maturity equals the time until the next reset date. For an interest rate derivative contract with a remaining maturity of greater than one year that meets these criteria, the minimum conversion factor is 0.005.
3 A [bank] must use the column labeled ‘‘Credit (investment-grade reference obligor)’’ for a credit derivative whose reference obligor has an
outstanding unsecured long-term debt security without credit enhancement that has a long-term applicable external rating of at least investment
grade. A [bank] must use the column labeled ‘‘Credit (non-investment-grade reference obligor)’’ for all other credit derivatives.
(6) Multiple OTC derivative contracts
subject to a qualifying master netting
agreement. Except as modified by paragraph
(c)(7) of this section, the EAD for multiple
OTC derivative contracts subject to a
qualifying master netting agreement is equal
to the sum of the net current credit exposure
and the adjusted sum of the PFE exposure for
all OTC derivative contracts subject to the
qualifying master netting agreement.
(i) Net current credit exposure. The net
current credit exposure is the greater of:
(A) The net sum of all positive and
negative mark-to-market values of the
individual OTC derivative contracts subject
to the qualifying master netting agreement; or
(B) zero.
(ii) Adjusted sum of the PFE. The adjusted
sum of the PFE, Anet, is calculated as Anet
= (0.4×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 singleproduct 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 SE 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
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internal models methodology for a particular
transaction type (OTC derivative contracts,
eligible margin loans, or repo-style
transactions) must use the internal models
methodology for all transactions of that
transaction type. A [bank] may choose to use
the internal models methodology for one or
two of these three types of exposures and not
the other types. A [bank] may also use the
internal models methodology for OTC
derivative contracts, eligible margin loans,
and repo-style transactions subject to a
qualifying cross-product netting agreement if:
(i) The [bank] effectively integrates the risk
mitigating effects of cross-product netting
into its risk management and other
information technology systems; and
(ii) The [bank] obtains the prior written
approval of the [AGENCY]. A [bank] that uses
the internal models methodology for a
transaction type must receive approval from
the [AGENCY] to cease using the
methodology for that transaction type or to
make a material change to its internal model.
(2) Under the internal models
methodology, a [bank] uses an internal model
to estimate the expected exposure (EE) for a
netting set and then calculates EAD based on
that EE.
(i) The [bank] must use its internal model’s
probability distribution for changes in the
market value of a netting set that are
attributable to changes in market variables to
determine EE.
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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 wrongway risk throughout the life of an exposure.
Wrong-way risk in this context is the risk that
future exposure to a counterparty will be
high when the counterparty’s probability of
default is also high.
(vii) The model must use current market
data to compute current exposures. When
estimating model parameters based on
historical data, at least three years of
historical data that cover a wide range of
economic conditions must be used and must
be updated quarterly or more frequently if
market conditions warrant. The [bank]
should consider using model parameters
based on forward-looking measures, where
appropriate.
(viii) A [bank] must subject its internal
model to an initial validation and annual
model review process. The model review
should consider whether the inputs and risk
factors, as well as the model outputs, are
appropriate.
(4) Maturity. (i) If the remaining maturity
of the exposure or the longest-dated contract
in the netting set is greater than one year, the
[bank] must set M for the exposure or netting
set equal to the lower of five years or
M(EPE),3 where:
(B) dfk is the risk-free discount factor for
future time period tk; and
(C) Dtk = tk¥tk¥1.
(ii) If the remaining maturity of the
exposure or the longest-dated contract in the
netting set is one year or less, the [bank] must
set M for the exposure or netting set equal
to one year, except as provided in paragraph
(d)(7) of section 31 of this appendix.
(5) Collateral agreements. A [bank] may
capture the effect on EAD of a collateral
agreement that requires receipt of collateral
when exposure to the counterparty increases
but may not capture the effect on EAD of a
collateral agreement that requires receipt of
collateral when counterparty credit quality
deteriorates. For this purpose, a collateral
agreement means a legal contract that
specifies the time when, and circumstances
under which, the counterparty is required to
pledge collateral to the [bank] for a single
financial contract or for all financial
contracts in a netting set and confers upon
the [bank] a perfected, first priority security
interest (notwithstanding the prior security
interest of any custodial agent), or the legal
equivalent thereof, in the collateral posted by
the counterparty under the agreement. This
security interest must provide the [bank]
with a right to close out the financial
positions and liquidate the collateral upon an
event of default of, or failure to perform by,
the counterparty under the collateral
agreement. A contract would not satisfy this
requirement if the [bank]’s exercise of rights
under the agreement may be stayed or
avoided under applicable law in the relevant
jurisdictions. Two methods are available to
capture the effect of a collateral agreement:
(i) With prior written approval from the
[AGENCY], a [bank] may include the effect of
a collateral agreement within its internal
model used to calculate EAD. The [bank] may
set EAD equal to the expected exposure at the
end of the margin period of risk. The margin
period of risk means, with respect to a
netting set subject to a collateral agreement,
the time period from the most recent
exchange of collateral with a counterparty
until the next required exchange of collateral
plus the period of time required to sell and
realize the proceeds of the least liquid
collateral that can be delivered under the
terms of the collateral agreement and, where
applicable, the period of time required to rehedge 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 rehedging of any market risk.
(ii) A [bank] that can model EPE without
collateral agreements but cannot achieve the
higher level of modeling sophistication to
model EPE with collateral agreements can set
effective EPE for a collateralized netting set
equal to the lesser of:
(A) The threshold, defined as the exposure
amount at which the counterparty is required
to post collateral under the collateral
agreement, if the threshold is positive, plus
an add-on that reflects the potential increase
in exposure of the netting set over the margin
period of risk. The add-on is computed as the
3 Alternatively, a [bank] that uses an internal
model to calculate a one-sided credit valuation
adjustment may use the effective credit duration
estimated by the model as M(EPE) in place of the
formula in paragraph (d)(4).
n
(A) EffectiveEPE t k = ∑ EffectiveEE t k × ∆t k
k =1
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(that is, effective EPE is the time-weighted
average of effective EE where the weights are
the proportion that an individual effective EE
represents in a one-year time interval) where:
(1) Effective EEtk = max (Effective EEtk−1,
EEtk) (that is, for a specific datetk, effective EE
is the greater of EE at that date or the
effective EE at the previous date); and
(2) tk represents the kth future time period
in the model and there are n time periods
represented in the model over the first year;
and
(B) a = 1.4 except as provided in paragraph
(d)(6), or when the [AGENCY] has
determined that the [bank] must set a higher
based on the [bank]’s specific characteristics
of counterparty credit risk.
(iii) A [bank] may include financial
collateral currently posted by the
counterparty as collateral (but may not
include other forms of collateral) when
calculating EE.
(iv) If a [bank] hedges some or all of the
counterparty credit risk associated with a
netting set using an eligible credit derivative,
the [bank] may take the reduction in
exposure to the counterparty into account
when estimating EE. If the [bank] recognizes
this reduction in exposure to the
counterparty in its estimate of EE, it must
also use its internal model to estimate a
separate EAD for the [bank]’s exposure to the
protection provider of the credit derivative.
(3) To obtain [AGENCY] approval to
calculate the distributions of exposures upon
which the EAD calculation is based, the
[bank] must demonstrate to the satisfaction of
the [AGENCY] that it has been using for at
least one year an internal model that broadly
meets the following minimum standards,
with which the [bank] must maintain
compliance:
(i) The model must have the systems
capability to estimate the expected exposure
to the counterparty on a daily basis (but is
not expected to estimate or report expected
exposure on a daily basis).
(ii) The model must estimate expected
exposure at enough future dates to reflect
accurately all the future cash flows of
contracts in the netting set.
(iii) The model must account for the
possible non-normality of the exposure
distribution, where appropriate.
(iv) The [bank] must measure, monitor, and
control current counterparty exposure and
the exposure to the counterparty over the
whole life of all contracts in the netting set.
(v) The [bank] must be able to measure and
manage current exposures gross and net of
(ii) Under the internal models
methodology, EAD = a x effective EPE, or,
subject to [AGENCY] approval as provided in
paragraph (d)(7), a more conservative
measure of EAD.
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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 remargining and daily marking-to-market, and
ten business days for all other netting sets;
or
(B) Effective EPE without a collateral
agreement.
(6) Own estimate of alpha. With prior
written approval of the [AGENCY], a [bank]
may calculate alpha as the ratio of economic
capital from a full simulation of counterparty
exposure across counterparties that
incorporates a joint simulation of market and
credit risk factors (numerator) and economic
capital based on EPE (denominator), subject
to a floor of 1.2. For purposes of this
calculation, economic capital is the
unexpected losses for all counterparty credit
risks measured at a 99.9 percent confidence
level over a one-year horizon. To receive
approval, the [bank] must meet the following
minimum standards to the satisfaction of the
[AGENCY]:
(i) The [bank]’s own estimate of alpha must
capture in the numerator the effects of:
(A) The material sources of stochastic
dependency of distributions of market values
of transactions or portfolios of transactions
across counterparties;
(B) Volatilities and correlations of market
risk factors used in the joint simulation,
which must be related to the credit risk factor
used in the simulation to reflect potential
increases in volatility or correlation in an
economic downturn, where appropriate; and
(C) The granularity of exposures (that is,
the effect of a concentration in the proportion
of each counterparty’s exposure that is driven
by a particular risk factor).
(ii) The [bank] must assess the potential
model uncertainty in its estimates of alpha.
(iii) The [bank] must calculate the
numerator and denominator of alpha in a
consistent fashion with respect to modeling
methodology, parameter specifications, and
portfolio composition.
(iv) The [bank] must review and adjust as
appropriate its estimates of the numerator
and denominator of alpha on at least a
quarterly basis and more frequently when the
composition of the portfolio varies over time.
(7) Other measures of counterparty
exposure. With prior written approval of the
[AGENCY], a [bank] may set EAD equal to a
measure of counterparty credit risk exposure,
such as peak EAD, that is more conservative
than an alpha of 1.4 (or higher under the
terms of paragraph (d)(2)(ii)(B) of this
section) times EPE for every counterparty
whose EAD will be measured under the
alternative measure of counterparty
exposure. The [bank] must demonstrate the
conservatism of the measure of counterparty
credit risk exposure used for EAD. For
material portfolios of new OTC derivative
products, the [bank] may assume that the
current exposure methodology in paragraphs
(c)(5) and (c)(6) of this section meets the
conservatism requirement of this paragraph
for a period not to exceed 180 days. For
immaterial portfolios of OTC derivative
contracts, the [bank] generally may assume
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that the current exposure methodology in
paragraphs (c)(5) and (c)(6) of this section
meets the conservatism requirement of this
paragraph.
Section 33. Guarantees and Credit
Derivatives: PD Substitution and LGD
Adjustment Approaches
(a) Scope. (1) This section applies to
wholesale exposures for which:
(i) Credit risk is fully covered by an eligible
guarantee or eligible credit derivative; or
(ii) Credit risk is covered on a pro rata basis
(that is, on a basis in which the [bank] and
the protection provider share losses
proportionately) by an eligible guarantee or
eligible credit derivative.
(2) Wholesale exposures on which there is
a tranching of credit risk (reflecting at least
two different levels of seniority) are
securitization exposures subject to the
securitization framework in part V.
(3) A [bank] may elect to recognize the
credit risk mitigation benefits of an eligible
guarantee or eligible credit derivative
covering an exposure described in paragraph
(a)(1) of this section by using the PD
substitution approach or the LGD adjustment
approach in paragraph (c) of this section or,
if the transaction qualifies, using the double
default treatment in section 34 of this
appendix. A [bank]’s PD and LGD for the
hedged exposure may not be lower than the
PD and LGD floors described in paragraphs
(d)(2) and (d)(3) of section 31 of this
appendix.
(4) If multiple eligible guarantees or
eligible credit derivatives cover a single
exposure described in paragraph (a)(1) of this
section, a [bank] may treat the hedged
exposure as multiple separate exposures each
covered by a single eligible guarantee or
eligible credit derivative and may calculate a
separate risk-based capital requirement for
each separate exposure as described in
paragraph (a)(3) of this section.
(5) If a single eligible guarantee or eligible
credit derivative covers multiple hedged
wholesale exposures described in paragraph
(a)(1) of this section, a [bank] must treat each
hedged exposure as covered by a separate
eligible guarantee or eligible credit derivative
and must calculate a separate risk-based
capital requirement for each exposure as
described in paragraph (a)(3) of this section.
(6) A [bank] must use the same risk
parameters for calculating ECL as it uses for
calculating the risk-based capital requirement
for the exposure.
(b) Rules of recognition. (1) A [bank] may
only recognize the credit risk mitigation
benefits of eligible guarantees and eligible
credit derivatives.
(2) A [bank] may only recognize the credit
risk mitigation benefits of an eligible credit
derivative to hedge an exposure that is
different from the credit derivative’s
reference exposure used for determining the
derivative’s cash settlement value,
deliverable obligation, or occurrence of a
credit event if:
(i) The reference exposure ranks pari passu
(that is, equally) with or is junior to the
hedged exposure; and
(ii) The reference exposure and the hedged
exposure are exposures to the same legal
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entity, and legally enforceable cross-default
or cross-acceleration clauses are in place to
assure payments under the credit derivative
are triggered when the obligor fails to pay
under the terms of the hedged exposure.
(c) Risk parameters for hedged exposures—
(1) PD substitution approach—(i) Full
coverage. If an eligible guarantee or eligible
credit derivative meets the conditions in
paragraphs (a) and (b) of this section and the
protection amount (P) of the guarantee or
credit derivative is greater than or equal to
the EAD of the hedged exposure, a [bank]
may recognize the guarantee or credit
derivative in determining the [bank]’s riskbased capital requirement for the hedged
exposure by substituting the PD associated
with the rating grade of the protection
provider for the PD associated with the rating
grade of the obligor in the risk-based capital
formula applicable to the guarantee or credit
derivative in Table 2 and using the
appropriate LGD as described in paragraph
(c)(1)(iii) of this section. If the [bank]
determines that full substitution of the
protection provider’s PD leads to an
inappropriate degree of risk mitigation, the
[bank] may substitute a higher PD than that
of the protection provider.
(ii) Partial coverage. If an eligible guarantee
or eligible credit derivative meets the
conditions in paragraphs (a) and (b) of this
section and the protection amount (P) of the
guarantee or credit derivative is less than the
EAD of the hedged exposure, the [bank] must
treat the hedged exposure as two separate
exposures (protected and unprotected) in
order to recognize the credit risk mitigation
benefit of the guarantee or credit derivative.
(A) The [bank] must calculate its risk-based
capital requirement for the protected
exposure under section 31 of this appendix,
where PD is the protection provider’s PD,
LGD is determined under paragraph (c)(1)(iii)
of this section, and EAD is P. If the [bank]
determines that full substitution leads to an
inappropriate degree of risk mitigation, the
[bank] may use a higher PD than that of the
protection provider.
(B) The [bank] must calculate its risk-based
capital requirement for the unprotected
exposure under section 31 of this appendix,
where PD is the obligor’s PD, LGD is the
hedged exposure’s LGD (not adjusted to
reflect the guarantee or credit derivative), and
EAD is the EAD of the original hedged
exposure minus P.
(C) The treatment in this paragraph
(c)(1)(ii) is applicable when the credit risk of
a wholesale exposure is covered on a partial
pro rata basis or when an adjustment is made
to the effective notional amount of the
guarantee or credit derivative under
paragraph (d), (e), or (f) of this section.
(iii) LGD of hedged exposures. The LGD of
a hedged exposure under the PD substitution
approach is equal to:
(A) The lower of the LGD of the hedged
exposure (not adjusted to reflect the
guarantee or credit derivative) and the LGD
of the guarantee or credit derivative, if the
guarantee or credit derivative provides the
[bank] with the option to receive immediate
payout upon triggering the protection; or
(B) The LGD of the guarantee or credit
derivative, if the guarantee or credit
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derivative does not provide the [bank] with
the option to receive immediate payout upon
triggering the protection.
(2) LGD adjustment approach—(i) Full
coverage. If an eligible guarantee or eligible
credit derivative meets the conditions in
paragraphs (a) and (b) of this section and the
protection amount (P) of the guarantee or
credit derivative is greater than or equal to
the EAD of the hedged exposure, the [bank]’s
risk-based capital requirement for the hedged
exposure is the greater of:
(A) The risk-based capital requirement for
the exposure as calculated under section 31
of this appendix, with the LGD of the
exposure adjusted to reflect the guarantee or
credit derivative; or
(B) The risk-based capital requirement for
a direct exposure to the protection provider
as calculated under section 31 of this
appendix, using the PD for the protection
provider, the LGD for the guarantee or credit
derivative, and an EAD equal to the EAD of
the hedged exposure.
(ii) Partial coverage. If an eligible guarantee
or eligible credit derivative meets the
conditions in paragraphs (a) and (b) of this
section and the protection amount (P) of the
guarantee or credit derivative is less than the
EAD of the hedged exposure, the [bank] must
treat the hedged exposure as two separate
exposures (protected and unprotected) in
order to recognize the credit risk mitigation
benefit of the guarantee or credit derivative.
(A) The [bank]’s risk-based capital
requirement for the protected exposure
would be the greater of:
(1) The risk-based capital requirement for
the protected exposure as calculated under
section 31 of this appendix, with the LGD of
the exposure adjusted to reflect the guarantee
or credit derivative and EAD set equal to P;
or
(2) The risk-based capital requirement for
a direct exposure to the guarantor as
calculated under section 31 of this appendix,
using the PD for the protection provider, the
LGD for the guarantee or credit derivative,
and an EAD set equal to P.
(B) The [bank] must calculate its risk-based
capital requirement for the unprotected
exposure under section 31 of this appendix,
where PD is the obligor’s PD, LGD is the
hedged exposure’s LGD (not adjusted to
reflect the guarantee or credit derivative), and
EAD is the EAD of the original hedged
exposure minus P.
(3) M of hedged exposures. The M of the
hedged exposure is the same as the M of the
exposure if it were unhedged.
(d) Maturity mismatch. (1) A [bank] that
recognizes an eligible guarantee or eligible
credit derivative in determining its risk-based
capital requirement for a hedged exposure
must adjust the effective notional amount of
the credit risk mitigant to reflect any maturity
mismatch between the hedged exposure and
the credit risk mitigant.
(2) A maturity mismatch occurs when the
residual maturity of a credit risk mitigant is
less than that of the hedged exposure(s).
(3) The residual maturity of a hedged
exposure is the longest possible remaining
time before the obligor is scheduled to fulfill
its obligation on the exposure. If a credit risk
mitigant has embedded options that may
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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 stepup in cost in conjunction with a call feature
or where the effective cost of protection
increases over time even if credit quality
remains the same or improves, the residual
maturity of the credit risk mitigant will be
the remaining time to the first call.
(4) A credit risk mitigant with a maturity
mismatch may be recognized only if its
original maturity is greater than or equal to
one year and its residual maturity is greater
than three months.
(5) When a maturity mismatch exists, the
[bank] must apply the following adjustment
to the effective notional amount of the credit
risk mitigant: Pm = E × (t – 0.25)/(T – 0.25),
where:
(i) Pm = effective notional amount of the
credit risk mitigant, adjusted for maturity
mismatch;
(ii) E = effective notional amount of the
credit risk mitigant;
(iii) t = the lesser of T or the residual
maturity of the credit risk mitigant, expressed
in years; and
(iv) T = the lesser of five or the residual
maturity of the hedged exposure, expressed
in years.
(e) Credit derivatives without restructuring
as a credit event. If a [bank] recognizes an
eligible credit derivative that does not
include as a credit event a restructuring of
the hedged exposure involving forgiveness or
postponement of principal, interest, or fees
that results in a credit loss event (that is, a
charge-off, specific provision, or other similar
debit to the profit and loss account), the
[bank] must apply the following adjustment
to the effective notional amount of the credit
derivative: Pr = Pm × 0.60, where:
(1) Pr = effective notional amount of the
credit risk mitigant, adjusted for lack of
restructuring event (and maturity mismatch,
if applicable); and
(2) Pm = effective notional amount of the
credit risk mitigant adjusted for maturity
mismatch (if applicable).
(f) Currency mismatch. (1) If a [bank]
recognizes an eligible guarantee or eligible
credit derivative that is denominated in a
currency different from that in which the
hedged exposure is denominated, the [bank]
must apply the following formula to the
effective notional amount of the guarantee or
credit derivative: Pc = Pr × (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
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(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-businessday holding period and daily marking-tomarket and remargining. A [bank] qualifies
for the use of its own internal estimates of
foreign exchange volatility if it qualifies for:
(i) The own-estimates haircuts in
paragraph (b)(2)(iii) of section 32 of this
appendix;
(ii) The simple VaR methodology in
paragraph (b)(3) of section 32 of this
appendix; or
(iii) The internal models methodology in
paragraph (d) of section 32 of this appendix.
(3) A [bank] must adjust HFX calculated in
paragraph (f)(2) of this section upward if the
[bank] revalues the guarantee or credit
derivative less frequently than once every ten
business days using the square root of time
formula provided in paragraph
(b)(2)(iii)(A)(2) of section 32 of this appendix.
Section 34. Guarantees and Credit
Derivatives: Double Default Treatment
(a) Eligibility and operational criteria for
double default treatment. A [bank] may
recognize the credit risk mitigation benefits
of a guarantee or credit derivative covering
an exposure described in paragraph (a)(1) of
section 33 of this appendix by applying the
double default treatment in this section if all
the following criteria are satisfied.
(1) The hedged exposure is fully covered
or covered on a pro rata basis by:
(i) An eligible guarantee issued by an
eligible double default guarantor; or
(ii) An eligible credit derivative that meets
the requirements of paragraph (b)(2) of
section 33 of this appendix and is issued by
an eligible double default guarantor.
(2) The guarantee or credit derivative is:
(i) An uncollateralized guarantee or
uncollateralized credit derivative (for
example, a credit default swap) that provides
protection with respect to a single reference
obligor; or
(ii) An nth-to-default credit derivative
(subject to the requirements of paragraph (m)
of section 42 of this appendix).
(3) The hedged exposure is a wholesale
exposure (other than a sovereign exposure).
(4) The obligor of the hedged exposure is
not:
(i) An eligible double default guarantor or
an affiliate of an eligible double default
guarantor; or
(ii) An affiliate of the guarantor.
(5) The [bank] does not recognize any
credit risk mitigation benefits of the
guarantee or credit derivative for the hedged
exposure other than through application of
the double default treatment as provided in
this section.
(6) The [bank] has implemented a process
(which has received the prior, written
approval of the [AGENCY]) to detect
excessive correlation between the
creditworthiness of the obligor of the hedged
exposure and the protection provider. If
excessive correlation is present, the [bank]
may not use the double default treatment for
the hedged exposure.
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(b) Full coverage. If the transaction meets
the criteria in paragraph (a) of this section
and the protection amount (P) of the
guarantee or credit derivative is at least equal
to the EAD of the hedged exposure, the
[bank] may determine its risk-weighted asset
amount for the hedged exposure under
paragraph (e) of this section.
(c) Partial coverage. If the transaction
meets the criteria in paragraph (a) of this
section and the protection amount (P) of the
guarantee or credit derivative is less than the
EAD of the hedged exposure, the [bank] must
treat the hedged exposure as two separate
exposures (protected and unprotected) in
order to recognize double default treatment
on the protected portion of the exposure.
(1) For the protected exposure, the [bank]
must set EAD equal to P and calculate its
risk-weighted asset amount as provided in
paragraph (e) of this section.
(2) For the unprotected exposure, the
[bank] must set EAD equal to the EAD of the
original exposure minus P and then calculate
its risk-weighted asset amount as provided in
section 31 of this appendix.
(d) Mismatches. For any hedged exposure
to which a [bank] applies double default
treatment, the [bank] must make applicable
adjustments to the protection amount as
(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) rOS (asset value correlation of the obligor)
is calculated according to the
appropriate formula for (R) provided in
Table 2 in section 31 of this appendix,
with PD equal to PDo.
(6) b (maturity adjustment coefficient) is
calculated according to the formula for b
provided in Table 2 in section 31 of this
appendix, with PD equal to the lesser of
PDo and PDg.
(7) M (maturity) is the effective maturity of
the guarantee or credit derivative, which
may not be less than one year or greater
than five years.
transaction is equal to or less than the market
standard for the instrument underlying the
transaction and equal to or less than five
business days.
(4) Positive current exposure. The positive
current exposure of a [bank] for a transaction
is the difference between the transaction
value at the agreed settlement price and the
current market price of the transaction, if the
difference results in a credit exposure of the
[bank] to the counterparty.
(b) Scope. This section applies to all
transactions involving securities, foreign
exchange instruments, and commodities that
have a risk of delayed settlement or delivery.
This section does not apply to:
(1) Transactions accepted by a qualifying
central counterparty that are subject to daily
marking-to-market and daily receipt and
payment of variation margin;
(2) Repo-style transactions, including
unsettled repo-style transactions (which are
addressed in sections 31 and 32 of this
appendix);
(3) One-way cash payments on OTC
derivative contracts (which are addressed in
sections 31 and 32 of this appendix); or
(4) Transactions with a contractual
settlement period that is longer than the
normal settlement period (which are treated
as OTC derivative contracts and addressed in
sections 31 and 32 of this appendix).
(c) System-wide failures. In the case of a
system-wide failure of a settlement or
clearing system, the [AGENCY] may waive
risk-based capital requirements for unsettled
and failed transactions until the situation is
rectified.
(d) Delivery-versus-payment (DvP) and
payment-versus-payment (PvP) transactions.
A [bank] must hold risk-based capital against
any DvP or PvP transaction with a normal
settlement period if the [bank]’s counterparty
has not made delivery or payment within five
business days after the settlement date. The
[bank] must determine its risk-weighted asset
amount for such a transaction by multiplying
the positive current exposure of the
transaction for the [bank] by the appropriate
risk weight in Table 5.
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
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required in paragraphs (d), (e), and (f) of
section 33 of this appendix.
(e) The double default dollar risk-based
capital requirement. The dollar risk-based
capital requirement for a hedged exposure to
which a [bank] has applied double default
treatment is KDD multiplied by the EAD of
the exposure. KDD is calculated according to
the following formula: KDD = Ko × (0.15 + 160
× PDg),
Where:
(1)
TABLE 5.—RISK WEIGHTS FOR UNSETTLED DVP AND PVP TRANSACTIONS
Number of business
days after contractual
settlement date
From
From
From
46 or
5 to 15 .................
16 to 30 ...............
31 to 45 ...............
more ....................
Risk weight to be
applied to positive
current exposure
(percent)
100
625
937.5
1,250
(e) Non-DvP/non-PvP (non-delivery-versuspayment/non-payment-versus-payment)
transactions. (1) A [bank] must hold riskbased capital against any non-DvP/non-PvP
transaction with a normal settlement period
if the [bank] has delivered cash, securities,
commodities, or currencies to its
counterparty but has not received its
corresponding deliverables by the end of the
same business day. The [bank] must continue
to hold risk-based capital against the
transaction until the [bank] has received its
corresponding deliverables.
(2) From the business day after the [bank]
has made its delivery until five business days
after the counterparty delivery is due, the
[bank] must calculate its risk-based capital
requirement for the transaction by treating
the current market value of the deliverables
owed to the [bank] as a wholesale exposure.
(i) A [bank] may assign an obligor rating to
a counterparty for which it is not otherwise
required under this appendix to assign an
obligor rating on the basis of the applicable
external rating of any outstanding unsecured
long-term debt security without credit
enhancement issued by the counterparty.
(ii) A [bank] may use a 45 percent LGD for
the transaction rather than estimating LGD
for the transaction provided the [bank] uses
the 45 percent LGD for all transactions
described in paragraphs (e)(1) and (e)(2) of
this section.
(iii) A [bank] may use a 100 percent risk
weight for the transaction provided the
[bank] uses this risk weight for all
transactions described in paragraphs (e)(1)
and (e)(2) of this section.
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(3) If the [bank] has not received its
deliverables by the fifth business day after
the counterparty delivery was due, the [bank]
must deduct the current market value of the
deliverables owed to the [bank] 50 percent
from tier 1 capital and 50 percent from tier
2 capital.
(f) Total risk-weighted assets for unsettled
transactions. Total risk-weighted assets for
unsettled transactions is the sum of the riskweighted asset amounts of all DvP, PvP, and
non-DvP/non-PvP transactions.
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.
Part V. Risk-Weighted Assets for
Securitization Exposures
Section 42. Risk-Based Capital Requirement
for Securitization Exposures
(a) Hierarchy of approaches. Except as
provided elsewhere in this section:
(1) A [bank] must deduct from tier 1 capital
any after-tax gain-on-sale resulting from a
securitization and must deduct from total
capital in accordance with paragraph (c) of
this section the portion of any CEIO that does
not constitute gain-on-sale.
(2) If a securitization exposure does not
require deduction under paragraph (a)(1) of
this section and qualifies for the RatingsBased Approach in section 43 of this
appendix, a [bank] must apply the RatingsBased Approach to the exposure.
(3) If a securitization exposure does not
require deduction under paragraph (a)(1) of
this section and does not qualify for the
Ratings-Based Approach, the [bank] may
either apply the Internal Assessment
Approach in section 44 of this appendix to
the exposure (if the [bank], the exposure, and
the relevant ABCP program qualify for the
Internal Assessment Approach) or the
Supervisory Formula Approach in section 45
of this appendix to the exposure (if the [bank]
and the exposure qualify for the Supervisory
Formula Approach).
(4) If a securitization exposure does not
require deduction under paragraph (a)(1) of
this section and does not qualify for the
Ratings-Based Approach, the Internal
Assessment Approach, or the Supervisory
Formula Approach, the [bank] must deduct
the exposure from total capital in accordance
with paragraph (c) of this section.
(5) If a securitization exposure is an OTC
derivative contract (other than a credit
derivative) that has a first priority claim on
the cash flows from the underlying exposures
(notwithstanding amounts due under interest
rate or currency derivative contracts, fees
due, or other similar payments), with
approval of the [AGENCY], a [bank] may
choose to set the risk-weighted asset amount
of the exposure equal to the amount of the
exposure as determined in paragraph (e) of
this section rather than apply the hierarchy
of approaches described in paragraphs (a) (1)
through (4) of this section.
(b) Total risk-weighted assets for
securitization exposures. A [bank]’s total
risk-weighted assets for securitization
exposures is equal to the sum of its riskweighted assets calculated using the RatingsBased Approach in section 43 of this
appendix, the Internal Assessment Approach
in section 44 of this appendix, and the
Supervisory Formula Approach in section 45
of this appendix, and its risk-weighted assets
amount for early amortization provisions
calculated in section 47 of this appendix.
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Section 41. Operational Criteria for
Recognizing the Transfer of Risk
(a) Operational criteria for traditional
securitizations. A [bank] that transfers
exposures it has originated or purchased to
a securitization SPE or other third party in
connection with a traditional securitization
may exclude the exposures from the
calculation of its risk-weighted assets only if
each of the conditions in this paragraph (a)
is satisfied. A [bank] that meets these
conditions must hold risk-based capital
against any securitization exposures it retains
in connection with the securitization. A
[bank] that fails to meet these conditions
must hold risk-based capital against the
transferred exposures as if they had not been
securitized and must deduct from tier 1
capital any after-tax gain-on-sale resulting
from the transaction. The conditions are:
(1) The transfer is considered a sale under
GAAP;
(2) The [bank] has transferred to third
parties credit risk associated with the
underlying exposures; and
(3) Any clean-up calls relating to the
securitization are eligible clean-up calls.
(b) Operational criteria for synthetic
securitizations. For synthetic securitizations,
a [bank] may recognize for risk-based capital
purposes the use of a credit risk mitigant to
hedge underlying exposures only if each of
the conditions in this paragraph (b) is
satisfied. A [bank] that fails to meet these
conditions must hold risk-based capital
against the underlying exposures as if they
had not been synthetically securitized. The
conditions are:
(1) The credit risk mitigant is financial
collateral, an eligible credit derivative from
an eligible securitization guarantor or an
eligible guarantee from an eligible
securitization guarantor;
(2) The [bank] transfers credit risk
associated with the underlying exposures to
third parties, and the terms and conditions in
the credit risk mitigants employed do not
include provisions that:
(i) Allow for the termination of the credit
protection due to deterioration in the credit
quality of the underlying exposures;
(ii) Require the [bank] to alter or replace
the underlying exposures to improve the
credit quality of the pool of underlying
exposures;
(iii) Increase the [bank]’s cost of credit
protection in response to deterioration in the
credit quality of the underlying exposures;
(iv) Increase the yield payable to parties
other than the [bank] in response to a
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69419
(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 gainon-sale or CEIOs associated with the
securitization) may not exceed the sum of:
(1) The [bank]’s total risk-based capital
requirement for the underlying exposures as
if the [bank] directly held the underlying
exposures; and
(2) The total ECL of the underlying
exposures.
(e) Amount of a securitization exposure. (1)
The amount of an on-balance sheet
securitization exposure that is not a repostyle transaction, eligible margin loan, or
OTC derivative contract (other than a credit
derivative) is:
(i) The [bank]’s carrying value minus any
unrealized gains and plus any unrealized
losses on the exposure, if the exposure is a
security classified as available-for-sale; or
(ii) The [bank]’s carrying value, if the
exposure is not a security classified as
available-for-sale.
(2) The amount of an off-balance sheet
securitization exposure that is not an OTC
derivative contract (other than a credit
derivative) is the notional amount of the
exposure. For an off-balance-sheet
securitization exposure to an ABCP program,
such as a liquidity facility, the notional
amount may be reduced to the maximum
potential amount that the [bank] could be
required to fund given the ABCP program’s
current underlying assets (calculated without
regard to the current credit quality of those
assets).
(3) The amount of a securitization exposure
that is a repo-style transaction, eligible
margin loan, or OTC derivative contract
(other than a credit derivative) is the EAD of
the exposure as calculated in section 32 of
this appendix.
(f) Overlapping exposures. If a [bank] has
multiple securitization exposures that
provide duplicative coverage of the
underlying exposures of a securitization
(such as when a [bank] provides a programwide credit enhancement and multiple poolspecific liquidity facilities to an ABCP
program), the [bank] is not required to hold
duplicative risk-based capital against the
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overlapping position. Instead, the [bank] may
apply to the overlapping position the
applicable risk-based capital treatment that
results in the highest risk-based capital
requirement.
(g) Securitizations of non-IRB exposures. If
a [bank] has a securitization exposure where
any underlying exposure is not a wholesale
exposure, retail exposure, securitization
exposure, or equity exposure, the [bank]
must:
(1) If the [bank] is an originating [bank],
deduct from tier 1 capital any after-tax gainon-sale resulting from the securitization and
deduct from total capital in accordance with
paragraph (c) of this section the portion of
any CEIO that does not constitute gain-onsale;
(2) If the securitization exposure does not
require deduction under paragraph (g)(1),
apply the RBA in section 43 of this appendix
to the securitization exposure if the exposure
qualifies for the RBA;
(3) If the securitization exposure does not
require deduction under paragraph (g)(1) and
does not qualify for the RBA, apply the IAA
in section 44 of this appendix to the exposure
(if the [bank], the exposure, and the relevant
ABCP program qualify for the IAA); and
(4) If the securitization exposure does not
require deduction under paragraph (g)(1) and
does not qualify for the RBA or the IAA,
deduct the exposure from total capital in
accordance with paragraph (c) of this section.
(h) Implicit support. If a [bank] provides
support to a securitization in excess of the
[bank]’s contractual obligation to provide
credit support to the securitization (implicit
support):
(1) The [bank] must hold regulatory capital
against all of the underlying exposures
associated with the securitization as if the
exposures had not been securitized and must
deduct from tier 1 capital any after-tax gainon-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 riskbased 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-creditenhancing 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 smallbusiness 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 small-business
concern established by the Small Business
Administration under section 3(a) of the
Small Business Act (15 U.S.C. 632).
(iv) The [bank] is well capitalized, as
defined in the [AGENCY]’s prompt corrective
action regulation—12 CFR part 6 (for national
banks), 12 CFR part 208, subpart D (for state
member banks or bank holding companies),
12 CFR part 325, subpart B (for state
nonmember banks), and 12 CFR part 565 (for
savings associations). For purposes of
determining whether a [bank] is well
capitalized for purposes of this paragraph,
the [bank]’s capital ratios must be calculated
without regard to the capital treatment for
transfers of small-business obligations with
recourse specified in paragraph (k)(1) of this
section.
(2) The total outstanding amount of
recourse retained by a [bank] on transfers of
small-business obligations receiving the
capital treatment specified in paragraph
(k)(1) of this section cannot exceed 15
percent of the [bank]’s total qualifying
capital.
(3) If a [bank] ceases to be well capitalized
or exceeds the 15 percent capital limitation,
the preferential capital treatment specified in
paragraph (k)(1) of this section will continue
to apply to any transfers of small-business
obligations with recourse that occurred
during the time that the [bank] was well
capitalized and did not exceed the capital
limit.
(4) The risk-based capital ratios of the
[bank] must be calculated without regard to
the capital treatment for transfers of smallbusiness obligations with recourse specified
in paragraph (k)(1) of this section as provided
in 12 CFR part 3, Appendix A (for national
banks), 12 CFR part 208, Appendix A (for
state member banks), 12 CFR part 225,
Appendix A (for bank holding companies),
12 CFR part 325, Appendix A (for state
nonmember banks), and 12 CFR
567.6(b)(5)(v) (for savings associations).
(l) Consolidated ABCP programs. (1) A
[bank] that qualifies as a primary beneficiary
and must consolidate an ABCP program as a
variable interest entity under GAAP may
exclude the consolidated ABCP program
assets from risk-weighted assets if the [bank]
is the sponsor of the ABCP program. If a
[bank] excludes such consolidated ABCP
program assets from risk-weighted assets, the
[bank] must hold risk-based capital against
any securitization exposures of the [bank] to
the ABCP program in accordance with this
part.
(2) If a [bank] either is not permitted, or
elects not, to exclude consolidated ABCP
program assets from its risk-weighted assets,
the [bank] must hold risk-based capital
against the consolidated ABCP program
assets in accordance with this appendix but
is not required to hold risk-based capital
against any securitization exposures of the
[bank] to the ABCP program.
(m) N th-to-default credit derivatives—(1)
First-to-default credit derivatives—(i)
Protection purchaser. A [bank] that obtains
credit protection on a group of underlying
exposures through a first-to-default credit
derivative must determine its risk-based
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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-todefault credit derivative must determine its
risk-weighted asset amount for the derivative
by applying the RBA in section 43 of this
appendix (if the derivative qualifies for the
RBA) or, if the derivative does not qualify for
the RBA, by setting its risk-weighted asset
amount for the derivative equal to the
product of:
(A) The protection amount of the
derivative;
(B) 12.5; and
(C) The sum of the risk-based capital
requirements of the individual underlying
exposures, up to a maximum of 100 percent.
(2) Second-or-subsequent-to-default credit
derivatives—(i) Protection purchaser. (A) A
[bank] that obtains credit protection on a
group of underlying exposures through a nthto-default credit derivative (other than a firstto-default credit derivative) may recognize
the credit risk mitigation benefits of the
derivative only if:
(1) The [bank] also has obtained credit
protection on the same underlying exposures
in the form of first-through-(n-1)-to-default
credit derivatives; or
(2) If n-1 of the underlying exposures have
already defaulted.
(B) If a [bank] satisfies the requirements of
paragraph (m)(2)(i)(A) of this section, the
[bank] must determine its risk-based capital
requirement for the underlying exposures as
if the [bank] had only synthetically
securitized the underlying exposure with the
nth lowest risk-based capital requirement and
had obtained no credit risk mitigant on the
other underlying exposures.
(ii) Protection provider. A [bank] that
provides credit protection on a group of
underlying exposures through a nth-to-default
credit derivative (other than a first-to-default
credit derivative) must determine its riskweighted asset amount for the derivative by
applying the RBA in section 43 of this
appendix (if the derivative qualifies for the
RBA) or, if the derivative does not qualify for
the RBA, by setting its risk-weighted asset
amount for the derivative equal to the
product of:
(A) The protection amount of the
derivative;
(B) 12.5; and
(C) The sum of the risk-based capital
requirements of the individual underlying
exposures (excluding the n-1 underlying
exposures with the lowest risk-based capital
requirements), up to a maximum of 100
percent.
Section 43. Ratings-Based Approach (RBA)
(a) Eligibility requirements for use of the
RBA—(1) Originating [bank]. An originating
[bank] must use the RBA to calculate its riskbased 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).
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(2) Investing [bank]. An investing [bank]
must use the RBA to calculate its risk-based
capital requirement for a securitization
exposure if the exposure has one or more
external or inferred ratings (and may not use
the RBA if the exposure has no external or
inferred rating).
(b) Ratings-based approach. (1) A [bank]
must determine the risk-weighted asset
amount for a securitization exposure by
multiplying the amount of the exposure (as
defined in paragraph (e) of section 42 of this
appendix) by the appropriate risk weight
provided in Table 6 and Table 7.
(2) A [bank] must apply the risk weights in
Table 6 when the securitization exposure’s
applicable external or applicable inferred
rating represents a long-term credit rating,
and must apply the risk weights in Table 7
when the securitization exposure’s
applicable external or applicable inferred
rating represents a short-term credit rating.
(i) A [bank] must apply the risk weights in
column 1 of Table 6 or Table 7 to the
securitization exposure if:
(A) N (as calculated under paragraph (e)(6)
of section 45 of this appendix) is six or more
(for purposes of this section only, if the
notional number of underlying exposures is
25 or more or if all of the underlying
exposures are retail exposures, a [bank] may
assume that N is six or more unless the
[bank] knows or has reason to know that N
is less than six); and
(B) The securitization exposure is a senior
securitization exposure.
(ii) A [bank] must apply the risk weights
in column 3 of Table 6 or Table 7 to the
securitization exposure if N is less than six,
regardless of the seniority of the
securitization exposure.
(iii) Otherwise, a [bank] must apply the
risk weights in column 2 of Table 6 or Table
7.
TABLE 6.—LONG-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA
Column 1
Column 2
Column 3
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
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¥) ...............................
7%
8%
10%
12%
20%
12%
15%
18%
20%
35%
Lowest investment grade—positive designation (for example, BBB+) .......................................
Lowest investment grade (for example, BBB) .............................................................................
35%
60%
Applicable external or inferred rating
(Illustrative rating example)
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 .......................................................................
20%
25%
35%
50%
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)
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Highest investment grade (for example, A1) ...............................................................................
Second highest investment grade (for example, A2) ..................................................................
Third highest investment grade (for example, A3) ......................................................................
All other ratings ............................................................................................................................
Section 44. Internal Assessment Approach
(IAA)
(a) Eligibility requirements. A [bank] may
apply the IAA to calculate the risk-weighted
asset amount for a securitization exposure
that the [bank] has to an ABCP program (such
as a liquidity facility or credit enhancement)
if the [bank], the ABCP program, and the
exposure qualify for use of the IAA.
(1) [Bank] qualification criteria. A [bank]
qualifies for use of the IAA if the [bank] has
received the prior written approval of the
[AGENCY]. To receive such approval, the
[bank] must demonstrate to the [AGENCY]’s
satisfaction that the [bank]’s internal
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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 riskbased capital purposes must be consistent
with those used in the [bank]’s internal risk
management process, management
information reporting systems, and capital
adequacy assessment process.
(iii) The [bank]’s internal credit assessment
process must have sufficient granularity to
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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%
60%
Deduction from tier 1
12%
20%
20%
35%
75%
75%
and tier 2 capital.
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
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two or more NRSROs and the different
NRSROs’’ benchmark stress factors require
different levels of credit enhancement to
achieve the same external rating equivalent,
the [bank] must apply the NRSRO stress
factor that requires the highest level of credit
enhancement.
(B) If any NRSRO that provides an external
rating to the ABCP program’s commercial
paper changes its methodology (including
stress factors), the [bank] must evaluate
whether to revise its internal assessment
process.
(v) The [bank] must have an effective
system of controls and oversight that ensures
compliance with these operational
requirements and maintains the integrity and
accuracy of the internal credit assessments.
The [bank] must have an internal audit
function independent from the ABCP
program business line and internal credit
assessment process that assesses at least
annually whether the controls over the
internal credit assessment process function
as intended.
(vi) The [bank] must review and update
each internal credit assessment whenever
new material information is available, but no
less frequently than annually.
(vii) The [bank] must validate its internal
credit assessment process on an ongoing
basis and at least annually.
(2) ABCP-program qualification criteria.
An ABCP program qualifies for use of the
IAA if all commercial paper issued by the
ABCP program has an external rating.
(3) Exposure qualification criteria. A
securitization exposure qualifies for use of
the IAA if the exposure meets the following
criteria:
(i) The [bank] initially rated the exposure
at least the equivalent of investment grade.
(ii) The ABCP program has robust credit
and investment guidelines (that is,
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underwriting standards) for the exposures
underlying the securitization exposure.
(iii) The ABCP program performs a detailed
credit analysis of the sellers of the exposures
underlying the securitization exposure.
(iv) The ABCP program’s underwriting
policy for the exposures underlying the
securitization exposure establishes minimum
asset eligibility criteria that include the
prohibition of the purchase of assets that are
significantly past due or of assets that are
defaulted (that is, assets that have been
charged off or written down by the seller
prior to being placed into the ABCP program
or assets that would be charged off or written
down under the program’s governing
contracts), as well as limitations on
concentration to individual obligors or
geographic areas and the tenor of the assets
to be purchased.
(v) The aggregate estimate of loss on the
exposures underlying the securitization
exposure considers all sources of potential
risk, such as credit and dilution risk.
(vi) Where relevant, the ABCP program
incorporates structural features into each
purchase of exposures underlying the
securitization exposure to mitigate potential
credit deterioration of the underlying
exposures. Such features may include winddown 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
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multiplying the amount of the exposure (as
defined in paragraph (e) of section 42 of this
appendix) by the appropriate risk weight in
Table 6 and Table 7 in paragraph (b) of
section 43 of this appendix.
Section 45. Supervisory Formula Approach
(SFA)
(a) Eligibility requirements. A [bank] may
use the SFA to determine its risk-based
capital requirement for a securitization
exposure only if the [bank] can calculate on
an ongoing basis each of the SFA parameters
in paragraph (e) of this section.
(b) Mechanics. Under the SFA, a
securitization exposure incurs a deduction
from total capital (as described in paragraph
(c) of section 42 of this appendix) and/or an
SFA risk-based capital requirement, as
determined in paragraph (c) of this section.
The risk-weighted asset amount for the
securitization exposure equals the SFA riskbased capital requirement for the exposure
multiplied by 12.5.
(c) The SFA risk-based capital
requirement. (1) If KIRB is greater than or
equal to L + T, the entire exposure must be
deducted from total capital.
(2) If KIRB is less than or equal to L, the
exposure’s SFA risk-based capital
requirement is UE multiplied by TP
multiplied by the greater of:
(i) 0.0056 * T; or
(ii) S[L + T] ¥ S[L].
(3) If KIRB is greater than L and less than
L + T, the [bank] must deduct from total
capital an amount equal to UE*TP*(KIRB ¥
L), and the exposure’s SFA risk-based capital
requirement is UE multiplied by TP
multiplied by the greater of:
(i) 0.0056 * (T ¥ (KIRB ¥ L)); or
(ii) S[L + T] ¥ S[KIRB].
(d) The supervisory formula:
E:\FR\FM\07DER2.SGM
07DER2
(11) In these expressions, b[Y; a, b] refers
to the cumulative beta distribution with
parameters a and b evaluated at Y. In the case
where N = 1 and EWALGD = 100 percent,
S[Y] in formula (1) must be calculated with
K[Y] set equal to the product of KIRB and Y,
and d set equal to 1 ¥ KIRB.
(e) SFA parameters—(1) Amount of the
underlying exposures (UE). UE is the EAD of
any underlying exposures that are wholesale
and retail exposures (including the amount of
any funded spread accounts, cash collateral
accounts, and other similar funded credit
enhancements) plus the amount of any
underlying exposures that are securitization
exposures (as defined in paragraph (e) of
section 42 of this appendix) plus the adjusted
carrying value of any underlying exposures
that are equity exposures (as defined in
paragraph (b) of section 51 of this appendix).
(2) Tranche percentage (TP). TP is the ratio
of the amount of the [bank]’s securitization
exposure to the amount of the tranche that
contains the securitization exposure.
(3) Capital requirement on underlying
exposures (KIRB). (i) KIRB is the ratio of:
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(A) The sum of the risk-based capital
requirements for the underlying exposures
plus the expected credit losses of the
underlying exposures (as determined under
this appendix as if the underlying exposures
were directly held by the [bank]); to
(B) UE.
(ii) The calculation of KIRB must reflect the
effects of any credit risk mitigant applied to
the underlying exposures (either to an
individual underlying exposure, to a group of
underlying exposures, or to the entire pool of
underlying exposures).
(iii) All assets related to the securitization
are treated as underlying exposures,
including assets in a reserve account (such as
a cash collateral account).
(4) Credit enhancement level (L). (i) L is the
ratio of:
(A) The amount of all securitization
exposures subordinated to the tranche that
contains the [bank]’s securitization exposure;
to
(B) UE.
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69423
(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.
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(4) Alternatively, if only C1 is available and
C1 is no more than 0.03, the [bank] may set
EWALGD = 0.50 if none of the underlying
exposures is a securitization exposure or
EWALGD = 1 if one or more of the
underlying exposures is a securitization
exposure and may set N = 1/C1.
Section 46. Recognition of Credit Risk
Mitigants for Securitization Exposures
(a) General. An originating [bank] that has
obtained a credit risk mitigant to hedge its
securitization exposure to a synthetic or
traditional securitization that satisfies the
operational criteria in section 41 of this
appendix may recognize the credit risk
mitigant, but only as provided in this section.
An investing [bank] that has obtained a credit
risk mitigant to hedge a securitization
exposure may recognize the credit risk
mitigant, but only as provided in this section.
A [bank] that has used the RBA in section 43
of this appendix or the IAA in section 44 of
this appendix to calculate its risk-based
capital requirement for a securitization
exposure whose external or inferred rating
(or equivalent internal rating under the IAA)
reflects the benefits of a credit risk mitigant
provided to the associated securitization or
that supports some or all of the underlying
exposures may not use the credit risk
mitigation rules in this section to further
reduce its risk-based capital requirement for
the exposure to reflect that credit risk
mitigant.
(b) Collateral—(1) Rules of recognition. A
[bank] may recognize financial collateral in
determining the [bank]’s risk-based capital
requirement for a securitization exposure
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Jkt 214001
(other than a repo-style transaction, an
eligible margin loan, or an OTC derivative
contract for which the [bank] has reflected
collateral in its determination of exposure
amount under section 32 of this appendix) as
follows. The [bank]’s risk-based capital
requirement for the collateralized
securitization exposure is equal to the riskbased capital requirement for the
securitization exposure as calculated under
the RBA in section 43 of this appendix or
under the SFA in section 45 of this appendix
multiplied by the ratio of adjusted exposure
amount (SE*) to original exposure amount
(SE), where:
(i) SE* = max {0, [SE—C x (1¥Hs¥Hfx)]};
(ii) SE = the amount of the securitization
exposure calculated under paragraph (e) of
section 42 of this appendix;
(iii) C = the current market value of the
collateral;
(iv) Hs = the haircut appropriate to the
collateral type; and
(v) Hfx = the haircut appropriate for any
currency mismatch between the collateral
and the exposure.
(2) Mixed collateral. Where the collateral is
a basket of different asset types or a basket
of assets denominated in different currencies,
the haircut on the basket will be
H = ∑ a i Hi ,
i
where ai is the current market value of the
asset in the basket divided by the current
market value of all assets in the basket and
Hi is the haircut applicable to that asset.
(3) Standard supervisory haircuts. Unless a
[bank] qualifies for use of and uses ownestimates 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
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Sfmt 4700
the collateral are denominated in different
currencies;
(iii) A [bank] must multiply the
supervisory haircuts obtained in paragraphs
(b)(3)(i) and (ii) by the square root of 6.5
(which equals 2.549510); and
(iv) A [bank] must adjust the supervisory
haircuts upward on the basis of a holding
period longer than 65 business days where
and as appropriate to take into account the
illiquidity of the collateral.
(4) Own estimates for haircuts. With the
prior written approval of the [AGENCY], a
[bank] may calculate haircuts using its own
internal estimates of market price volatility
and foreign exchange volatility, subject to
paragraph (b)(2)(iii) of section 32 of this
appendix. The minimum holding period
(TM) for securitization exposures is 65
business days.
(c) Guarantees and credit derivatives—(1)
Limitations on recognition. A [bank] may
only recognize an eligible guarantee or
eligible credit derivative provided by an
eligible securitization guarantor in
determining the [bank]’s risk-based capital
requirement for a securitization exposure.
(2) ECL for securitization exposures. When
a [bank] recognizes an eligible guarantee or
eligible credit derivative provided by an
eligible securitization guarantor in
determining the [bank]’s risk-based capital
requirement for a securitization exposure, the
[bank] must also:
(i) Calculate ECL for the protected portion
of the exposure using the same risk
parameters that it uses for calculating the
risk-weighted asset amount of the exposure
as described in paragraph (c)(3) of this
section; and
(ii) Add the exposure’s ECL to the [bank]’s
total ECL.
(3) Rules of recognition. A [bank] may
recognize an eligible guarantee or eligible
credit derivative provided by an eligible
securitization guarantor in determining the
E:\FR\FM\07DER2.SGM
07DER2
ER07DE07.023</GPH>
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].
where LGDi represents the average LGD
associated with all exposures to the ith
obligor. In the case of a re-securitization, an
LGD of 100 percent must be assumed for the
underlying exposures that are themselves
securitization exposures.
(f) Simplified method for computing N and
EWALGD. (1) If all underlying exposures of
a securitization are retail exposures, a [bank]
may apply the SFA using the following
simplifications:
(i) h = 0; and
(ii) v = 0.
(2) Under the conditions in paragraphs
(f)(3) and (f)(4) of this section, a [bank] may
employ a simplified method for calculating N
and EWALGD.
(3) If C1 is no more than 0.03, a [bank] may
set EWALGD = 0.50 if none of the underlying
exposures is a securitization exposure or
EWALGD = 1 if one or more of the
underlying exposures is a securitization
exposure, and may set N equal to the
following amount:
ER07DE07.020</GPH>
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:
ER07DE07.019</GPH>
(5) Thickness of tranche (T). T is the ratio
of:
(i) The amount of the tranche that contains
the [bank]’s securitization exposure; to
(ii) UE.
(6) Effective number of exposures (N). (i)
Unless the [bank] elects to use the formula
provided in paragraph (f) of this section,
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[bank]’s risk-based capital requirement for
the securitization exposure as follows:
(i) Full coverage. If the protection amount
of the eligible guarantee or eligible credit
derivative equals or exceeds the amount of
the securitization exposure, the [bank] may
set the risk-weighted asset amount for the
securitization exposure equal to the riskweighted asset amount for a direct exposure
to the eligible securitization guarantor (as
determined in the wholesale risk weight
function described in section 31 of this
appendix), using the [bank]’s PD for the
guarantor, the [bank]’s LGD for the guarantee
or credit derivative, and an EAD equal to the
amount of the securitization exposure (as
determined in paragraph (e) of section 42 of
this appendix).
(ii) Partial coverage. If the protection
amount of the eligible guarantee or eligible
credit derivative is less than the amount of
the securitization exposure, the [bank] may
set the risk-weighted asset amount for the
securitization exposure equal to the sum of:
(A) Covered portion. The risk-weighted
asset amount for a direct exposure to the
eligible securitization guarantor (as
determined in the wholesale risk weight
function described in section 31 of this
appendix), using the [bank]’s PD for the
guarantor, the [bank]’s LGD for the guarantee
or credit derivative, and an EAD equal to the
protection amount of the credit risk mitigant;
and
(B) Uncovered portion. (1) 1.0 minus the
ratio of the protection amount of the eligible
guarantee or eligible credit derivative to the
amount of the securitization exposure);
multiplied by
(2) The risk-weighted asset amount for the
securitization exposure without the credit
risk mitigant (as determined in sections 42–
45 of this appendix).
(4) Mismatches. The [bank] must make
applicable adjustments to the protection
amount as required in paragraphs (d), (e), and
(f) of section 33 of this appendix for any
hedged securitization exposure and any more
senior securitization exposure that benefits
from the hedge. In the context of a synthetic
securitization, when an eligible guarantee or
eligible credit derivative covers multiple
hedged exposures that have different residual
maturities, the [bank] must use the longest
residual maturity of any of the hedged
exposures as the residual maturity of all the
hedged exposures.
Section 47. Risk-Based Capital Requirement
for Early Amortization Provisions
(a) General. (1) An originating [bank] must
hold risk-based capital against the sum of the
originating [bank]’s interest and the
investors’ interest in a securitization that:
(i) Includes one or more underlying
exposures in which the borrower is permitted
to vary the drawn amount within an agreed
limit under a line of credit; and
(ii) Contains an early amortization
provision.
(2) For securitizations described in
paragraph (a)(1) of this section, an originating
[bank] must calculate the risk-based capital
requirement for the originating [bank]’s
interest under sections 42–45 of this
appendix, and the risk-based capital
requirement for the investors’ interest under
paragraph (b) of this section.
(b) Risk-weighted asset amount for
investors’ interest. The originating [bank]’s
risk-weighted asset amount for the investors’
interest in the securitization is equal to the
product of the following 5 quantities:
(1) The investors’ interest EAD;
(2) The appropriate conversion factor in
paragraph (c) of this section;
69425
(3) KIRB (as defined in paragraph (e)(3) of
section 45 of this appendix);
(4) 12.5; and
(5) The proportion of the underlying
exposures in which the borrower is permitted
to vary the drawn amount within an agreed
limit under a line of credit.
(c) Conversion factor. (1) (i) Except as
provided in paragraph (c)(2) of this section,
to calculate the appropriate conversion
factor, a [bank] must use Table 8 for a
securitization that contains a controlled early
amortization provision and must use Table 9
for a securitization that contains a noncontrolled early amortization provision. In
circumstances where a securitization
contains a mix of retail and nonretail
exposures or a mix of committed and
uncommitted exposures, a [bank] may take a
pro rata approach to determining the
conversion factor for the securitization’s
early amortization provision. If a pro rata
approach is not feasible, a [bank] must treat
the mixed securitization as a securitization of
nonretail exposures if a single underlying
exposure is a nonretail exposure and must
treat the mixed securitization as a
securitization of committed exposures if a
single underlying exposure is a committed
exposure.
(ii) To find the appropriate conversion
factor in the tables, a [bank] must divide the
three-month average annualized excess
spread of the securitization by the excess
spread trapping point in the securitization
structure. In securitizations that do not
require excess spread to be trapped, or that
specify trapping points based primarily on
performance measures other than the threemonth average annualized excess spread, the
excess spread trapping point is 4.5 percent.
TABLE 8.—CONTROLLED EARLY AMORTIZATION PROVISIONS
Uncommitted
Retail Credit Lines .......................................
Non-retail Credit Lines ................................
Committed
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.
90% CF ............................................................................................................................
90% CF
90% CF
TABLE 9.—NON-CONTROLLED EARLY AMORTIZATION PROVISIONS
Uncommitted
Retail Credit Lines .......................................
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Non-retail Credit Lines ................................
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, 50% CF.
less than 50% of trapping point, 100% CF.
100% CF ..........................................................................................................................
(2) For a securitization for which all or
substantially all of the underlying exposures
are residential mortgage exposures, a [bank]
may calculate the appropriate conversion
factor using paragraph (c)(1) of this section or
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Committed
may use a conversion factor of 10 percent. If
the [bank] chooses to use a conversion factor
of 10 percent, it must use that conversion
factor for all securitizations for which all or
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100% CF
100% CF
substantially all of the underlying exposures
are residential mortgage exposures.
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Part VI. Risk-Weighted Assets for Equity
Exposures
Section 51. Introduction and Exposure
Measurement
(a) General. To calculate its risk-weighted
asset amounts for equity exposures that are
not equity exposures to investment funds, a
[bank] may apply either the Simple Risk
Weight Approach (SRWA) in section 52 of
this appendix or, if it qualifies to do so, the
Internal Models Approach (IMA) in section
53 of this appendix. A [bank] must use the
look-through approaches in section 54 of this
appendix to calculate its risk-weighted asset
amounts for equity exposures to investment
funds.
(b) Adjusted carrying value. For purposes
of this part, the adjusted carrying value of an
equity exposure is:
(1) For the on-balance sheet component of
an equity exposure, the [bank]’s carrying
value of the exposure reduced by any
unrealized gains on the exposure that are
reflected in such carrying value but excluded
from the [bank]’s tier 1 and tier 2 capital; and
(2) For the off-balance sheet component of
an equity exposure, the effective notional
principal amount of the exposure, the size of
which is equivalent to a hypothetical onbalance sheet position in the underlying
equity instrument that would evidence the
same change in fair value (measured in
dollars) for a given small change in the price
of the underlying equity instrument, minus
the adjusted carrying value of the on-balance
sheet component of the exposure as
calculated in paragraph (b)(1) of this section.
For unfunded equity commitments that are
unconditional, the effective notional
principal amount is the notional amount of
the commitment. For unfunded equity
commitments that are conditional, the
effective notional principal amount is the
[bank]’s best estimate of the amount that
would be funded under economic downturn
conditions.
mstockstill on PROD1PC66 with RULES2
Section 52. Simple Risk Weight Approach
(SRWA)
(a) General. Under the SRWA, a [bank]’s
aggregate risk-weighted asset amount for its
equity exposures is equal to the sum of the
risk-weighted asset amounts for each of the
[bank]’s individual equity exposures (other
than equity exposures to an investment fund)
as determined in this section and the riskweighted asset amounts for each of the
[bank]’s individual equity exposures to an
investment fund as determined in section 54
of this appendix.
(b) SRWA computation for individual
equity exposures. A [bank] must determine
the risk-weighted asset amount for an
individual equity exposure (other than an
equity exposure to an investment fund) by
multiplying the adjusted carrying value of
the equity exposure or the effective portion
and ineffective portion of a hedge pair (as
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defined in paragraph (c) of this section) by
the lowest applicable risk weight in this
paragraph (b).
(1) 0 percent risk weight equity exposures.
An equity exposure to an entity whose credit
exposures are exempt from the 0.03 percent
PD floor in paragraph (d)(2) of section 31 of
this appendix is assigned a 0 percent risk
weight.
(2) 20 percent risk weight equity exposures.
An equity exposure to a Federal Home Loan
Bank or Farmer Mac is assigned a 20 percent
risk weight.
(3) 100 percent risk weight equity
exposures. The following equity exposures
are assigned a 100 percent risk weight:
(i) Community development equity
exposures. An equity exposure that qualifies
as a community development investment
under 12 U.S.C. 24 (Eleventh), excluding
equity exposures to an unconsolidated small
business investment company and equity
exposures held through a consolidated small
business investment company described in
section 302 of the Small Business Investment
Act of 1958 (15 U.S.C. 682).
(ii) Effective portion of hedge pairs. The
effective portion of a hedge pair.
(iii) Non-significant equity exposures.
Equity exposures, excluding exposures to an
investment firm that would meet the
definition of a traditional securitization were
it not for the [AGENCY]’s application of
paragraph (8) of that definition and has
greater than immaterial leverage, to the
extent that the aggregate adjusted carrying
value of the exposures does not exceed 10
percent of the [bank]’s tier 1 capital plus tier
2 capital.
(A) To compute the aggregate adjusted
carrying value of a [bank]’s equity exposures
for purposes of this paragraph (b)(3)(iii), the
[bank] may exclude equity exposures
described in paragraphs (b)(1), (b)(2), (b)(3)(i),
and (b)(3)(ii) of this section, the equity
exposure in a hedge pair with the smaller
adjusted carrying value, and a proportion of
each equity exposure to an investment fund
equal to the proportion of the assets of the
investment fund that are not equity
exposures or that meet the criterion of
paragraph (b)(3)(i) of this section. If a [bank]
does not know the actual holdings of the
investment fund, the [bank] may calculate
the proportion of the assets of the fund that
are not equity exposures based on the terms
of the prospectus, partnership agreement, or
similar contract that defines the fund’s
permissible investments. If the sum of the
investment limits for all exposure classes
within the fund exceeds 100 percent, the
[bank] must assume for purposes of this
paragraph (b)(3)(iii) that the investment fund
invests to the maximum extent possible in
equity exposures.
(B) When determining which of a [bank]’s
equity exposures qualify for a 100 percent
risk weight under this paragraph, a [bank]
first must include equity exposures to
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unconsolidated small business investment
companies or held through consolidated
small business investment companies
described in section 302 of the Small
Business Investment Act of 1958 (15 U.S.C.
682), then must include publicly traded
equity exposures (including those held
indirectly through investment funds), and
then must include non-publicly traded equity
exposures (including those held indirectly
through investment funds).
(4) 300 percent risk weight equity
exposures. A publicly traded equity exposure
(other than an equity exposure described in
paragraph (b)(6) of this section and including
the ineffective portion of a hedge pair) is
assigned a 300 percent risk weight.
(5) 400 percent risk weight equity
exposures. An equity exposure (other than an
equity exposure described in paragraph (b)(6)
of this section) that is not publicly traded is
assigned a 400 percent risk weight.
(6) 600 percent risk weight equity
exposures. An equity exposure to an
investment firm that:
(i) Would meet the definition of a
traditional securitization were it not for the
[AGENCY]’s application of paragraph (8) of
that definition; and
(ii) Has greater than immaterial leverage is
assigned a 600 percent risk weight.
(c) Hedge transactions—(1) Hedge pair. A
hedge pair is two equity exposures that form
an effective hedge so long as each equity
exposure is publicly traded or has a return
that is primarily based on a publicly traded
equity exposure.
(2) Effective hedge. Two equity exposures
form an effective hedge if the exposures
either have the same remaining maturity or
each has a remaining maturity of at least
three months; the hedge relationship is
formally documented in a prospective
manner (that is, before the [bank] acquires at
least one of the equity exposures); the
documentation specifies the measure of
effectiveness (E) the [bank] will use for the
hedge relationship throughout the life of the
transaction; and the hedge relationship has
an E greater than or equal to 0.8. A [bank]
must measure E at least quarterly and must
use one of three alternative measures of E:
(i) Under the dollar-offset method of
measuring effectiveness, the [bank] must
determine the ratio of value change (RVC).
The RVC is the ratio of the cumulative sum
of the periodic changes in value of one equity
exposure to the cumulative sum of the
periodic changes in the value of the other
equity exposure. If RVC is positive, the hedge
is not effective and E equals 0. If RVC is
negative and greater than or equal to ¥1 (that
is, between zero and ¥1), then E equals the
absolute value of RVC. If RVC is negative and
less than ¥1, then E equals 2 plus RVC.
(ii) Under the variability-reduction method
of measuring effectiveness:
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Section 53. Internal Models Approach (IMA)
(a) General. A [bank] may calculate its riskweighted asset amount for equity exposures
using the IMA by modeling publicly traded
and non-publicly traded equity exposures (in
accordance with paragraph (c) of this section)
or by modeling only publicly traded equity
exposures (in accordance with paragraph (d)
of this section).
(b) Qualifying criteria. To qualify to use the
IMA to calculate risk-based capital
requirements for equity exposures, a [bank]
must receive prior written approval from the
[AGENCY]. To receive such approval, the
[bank] must demonstrate to the [AGENCY]’s
satisfaction that the [bank] meets the
following criteria:
(1) The [bank] must have one or more
models that:
(i) Assess the potential decline in value of
its modeled equity exposures;
(ii) Are commensurate with the size,
complexity, and composition of the [bank]’s
modeled equity exposures; and
(iii) Adequately capture both general
market risk and idiosyncratic risk.
(2) The [bank]’s model must produce an
estimate of potential losses for its modeled
equity exposures that is no less than the
estimate of potential losses produced by a
VaR methodology employing a 99.0 percent,
one-tailed confidence interval of the
distribution of quarterly returns for a
benchmark portfolio of equity exposures
comparable to the [bank]’s modeled equity
exposures using a long-term sample period.
(3) The number of risk factors and
exposures in the sample and the data period
used for quantification in the [bank]’s model
and benchmarking exercise must be
sufficient to provide confidence in the
accuracy and robustness of the [bank]’s
estimates.
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(4) The [bank]’s model and benchmarking
process must incorporate data that are
relevant in representing the risk profile of the
[bank]’s modeled equity exposures, and must
include data from at least one equity market
cycle containing adverse market movements
relevant to the risk profile of the [bank]’s
modeled equity exposures. In addition, the
[bank]’s benchmarking exercise must be
based on daily market prices for the
benchmark portfolio. If the [bank]’s model
uses a scenario methodology, the [bank] must
demonstrate that the model produces a
conservative estimate of potential losses on
the [bank]’s modeled equity exposures over
a relevant long-term market cycle. If the
[bank] employs risk factor models, the [bank]
must demonstrate through empirical analysis
the appropriateness of the risk factors used.
(5) The [bank] must be able to demonstrate,
using theoretical arguments and empirical
evidence, that any proxies used in the
modeling process are comparable to the
[bank]’s modeled equity exposures and that
the [bank] has made appropriate adjustments
for differences. The [bank] must derive any
proxies for its modeled equity exposures and
benchmark portfolio using historical market
data that are relevant to the [bank]’s modeled
equity exposures and benchmark portfolio
(or, where not, must use appropriately
adjusted data), and such proxies must be
robust estimates of the risk of the [bank]’s
modeled equity exposures.
(c) Risk-weighted assets calculation for a
[bank] modeling publicly traded and nonpublicly traded equity exposures. If a [bank]
models publicly traded and non-publicly
traded equity exposures, the [bank]’s
aggregate risk-weighted asset amount for its
equity exposures is equal to the sum of:
(1) The risk-weighted asset amount of each
equity exposure that qualifies for a 0 percent,
20 percent, or 100 percent risk weight under
paragraphs (b)(1) through (b)(3)(i) of section
52 (as determined under section 52 of this
appendix) and each equity exposure to an
investment fund (as determined under
section 54 of this appendix); and
(2) The greater of:
(i) The estimate of potential losses on the
[bank]’s equity exposures (other than equity
exposures referenced in paragraph (c)(1) of
this section) generated by the [bank]’s
internal equity exposure model multiplied by
12.5; or
(ii) The sum of:
(A) 200 percent multiplied by the aggregate
adjusted carrying value of the [bank]’s
publicly traded equity exposures that do not
belong to a hedge pair, do not qualify for a
0 percent, 20 percent, or 100 percent risk
weight under paragraphs (b)(1) through
(b)(3)(i) of section 52 of this appendix, and
are not equity exposures to an investment
fund;
(B) 200 percent multiplied by the aggregate
ineffective portion of all hedge pairs; and
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(C) 300 percent multiplied by the aggregate
adjusted carrying value of the [bank]’s equity
exposures that are not publicly traded, do not
qualify for a 0 percent, 20 percent, or 100
percent risk weight under paragraphs (b)(1)
through (b)(3)(i) of section 52 of this
appendix, and are not equity exposures to an
investment fund.
(d) Risk-weighted assets calculation for a
[bank] using the IMA only for publicly traded
equity exposures. If a [bank] models only
publicly traded equity exposures, the [bank]’s
aggregate risk-weighted asset amount for its
equity exposures is equal to the sum of:
(1) The risk-weighted asset amount of each
equity exposure that qualifies for a 0 percent,
20 percent, or 100 percent risk weight under
paragraphs (b)(1) through (b)(3)(i) of section
52 (as determined under section 52 of this
appendix), each equity exposure that
qualifies for a 400 percent risk weight under
paragraph (b)(5) of section 52 or a 600
percent risk weight under paragraph (b)(6) of
section 52 (as determined under section 52
of this appendix), and each equity exposure
to an investment fund (as determined under
section 54 of this appendix); and
(2) The greater of:
(i) The estimate of potential losses on the
[bank]’s equity exposures (other than equity
exposures referenced in paragraph (d)(1) of
this section) generated by the [bank]’s
internal equity exposure model multiplied by
12.5; or
(ii) The sum of:
(A) 200 percent multiplied by the aggregate
adjusted carrying value of the [bank]’s
publicly traded equity exposures that do not
belong to a hedge pair, do not qualify for a
0 percent, 20 percent, or 100 percent risk
weight under paragraphs (b)(1) through
(b)(3)(i) of section 52 of this appendix, and
are not equity exposures to an investment
fund; and
(B) 200 percent multiplied by the aggregate
ineffective portion of all hedge pairs.
Section 54. Equity Exposures to Investment
Funds
(a) Available approaches. (1) Unless the
exposure meets the requirements for a
community development equity exposure in
paragraph (b)(3)(i) of section 52 of this
appendix, a [bank] must determine the riskweighted asset amount of an equity exposure
to an investment fund under the Full LookThrough Approach in paragraph (b) of this
section, the Simple Modified Look-Through
Approach in paragraph (c) of this section, the
Alternative Modified Look-Through
Approach in paragraph (d) of this section, or,
if the investment fund qualifies for the
Money Market Fund Approach, the Money
Market Fund Approach in paragraph (e) of
this section.
(2) The risk-weighted asset amount of an
equity exposure to an investment fund that
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(A) Xt = At ¥ Bt;
(B) At = the value at time t of one exposure
in a hedge pair; and
(C) Bt = the value at time t of the other
exposure in a hedge pair.
(iii) Under the regression method of
measuring effectiveness, E equals the
coefficient of determination of a regression in
which the change in value of one exposure
in a hedge pair is the dependent variable and
the change in value of the other exposure in
a hedge pair is the independent variable.
However, if the estimated regression
coefficient is positive, then the value of E is
zero.
(3) The effective portion of a hedge pair is
E multiplied by the greater of the adjusted
carrying values of the equity exposures
forming a hedge pair.
(4) The ineffective portion of a hedge pair
is (1–E) multiplied by the greater of the
adjusted carrying values of the equity
exposures forming a hedge pair.
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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations
meets the requirements for a community
development equity exposure in paragraph
(b)(3)(i) of section 52 of this appendix is its
adjusted carrying value.
(3) If an equity exposure to an investment
fund is part of a hedge pair and the [bank]
does not use the Full Look-Through
Approach, the [bank] may use the ineffective
portion of the hedge pair as determined
under paragraph (c) of section 52 of this
appendix as the adjusted carrying value for
the equity exposure to the investment fund.
The risk-weighted asset amount of the
effective portion of the hedge pair is equal to
its adjusted carrying value.
(b) Full Look-Through Approach. A [bank]
that is able to calculate a risk-weighted asset
amount for its proportional ownership share
of each exposure held by the investment fund
(as calculated under this appendix as if the
proportional ownership share of each
exposure were held directly by the [bank])
may either:
(1) Set the risk-weighted asset amount of
the [bank]’s exposure to the fund equal to the
product of:
(i) The aggregate risk-weighted asset
amounts of the exposures held by the fund
as if they were held directly by the [bank];
and
(ii) The [bank]’s proportional ownership
share of the fund; or
(2) Include the [bank]’s proportional
ownership share of each exposure held by
the fund in the [bank]’s IMA.
(c) Simple Modified Look-Through
Approach. Under this approach, the riskweighted asset amount for a [bank]’s equity
exposure to an investment fund equals the
adjusted carrying value of the equity
exposure multiplied by the highest risk
weight in Table 10 that applies to any
exposure the fund is permitted to hold under
its prospectus, partnership agreement, or
similar contract that defines the fund’s
permissible investments (excluding
derivative contracts that are used for hedging
rather than speculative purposes and that do
not constitute a material portion of the fund’s
exposures).
TABLE 10.—MODIFIED LOOK-THROUGH APPROACHES FOR EQUITY EXPOSURES TO INVESTMENT FUNDS
Risk weight
Exposure class
0 percent ...........................
Sovereign exposures with a long-term applicable external rating in the highest investment-grade rating category and
sovereign exposures of the United States.
Non-sovereign exposures with a long-term applicable external rating in the highest or second-highest investmentgrade rating category; exposures with a short-term applicable external rating in the highest investment-grade rating category; and exposures to, or guaranteed by, depository institutions, foreign banks (as defined in 12 CFR
211.2), or securities firms subject to consolidated supervision and regulation comparable to that imposed on U.S.
securities broker-dealers that are repo-style transactions or bankers’ acceptances.
Exposures with a long-term applicable external rating in the third-highest investment-grade rating category or a
short-term applicable external rating in the second-highest investment-grade rating category.
Exposures with a long-term or short-term applicable external rating in the lowest investment-grade rating category.
Exposures with a long-term applicable external rating one rating category below investment grade.
Publicly traded equity exposures.
Non-publicly traded equity exposures; exposures with a long-term applicable external rating two rating categories or
more below investment grade; and exposures without an external rating (excluding publicly traded equity exposures).
OTC derivative contracts and exposures that must be deducted from regulatory capital or receive a risk weight
greater than 400 percent under this appendix.
20 percent .........................
50 percent .........................
100
200
300
400
percent
percent
percent
percent
.......................
.......................
.......................
.......................
mstockstill on PROD1PC66 with RULES2
1,250 percent ....................
(d) Alternative Modified Look-Through
Approach. Under this approach, a [bank]
may assign the adjusted carrying value of an
equity exposure to an investment fund on a
pro rata basis to different risk weight
categories in Table 10 based on the
investment limits in the fund’s prospectus,
partnership agreement, or similar contract
that defines the fund’s permissible
investments. The risk-weighted asset amount
for the [bank]’s equity exposure to the
investment fund equals the sum of each
portion of the adjusted carrying value
assigned to an exposure class multiplied by
the applicable risk weight. If the sum of the
investment limits for exposure classes within
the fund exceeds 100 percent, the [bank]
must assume that the fund invests to the
maximum extent permitted under its
investment limits in the exposure class with
the highest risk weight under Table 10, and
continues to make investments in order of
the exposure class with the next highest risk
weight under Table 10 until the maximum
total investment level is reached. If more
than one exposure class applies to an
exposure, the [bank] must use the highest
applicable risk weight. A [bank] may exclude
derivative contracts held by the fund that are
used for hedging rather than for speculative
purposes and do not constitute a material
portion of the fund’s exposures.
(e) Money Market Fund Approach. The
risk-weighted asset amount for a [bank]’s
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21:05 Dec 06, 2007
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equity exposure to an investment fund that
is a money market fund subject to 17 CFR
270.2a–7 and that has an applicable external
rating in the highest investment-grade rating
category equals the adjusted carrying value of
the equity exposure multiplied by 7 percent.
Section 55. Equity Derivative Contracts
Under the IMA, in addition to holding riskbased capital against an equity derivative
contract under this part, a [bank] must hold
risk-based capital against the counterparty
credit risk in the equity derivative contract
by also treating the equity derivative contract
as a wholesale exposure and computing a
supplemental risk-weighted asset amount for
the contract under part IV. Under the SRWA,
a [bank] may choose not to hold risk-based
capital against the counterparty credit risk of
equity derivative contracts, as long as it does
so for all such contracts. Where the equity
derivative contracts are subject to a qualified
master netting agreement, a [bank] using the
SRWA must either include all or exclude all
of the contracts from any measure used to
determine counterparty credit risk exposure.
Part VII. Risk-Weighted Assets for
Operational Risk
Section 61. Qualification Requirements for
Incorporation of Operational Risk Mitigants
(a) Qualification to use operational risk
mitigants. A [bank] may adjust its estimate of
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Fmt 4701
Sfmt 4700
operational risk exposure to reflect qualifying
operational risk mitigants if:
(1) The [bank]’s operational risk
quantification system is able to generate an
estimate of the [bank]’s operational risk
exposure (which does not incorporate
qualifying operational risk mitigants) and an
estimate of the [bank]’s operational risk
exposure adjusted to incorporate qualifying
operational risk mitigants; and
(2) The [bank]’s methodology for
incorporating the effects of insurance, if the
[bank] uses insurance as an operational risk
mitigant, captures through appropriate
discounts to the amount of risk mitigation:
(i) The residual term of the policy, where
less than one year;
(ii) The cancellation terms of the policy,
where less than one year;
(iii) The policy’s timeliness of payment;
(iv) The uncertainty of payment by the
provider of the policy; and
(v) Mismatches in coverage between the
policy and the hedged operational loss event.
(b) Qualifying operational risk mitigants.
Qualifying operational risk mitigants are:
(1) Insurance that:
(i) Is provided by an unaffiliated company
that has a claims payment ability that is rated
in one of the three highest rating categories
by a NRSRO;
(ii) Has an initial term of at least one year
and a residual term of more than 90 days;
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(iii) Has a minimum notice period for
cancellation by the provider of 90 days;
(iv) Has no exclusions or limitations based
upon regulatory action or for the receiver or
liquidator of a failed depository institution;
and
(v) Is explicitly mapped to a potential
operational loss event; and
(2) Operational risk mitigants other than
insurance for which the [AGENCY] has given
prior written approval. In evaluating an
operational risk mitigant other than
insurance, the [AGENCY] will consider
whether the operational risk mitigant covers
potential operational losses in a manner
equivalent to holding regulatory capital.
Section 62. Mechanics of Risk-Weighted
Asset Calculation
(a) If a [bank] does not qualify to use or
does not have qualifying operational risk
mitigants, the [bank]’s dollar risk-based
capital requirement for operational risk is its
operational risk exposure minus eligible
operational risk offsets (if any).
(b) If a [bank] qualifies to use operational
risk mitigants and has qualifying operational
risk mitigants, the [bank]’s dollar risk-based
capital requirement for operational risk is the
greater of:
(1) The [bank]’s operational risk exposure
adjusted for qualifying operational risk
mitigants minus eligible operational risk
offsets (if any); or
(2) 0.8 multiplied by the difference
between:
(i) The [bank]’s operational risk exposure;
and
(ii) Eligible operational risk offsets (if any).
(c) The [bank]’s risk-weighted asset amount
for operational risk equals the [bank]’s dollar
risk-based capital requirement for operational
risk determined under paragraph (a) or (b) of
this section multiplied by 12.5.
Administrative practice and
procedure, Banks, banking, Federal
Reserve System, Holding companies,
Reporting and recordkeeping
requirements, Securities.
12 CFR Part 325
Administrative practice and
procedure, Banks, banking, Capital
Adequacy, Reporting and recordkeeping
requirements, Savings associations,
State nonmember banks.
12 CFR Part 559
Reporting and recordkeeping
requirements, Savings associations,
Subsidiaries.
12 CFR Part 560
Consumer protection, Investments,
Manufactured homes, Mortgages,
Reporting and recordkeeping
requirements, Savings associations,
Securities.
12 CFR Part 563
Accounting, Administrative practice
and procedure, Advertising, Conflict of
interest, Crime, Currency, Holding
companies, Investments, Mortgages,
Reporting and recordkeeping
requirements, Savings associations,
Securities, Surety bond.
12 CFR Part 567
Capital, Reporting and recordkeeping
requirements, Savings associations.
Adoption of Common Appendix
Section 71. Disclosure Requirements
(a) Each [bank] must publicly disclose each
quarter its total and tier 1 risk-based capital
ratios and their components (that is, tier 1
capital, tier 2 capital, total qualifying capital,
and total risk-weighted assets).4
[Disclosure paragraph (b)]
[Disclosure paragraph
(c)]
■
END OF COMMON RULE
Authority and Issuance
[END OF COMMON TEXT]
For the reasons stated in the common
preamble, the Office of the Comptroller
of the Currency amends part 3 of
chapter I of Title 12, Code of Federal
Regulations as follows:
12 CFR Part 3
Administrative practices and
procedure, Capital, National banks,
Reporting and recordkeeping
requirements, Risk.
4 Other public disclosure requirements continue
to apply—for example, Federal securities law and
regulatory reporting requirements.
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21:05 Dec 06, 2007
Jkt 214001
The adoption of the final common
rules by the agencies, as modified by
agency-specific text, is set forth below:
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the
Currency
12 CFR Chapter I
PART 3—MINIMUM CAPITAL RATIOS;
ISSUANCE OF DIRECTIVES
12 CFR Part 208
Confidential business information,
Crime, Currency, Federal Reserve
System, Mortgages, reporting and
recordkeeping requirements, Securities.
1. The authority citation for part 3
continues to read as follows:
■
Authority: 12 U.S.C. 93a, 161, 1818,
1828(n), 1828 note, 1831n note, 1835, 3907,
and 3909.
2. New Appendix C to part 3 is added
as set forth at the end of the common
preamble.
■
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3. Appendix C to part 3 is amended
as set forth below:
■ a. Remove ‘‘[AGENCY]’’ and add
‘‘OCC’’ in its place wherever it appears.
■ b. Remove ‘‘[bank]’’ and add ‘‘bank’
@FedFRASER