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Federal R eserve Bank OF DALLAS R O B E R T D. M c T E E R , J R . p re s id e n t AND C H IE F E X E C U T I V E O F F I C E R DALLAS, TE XAS 7 5 2 6 5 -5 9 0 6 October 4, 1996 Notice 96-95 TO: The Chief Executive Officer of each member bank and bank holding company in the Eleventh Federal Reserve District SUBJECT Final Amendment to the Risk-based Capital Standards DETAILS The Board of Governors of the Federal Reserve System, along with the Comptroller of the Currency and the Federal Deposit Insurance Corporation, has issued a final rule amending risk-based capital standards to incorporate a measure for market risk. The final rule implements an amendment to the Basle Capital Accord that sets forth a supervisory framework for measuring market risk to cover debt and equity positions located in an institution’s trading account and foreign exchange and commodity positions wherever located. The final rule is effective January 1, 1997; however, compli ance is not mandatory until January 1, 1998. ATTACHMENT A copy of the Board’s notice as it appears on pages 47358-78, Vol. 61, No. 174, of the Federal Register dated September 6, 1996, is attached. MORE INFORMATION For more information, please contact Dorsey Davis at (214) 922-6051. For additional copies of this Bank’s notice, please contact the Public Affairs Department at (214) 922-5254. Sincerely yours, For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal Reserve Bank of Dallas: Dallas Office (800) 333 -4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012; Houston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810. This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org) 47358 Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations DEPARTMENT OF THE TREASURY Office of the Comptroller of the Currency 12CFR Part 3 [Docket No. 96-18] RIN 1557-AB14 FEDERAL RESERVE SYSTEM 12CFR Parts 208 and 225 [Regulations H and Y; Docket No. R-0884] FEDERAL DEPOSIT INSURANCE CORPORATION 12CFR Part 325 RIN 3064-AB64 Risk-Based Capital Standards: Market Risk AGENCIES: Office of the C om ptroller of the C urrency, Treasury; B oard of G overnors of th e Federal Reserve System; an d F ederal D eposit Insurance Corporation. ACTION: Joint final rule. SUMMARY: The Office of the Com ptroller of the C urrency (OCC), th e Board of G overnors of the F ederal Reserve System (Board), an d the Federal Deposit Insurance C orporation (FDIC) (collectively, the Agencies) are am ending th eir respective risk-based capital standards to incorporate a m easure for m arket risk to cover all positions located in an in stitu tio n ’s trading account and foreign exchange and com m odity positions w herever located. The final ru le im p lem en ts an am endm ent to th e Basle C apital A ccord th at sets forth a supervisory fram ew ork for m easuring m arket risk. T he effect of the final rule is th a t any ban k or bank holding com pany (institution) regulated by th e OCC, the Board, or th e FDIC, w ith significant exposure to m arket risk m u st m easure th a t risk using its ow n in ternal value-at-risk m odel, subject to the param eters co ntained in th is final rule, an d m ust h o ld a com m ensurate am oun t of capital. DATES: E ffective date: January 1,1997. C om pliance date: M andatory com pliance January 1,1998. FOR FURTHER INFORMATION CONTACT: OCC: Margot S chw adron, Financial A nalyst, Roger Tufts, S enior Econom ic A dvisor, or C hristina Benson, Capital M arkets Specialist, Office of the Chief N ational Bank Exam iner (202/8745070). For legal issues, A ndrew G utierrez, A ttorney, or Ron Shim abukuro, S enior A ttorney, Legislative an d Regulatory A ctivities D ivision (202/874—5090), Office of the C om ptroller of the C urrency, 250 E Street, SW, W ashington, D.C. 20219. Board: Roger Cole, D eputy A ssociate D irector (202/452-2618), Jam es H oupt, A ssistant D irector (202/452-3358), Barbara B ouchard, S upervisory F inancial A nalyst (202/452-3072), D ivision of Banking S upervision and Regulation; or S tephanie M artin, Senior A ttorney (202/452-3198), Legal D ivision. For th e H earing im p aired only, T elecom m unication D evice for the Deaf (TDD), D orothea T hom pson (202/452— 3544), F ederal Reserve Board, 20th and C Streets, NW, W ashington, D.C. 20551. FDIC: W illiam A. Stark, A ssistant Director (202/898-6972), M iguel Brow ne, D eputy A ssistant D irector (202/ 898—6789), K enton Fox, S enior Capital M arkets Specialist (202/898-7119), D ivision of Supervision; Jam ey Basham, Counsel (202/898-7265), Legal Division, Federal D eposit Insurance Corporation, 550 17th Street, NW, W ashington, D.C. 20429. SUPPLEMENTARY INFORMATION: I. Background T he A gencies’ risk-based capital standards are based u p o n p rinciples contained in th e July 1988 agreem ent en titled “International Convergence of C apital M easurem ent an d Capital S tan d a rd s” (Accord). T he A ccord, developed by the Basle C om m ittee on Banking S upervision (Committee) and en dorsed by the central ban k governors of th e G roup of T en (G-10) co u n tries,1 provides a fram ew ork for assessing an in stitu tio n ’s capital adequacy by w eighting its assets an d off-balancesheet exposures on the basis of counterparty credit risk. In A pril 1995, th e Com m ittee issued a consultative proposal to am end the A ccord and require in stitu tio n s to m easure an d hold capital to cover th eir exposure to m arket risk, specifically, m arket risk associated w ith foreign exchange an d com m odity positions, and w ith debt a n d equity positions located in th e trading account.2 1The G-10 countries are Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, the United Kingdom, and the United States. The Committee is comprised of representatives of the central banks and supervisory authorities from the G-10 countries and Luxembourg. The Agencies each adopted risk-based capital standards implementing the Accord in 1989. 2 Market risk consists of general market risk and specific risk. General market risk refers to changes in the market value of on-balance-sheet assets and liabilities and off-balance-sheet items resulting from broad market movements, such as changes in the general level of interest rates, equity prices, foreign exchange rates, and commodity prices. Specific risk refers to changes in the market value of individual M arket R isk Proposal O n July 25,19 95, th e A gencies p u b lish ed a join t proposal to am end th eir respective risk-based capital stan dards in accordance w ith the C om m ittee’s consu ltative propo sal (60 FR 38082) (market risk proposal). U nder th e m arket risk proposal, an institu tion w ith significant trading activity m ust calculate a capital charge for m arket risk usin g eith er its ow n in tern al risk m easurem ent m odel (internal m odels approach) or a risk-w eighting process developed by th e Com m ittee (standardized approach). T he m arket risk proposal requires an institu tio n to integrate the m arket risk capital charge in to its risk-based capital ratios used for supervisory purp o ses no later th an yearen d 1997. T he proposed in tern al m odels approach requires an in stitu tio n to em ploy an internal m od el to calculate daily value-at-risk (VAR) m easures 3 for each of four risk categories: interest rates, equity prices, foreign exchange rates, an d com m odity prices, including related options in each category. For regulatory capital purposes, th e m arket risk proposal requires an institu tio n to calibrate VAR m easures to a ten-day m ovem ent in rates an d prices and a 99 percent confidence level. A n in stitu tio n m u st base its VAR m easures u p o n rates an d prices observed over a p eriod of at least one year. In deriving th e overall VAR m easure, an in stitu tio n could take in to account historical correlations w ith in a risk category (e.g., betw een interest rates), b u t n o t across risk categories (e.g., n o t b etw een interest rates and equity prices); in other w ords, the overall VAR m easure equals the sum of the VAR m easures for each risk category. An in stitu tio n ’s capital charge for general m arket risk equals the greater of (1) the previous d a y ’s overall VAR m easure, or (2) the average of the preceding 60 d ay s’ overall VAR m easures m u ltip lied by a factor of three (the m u ltiplicatio n factor). Moreover, th e m arket risk proposal requires an in stitu tio n to h o ld ad d itio n a l capital for specific risk associated w ith debt and equity positions in th e trading account to th e extent th a t its in tern al m odel does no t incorporate that risk. U nder the m arket risk proposal, an in stitu tio n ’s supervisor evaluates its in tern al m odeling an d risk m anagem ent process to ensure th a t th e institu tio n is, positions due to factors other than broad market movements and includes such risks as the credit risk of an instrum ent’s issuer. 3 The VAR measure represents an estimate of the am ount by w hich an institution’s positions in a risk category could decline due to general market movements during a given holding period, measured with a specified confidence level. Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations in fact, using its internal m odel for risk m anagem ent purposes, th a t the calculation of VAR for capital p urposes conform s w ith the specified quantitative criteria, an d th at th e risk m anagem ent process m eets certain qualitative criteria, such as requiring in d e p en d e n t m o d el validations 4 an d having an in d e p en d e n t risk m anagem ent unit. The m arket risk proposal allow s an in stitu tio n ’s supervisor to increase its m u ltip licatio n factor (w hich applies to the 60-day VAR average) if backtesting results suggest problem s w ith the in stitu tio n ’s internal m odel or risk m anagem ent process. T he standardized approach, the m arket risk proposal’s alternative to the internal m odels approach, requires an in stitu tio n to apply certain uniform techn iques to calculate a capital charge for th e general m arket risk of positions in th e four risk categories, as w ell as for th e specific risk of debt an d equity positions located in the trading account. T he total capital charge is the sum of the capital charges for each risk category. A n in stitution supports its m arket risk capital charges using a com bination of T ier 1 an d T ier 2 capital instru m en ts (as defined in th e credit risk-based capital standards), as w ell as a proposed new type of capital (Tier 3). G enerally, Tier 3 capital consists of short-term subordinated debt subject to certain criteria, inclu ding a lock-in provision th a t prevents th e issuer from repaying th e debt even at m aturity if th e issu er’s risk-based capital ratio is less th a n 8.0 percent follow ing the paym ent. In D ecem ber 1995, th e G -10 G overnors endorsed a final am endm ent to the A ccord adopting, w ith som e m odification, th e C om m ittee’s m arket risk consultative proposal. A t th a t sam e tim e, the Com m ittee issu ed supervisory guidance specifying the effect of backtesting results on an in stitu tio n ’s m u ltip licatio n factor. B acktesting Proposal O n M arch 7,1996, th e A gencies p u b lish ed for pu b lic com m ent a joint proposal on backtesting (61 FR 9114) (backtesting proposal) th a t reflected the C om m ittee’s backtesting guidance. The backtesting proposal requires an in stitu tio n to com pare its daily net profits an d losses for the m ost recent 250 business days to th e corresponding daily VAR m easures generated for 4 The proposed qualitative criteria identify backtesting and stress testing as two model validation techniques. Backtests provide information about the accuracy of an internal model by comparing an institution’s daily VAR measures to its corresponding daily trading profits and losses. Stress tests provide information about the impact of adverse market events on an institution’s positions. in tern al risk m anagem ent purposes, using a 99 percent confidence level and a one-day period of rate an d price m ovem ent. Each day for w h ich a net trading loss exceeds the corresponding VAR m easure is counted as an exception. A n in stitu tion w ith five or m ore exceptions is presu m ed to have an inaccurate internal m odel an d m ust increase its m ultiplication factor from three u p to a m axim um of four, depending on the num ber of exceptions. T he backtesting proposal requires an in stitu tio n to begin backtesting one year after it begins to calculate m arket risk capital charges. T he delayed effective date for backtesting provides an in stitu tio n w ith sufficient tim e to accum ulate th e required d ata for 250 busin ess days. II. Comment Summary M arket R isk Proposal Together, the A gencies received 33 public com m ents on the m arket risk proposal. Com m enters strongly su p p o rted the proposed in tern al m odels approach.5 M ost com m enters believed that approach provides greater accuracy in m easuring m arket risk th an the standard ized approach an d creates incentives for institutions to continue im proving th eir risk m odeling and m anagem ent techniques. N evertheless, m ost com m enters stated th at the proposed m odeling constraints w ere unnecessarily rigid and, especially w h en com bined w ith the m u ltip lication factor of three, result in excessive capital charges. T he follow ing discussion sum m arizes th e responses to th e A gencies’ specific questions about the proposal. G eneral Topics T he A gencies asked com m enters about the proposed criteria for determ ining w hich in stitu tio n s m ust calculate capital charges for m arket risk. As proposed, the rule ap p lied to: (1) Any institu tio n w ith total assets exceeding $5 b illio n an d eith er trading activity totaling at least 3 percen t of total assets or the notional am o u n t of trading account derivative contracts in excess of $5 billion; an d (2) any in stitu tio n w ith total assets of $5 b illion or less an d trading activity representing at least 10 percent of total assets. Com m enters generally agreed that an in stitu tio n w ith significant exposure to m arket risk should ho ld capital against th a t exposure. However, som e believed it inappro priate to use the notional am ount of trading account derivative 5 Early versions of the Basle Committee’s market risk am endm ent did not allow for the use of internal models to determine capital charges. 47359 contracts as a criterion. F urther, some objected to different criteria for in stitu tio n s of different asset size. T he Agencies asked about the burden associated w ith applying the m arket risk m easure to both banks an d b ank holding com panies and, w ith regard to bank holding com panies, th e b u rd en associated w ith applying the m easure both w ith an d w ithout Section 20 subsidiaries. The. A gencies received m ixed com m ents on the b ank and bank holding com pany issue. Some believed th e m easure shou ld apply only at the bank ho lding com pany level, pointing out that m arket risk usually is managed on a consolidated basis at the bank holding com pany level. Som e favored applying the m easure at the bank level. O thers believed that an in stitutio n sh o u ld have a choice, depend ing on how it m anages risk. M ost com m enters discussing the Section 20 subsidiary issue su p p o rted applying the rule on a fully consolidated basis (i.e., including Section 20 subsidiaries). T he A gencies also asked w hether to allow an in stitution to choose either the stand ardized or internal m odels approaches, w hether to allow an in stitu tio n to com bine the tw o approaches for different risk categories, an d w h eth er the tw o approaches result in sim ilar capital charges. W hile some com m enters supported the flexibility of choosing betw een the internal m odels and standardized approaches, those com m enters w ho anticipated that they w o u ld be subject to th e m arket risk capital requirem ents in d icated th at they in ten d to use only th e in tern al m odels approach. O ther com m enters thought th a t a choice of approaches co uld be useful in certain situations, for exam ple, w h en an in stitution suddenly m eets the applicability criteria but does not have a com pletely developed in tern al m odel. Several com m enters expressed concerns about th e accuracy of the standardized ap proach and urged its elim ination. The few com m enters that addressed the question about com bining the tw o approaches sup ported the flexibility th a t th is could provide. A few com m enters stated that capital charges w o u ld be higher u n d er the internal m odels approach than u n d er the standard ized approach.6 6 The summary does not include comments on particular issues that might arise in applying the standardized approach (other than comments on specific risk) because, as discussed below, the Agencies have decided not to adopt the standardized approach in the final rule. Public comments are available from the Board’s and OCC’s Freedom of Information Office and the FDIC’s Reading Room. 47360 Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations T he Intern al M odels A pproach T he m arket risk proposal im posed several q u antitative standards on VAR m easures u se d for regulatory capital purposes. T he A gencies asked about th e potential b u rd e n associated w ith these standards an d w h eth e r th e resulting capital charge sufficiently covered m arket risk. C om m enters overw helm ingly resp o n d ed that the proposed m odeling constraints, w ere unnecessarily rigid an d w o u ld result in an excessive capital charge. M any com m enters suggested the A gencies allow an in stitu tio n to u se the same internal m odeling param eters for regulatory capital purposes as for intern al risk m anagem ent. M odeling C onstraints. W ith regard to the propo sed m odeling constraints, a few com m enters su p p o rted basing capital charges on a ten-day p eriod of rate a n d p rice m ovem ents. O thers in dicated th a t th e p eriod w as too long, w ith m ost suggesting a one-day period. Som e com m enters objected to any specified period. Several com m enters opposed th e pro p o sed 99 percent confidence level, noting that m any in stitu tio n s use low er confidence levels. O thers su p p o rted the proposed level an d still others suggested that regulators sh ould not specify a confidence level. M any com m enters strongly asserted th a t th e pro p o sed m u ltiplication factor of three w as too hig h and suggested, instead, a m in im u m factor of one. M ost of these com m enters believed that the proposal d id n o t adequately exp lain the rationale for a m u ltip licatio n factor greater th a n one. Several asked for clarification about how the Agencies w ill m easure a m o d e l’s accuracy and adjust an in stitu tio n ’s m ultiplication factor. T hey advocated objective, welldefined criteria to ensure th a t the Agencies ap ply d ie rules consistently. C om m enters strongly opposed the p roposal’s requ irem en t th a t an in stitu tio n aggregate VAR m easures by sim ple sum m ation across th e risk categories. T hey asserted that ignoring th e effects of cross correlation am ong risk categories overstates exposure and understates th e m erits of diversified portfolios. T he A gencies asked w h eth er to require an in stitu tio n to calculate VARs using tw o observation periods. Specifically, the A gencies asked about th e tradeoff betw een enhanced p ru d en tial coverage and additional b u rd en associated w ith requiring an in stitu tio n to m ake tw o VAR m easures, one based on a short observation p eriod an d one based on a longer (over one year) period. M ost com m enters believed dual observation periods w ould result in unnecessary costs and operational burden. C om m enters h ad varying o pinions about th e optim al length of tim e for an observation period. Some com m enters suggested that the A gencies allow an in stitu tio n to choose an appropriate observation period. B acktesting. T he Agencies asked for com m ents about th e potential bu rd en associated w ith backtesting to evaluate the accuracy of an in stitu tio n ’s in ternal m odel. C om m enters generally view ed backtesting as a useful tool for m odel validation purposes. M ost believed th at backtesting sh o u ld com pare an in stitu tio n ’s VAR calculated for in tern al risk m anagem ent purposes (rather th an for regulatory capital purposes) w ith actual profits an d losses. A few com m enters, no ting the developing nature of backtesting generally, urged regulators not to prescribe specific regulations, guidelines, or m ethodologies for backtesting. The A gencies also asked for com m ent about th e ty pes of stress tests in stitu tio n s sh o u ld perform as part of th eir in tern al risk m anagem ent process. Several com m enters recognized generally th e im portance of stress testing. T hese and other com m enters resp o n d ed th a t the A gencies should allow an in stitu tio n to choose its m ethodology. O ther com m enters questioned w h eth e r a stress testing requirem ent w as necessary. S p ecific R isk. T he Agencies n oted that the in tern al m odels approach requires an in stitu tio n to ad d a specific risk capital charge calculated using the stand ardized approach if its internal m odel does n o t adequately capture specific risk, an d asked w hat m odeling techniques th e A gencies should consider w h en evaluating an in stitu tio n ’s m odel for specific risk. W hile com m enters generally agreed th a t an in stitu tio n sh o u ld integrate specific risk into its in tern al m odel, several objected to u sin g capital charges calculated u n d e r the standardized approach as th e benchm ark for specific risk u n d e r th e in tern al m odels approach. A few com m enters asked for clarification ab o u t w hat constitutes sufficient integration of specific risk into a m od el to avoid the add-on capital charge. Som e com m enters n oted that internal m odels that incorporate specific risk elem ents are still in the developm ent stage, and stated that the A gencies sh o u ld not in clu d e a specific risk requ irem en t in the internal m odels approach. T he A gencies asked w h eth er they sh ould specifically define th e term “liq u id a n d w ell-diversified,” as ap p lied to specific risk in equities, entitling an in stitu tio n to a low er capital charge u n d e r th e standardized approach. C om m enters differed as to the appropriate degree of specificity. Some preferred a qualitative definition, as proposed, a n d others su p p o rted a m ore explicit an d objective definition. O ther Issues Some com m en ters raised issues not directly ad d re ssed in the A gencies’ specific q u estio n s on the m arket risk proposal. O ne com m enter suggested that an in stitu tio n co uld determ ine internally w h e th e r to classify a debt in stru m en t as qualifying or n o n qualifying for purp o ses of determ ining the applicable specific risk w eight factor (qualifying in stru m en ts receive a low er specific risk charge th an non-qualifying instrum ents). A nother com m enter recom m ended a zero percent specific risk charge for deb t in strum ents issued by local an d regional governm ents. A nother recom m end ed a zero percent specific risk charge for instru m ents tracking an equity index. Several com m enters said th a t the proposed qualitative standards for an in stitu tio n ’s risk m anagem ent system w ere reasonable. O ne in stitutio n noted th e qualitative stan dards provided a com prehensive set of guidelines. Some com m enters questioned the m arketability of short-term subordinated debt in c lu d e d as T ier 3 capital. A few com m enters d iscu ssed the relationship betw een m arket risk an d credit risk, w ith som e arguing th a t w h en aggregating capital charges for credit and m arket risk th e Agencies should perm it an in stitu tio n to recognize correlations betw een the tw o types of risk. B acktesting P roposal Together, the A gencies received 17 public com m ents on the backtesting proposal. C om m enters to th a t proposal generally su p p o rted backtesting as a useful com p o n en t of risk m anagem ent. Several expressed concern th a t the proposal w as unn ecessarily rigid, noting that backtesting techniques are evolving, an d suggested th a t the Agencies reexam ine backtesting prior to im plem entation of the final rule. A few com m enters q u estio n ed linking backtesting resu lts to capital requirem ents. Som e com m enters expressed th e view th a t the Agencies sh ould take into account th e severity of an exception, n o t just th e num b er of exceptions. O ther com m enters believed that the A gencies sh o u ld base capital requirem ents on an overall evaluation of an in stitu tio n ’s risk m anagem ent process an d n o t m erely on the num ber of exceptions. A few com m enters suggested th a t the A gencies retain the Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations 47361 an d of foreign exchange an d com m odity ho w it adapts its in tern al m odel to take flexibility to adjust the m ultiplication positions, w herever located. in to account changed conditions. A few factor below three if an in stitu tio n ’s A dditionally, the institu tio n m ust com m enters stated the A gencies should m odel exhibits superior perform ance. Am ong other specific questions, the account for the specific risk of debt and n o t penalize an in stitu tio n for equity positions located in its trading A gencies asked about th e m erits and exceptions after it adjusts its model. T he Agencies asked about the account. T he positions covered by th is problem s associated w ith backtesting hypothetical trading outcom es (profits proposed sam ple size of 250 final rule (except for foreign exchange in dependent observations. W hile positions outside the trading account an d losses) versus backtesting actual several com m enters on th is question an d over-the-counter (OTC) derivatives) trading outcom es.7 A lm ost all responded that the proposed sam ple are excluded from the cred it risk capital com m enters supported using actual size w as appropriate, som e believed that charge. Foreign exchange positions trading outcom es for backtesting an in stitu tio n sh o u ld have flexibility to outside the trading account and OTC purposes rath er th a n hypothetical derivatives are subject to the m arket risk increase or decrease the sam ple size. A outcom es. O ne com m enter supported few com m enters asserted that all capital charge, as w ell as th e credit risk giving an institu tio n the option of w hat in stitutions sh ould use the sam e sam ple capital charge. type of outcom es it w ill backtest. T hus, the m inim um capital charge for Com m enters w h o su p p o rted using size. Finally, th e A gencies asked w hether an in stitution that m eets the actual trading outcom es believed that to require an in stitu tio n to backtest applicability criteria is its cred it risk these results approp riately in clud ed against its VAR m easures generated for capital charge as calculated u n d er the such factors as gains an d losses from A gencies’ credit risk-based capital in tern al risk m anagem ent purposes, or trading activity, fee incom e, n et interest standards (excluding the positic i s against VAR m easures calcu lated for incom e, an d m anagem ent responses to previously noted) p lus its m easi r e for m arket risk capital requirem ents. Most changing portfolio conditions. com m enters su p p o rted the form er m arket risk as calculated u n d er this Com m enters w ho objected to using final rule. T he in stitu tio n ’s risk-based approach. hypothetical resu lts n o te d th a t costs capital ratio adjusted for m arket risk is associated w ith creating an d operating a m . Final Rule its risk-based capital ratio for purposes system for determ ining hypothetical T he Agencies believe it is im portant of prom pt corrective action an d other resu lts w ere significant. O ther for an in stitu tio n w ith significant statutory and regulatory purposes. com m enters discussed th e potential m arket risk to m easure its exposure and Subject to supervisory approval that b u rd en of requiring an institu tio n to ho ld com m ensurate am ounts of capital. its internal m odel an d risk m anagem ent calculate daily profits an d losses w ith T he Agencies suppo rt th e m arket risk processes m eet th e final ru le ’s an unreasonable degree of exactness. am endm ent to th e A ccord an d are now regulatory criteria, an institu tio n m ay T hey noted that global VARs are issuing uniform m arket risk standards choose to com ply w ith the final rule as calculated by sim ulating changes in all th a t w ill im plem ent that am endm ent for early as January 1, 1997. A ny institution m arket factors and calculating resulting in stitu tio n s regulated by th e Agencies. th at voluntarily com plies w ith the final changes in portfolio values. They T he final ru le incorporates a m easure rule prior to January 1, 1998, m ust suggested letting an in stitu tio n estim ate for exposure to m arket risk into the com ply w ith all of its provisions, except daily profit and losses using a A gencies’ credit risk-based capital for the backtesting provisions, w hich consistent, reasonable m ethodology. standards. By January 1,1 9 9 8 , an apply one year after the in stitution T he Agencies asked for com m ent on in stitu tio n th a t m eets th e applicability begins to com ply w ith the other w h at types of events or regim e shifts criteria m ust use its in tern al m odel to provisions of the final rule. (i.e., dram atic changes in m arket m easure its exposure to m arket risk an d conditions that result in num ero us h o ld capital in su p p o rt of th a t exposure. In stitu tio n s S ub ject to th e F inal R ule exceptions in a short p eriod of tim e for (Section 1(b)) T he A gencies concur w ith com m enters the same reason) m ight generate th a t an institu tio n w ith significant T he A gencies agree w ith ctfm menters exceptions th a t do n o t w arrant an exposure to m arket risk can m ost th a t all institutions w ith significant “increase in an in stitu tio n ’s accurately m easure th a t risk using m arket risk, regardless of size, should m ultiplication factor. Several detailed inform ation available to the m easure th eir exposure an d hold com m enters asserted that th e Agencies institu tio n about its p articular portfolio appropriate levels of capital. Thus, the sh o u ld not list the types of regim e shifts processed by its ow n risk m easurem ent A gencies have revised the applicability in advance. Tw o com m enters suggested m odel. T he final ru le does n o t in clu de criteria to elim inate the differential th at th e A gencies sh o u ld treat any th e proposed standardized approach for criteria based on total asset size. The m arket-w ide or asset-class event m easuring general m arket risk. T he final A gencies believe th a t the capital affecting a large n u m b er of institu tion s requirem ents are appropriate both for an as a regim e shift. C om m enters suggested ru le does retain, how ever, the standardized approach m ethodologies in stitu tio n w hose trading activity is th e follow ing exam ples of regim e shifts: for determ ining capital charges for large relative to its total assets, an d for sudden abnorm al changes in interest or specific risk, w h ich an in stitu tio n m ust an in stitutio n w ith a substantial volum e exchange rates, m ajor political events, of trading activity. an d natural disasters. Som e com m enters use as the basis for its specific risk T he final ru le applies to any bank or charge for debt an d equity positions in suggested that the A gencies should take ban k holding com pany w hose trading its trading account. in to account an in stitu tio n ’s reaction to T he final ru le sup p lem en ts the activity equals 10 percent or m ore of its u n an ticip ated trading results, such as existing credit risk-based capital total assets, or w hose trading activity standards by requiring an affected equals $1 b illion or m ore.8 For purposes 7 Generally, hypothetical outcomes are trading institu tio n to adjust its risk-based outcomes that w ould result if the trading position 8 The Federal Reserve agrees w ith commenters as of the end of one business day went unchanged capital ratio to reflect m arket risk. that since market risk usually is managed on a during the next business day. Hypothetical Specifically, an in stitu tio n m u st adjust consolidated basis at the bank holding company outcomes differ from actual outcomes because of its risk-based capital ratio to take into level, market risk should be m easured at that level the effects of such items as changes in portfolio account the general m arket risk of all for risk-based capital purposes. Thus, the final rule composition over the holding period, fee income, Continued commissions, and income from trading. positions located in its trading account 47362 Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations of these criteria, an in stitu tio n ’s trading activity is defined as th e sum of its trading assets an d trading liabilities as reported in its m ost recent C onsolidated Report of C ondition an d Incom e (Call Report) for a bank, or its m ost recent Y 9C Report for a bank holding com pany. Total assets m eans quarter-end total assets as m ost recently repo ted by the institution. In addition, on a case-by-case basis, an A gency m ay require an in stitu tio n th a t does not m eet the applicability criteria to com ply w ith the final rule if th e Agency deem s it necessary for safety an d so undness purposes, or m ay exclude an in stitu tio n that m eets the applicability criteria. For exam ple, an A gency m ay require an in stitu tio n w ith trading activity less th an $1 b illio n and less thar. 10 percent of total assets, b u t w ith significant foreign exchange exposure outside of its trading account to com ply w ith th e provisions of the final rule. O n the other han d , an A gency m ay exem pt an in stitu tio n w ith trading activity th a t exceeds 10 percent of its to tal assets as a resu lt of accounting, operational, or sim ilar considerations, provided this does n o t raise safety and so undness concerns. An institu tio n th a t does n o t m eet the ' applicability criteria m ay, subject to supervisory approval, com ply voluntarily w ith the m arket risk rule, b u t only if it com plies w ith all of the final ru le’s provisions (e.g., the backtesting requirem ents, after accum ulating sufficient trading outcomes). Covered P ositions (Section 2(a)) A n in stitution subject to the final rule m u st ho ld capital to su p p o rt its exposure to general m arket risk arising from fluctuations in interest rates, equity prices, foreign exchange rates, an d com m odity prices an d its exposure to specific risk associated w ith certain debt and equity positions. Covered positions in clu d e all positions in an in stitu tio n ’s trading account an d foreign exchange an d com m odity positions throughout the institu tio n (w hether or n o t in the trading account). For m arket risk capital purposes, an in stitu tio n ’s trading account is defined in th e instructions to the Call Report. For exam ple, the trading account in clu d es on- an d off-balance-sheet positions in financial instrum ents applies to bank holding companies on a fully consolidated basis. In addition, because the Accord applies to internationally active banks, the final rule applies to consolidated banks. The Agencies may monitor the market risk exposure of institutions on a non-consolidated basis to ensure that significant imbalances w ithin an organization do not avoid supervision. acquired w ith the in ten t to resell in order to profit from short-term price or rate m ovem ents (or other p rice or rate variations). A n institu tio n m ay include in its m easure for general m arket risk certain non-trading account in stru m en ts th a t it deliberately uses to hedge trading positions. T hose in stru m en ts are not subject to a specific risk capital charge, b u t instead, rem ain subject to th e credit risk capital requirem ents. A n in stitu tio n m ay n o t in c lu d e item s in, or exclude item s from, its trading account to m an ip u late associated capital charges. A ll positions in c lu d ed in th e trading account m ust be m arked to m arket an d reflected in an in stitu tio n ’s earnings statem ent. T he m arket risk capital charge ap plies to all of an in stitu tio n ’s foreign exchange an d com m odities positions. A n in stitu tio n ’s foreign exchange positions include, for each currency, su c h item s as its n et spot position (including ordinary assets an d liabilities denom inated in a foreign currency), forw ard positions, guarantees th a t are certain to be called and likely to be unrecoverable, an d any other item s that react p rim arily to changes in exchange rates. A n institu tio n m ay, subject to supervisory approval, exclude from the m arket risk m easure any structural positions in foreign currencies. For th is purpose, structural po sitio n s in clu d e transactions designed to hedge an in stitu tio n ’s capital ratios against the effect of adverse exchange rate m ovem ents on (1) subo rdinated debt, equity, or m inority interests in conso lid ated subsidiaries an d capital assigned to foreign branches th a t are denom inated in foreign currencies, an d (2) any positions related to u n con solidated subsidiaries and other item s th at are d ed u cted from an in stitu tio n ’s capital w h en calculating its capital base. A n in stitu tio n ’s com m odity positions in c lu d e all positions th a t react prim arily to changes in com m odity prices. A d ju stm e n t to th e R isk-B ased C apital R atio C alculation (Section 3) A n in stitu tio n subject to th e final rule m u st m easure its m arket risk an d h o ld capital on a daily basis to m aintain an overall m in im u m 8.0 percent ratio of total qualifying capital to risk-w eighted assets adjusted for m arket risk. Risk-Based Capital Ratio D enom inator (Section 3(a)) A n in stitu tio n ’s risk-based capital ratio denom inator equals its adjusted risk-w eighted assets p lu s its m arket risk equivalent assets. A djusted riskw eighted assets are risk-w eighted assets, as determ ined u n d er the credit risk- b ased capital standards, less th e riskw eighted am ounts of all covered positions other th an foreign exchange positions outside the trading account and OTC derivatives. Covered positions (except for foreign exchange positions outside the trading account an d OTC derivatives) are no longer subject to a credit risk capital charge. A n in stitu tio n ’s m arket risk equivalent assets equals the m easure for m arket risk, as determ in ed u n d e r th is final rule, m u ltip lied by 12.5 (the reciprocal of the m inim um 8.0 percent capital ratio). M easure for M arket Risk (Section 3(a)(2)) T he m easure for m arket risk consists of an in stitu tio n ’s VAR-based capital charge p lu s an add-on capital charge for specific risk.9 T he VAR-based capital charge is the larger of either (1) the average VAR m easure for the last 60 business days, calculated u n d e r the regulatory criteria and increased by a m u ltip licatio n factor of betw een three and four; or (2) the previous d ay ’s VAR, calculated u n d e r the regulatory criteria b u t w ith o u t th e m u ltip licatio n factor. A n in stitu tio n ’s m u ltip licatio n factor is three un less its backtesting results in dicate th a t a higher factor is appropriate or un less th e in stitu tio n ’s supervisor determ ines th a t another action is appropriate. T he A gencies believe this com parative approach w ill result in an institu tio n holding capital sufficient to cover peak levels of m arket volatility. W hile the A gencies acknow ledge som e com m enters’ concerns th a t a m u ltip licatio n factor of three (or higher) im poses excessive capital charges, th e * A gencies believe th a t adjustm ents in the final rule to the internal m odels approach (e.g., requiring only a single observation period and recognizing cross correlations am ong risk categories) resu lt in capital charges th a t are appropriate, given existing industry practices. As in stitu tio n s im p lem en t th e final rule, the A gencies w ill m onitor resulting capital charges, w ill continue to evaluate the ap propriateness of the m u ltip licatio n factor, a n d m ay consider further refinem ents or adjustm ents to the final rule. 9 The final rule also provides that, on a case-bycase basis, an Agency may permit an institution to measure de minim is exposures to market risk using other techniques, provided the exposure is truly de minimis, the associated risk is adequately measured, and integration of the exposure into the institution's internal model would impose an unnecessary regulatory burden. Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations Risk-Based Capital Ratio N um erator (Section 3(b)) A n in stitu tio n ’s risk-based capital ratio num erator consists of a com bination of core (Tier 1) capital, su p p lem en tal (Tier 2) capital10 an d a th ird tier of capital (Tier 3), w hich consists of short-term subordinated debt th a t m eets certain conditions. S pecifically, T ier 3 capital m u st have an original m aturity of at least tw o years; it m u st be u n secured an d fully paid up; it m u st be subject to a lock-in clause th a t prev ents th e issuer from repaying the debt even at m aturity if th e issu er’s capital ratio is, or w ith repaym ent w o u ld becom e, less th an th e m inim um 8.0 percent risk-based capital ratio; it m ust n o t be redeem able before m aturity w ith o u t th e prior approval of the in stitu tio n ’s supervisor; an d it m u st n o t con tain or be covered by any covenants, term s, or restrictions that m ay be in co n sisten t w ith safe and soun d b anking practices. An institu tio n may use T ier 3 capital only to m eet m arket risk capital requirem ents. To determ ine its risk-based capital ratio num erator, an institu tio n should first allocate T ier 1 and T ier 2 capital equal to 8.0 percen t of its risk-w eighted assets (adjusted for the positions that are no longer subject to the credit risk rules). Next, the in stitution should allocate T ier 1, T ier 2, an d T ier 3 capital to su p p o rt its m easure for m arket risk. T he risk-based capital ratio num erator (i.e., total qualifying capital), is the sum of T ier 1 capital (w hether or not allocated for credit risk or m arket risk), T ier 2 capital (w hether or n o t allocated for credit risk or m arket risk an d subject to certain lim its), an d T ier 3 capital (allocated for m arket risk and subject to certain lim its). T he A gencies continu e to believe that T ier 1 capital sh o u ld constitute a substantial proportion of an in stitu tio n ’s total capital. T hus, the final rule in clu d es th e existing credit risk-based capital co nstraints that at least 50 percen t of an in stitu tio n ’s total qualifying capital m ust be T ier 1 capital, an d th a t term subordinated debt (and interm ediate-term preferred stock and related surplus) m ay no t exceed 50 percent of T ier 1 capital. In add ition, the sum of T ier 2 an d T ier 3 capital 10 Tier 1 and Tier 2 capital components are discussed in the Agencies’ credit risk capital standards. Generally, Tier 1 includes common stockholder’s equity, noncumulative perpetual preferred stock, and minority equity interests in consolidated subsidiaries, less goodwill and other deductions. Bank holding companies may include certain am ounts of cumulative perpetual preferred stock in Tier 1. Tier 2 includes the allowance for loan and lease losses, other preferred stock, and subordinated debt with an original average maturity of at least five years. allocated for m arket risk m ust not exceed 250 percent of T ier 1 capital allocated for m arket risk. This requirem ent m eans th at an institu tio n m u st su p p o rt at least 28.6 percent of its m easure for m arket risk w ith T ier 1 capital. Interna l M odels (Section 4) T he A gencies recognize that in stitu tio n s can and w ill use different assum ptions and m odeling techniques a n d th a t such differences often reflect d istin ct business strategies an d approaches to risk m anagem ent. For exam ple, an in stitu tion m ay calculate VAR using internal m odels based on variance-covariance m atrices, historical sim ulations, M onte Carlo sim ulations, or other statistical approaches. In all cases, how ever, th e m odel m ust cover th e in stitu tio n ’s m aterial risks.11 W hile the A gencies are not specifying m odeling param eters for internal risk m anagem ent purposes, the final rule does in clu d e m inim um qualitative requirem ents for internal risk m anagem ent processes, as w ell as certain quantitative requirem ents for th e param eters an d assum ptions for internal m odels u sed to m easure m arket risk exposure for regulatory capital purposes. Q ualitative Requirem ents (Section 4(b)) T he qualitative requirem ents reiterate several basic com ponents of sound risk m anagem ent. For exam ple, one of the final ru le ’s qualitative requirem ents is th a t an in stitu tio n m ust have a risk control u n it that reports directly to senior m anagem ent and that is in d e p en d e n t from business trading functions. T he Agencies expect that a risk control u n it w ill conduct regular backtests to evaluate the m o d e l’s accuracy an d stress tests to identify the im pact of adverse m arket events on the in stitu tio n ’s portfolio. T he other qualitative requirem ents in th e final ru le are also elem ents of soun d risk m anagem ent practices. For exam ple, an in stitution m u st have an in tern al m odel th a t is integrated into its daily m anagem ent, m u st have policies a n d procedures for conducting ap propriate stress tests and backtests an d for responding to the results of those tests, and m u st conduct in d e p en d e n t review s of its risk 11 For an institution using an externally developed or outsource risk measurement model, the model may be used for risk-based capital purposes provided it complies w ith the requirem ents of the final rule, management fully understands the model, the model is integrated into the institution’s daily risk management, and the institution’s overall risk management process is sound. 47363 m easurem ent and m anagem ent system s at least annually. T he A gencies agree w ith com m enters th a t an institu tio n sh ould develop and use stress tests appropriate to its p articu lar situation. T hus, the final rule does not require specific stress test m ethodologies. T he A gencies expect an in stitu tio n to conduct stress tests that are rigorous an d com prehensive and th a t cover a range of factors th a t could create extraordinary losses in a trading portfolio, or m ake'die control of risk in a portfolio difficult. T he Agencies believe stress tests should be both qualitative and quantitative, should incorporate both m arket risk and liquidity aspects of m arket disturbances, an d sh o u ld reflect the im pact of an event on positions w ith linear an d n o n linear price characteristics. W here stress tests reveal a p articu lar vulnerability, th e institu tio n shou ld take effective steps to appropriately m anage those risks. A n in stitu tio n ’s in d e p en d e n t review of its risk m anagem ent process should in clu d e both the activities of b u s in e s s , trading u n its and the risk control unit. For exam ple, the Agencies expect that an in stitu tio n ’s review w o uld include assessing w h eth er its risk m anagem ent system is fully integrated into th e daily m anagem ent process an d w h eth er its risk m anagem ent system is adequately docum ented. T he review should evaluate the organizational structure of th e risk control u n it and analyze the approval process for risk pricing m odels an d valuation systems. T he review sh o u ld also consider the scope of m arket risks captured by the risk m easurem ent m odel, the accuracy and com pleteness of position data, the verification of the consistency , tim eliness, and reliability of data sources used to ru n th e intern al m odel, th e accuracy an d ap propriateness of volatility and correlation assum ptions, and the validity of valuation an d risk transform ation calculations. M arket Risk Factors (Section 4(c)) T he final rule provides th a t an in stitu tio n ’s in tern al m odel m ust use risk factors that address m arket risk associated w ith interest rates, equity prices, exchange rates, an d com m odity prices, including the m arket risk associated w ith options in each of these risk categories. A lthough an institution h as discretion to use m arket risk factors th a t it h as determ ined affect the value of its positions an d the risks to w hich it is exposed, th e A gencies expect an in stitu tio n to use sufficient risk factors to cover th e risks inherent in its portfolio. 47364 Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations For exam ple, th e Agencies believe that interest rate risk factors should correspond to interest rates in each currency in w h ich th e in stitu tion has interest-rate-sensitive positions. The risk m easurem ent system sh ou ld m odel th e yield curve using one of a num ber of generally accepted approaches, such as by estim ating forw ard rates or zero coupon yields, an d sh o uld incorporate risk factors to captu re spread risk. The yield curve sh o u ld be d iv ided into various m aturity segm ents to capture variation in th e volatility of rates along the yield curve. For m aterial exposures to interest rate m ovem ents in the m ajor currencies an d m arkets, m odeling techniques sh o uld capture at least six segm ents of the yield curve. T he risk m easurem ent system should incorporate risk factors corresponding to in d iv id u al foreign currencies in w hich the in stitu tio n ’s positions are denom inated, to each of the equity m arkets in w h ich the institu tio n has significant p ositions [at a m inim um , a risk factor sh o u ld captvire m arket-w ide m ovem ents in equity prices), an d to each of the com m odity m arkets in w h ich the in stitu tio n has significant positions. Risk factors should m easure the volatilities of rates and prices und erlying option positions. An in stitu tio n w ith a large or com plex options portfolio sh o uld m easure the volatilities of options positions by different m aturities. T he sophistication an d nature o f th e m odeling techniques should correspond to th e level of the in stitu tio n ’s exposure. Q uantitative R equirem ents (Section 4(d)) W hile an in stitu tio n has flexibility in developing the precise nature of its m odel for in tern al risk m anagem ent purposes, the A gencies continue to believe that w hen determ ining capital charges for exposure to m arket risk an in stitu tio n ’s VAR m easures should m eet certain quantitative requirem ents. Such requirem ents are designed to ensure that an in stitutio n w ith significant m arket risk holds p ru d en tial levels of capital an d th at capital charges are sufficiently consistent across in stitu tio n s w ith sim ilar exposures. T he Agencies have considered co m m enters’ concerns that the proposed m odeling constraints, w h en com bined, w o u ld result in excessive capital charges. The Agencies believe th a t certain of the proposed constraints, such as a 99 percent (one tailed) confidence level and a ten-day m ovem ent in rates a n d prices, are appropriate a n d therefore they have been retained in th e final rule. H owever, th e Agencies agree w ith com m enters th a t other pro p o sed or considered requirem ents are n o t necessary. For exam ple, the A gencies have determ ined that a dual observation p eriod w ould unnecessarily increase regulatory b u rd en w ith o u t providing a substantial benefit. T hus, the final rule em ploys a single observation period. T he A gencies also agree w ith com m enters that, for regulatory capital purposes, an in stitu tio n should be peixnitted to use m odels that recognize cross correlations am ong risk categories. The final ru le p erm its an in stitu tio n to recognize cross correlations. The A gencies believe th is revision elim inates a significant source of rigidity in the m arket risk proposal and sh o u ld result in in ternal m odeling for capital p urposes th at is m ore consistent w ith observed in d u stry practice. The A gencies also believe th is revision w ill appropriately recognize an d rew ard portfolio diversification. These adjustm ents to the qu antitative requirem ents are consistent w ith the final am endm ent to the Accord. T he final ru le contains th e following quantitative requirem ents for an in stitu tio n ’s VAR m easures, u p o n w h ich regulatory capital requirem ents are based: (1) VAR m easures m ust be com puted each business day b ased on a 99 percent (one-tailed) confidence level of estim ated m axim um loss. (2) VAR m easures m u st be based on a price shock eq uivalen t to a ten-day m ovem ent in rates or prices. An in stitution m ay adjust VAR m easures (including VAR m easures for options) based on shorter p erio d s to a ten-day standard (e.g., by m ultiplying by the square root of tim e).12 T he A gencies do n o t believe that a p rice or rate m ovem ent period less th an ten days is sufficient to reflect the risk associated w ith options p ositions (or other instrum ents w ith no n-linear price characteristics), b u t recognize that it m ay be overly b urdenso m e for an in stitu tio n to apply a ten-day price or rate m ovem ent to su ch positions at this tim e. T he A gencies expect an in stitution w ith concentrations of options to m ake substantive progress in developing a m odeling system th a t m easures the n o n linear price characteristics of options positions (or o ther in stru m en ts w ith non-linear price characteristics), over a full ten-day period. (3) Internal m odels m u st in clu d e th e non-linear price characteristics of options positions an d th e sensitivity of the m arket value of those positions to T he A gencies have considered com m enters’ responses to the backtesting proposal. T he Agencies believe backtesting can be a useful tool for internal m o del validation, and have determ ined to in c lu d e th e backtesting provisions in th e final rule, as proposed. A n in stitution subject to the final rule m u st perform backtests of its VAR m easures as calculated for internal risk m anagem ent purposes. T he backtests m u st com pare daily VAR m easures 12 For example, under certain statistical assumptions, an institution can estimate the ten-day price volatility of an instrum ent by m ultiplying the volatility calculated on one-day changes by the square root of ten (approximately 3.16). 13 When reviewing an institution’s internal model for risk-based capital purposes, the Agencies may consider reports and opinions about the accuracy of the model that have been generated by external auditors or qualified consultants. changes in the volatility of the o p tio n ’s u nderlying rates and prices. (4) VAR m easures m ust be based on a m inim um historical observation period of at least one year for estim ating future price a n d rate changes. A m odel th at uses a w eighting schem e or other m ethod for th e h istorical observation period m ust use an effective observation p eriod of at least one year. T hat is, the w eighted average tim e lag of the in d iv id u al observations m ust be at least six m onths, th e figure th a t w ould prevail in an equally w eighted one-year observation period. (5) A n in stitu tio n m u st upd ate its m odel data at least once every three m onths an d m ore frequently if m arket conditions w arrant. (6) VAR m easures m ay incorporate em pirical correlations (calculated from historical data on rates an d prices) both w ith in broad risk categories and across broad risk categories, subject to agreem ent by the in stitu tio n ’s supervisor that the m o d e l’s system for m easuring such correlation is sound. If an in stitu tio n ’s m odel does not incorporate em pirical correlations across risk categories, th e n the bank m u st calculate the VAR m easures used for regulatory capital purposes by sum m ing th e separate VAR m easures for th e four broad risk categories (i.e., interest rates, equity prices, foreign exchange rates, an d com m odity prices). T he A gencies believe that, taken together, the m odeling param eters are appropriate for regulatory capital purposes an d also th a t they are com patible, as m u c h as practicable, w ith existing m odeling procedures. D uring th e exam ination process, the A gencies w ill review an in stitu tio n ’s risk m anagem ent process and internal m odel to en sure th a t the m odel processes all relevant data an d that m odeling an d risk m anagem ent practices conform to th e param eters and requirem ents of the final ru le .13 B acktesting (Section 4(e)) Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations calibrated to a one-day m ovem ent in rates an d prices a n d a 99 percen t (one tailed) confidence level against the in stitu tio n ’s actual daily n e t trading profit or loss (trading outcom e) for each of th e preceding 250 b usiness days. The backtests m u st be perform ed once each q uarter.14 Net trading outcom es include such item s as fees an d com m issions associated w ith trading activities, as w ell as changes in m arket valuations associated w ith changing portfolio positions. A n institu tio n m ust identify the num ber of occurrences w h en its n et trading loss (if any) for a p articu lar day exceeds th e corresponding daily VAR m easure. In general, an in stitu tio n ’s m u ltip licatio n factor increases in crem entally beginning w ith five or m ore exceptions during the previous 250 b usiness days, an d rises to a m u ltip licatio n factor of four for an institu tio n w ith 10 or m ore exceptions during th e period. W hile th e num ber of exceptions creates a p resu m p tio n as to an in stitu tio n ’s m ultip licatio n factor, the in stitu tio n ’s supervisor m ay m ake other adjustm ents to th e m u ltip licatio n factor or m ay take other appropriate actions. For exam ple, th e supervisor m ay exclude exceptions th a t result from regim e shifts, such as su d d e n abnorm al changes in interest rates or exchange rates, m ajor political events, or natural disasters. T he supervisor m ay also consider such other factors as th e m agnitude of an exception (that is, the extent of the difference b etw een the VAR m easure and the actual trading loss), an d an in stitu tio n ’s reaction in response to an exception. T he A gencies recognize that backtesting is evolving and acknow ledge com m enters’ concerns that it m ay n o t be approp riate to penalize an in stitution by applying a h igher m u ltip lication factor if the in stitution has refined th e accuracy o f its m odel in response to an exception or h a s taken other action to im prove its risk m anagem ent processes. T he Agencies em phasize th a t they w ill im p lem en t the backtesting requirem ents of th e final ru le w ith significant flexibility and exam iner judgm ent. T he A gencies w ill continue to m onitor in d u stry progress in developing backtesting m ethodologies and m ay consider adjusting the backtesting requirem ents in th e near future. 14 An institution’s obligation to backtest for regulatory capital purposes does not arise until the institution has been subject to the final rule for 250 business days (approximately one year) and, thus, has accum ulated the requisite num ber of observations to be used in backtesting. S p ecific R isk (Section 5) T he A gencies agree w ith the provisions in th e final am endm ent to th e A ccord th a t require an in stitu tio n to h o ld capital in su p p o rt of th e specific risk associated w ith debt an d equity positions in an in stitu tio n ’s trading account. T hus, the final ru le provides that an institu tio n m u st m easure and hold capital in su p p o rt of specific risk associated w ith those positions. T he capital charge for specific risk is determ ined either by an in stitu tio n ’s intern al m odel or by the standardized risk m easurem ent techniques specified by th e A gencies (the standardized approach). S tandardized A pproach U nder the standard ized approach, the specific risk charge for debt positions is calculated by m ultiplying th e curren t m arket value of each n et long or short position in a trading account debt instru m ent by th e approp riate specific risk w eighting factor as set forth in the final rule, based on th e id en tity of the obligor, an d in th e case of som e in stru m en ts such as corporate debt, on th e credit rating and rem aining m aturity of the instrum ent. A n in stitu tio n m ust risk w eight derivatives (e.g., sw aps, futures, forw ards, or options on certain debt instrum ents) according to the relevant u nderlying instrum ent. For exam ple, for a forw ard contract, an institutio n m ust risk w eight the m arket value of the effective n o tional am ount of the underlying in stru m en t (or index portfolio). A n in stitu tio n m ay n et long an d short positions in id en tical debt in strum ents w ith exactly the sam e issuer, coupon, currency, an d m aturity. An institu tio n m ay also offset a m atched position in a derivative in stru m en t and its corresponding underlying instrum ent. T he specific risk w eighting factor for debt in stru m en ts of OEGD 15 central governm ents is zero percent. O ther debt in stru m en ts w ith qualifying ratings (essentially investm ent grade corporate securities) receive risk w eights ranging from 0.25 percent to 1.6 percent, depend ing on rem aining m aturity. N onqualifying debt instrum ents receive a risk w eight of 8.0 percent. T he specific risk charge for equity positions is based on an in stitu tio n ’s gross equity position for each national m arket. T he gross equity position is defined as the sum of all long an d short equity positions, in clu d in g positions arising from derivatives such as equity sw aps, forw ards, futures, an d options. 15The Organization for Economic Cooperation and Development (OECD) is defined in the credit risk-based capital standards. 47365 A n in stitu tio n m ust risk w eight the current m arket value of each gross equity p o sitio n by th e appropriate factor. A n institu tio n m ust risk w eight derivatives according to th e relevant underlying equity instrum ent. An in stitu tio n m ay net long an d short positions in id en tical equity issues or in dices in each n ational m arket. An in stitution m ay also offset a m atched position in a derivative in stru m en t and its corresponding underlying instrum ent. T he specific risk charge is 8.0 percent of the gross equity position, un less the in stitu tio n ’s portfolio is bo th liquid and w ell-diversified, in w h ich case the capital charge is 4.0 percent. A portfolio is liquid and w ell-diversified if: (1) it is characterized by a lim ited sensitivity to price changes of any single equity or closely related group of equity issues held in a portfolio; (2) th e volatility of th e portfolio’s value is n o t dom inated by th e volatility of any in d iv id u al equity issue or by equity issues from any single in d u stry or econom ic sector; (3) it contains a large num ber of in d iv id u al equity positions, w ith no single position representing a substantial portion of the portfolio’s total m arket value; and (4) it consists m ainly of issues traded on organized exchanges or in wellestablished over-the-counter m arkets. For positions in an index com prising a diversified portfolio of equities, the specific risk charge is 2.0 p ercent of the n et long or short po sition in the index. In addition, a 2.0 percent specific risk charge app lies to only one side (long or short) in the case of certain futuresrelated arbitrage strategies (for instance, long and short positions in the same index at different dates or different m arket centers, an d long an d phort positions at th e same date in different, b u t sim ilar indices). Finally, u n d er certain conditions, futures positions on a broadly-based index th a t are m atched against positions in the equities com prising the index are subject to a specific risk charge of 2.0 percent against each side of th e transaction. Internal M odels A pproach T he final rule perm its an in stitution to use its in tern al m odel to determ ine capital charges for specific risk if it can dem onstrate to its sup erviso r th a t the m odeling process adequately addresses elem ents of specific risk for debt an d /o r equity positions. In particular, an institu tio n m ay use th e m odel-based estim ates of specific risk in place of the standard ized capital charge. H owever, if th e specific risk com ponent of the in stitu tio n ’s VAR m easure (w hen m u ltip lied by th e backtesting m u ltip lication factor, w ith respect to a 47366 Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations 60-day average VAR figure) is not equal to at least 50 p ercen t of the specific risk charge resulting from th e standardized calculation, th e n th e in stitu tio n has a specific risk add-on in the am o u n t of the difference. F or exam ple, if the stand ardized app ro ach indicates a specific risk charge of $100, b u t the in stitu tio n ’s 60-day average VAR figure includes only $10 for specific risk, then the institu tio n h as a specific risk add-on of $20 (that is, 50 percen t of $100 m inus three tim es $10). H ow ever, if the 60-day average VAR figure in clu d es $20 from specific risk, th e n th e in stitu tio n w o uld have no specific risk add-on because the VAR-based charge (three tim es $20) exceeds 50 p ercen t of $100. A n in stitu tio n (in conjunction w ith its supervisor) m u st separately determ ine w hether its m odel incorporates specific risk for debt p ositions an d equity positions. For instance, if th e m odel addresses th e specific risk of debt positions b u t n o t equity positions, th en the institu tio n can use th e m odel-based specific risk charge (subject to the lim itations described earlier) for debt positions, b u t m u st use th e full standard specific risk charge for equity positions. If, how ever, the m odel addresses the specific risk of b oth debt an d equity positions, th e n th e in stitu tio n m ust m ake th e com parison based on th e total specific risk figure for debt an d equity positions, taking in to account any correlations betw een th e specific risk of debt and equity po sitio n s th a t are built into the m odel. This treatm ent provides an institution w ith an incentive to incorporate specific risk into its in tern al m odel, w hile m aintaining an overall floor on the am oun t of capital it m ust h o ld against specific risk. T he A gencies believe that a m inim um requirem ent for specific risk is useful, at least for an initial period, since m ethods for incorporating specific risk into VAR m odels are still in a process of d evelopm ent at m any institutions. T he A gencies w ill continue to stud y th ese developm ents and likely w ill issue further guidance on these procedures as in stitu tio n s im plem ent th is final ru le in th e com ing m onths. IV. Regulatory Flexibility Act A nalysis OCC R egulatory F lexib ility A c t A n a lysis P ursuant to section 605(b) of the Regulatory F lexibility Act, the OCC certifies th a t th is final ru le w ill not have a significant im p act on a substantial num ber of sm all b usin ess entities in accord w ith th e sp irit an d p urposes of th e Regulatory F lexibility Act (5 U.S.C. 601 et seq.). A ccordingly, a regulatory flexibility analysis is n o t required. The im pact of th is final ru le on banks regardless of size is expected to be m inim al. F urther, th e OCC’s com parison of the applicability section of this final i ule to Call Report d ata on all existing banks show s th a t ap p lica tio n of the rule to sm all banks w ill be th e rare exception. Board R egulatory F lexib ility A c t A n a lysis P ursuan t to section 605(b) of the Regulatory F lexibility Act, th e Board does n o t believe th is final ru le w ill have a significant im pact on a substantial num ber of sm all b u sin ess entities in accord w ith th e sp irit an d pu rposes of the Regulatory F lexibility Act-(5 U.S.C. 601 et seq.). T he B oard’s com parison of the applicability section of th is final rule to Call Report data on all existing banks show s th a t ap p licatio n of th e rule to sm all en tities w ill be th e rare exception. A ccordingly, a regulatory flexibility analysis is n o t required. In addition, because th e risk-based capital standards generally do not ap ply to bank holding com panies w ith consolidated assets of less th a n $150 m illion, th is ru le w ill n o t affect such com panies. FDIC R egulatory F lexib ility A c t A n a lysis P ursuant to section 605(b) of the Regulatory F lexibility A ct (Pub. L. 9 6 354, 5 U.S.C. 601 et seq.), it is certified th a t the final ru le w ill n o t have a significant im pact on a substantial n um ber of sm all entities. T he FDIC’s com parison of th e applicability section of th is final rule to Call R eport data on all existing banks show s that applicatio n of th e ru le to sm all entities w ill be the rare exception. V. Paperwork R eduction Act OCC P aperw ork R ed uction A c t T he OCC h as d eterm ined th a t h is final ru le does not increase the regulatory paperw ork b u rd en of banking organizations p u rsu a n t to th e provisions of the P aperw ork R eduction A ct (44 U.S.C. 3501 et seq.). B oard P aperw ork R edu ctio n A c t In accordance w ith th e Paperw ork Reductiori Act o f 1995 (44 U.S.C. Ch. 3506; 5 CFR 1320 A p p en d ix A .l), the Board review ed th e proposed rule u n d er th e authority delegated to th e Board by the Office of M anagem ent an d Budget. No collections of inform ation p u rsuant to the P aperw ork R eduction A ct are contained in th e final rule. FDIC Paperw ork R ed uctio n A c t T he FDIC h as determ ined that this final ru le does not co n tain any collections of inform ation as defined by th e Paperw ork R eduction A ct (44 U.S.C. 3501 etseq .). VI. OCC Executive Order 12866 Determination The OCC has d eterm in ed th a t this final ru le is n o t a significant regulatory action u n d e r Executive O rder 12866. VII. OCC Unfunded M andates Reform Act o f 1995 Determination T he OCC has determ in ed th a t this final ru le w ill n o t resu lt in expenditures by state, local, a n d trib al governm ents, or by the private sector, of $100 m illion or m ore in any one year. A ccordingly, a budgetary im p act statem ent is not required u n d e r section 202 of the U nfunded M andates Reform Act of 1995. T his final ru le w ill ap ply only to a sm all n u m b er of n atio n al banks. M oreover, m ost (if n o t all) of those banks already have in tern al VAR m odels th a t m easure m arket risk, thus reducing th is final ru le ’s im plem entation costs. List o f Subjects 12 CFR Part 3 A dm inistrative p ractice and procedure, Capital, N ational banks, Reporting an d recordkeeping requirem ents, Risk. 12 CFR Part 208 A ccounting, A griculture, Banks, banking, C onfidential b usin ess inform ation, Crim e, C urrency, Federal Reserve System , M ortgages, Reporting an d recordkeeping requirem ents, Securities. 12 CFR Part 225 A dm inistrative p ractice and procedure, Banks, banking, Federal Reserve System , H olding com panies, R eporting and recordkeeping requirem ents, Securities. 12 CFR Part 325 A dm inistrative practice and procedure, Banks, banking, Capital adequacy, R eporting a n d recordkeeping requirem ents, Savings associations, State non-m em ber banks. Office of the Comptroller of the Currency 12 CFR CHAPTER I Authority and Issuance For the reasons set out in th e joint pream ble, p art 3 of title 12, chap ter I of th e Code of F ederal Regulations is am ended as follows: PART 3— [AMENDED] 1. The authority citatio n for part 3 con tin u es to read as follows: Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n note, 1835, 3907, and 3909. A 2. Section 3.6 is am ended by revising paragraph (a) to read as follows: § 3.6 Minimum capital ratios. (a) R isk-based capital ratio. All natio n al banks m ust have an d m aintain th e m in im u m risk-based capital ratio as set forth in app en d ix A (and, for certain banks, in app en d ix B). * * * * * 3. A new appen dix B is ad ded to part 3 to read as follows: Appendix B to Part 3— Risk-Based Capital Guidelines; Market Risk Adjustment Section J. Purpose, Applicability, Scope, and Effective Date (a) Purpose. The purpose of this appendix is to ensure that banks with significant exposure to market risk maintain adequate capital to support that exposure.1 This appendix supplements and adjusts the riskbased capital ratio calculations under appendix A of this part w ith respect to those banks. (b) Applicability. (1) This appendix applies to any national bank whose trading activity2 (on a w orldwide consolidated basis) equals: (1) 10 percent or more of total assets;3 or (ii) $1 billion or more. (2) The OCC may apply this appendix to any national bank if the OCC deems it necessary or appropriate for safe and sound banking practices. (3) The OCC may exclude a national bank otherwise meeting the criteria of paragraph (b)(1) of this section from coverage under this appendix if it determines the bank meets such criteria as a consequence of accounting, operational, or similar considerations, and the OCC deems it consistent w ith safe and sound banking practices. (c) Scope. The capital requirements of this appendix support market risk associated with a bank’s covered positions. (d) Effective date. This appendix is effective as of January 1,1997. Compliance is not mandatory until January 1, 1998.” Subject to supervisory approval, a bank may opt to comply with this appendix as early as January 1, 1997.4 ' This appendix is based on a framework developed jointly by supervisory authorities from the countries represented on the Basle Committee on Banking Supervision and endorsed by the Group of Ten Central Bank Governors. The framework is described in a Basie Committee paper entitled "Am endm ent to the Capital Accord to Incorporate Market Risk,” January 1996. 2Trading activity means the gross sum of trading assets and liabilities as reported in the bank’s most recent quarterly Consolidated Report of Condition and Income (Call Report). 3 Total assets means quarter-end total assets as reported in the bank’s most recent Call Report. 4 A bank that voluntarily complies w ith the final rule prior to January 1, 1998, m ust comply with all of its provisions. 47367 sum of the VAR-based capital charge, the specific risk add-on (if any), and the capital charge for de minimis exposure (if any). (i) VAR-based capital charge. The VARbased capital charge equals the higher of: (A) The previous day’s VAR measure; or (B) The average of the daily VAR measures for each of the preceding 60 business days m ultiplied by three, except as provided in section 4(e) of this appendix; (ii) Specific risk add-on. The specific risk add-on is calculated in accordance with section 5 of this appendix; and (iii) Capital charge fo r de m inim is exposure. The capital charge for de minimis exposure is calculated in accordance with section 4(a) of this appendix. (3) Market risk equivalent assets. Calculate market risk equivalent assets by multiplying the m easure for market risk (as calculated in paragraph (a)(2) of this section) by 12.5. (4) Denominator calculation. Add market risk equivalent assets (as calculated in paragraph (a)(3) of this section) to adjusted risk-weighted assets (as calculated in paragraph (a)(1) of this section). The resulting sum is the bank’s risk-based capital ratio denominator. (b) Risk-based capital ratio numerator. A bank subject to this appendix shall calculate its risk-based capital ratio numerator by allocating capital as follows: (1) Credit risk allocation. Allocate Tier 1 ' and Tier 2 capital equal to 8.0 percent of adjusted risk-weighted assets (as calculated in paragraph (a)(1) of this section).8 (2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3 capital equal to the measure for market risk as calculated in paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3 capital allocated for market risk m ust not exceed 250 percent of Tier 1 capital allocated for market risk. (This requirement means that Tier 1 capital allocated in this paragraph (b)(2) must equal at least 28.5 percent of the measure for market risk.) (3) Restrictions, (i) The sum of Tier 2 capital (both allocated and excess) and Tier 3 capital (allocated in paragraph (b)(2) of this section) may not exceed 100 percent of Tier Section 3. A djustm ents to the Risk-Based 1 capital (both allocated and excess).9 Capital Ratio Calculations (ii) Term subordinated debt (and (a) Risk-based capital ratio denominator. A intermediate-term preferred stock and related bank subject to this appendix shall calculate surplus) included in Tier 2 capital (both its risk-based capital ratio denominator as allocated and excess) may not exceed 50 follows: percent of Tier 1 capital (both allocated and (1) A djusted risk-weighted assets. Calculate excess). adjusted risk-weighted assets, w hich equals (4) Numerator calculation. Add Tier 1 risk-weighted assets (as determined in capital (both allocated and excess), Tier 2 accordance w ith appendix A of this part), capital (both allocated and excess), and Tier excluding the risk-weighted amounts of all 3 capital (allocated under paragraph (b)(2) of covered positions (except foreign exchange this section). The resulting sum is the bank’s positions outside the trading account and risk-based capital ratio numerator. over-the-counter derivative positions).7 Section 4. Internal Models (2) Measure fo r m arket risk. Calculate the measure for market risk, w hich equals the (a) General. For risk-based capital purposes, a bank subject to this appendix Section 2. Definitions For purposes of this appendix, the following definitions apply: (a) Covered positions means all positions in a bank’s trading account, and all foreign exchange5 and commodity positions, whether or not in the trading account.6 Positions include on-balance-sheet assets and liabilities and off-balance-sheet items. Securities subject to repurchase and lending agreements are included as if they are still owned by the lender. (b) M arket risk means the risk of loss resulting from movements in market prices. Market risk consists of general market risk and specific risk components. (1) General m arket risk means changes in the market value of covered positions resulting from broad market movements, such as changes in the general level of interest rates, equity prices, foreign exchange rates, or commodity prices. (2) Specific risk means changes in the market value of specific positions due to factors other than broad market movements and includes such risk as the credit risk of an instrum ent’s issuer. (c) Tier 1 and Tier 2 capital are the same as defined in appendix A of this part. (d) Tier 3 capital is subordinated debt that is unsecured; is fully paid up; has an original maturity of at least two years; is not redeemable before maturity w ithout prior approval by the OCC; includes a lock-in clause precluding payment of either interest or principal (even at maturity) if the payment w ould cause the issuing bank’s risk-based capital ratio to fall or remain below the minim um required under appendix A of this part; and does not contain and is not covered by any covenants, terms, or restrictions that are inconsistent w ith safe and sound banking practices. (e) Value-at-risk (VAR) means the estimate of the maximum am ount that the value of covered positions could decline during a fixed holding period w ithin a stated confidence level, measured in accordance with section 4 of this appendix. 5 Subject to supervisory review, a bank may exclude structural positions in foreign currencies from its covered positions. 6 The term trading account is defined in the instructions to the Call Report. 7 Foreign exchange positions outside the trading account and all over-the-counter derivative positions, whether or not in the trading account, m ust be included in adjusted risk-weighted assets as determ ined in appendix A of this part. 8 A bank may not allocate Tier 3 capital to support credit risk (as calculated under appendix A). 9Excess Tier 1 capital means Tier 1 capital that has not been allocated in paragraphs (b)(1) and (b)(2) of this section. Excess Tier 2 capital means Tier 2 capital that has not been allocated in paragraph (b)(1) and (b)(2) of this section, subject to the restrictions in paragraph (b)(3) of this section. 47368 Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations m ust use its internal model to measure its daily VAR, in accordance w ith the requirements of this section.10 The OCC may perm it a bank to use alternative techniques to measure the market risk of de minimis exposures so long as the techniques adequately measure associated market risk. (b) Qualitative requirements. A bank subject to this appendix m ust have a risk management system that meets the following m inim um qualitative requirements: (1) The bank m ust have a risk control unit that reports directly to senior management and is independent from business trading units. (2) The bank’s internal risk measurement model m ust be integrated into the daily management process. (3) The bank’s policies and procedures m ust identify, and the bank m ust conduct, appropriate stress tests and backtests.11 The bank’s policies and procedures must identify the procedures to follow in response to the results of such tests. (4) The bank m ust conduct independent reviews of its risk measurement and risk management systems at least annually. (c) Market risk factors. The bank’s internal model m ust use risk factors sufficient to measure the market risk inherent in all covered positions. The risk factors must address interest rate risk,12 equity price risk, foreign exchange rate risk, and commodity price risk. (d) Q uantitative requirements. For regulatory capital purposes, VAR measures m ust meet the following quantitative requirements: (1) The VAR measures must be calculated on a daily basis using a 99 percent, one-tailed confidence level w ith a price shock equivalent to a ten-business day movement in rates and prices. In order to calculate VAR measures based on a ten-day price shock, the bank may either calculate ten-day figures directly or convert VAR figures based on holding periods other than ten days to the equivalent of a ten-day holding period (for instance, by multiplying a one-day VAR measure by the square root of ten). (2) The VAR measures m ust be based on an historical observation period (or effective observation period for a bank using a l0A bank’s internal mode! may use any generally accepted m easurement techniques, such as variance-'covariance models, historical simulations, or Monte Carlo simulations. However, the level of sophistication and accuracy of a bank's internal model m ust be commensurate w ith the nature and size of its covered positions. A bank that modifies its existing m odeling procedures to comply with the requirements of this appendix for risk-based capital purposes should, nonetheless, continue to use the internal model it considers most appropriate in evaluating risks for other purposes. 1' Stress tests provide information about the impact of adverse market events on a bank’s covered positions. Backtests provide information about the accuracy of an internal model by comparing a bank's daily VAR measures to its corresponding daily trading profits and losses. l2For material exposures in the major currencies and markets, modeling techniques m ust capture spread risk and m ust incorporate enough segments of the yield curve—at least six—to capture differences in volatility and less than perfect correlation of rates along the yield curve. weighting scheme or other similar method) of covered debt and/or equity positions and that at least one year. The bank m ust update data those measures are included in the VARsets at least once every three months or more based capital charge in section 3(a)(2)(i) of frequently as market conditions warrant. this appendix, then the bank may reduce or (3) The VAR measures must include the eliminate its specific risk add-on under this risks arising from the non-linear price section. The determination as to w hether a characteristics of options positions and the m odel incorporates specific risk m ust be sensitivity of the market value of the made separately for covered debt and equity positions to changes in the volatility of the positions. underlying rates or prices. A bank with a (1) If a model includes the specific risk of large or complex options portfolio must covered debt positions but not covered equity measure the volatility of options positions by positions (or vice versa), then the bank can different maturities. reduce its specific risk charge for the (4) The VAR measures may incorporate included positions under paragraph Co) of empirical correlations w ithin and across risk this section. The specific risk charge for the categories, provided that the bank’s process positions not included equals the standard for measuring correlations is sound. In the specific risk capital charge under paragraph event that the VAR measures do not (c) of this section. incorporate empirical correlations across risk (2) If a model addresses the specific risk of categories, then the bank m ust add the both covered debt and equity positions, then separate VAR measures for the four major the bank can reduce its specific risk charge risk categories to determine its aggregate VAR for both covered debt and equity positions measure. u n d er paragraph (b) of this section. In this (e) Backtesting. (1) Beginning one year after case, the comparison described in paragraph a bank starts to com ply w ith this appendix, (b) of this section m ust be based on the total a bank must conduct backtesting by VAR-based figure for the specific risk of debt comparing each of its most recent 250 and equity positions, taking into account any business days’ actual net trading profit or correlations that are built into the model. lo s s 13 w ith the corresponding daily VAR (b) VAR-based specific risk capital charge. measures generated for internal risk In all cases where a bank measures specific measurem ent purposes and calibrated to a risk in its internal model, the total capital one-day holding period and a 99 percent, charge for specific risk (i.e., the VAR-based one-tailed confidence level. specific risk capital charge plus the specific (2) Once each quarter, the bank must risk add-on) must equal at least 50 percent identify the num ber of exceptions, that is, the of the standard specific risk capital charge number of business days for w hich the (this am ount is the m inim um specific risk m agnitude of the actual daily net trading charge). loss, if any, exceeds the corresponding daily (1) If the portion of a bank’s VAR measure VAR measure. that is attributable to specific risk (multiplied (3) A bank m ust use the m ultiplication by the bank’s multiplication factor if required factor indicated in Table 1 of this appendix in section 3(a)(2) of this appendix) is greater in determining its capital charge for market than or equal to the minim um specific risk risk under section 3(a)(2)(i)(B) of this charge, then the bank has no specific risk appendix until it obtains the next quarter’s add-on and its capital charge for specific risk backtesting results, unless the OCC is the portion included in the VAR measure. determines that a different adjustment or (2) If the portion of a bank’s VAR measure other action is appropriate. that is attributable to specific risk (multiplied by the bank’s multiplication factor if required T a b l e 1 — M u l t ip l ic a t io n F a c t o r in section 3(a)(2) of this appendix) is less than the m inim um specific risk charge, then B a s e d o n R e s u l t s o f B a c k t e s t in g the bank’s specific risk add-on is the Multiplica difference between the m inim um specific Number of exceptions tion factor risk charge and the specific risk portion of the VAR measure (m ultiplied by the bank’s 4 or few er.................................... 3.00 m ultiplication factor if required in section 5 ................................................... 3.40 3(a)(2) of this appendix). 6 ................................................... 3.50 (c) Standard specific risk capital charge. 7 ................................................... 3.65 The standard specific risk capital charge 8 ................................................... 3.75 equals the sum of the components for 9 ................................................... 3.85 covered debt and equity positions as follows: 10 or more .................................. 4.00 (1) Covered debt positions, (i) For purposes of this section 5, covered debt positions Section 5. Specific Risk means fixed-rate or floating-rate debt instrum ents located in the trading account (a) Specific risk add-on. For purposes of and instrum ents located in the trading section 3(a)(2)(ii) of this appendix, a bank’s account w ith values that react primarily to specific risk add-on equals the standard changes in interest rates, including certain specific risk capital charge calculated under non-convertible preferred stock, convertible paragraph (c) of this section. If, however, a bonds, and instrum ents subject to repurchase bank can demonstrate to the OCC that its and lending agreements. Also included are internal model measures the specific risk of derivatives (including w ritten and purchased options) for w hich the underlying instrument 13 Actual net trading profits and losses typically is a covered debt instrum ent that is subject include such things as realized and unrealized to a non-zero specific risk capital charge. gains and losses on portfolio positions as well as (A) For covered debt positions that are fee income and commissions associated with trading activities. derivatives, a bank m ust risk-weight (as Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations described in paragraph (c)(l)(iii) of this section) the market value of the effective notional am ount of the underlying debt instrument or index portfolio, Swaps must be included as the notional position in the underlying debt instrum ent or index portfolio, w ith a receiving side treated as a long position and a paying side treated as a short position; and (B) For covered debt positions that are options, whether long or short, a bank m ust risk-weight (as described in paragraph (c)(l)(iii) of this section) the market value of the effective notional amount of the underlying debt instrum ent or index m ultiplied by the option’s delta. (ii) A bank may net long and short covered debt positions (including derivatives) in identical debt issues or indices. (iii) A bank m ust m ultiply the absolute value of the current market value of each net long or short covered debt position by the appropriate specific risk weighting factor indicated in Table 2 of this appendix. The specific risk capital charge component for covered debt positions is the sum of the weighted values. 3 The “other”’ category includes debt instru ments that are not included in the government or qualifying categories. (2) Covered equity positions, (i) For purposes of this section 5, covered equity positions means equity instruments located in the trading account and instruments located in the trading account w ith values that react primarily to changes in equity prices, including voting or non-voting common stock, certain convertible bonds, and commitments to buy or sell equity instruments. Also included are derivatives (including written and purchased options) for which the underlying is a covered equity position. (A) For covered equity positions that are derivatives, a bank m ust risk weight (as described in paragraph (c)(2)(iii) of this section) the market value of the effective notional am ount of the underlying equity instrum ent or equity portfolio. Swaps must be included as the notional position in the underlying equity instrum ent or index portfolio, with a receiving side treated as a long position and a paying side treated as a short position; and (B) For covered equity positions that are options, w hether long or short, a bank must T a b l e 2— S p e c if ic R isk W e ig h t in g risk weight (as described in paragraph Fa c t o r s f o r C o v e r e d D e b t P o s i (c)(2)(iii) of this section) the market value of the effective notional am ount of the t io n s underlying equity instrum ent or index m ultiplied by the option’s delta. Remaining ma Weighting (ii) A bank may net long and short covered Category turity (contrac factor (in tual) percent) equity positions (including derivatives) in identical equity issues or equity indices in Government1 N/A ................... 0.00 the same market.14 (iii)(A) A bank m ust m ultiply the absolute Qualifying2 .... 6 months or less 0.25 Over 6 months 1.00 value of the current market value of each net long or short covered equity position by a to 24 months. Over 24 months 1.60 risk weighting factor of 8.0 percent, or by 4.0 Other3 ........... N/A .................. 8.00 percent if the equity is held in a portfolio that is both liquid and well-diversified.15 For 1The "government” category includes all covered equity positions that are index debt instruments of central governments of contracts comprising a well-diversified OECD countries (as defined in appendix A of portfolio of equity instruments, the net long this part) including bonds, Treasury bills, and other short-term instruments, as well as local or short position is m ultiplied by a risk currency instruments of non-OECD central weighting factor of 2.0 percent. (B) For covered equity positions from the governments to the extent the bank has liabil ities booked in that currency. following futures-related arbitrage strategies, 2 The “qualifying” category includes debt in a bank may apply a 2.0 percent risk struments of U.S. government-sponsored weighting factor to one side (long or short) agencies (as defined in appendix A of this part), general obligation debt instruments is of each position w ith the opposite side sued by states and other political subdivisions exempt from charge: of OECD countries, multilateral development banks (as defined in appendix A of this part), 14A bank may also net positions in depository and debt instruments issued by U.S. deposi receipts against an opposite position in the tory institutions or OECD-banks (as defined in underlying equity or identical equity in different appendix A of this part) that do not qualify as markets, provided that the bank includes the costs capital of the issuing institution. This category of conversion. also includes other debt instruments, including 15A portfolio is liquid and well-diversified if: (1) corporate debt and revenue instruments is sued by states and other political subdivisions It is characterized by a limited sensitivity to price of OECD countries, that are: (1) Rated invest changes of any single equity issue or closely related ment grade by at least two nationally recog group of equity issues held in the portfolio; (2) the nized credit rating services; (2) rated invest volatility of the portfolio's value is not dominated ment grade by one nationally recognized cred by the volatility of any individual equity issue or it rating agency and not rated less than invest by equity issues from any single industry or ment grade by any other credit rating agency; economic sector; (3) it contains a large number of or (3) unrated, but deemed to be of com- individual equity positions, with no single position rable investment quality by the reporting representing a substantial portion of the portfolio’s nk and the issuer has instruments listed on total market value; and (4) it consists mainly of a recognized stock exchange, subject to re issues traded on organized exchanges or in wellview by the OCC. established over-the-counter markets. 47369 (1) Long and short positions in exactly the same index at different dates or in different market centers; or (2) Long and short positions in index contracts at the same date in different but similar indices. (C) For futures contracts on broadly-based indices that are matched by offsetting positions in a basket of stocks comprising the index, a bank may apply a 2.0 percent risk weighting factor to the futures and stock basket positions (long and short), provided that such trades are deliberately entered into and separately controlled, and that the basket of stocks comprises at least 90 percent of the capitalization of the index. (iv) The specific risk capital charge component for covered equity positions is the sum of the weighted values. Section 6. Reservation o f A uthority The OCC reserves the authority to modify the application of any of the provisions in this appendix to any bank, upon reasonable justification. Dated: August 6, 1996. Eugene A. Ludwig, Comptroller o f the Currency. Federal Reserve System 12 CFR CHAPTER II For th e reasons set out in the joint pream ble, parts 208 an d 225 of title 12 of chapter II of the Code of Federal Regulations are am ended as follows: PART 208—MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL RESERVE SYSTEM (REGULATION H) 1. T he authority citation for part 208 is revised to read as follows: Authority: 12 U.S.C. 36, 248(a), 248(c), 321—338a, 371d, 461, 481-486, 601, 611, 1814, 1823(j), 1828(o), 18310, 1831p-l, 3105, 3310, 3331-3351, and 3906-3909; 15 U..S.C. 78b, 781(b), 781(g), 78l(i), 78o-4(c)(5), 78q, 78q—1, and 78w; 31 U.S.C. 5318; 42 U.S.C. 4012a, 4104a, 4104b, 4106, and 4128. 2. Section 208.13 is revised to read as follows: §208:13 Capital Adequacy. The standards and guidelines by w hich the capital adequacy of state m em ber banks w ill be evaluated by the Board are set forth in ap p en d ix A and ap p en d ix E for risk-based capital purposes, and, w ith respect to the ratios relating capital to total assets, in ap pendix B to part 208 and in appendix B to the B oard’s Regulation Y, 12 CFR part 225. 3. A p pendix A is am ended in the introductory text by adding a new paragraph after the second undesignated paragraph to read as follows: 47370 Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations Appendix A to Part 208—Capital Adequacy G uidelines for State Member Banks; Risk Based Measure * * * * * In ad d ition, w h en certain b an k s that engage in trading activities calculate th e ir risk-based capital ratio u n d e r this a p p en d ix A, they m ust also refer to a p p en d ix E of th is part, w h ich incorporates capital charges for certain m arket risks into the risk-based capital ratio. W hen calculating th e ir risk-based capital ratio u n d er th is ap p e n d ix A, such banks are required to refer to app en d ix E of th is part for su pplem ental rules to determ ine qualifying a n d excess capital, calculate risk-w eighted assets, calculate m arket risk equivalent assets, and calculate risk-based capital ratios adjusted for m arket risk. (c) Scope. The capital requirem ents o f this appendix support market risk associated with a bank’s covered positions. (d) Effective date. This appendix is effective as of January 1,1997. Compliance is not mandatory until January 1,1998. Subject to supervisory approval, a bank may opt to comply w ith this appendix as early as January 1 , 1997.4 risk-weighted assets (as determ ined in accordance w ith appendix A of this part), excluding the risk-weighted am ounts of all covered positions (except foreign exchange positions outside the trading account and over-the-counter derivative positions).7 (2) Measure fo r m arket risk. Calculate the measure for market risk, w hich equals the sum of the VAR-based capital charge, the specific risk add-on (if any), and the capital charge for de minimis exposures (if any). (i) VAR-based capital charge. The VARbased capital charge equals the higher of: (A) The previous day’s VAR measure; or (B) The average of the daily VAR measures for each of the preceding 60 business days m ultiplied by three, except as provided in section 4(e) of this appendix; (ii) Specific risk add-on. The specific risk add-on is calculated in accordance with section 5 of this appendix; and (iii) Capital charge fo r de m inim is exposure. The capital charge for de minimis exposure is calculated in accordance with section 4(a) of this appendix. (3) M arket risk equivalent assets. Calculate market risk equivalent assets by m ultiplying the measure for market risk (as calculated in paragraph (a)(2) of this section) by 12.5: (4) Denominator calculation. A dd market risk equivalent assets (as calculated in paragraph (a)(3) of this section) to adjusted risk-weighted assets (as calculated in paragraph (a)(1) of this section). The resulting sum is the bank’s risk-based capital ratio denominator. (b) Risk-based capital ratio numerator. A bank subject to this appendix shall calculate its risk-based capital ratio num erator by allocating capital as follows: (1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital equal to 8.0 percent of adjusted risk-weighted assets (as calculated in paragraph (a)(1) of this section).8 (2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3 capital equal to the measure for market risk as calculated in paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3 capital allocated for market risk m ust not exceed 250 percent of Tier 1 capital allocated for market risk. (This requirem ent means that Tier 1 capital allocated in this paragraph (b)(2) m ust equal at least 28.6 percent of the m easure for market risk.) (3) Restrictions, (i) The sum of Tier 2 capital (both allocated and excess) and Tier 3 capital (allocated in paragraph (b)(2) of this section) may not exceed 100 percent of Tier 1 capital (both allocated and excess).9 (ii) Term subordinated debt (and A intermediate-term preferred stock and related Section 2. Definitions For purposes of this appendix, the following definitions apply: (a) Covered positions means all positions in a bank’s trading account, and all foreign exchange 5 and commodity positions, whether or not in the trading account.6 Positions include on-balance-sheet assets and liabilities and off-balance-sheet items. Securities subject to repurchase and lending agreements are included as if they are still owned by the lender. (b) M arket risk means the risk of loss resulting from movements in market prices. * * * * * Market risk consists of general market risk 4. A n ew ap p e n d ix E is a d d e d to read and specific risk components. (1) General m arket risk means changes in as follows: the market value of covered positions Appendix E to Part 208—Capital resulting from broad market m ovements, Adequacy G uidelines for State Member such as changes in the general level of interest rates, equity prices, foreign exchange Banks; Market Risk Measure rates, or commodity prices. Section 1. Purpose, Applicability, Scope, and (2) Specific risk means changes in the Effective Date market value of specific positions due to factors other than broad market movements (a) Purpose. The purpose of this appendix and includes such risk as the credit risk of is to ensure that banks w ith significant an instrum ent’s issuer. exposure to market risk m aintain adequate (c) Tier 1 and Tier 2 capital are defined in capital to support that exposure.1 This appendix A of this part. appendix supplements and adjusts the risk(d) Tier 3 capital is subordinated debt that based capital ratio calculations under is unsecured; is fully paid up; has an original appendix A of this part w ith respect to those m aturity of at least two years; is not banks. (b) Applicability. (1) This appendix applies redeemable before m aturity w ithout prior approval by the Federal Reserve; includes a to any insured state member bank whose lock-in clause precluding paym ent of either trading activity2 (on a w orldwide interest or principal (even at maturity) if the consolidated basis) equals: payment w ould cause the issuing bank’s risk(1) 10 percent or more of total assets;3 or based capital ratio to fall or rem ain below the (ii) $1 billion or more. m inim um required under appendix A of this (2) The Federal Reserve may additionally part; and does not contain and is not covered apply this appendix to any insured state member bank if the Federal Reserve deems it by any covenants, terms, or restrictions that are inconsistent w ith safe and sound banking necessary or appropriate for safe and sound practices. banking practices. (e) Value-at-risk (VAR) means the estimate (3) The Federal Reserve may exclude an of the maximum am ount that the value of insured state member bank otherwise meeting the criteria of paragraph (b)(1) of this covered positions could decline during a fixed holding period w ithin a stated section from coverage under this appendix if confidence level, measured in accordance it determines the bank meets such criteria as w ith section 4 of this appendix. a consequence of accounting, operational, or similar considerations, and the Federal Section 3. A djustm ents to the Risk-Based Reserve deems it consistent w ith safe and Capital Ratio Calculations sound banking practices. (a) Risk-based capital ratio denominator. bank subject to this appendix shall calculate 7 Foreign exchange positions outside the trading 1This appendix is based on a framework its risk-based capital ratio denom inator as account and all over-the-counter derivative developed jointly by supervisory authorities from follows: w hether or not in the trading account, the countries represented on the Basle Committee (1) A djusted risk-weighted assets. Calculate positions, m ust be included in adjusted risk weighted assets on Banking Supervision and endorsed by the Group adjusted risk-weighted assets, w hich equals as determ ined in appendix A of this part. of Ten Central Bank Governors. The framework is described in a Basle Committee paper entitled “Am endm ent to the Capital Accord to Incorporate Market Risk,” January 1996. 2 Trading activity m eans the gross sum of trading assets and liabilities as reported in the bank’s most recent quarterly Consolidated Report of Condition and Income (Call Report). 3Total assets m eans quarter-end total assets as reported in the bank’s most recent Call Report. 4 A bank that voluntarily complies w ith the final rule prior to January 1,1998, m ust com ply w ith all of its provisions. 5 Subject to supervisory review, a bank may exclude structural positions in foreign currencies from its covered positions. 6The term trading account is defined in the instructions to the Call Report. 8A bank may not allocate Tier 3 capital to support credit risk (as calculated under appendix A of this part). 9 Excess Tier 1 capital m eans Tier 1 capital that has not been allocated in paragraphs (b)(1) and (b)(2) of this section. Excess Tier 2 capital means Tier 2 capital that has not been allocated in paragraph (b)(1) and (b)(2) of this section, subject to the restrictions in paragraph (b)(3) of this section. Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations surplus] included in Tier 2 capital (both allocated and excess) may not exceed 50 percent of Tier 1 capital (both allocated and excess). (4) Numerator calculation. Add Tier 1 capital (both allocated and excess), Tier 2 capital (both allocated and excess), and Tier 3 capital (allocated under paragraph (b)(2) of this section). The resulting sum is the bank’s risk-based capital ratio numerator. 47371 confidence level with a price shock T a b le 1 M u lt ip lic a t io n F a c to r equivalent to a ten-business day movement B ased on R e s u lts of in rates and prices. In order to calculate VAR B a c k te s tin g — Continued measures based on a ten-day price shock, the bank may either calculate ten-day figures Multiplica directly or convert VAR figures based on Number of exceptions tion factor holding periods other than ten days to the equivalent of a ten-day holding period (for 7 ................ ................................. 3.65 instance, by multiplying a one-day VAR 8 .................................................. 3.75 measure by the square root of ten). 3.85 9 ................................................ ... (2) The VAR measures must be based on Section 4. Internal Models. 10 or more .................................. 4.00 an historical observation period (or effective (a) General. For risk-based capital observation period for a bank using a purposes, a bank subject to this appendix weighting scheme or other similar method) of Section 5. Specific B isk m ust use its internal model to measure its at least one year. The bank m ust update data (a) Specific risk add-on. For purposes of daily VAR, in accordance w ith the sets at least once every three m onths or more section 3(a)(2)(ii) of this appendix, a bank’s requirements of this section.10 The Federal frequently as market conditions warrant. specific risk add-on equals the standard Reserve may permit a bank to use alternative (3) The VAR measures m ust include the specific risk capital charge calculated under techniques to measure the market risk of de risks arising from the non-linear price paragraph (c) of this section. If, however, a m inim is exposures so long as the techniques characteristics of options positions and the bank can demonstrate to the Federal Reserve adequately measure associated market risk. sensitivity of the market value of the that its internal model measures the specific (b) Q ualitative requirements. A bank positions to changes in the volatility of the risk of covered debt and/or equity positions subject to this appendix m ust have a risk underlying rates or prices. A bank w ith a and that those measures are included in the management system that meets the following VAR-based capital charge in section 3(a)(2)(i) large or complex options portfolio must minim um qualitative requirements: measure the volatility of options positions by of this appendix, then the bank may reduce (1) The bank must have a risk control unit or eliminate its specific risk add-on under different maturities. that reports directly to senior management this section. The determination as to whether (4) The VAR measures may incorporate and is independent from business trading a model incorporates specific risk must be empirical correlations w ithin and across risk units. made separately for covered debt and equity categories, provided that the bank’s process (2) The bank’s internal risk measurement positions. for measuring correlations is sound. In the model m ust be integrated into the daily (1) If a model includes the specific risk of event that the VAR measures do not management process. incorporate empirical correlations across risk covered debt positions but not covered equity (3) The bank’s policies and procedures positions (or vice versa), then the bank can categories, then the bank m ust add the m ust identify, and the bank m ust conduct, reduce its specific risk charge for the separate VAR measures for the four major appropriate stress tests and backtests." The included positions under paragraph (b) of bank’s policies and procedures must identify risk categories to determine its aggregate VAR this section. The specific risk charge for the measure. the procedures to follow in response to the (e) Back'esting. (1) Beginning one year after positions not included equals the standard results of such tests. specific risk capital charge under paragraph a bank starts to comply w ith this appendix, (4) The bank must conduct independent (c) of this section. a bank must conduct backtesting by reviews of its risk measurement and risk (2) If a model addresses the specific risk of comparing each of its most recent 250 management systems at least annually. both covered debt and equity positions, then business days’ actual net trading profit or (c) Market risk factors. The bank’s internal the bank can reduce its specific risk charge loss 13 w ith the corresponding daily VAR model m ust use risk factors sufficient to for both covered debt and equity positions measures generated for internal risk measure the market risk inherent in all under paragraph (b) of this section. In this measurement purposes and calibrated to a covered positions. The risk factors must case, the comparison described in paragraph one-day holding period and a 99 percent, address interest rate risk,12 equity price risk, (b) of this section must be based on the total one-tailed confidence level. foreign exchange rate risk, and commodity VAR-based figure for the specific risk of debt (2) Once each quarter, the bank m ust price risk. identify the number of exceptions, that is, the and equity positions, taking into account any (d) Q uantitative requirements. For correlations that are built into the model. number of business days for w hich the regulatory capital purposes, VAR measures (b) VAR-based specific risk capital charge. magnitude of the actual daily net trading must meet the following quantitative In all cases where a bank measures specific loss, if any, exceeds the corresponding daily requirements: risk in its internal model, the total capital (1) The VAR measures must be calculated VAR measure. charge for specific risk (i.e., the VAR-based (3) A bank must use the multiplication on a daily basis using a 99 percent, one-tailed specific risk capital charge plus the specific factor indicated in Table 1 of this appendix risk add-on) must equal at least 50 percent in determining its capital charge for market of the standard specific risk capital charge 10A bank’s internal m odel m ay use any generally risk under section 3(a)(2)(i)(B) of this accepted measurement techniques, such as (this amount is the m inim um specific risk appendix until it obtains the next quarter’s variance-covariance models, historical simulations, charge). backtesting results, unless the Federal or Monte Carlo simulations. However, the level of (1) If the portion of a bank’s VAR measure sophistication and accuracy of a bank’s internal Reserve determines that a different that is attributable to specific risk (multiplied model m ust be commensurate w ith the nature and adjustment or other action is appropriate. by the bank’s multiplication factor if required size of its covered positions. A bank that modifies in section 3(a)(2) of this appendix) is greater its existing modeling procedures to comply with the T a b l e 1 — M u l t ip l ic a t io n F a c t o r than or equal to the m inim um specific risk requirements of this appendix for risk-based capital charge, then the bank has no specific risk purposes should, nonetheless, continue to use the B a s e d o n R e s u l t s o f B a c k t e s t in g add-on and its capital charge for specific risk internal model it considers moot appropriate in evaluating risks for other purposes. j s the portion included in the VAR measure. Multiplica Number of exceptions 11 Stress tests provide information about the (2) If the portion of a bank’s VAR measure tion factor impact of adverse market events on a bank’s that is attributable to specific risk (multiplied covered positions. Backtests provide information 3.00 by the bank’s multiplication factor if required 4 or few er.................................... about the accuracy of an internal model by 5 ................................................... 3.40 in section 3(a)(2) of this appendix) is less comparing a bank’s daily VAR measures to its 6 ................................................... 3.50 than the minimum specific risk charge, then corresponding daily trading profits and losses. the bank’s specific risk add-on is the 12For m aterial exposures in the major currencies difference between the m inim um specific and markets, modeling techniques m ust capture 13Actual net trading profits and losses typically risk charge and the specific risk portion of spread risk and m ust incorporate enough segments include such things as realized and unrealized the VAR measure (multiplied by the bank’s of the yield curve—at least six—to capture gains and losses on portfolio positions as well as multiplication factor if required in section differences in volatility and less than perfect fee income and commissions associated with 3(a)(2) of this appendix). correlation of rates along the yield curve. trading activities. 47372 Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations (c) Standard specific risk capital charge. (B) The qualifying category includes debt instrum ents of U.S. government-sponsored The standard specific risk capital charge agencies, general obligation debt instruments equa s the sum of the com ponents for issued by states and other political covered debt and equity positions as follows: (1) Covered debt positions, (i) For purposes subdivisions of OECD-based countries, multilateral development banks, and debt of this section 5, covered debt positions instrum ents issued by U.S. depository means fixed-rate or floating-rate debt institutions or OECD-banks that do not instrum ents located in the trading account qualify as capital of the issuing institution.15 and instrum ents located in the trading This category also includes other debt account w ith values that react primarily to instruments, including corporate debt and changes in interest rates, including certain revenue instrum ents issued by states and non-convertible preferred stock, convertible bonds, and instrum ents subject to repurchase other political subdivisions of OECD countries, that are: and lending agreements. Also included are (3) Rated investment-grade by at least two derivatives (including w ritten and purchased options) for w hich the underlying instrument nationally recognized credit rating services; (2) Rated investment-grade by one is a covered debt instrum ent that is subject nationally recognized credit rating agency to a non-zero specific risk capital charge. and not rated less than investment-grade by (A) For covered debt positions that are any other credit rating agency; dr derivatives, a bank m ust risk-weight (as (3) Unrated, but deemed to be of described in paragraph (c)(l)(iii) of this comparable investment quality by the section) the market value of the effective reporting bank and the issuer has notional amount of the underlying debt instrum ent or index portfolio. Swaps m ust be instruments listed on a recognized stock exchange, subject to review by the Federal included as the notional position in the Reserve. underlying debt instrum ent or index (C) The other category includes debt portfolio, w ith a receiving side treated as a instrum ents that are not included in the long position and a paying side treated as a government or qualifying categories. short position; and (2) Covered equity positions, (i) For (B) For covered debt positions that are purposes of this section 5, covered equity options, w hether long or short, a bank must positions m eans equity instrum ents located risk-weight (as described in paragraph (c)(l)(iii) of this section) the market value of * in the trading account and instrum ents located in the trading account w ith values the effective notional amount of the that react primarily to changes in equity underlying debt instrum ent or index prices, including voting or non-voting m ultiplied by the option’s delta. common stock, certain convertible bonds, (ii) A bank may net long and short covered and commitments to buy or sell equity debt positions (including derivatives) in instruments. Also included are derivatives identical debt issues or indices. (including written and purchased options) (iii) A bank m ust m ultiply the absolute for w hich the underlying is a covered equity value of the current market value of each net position. long or short covered debt position by the (A) For covered equity positions that are appropriate specific risk w eighting factor derivatives, a bank m ust risk weight (as indicated in Table 2 of this appendix. The described in paragraph (c)(2)(iii) of this specific risk capital charge component for section) the market value of the effective covered debt positions is the sum of the notional amount of the underlying equity weighted values. instrum ent or equity portfolio. Swaps must be included as the notional position in the T a b l e 2 .— S p e c if ic R is k W e ig h tin g underlying equity instrum ent or index F a c t o r s f o r C o v e r e d D e b t P o s i portfolio, With a receiving side treated as a long position and a paying side treated as a t io n s short position; and (B) For covered equity positions that are Remaining ma Weighting Category factor (in options, whether long or short, a bank must turity (contrac tual) percent) risk weight (as described in paragraph (c)(2)(iii) of this section) the market value of Government ... N/A ................... 0.00 the effective notional am ount of the Qualifying ...... 6 months or less 0.25 underlying equity instrum ent or index Over 6 months 1.00 m ultiplied by the option’s delta. (ii) A bank may net long and short covered to 24 months. Over 24 months 1.60 equity positions (including derivatives) in Other ............. N/A ................... 8.00 identical equity issues or equity indices in the same market.16 (iii)(A) A bank must m ultiply the absolute (A) The governm ent category includes all value of the current market value of each net debt instrum ents of central governments of long or short covered equity position by a OECD-based countries 14 including bonds, risk weighting factor of 8.0 percent, or by 4.0 Treasury bills, and other short-term instruments, as well as local currency 15 U.S. government-sponsored agencies, instrum ents of non-OECD central multilateral development banks, and OECD banks governments to the extent the bank has are defined in appendix A of this part. liabilities booked in that currency. 14 Organization for Economic Cooperation and Development (OECD)-based countries is defined in appendix A of this part. I6A bank may also net positions in depository receipts against an opposite position in the underlying equity or identical equity in different markets, provided that the bank includes the costs of conversion. percent if the equity is held in a portfolio that is both liquid and w ell-diversified.17 For covered equity positions that are index contracts comprising a well-diversified portfolio of equity instruments, the net long or short position is m ultiplied by a risk weighting factor of 2.0 percent. (B) For covered equity positions from the following futures-related arbitrage strategies, a bank may apply a 2.0 percent risk weighting factor to one side (long or short) of each position w ith the opposite side exempt from charge, subject to review by the Federal Reserve: (1) Long and short positions in exactly the same index at different dates or in different market centers; or (2) Long and short positions in index contracts at the same date in different but similar indices. (C) For futures contracts on broadly-based indices that are m atched by offsetting positions in a basket of stocks comprising the index, a bank may apply a 2.0 percent risk weighting factor to the futures and stock basket positions (long and short), provided that such trades are deliberately entered into and separately controlled, and that the basket of stocks comprises at least 90 percent of the capitalization of the index. (iv) The specific risk capital charge component for covered equity positions is the sum of the weighted values. PART 225— BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL (REGULATION Y) 1. T he autho rity citation for part 225 co ntinu es to read as follows: Authority: 12 U.S.C. 1817(j)(13), 1818, 1831i, 1831p—1 , 1843(c)(8), 1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 3907, and 3909. 2. A p p en d ix A is am ended in the introductory text, by adding a new paragraph after the second undesignated paragraph to read as follows: A ppendix A to Part 225—Capital Adequacy G uidelines for Bank Holding Companies: Risk-Based Measure * * * * * In addition, w hen certain organizations that engage in trading activities calculate their risk-based capital ratio under this appendix A, they must also refer to appendix E of this part, w hich incorporates capital charges for certain market risks into the riskbased capital ratio. When calculating their risk-based capital ratio under this appendix A, such organizations are required to refer to 17A portfolio is liquid and well-diversified if: (1) It is characterized by a limited sensitivity to price changes of any single equity issue or closely related group of equity issues held in the portfolio; (2) the volatility of the portfolio’s value is not dominated by the volatility of any individual equity issue or by equity issues from any single industry or economic sector; (3) it contains a large num ber of individual equity positions, w ith no single position representing a substantial portion of the portfolio’s total market value; and (4) it consists m ainly of issues traded on organized exchanges or in wellestablished over-the-counter markets. Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations appendix E of this part for supplemental rules to determine qualifying and excess capital, calculate risk-weighted assets, calculate market risk equivalent assets, and calculate risk-based capital ratios adjusted for market risk. foreign exchange5 and commodity positions, w hether or not in the trading account.6 Positions include on-balance-sheet assets and liabilities and off-balance-sheet items. Securities subject to repurchase and lending agreements are included as if still owned by * * * * * the lender. 3. A new ap p e n d ix E is added to read (b) M arket risk means the risk of loss resulting from movements in market prices. as follows: Market risk consists of general market risk and specific risk components. A ppendix E to Part 225—Capital (1) General m arket risk means changes in Adequacy G uidelines for Bank Holding the market value of covered positions Companies: Market Risk Measure resulting from broad market movements, Section 1. Purpose, Applicability, Scope, and such as changes in the general level of Effective Date interest rates, equity prices, foreign exchange rates, or commodity prices. (a) Purpose. The purpose of this appendix (2) Specific risk means changes in the is to ensure that bank holding companies market value of specific positions due to (organizations) w ith significant exposure to factors other than broad market movements market risk m aintain adequate capital to and includes such risk as the credit risk of support that exposure.1 This appendix an instrum ent’s issuer. supplements and adjusts the risk-based (c) Tier 1 and Tier 2 capital are defined in capital ratio calculations under appendix A appendix A of this part. of this part w ith respect to those (d) Tier 3 capital is subordinated debt that organizations. (b) Applicability. (1) This appendix applies is unsecured; is fully paid up; has an original maturity of at least two years; is not to any bank holding company whose trading activity2 (on a worldwide consolidated basis) redeemable before maturity without prior approval by the Federal Reserve; includes a equals: lock-in clause precluding payment of either (1) 10 percent or more of total assets;3 or interest or principal (even at maturity) if the (ii) $1 billion or more. payment w ould cause the issuing (2) The Federal Reserve may additionally organization’s risk-based capital ratio to fall apply this appendix to any bank holding or rem ain below the m inim um required company if the Federal Reserve deems it under appendix A of this part; and does not necessary or appropriate for safe and sound contain and is not covered by any covenants, banking practices. terms, or restrictions that are inconsistent (3) The Federal Reserve may exclude a bank holding company otherwise meeting the w ith safe and sound banking practices. (e) Value-at-risk (VAR) means the estimate criteria of paragraph (b)(1) of this section of the maximum am ount that the value of from coverage under this appendix if it covered positions could decline due to determines the organization meets such market price or rate movements during a criteria as a consequence of accounting, fixed holding period w ithin a stated operational, or similar considerations, and confidence level, measured in accordance the Federal Reserve deems it consistent with with section 4 of this appendix. safe and sound banking practices. (c) Scope. The capital requirements of this Section 3. A djustm ents to the Risk-Based appendix support market risk associated with Capital Ratio Calculations an organization’s covered positions. (a) Risk-based capital ratio denominator. (d) Effective date. This appendix is An organization subject to this appendix effective as of January 1, 1997. Compliance shall calculate its risk-based capital ratio is not mandatory until January 1, 1998. denom inator as follows: Subject to supervisory approval, a bank (1) A djusted risk-weighted assets. Calculate holding company may opt to comply with adjusted risk-weighted assets, w hich equals this appendix as early as January 1,1997.4 risk-weighted assets (as determined in Section 2. Definitions accordance with appendix A of this part) excluding the risk-weighted amounts of all For purposes of this appendix, the covered positions (except foreign exchange following definitions apply: (a) Covered positions means all positions positions outside the trading account and over-the-counter derivative positions).7 in an organization’s trading account, and all (2) Measure fo r m arket risk. Calculate the measure for market risk, w hich equals the 1This appendix is based on a framework sum of the VAR-based capital charge, the developed jointly by supervisory authorities from specific risk add-on (if any), and the capital the countries represented on the Basle Committee charge for de minim is exposures (if any). on Banking Supervision and endorsed by the Group (i) VAR-based capital charge. The VARof Ten Central Bank Governors. The framework is based capital charge equals the higher of: described in a Basle Committee paper entitled “Amendment to the Capital Accord to Incorporate Market Risk," January 1996. 2 Trading activity m eans the gross sum of trading assets and liabilities as reported in the bank holding company’s most recent quarterly Y-9C Report. 3Total assets means quarter-end total assets as reported in the bank holding com pany’s most recent Y-9C Report. 4 A bank holding company that voluntarily complies with the final rule prior to January 1, 1998, m ust comply with all of its provisions. 5 Subject to supervisory review, a bank may exclude structural positions in foreign currencies from its covered positions. 6 The term trading account is defined in the instructions to the Call Report. 7 Foreign exchange positions outside the trading account and all over-the-counter derivative positions, whether or not in the trading account, m ust be included in adjusted risk weighted assets as determined in appendix A of this part. 47373 (A) The previous day’s VAR measure; or (B) The average of the daily VAR measures for each of the preceding 60 business days m ultiplied by three, except as provided in section 4(e) of this appendix; (ii) Specific risk add-on. The specific risk add-on is calculated in accordance with section 5 of this appendix; and (iii) Capital charge for de m inim is exposure. The capital charge for de minimis exposure is calculated in accordance with section 4(a) of this appendix. (3) M arket risk equivalent assets. Calculate market risk equivalent assets by multiplying the measure for market risk (as calculated in paragraph (a)(2) of this section) by 12.5. (4) Denominator calculation. Add market risk equivalent assets (as calculated in paragraph (a)(3) of this section) to adjusted risk-weighted assets (as calculated in paragraph (a)(1) of this section). The resulting sum is the organization’s risk-based capital ratio denominator. (b) Risk-based capital ratio numerator. An organization subject to this appendix shall calculate its risk-based capital ratio num erator by allocating capital as follows: (1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital equal to 8.0 percent of adjusted risk-weighted assets (as calculated in paragraph (a)(1) of this section).* (2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3 capital equal to the measure for market risk as calculated in paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3 capital allocated for market risk m ust not exceed 250 percent of Tier 1 capital allocated for market risk. (This requirement means that Tier 1 capital allocated in this paragraph (b)(2) m ust equal at least 28.6 percent of the measure for market risk.) (3) Restrictions, (i) The sum of Tier 2 capital (both allocated and excess) and Tier 3 capital (allocated in paragraph (b)(2) of this section) may not exceed 100 percent of Tier 1 capital (both allocated and excess).9 (ii) Term subordinated debt (and intermediate-term preferred stock and related surplus) included in Tier 2 capit'al (both allocated and excess) may not exceed 50 percent of Tier 1 capital (both allocated and excess). (4) Numerator calculation. Add Tier 1 capital (both allocated and excess), Tier 2 capital (both allocated and excess), and Tier 3 capital (allocated under paragraph (b)(2) of this section). The resulting sum is the organization’s risk-based capital ratio numerator. Section 4. Internal M odels (a) General. For risk-based capital purposes, a bank holding company subject to this appendix must use its internal model to measure its daily VAR, in accordance with 8An institution may not allocate Tier 3 capital to support credit risk (as calculated under appendix A of this part). 9 Excess Tier 1 capital means Tier 1 capital that has not been allocated in paragraphs (b)(1) and (b)(2) of this section. Excess Tier 2 capital means Tier 2 capital that has not been allocated in paragraph (b)(1) and (b)(2) of this section, subject to the restrictions in paragraph (b)(3) of this section. 47374 Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations holding com pany’s specific risk add-on (2) The VAR measures m ust be based on equals the standard specific risk capital an historical observation period (or effective charge calculated under paragraph (c) of this observation period for an organization using section. If, however, an organization can a weighting scheme or other similar method) demonstrate to the Federal Reserve that its of at least one year. The organization must internal model measures the specific risk of update data sets at least once every three covered debt and/or equity positions and that m onths or more frequently as market (b) Q ualitative requirem ents. A bank those measures are included in the VARconditions warrant. holding com pany subject to this (3) The VAR measures m ust include the based capital charge in section 3(a)(2)(i) of a p p e n d ix m u st have a risk m anagem ent risks arising from the non-linear price this appendix, then it may reduce or system th a t m eets the follow ing characteristics of options positions and the eliminate its specific risk add-on under this m in im u m q ualitative requirem ents: sensitivity of the market value of the section. The determ ination as to whether a (1) The organization m ust have a risk positions to changes in the volatility of the m odel incorporates specific risk must be control unit that reports directly to senior underlying rates or prices. An organization made separately for covered debt and equity management and is independent from w ith a large or complex options portfolio positions. business trading units. must measure the volatility of options (1) If a model includes the specific risk of (2) The organization’s internal risk positions by different maturities. covered debt positions but not covered equity m easurem ent m odel m ust be integrated into (4) The VAR measures may incorporate positions (or vice versa), then the the daily management process. empirical correlations w ithin and across risk organization can reduce its specific risk (3) The organization’s policies and categories, provided that the organization’s charge for the included positions under procedures m ust identify, and the process for measuring correlations is sound. paragraph (b) of this section. The specific risk organization must conduct, appropriate stress In the event that the VAR measures do not charge for the positions not included equals tests and backtests.11 The organization’s incorporate empirical correlations across risk the standard specific risk capital charge policies and procedures must identify the categories, then the organization must add under paragraph (c) of this section. procedures to follow in response to the the separate VAR measures for the four major (2) If a model addresses the specific risk of results of such tests. risk categories to determine its aggregate VAR both covered debt and equity positions, then (4) The organization m ust conduct measure. the organization can reduce its specific risk independent reviews of its risk measurement (e) Backtesting. (1) Beginning one year after charge for both covered debt and equity and risk management systems at least a bank holding company starts to comply positions under paragraph (b) of this section. annually. with this appendix, it must conduct In this case, the comparison described in (c) M arket risk factors. The organization’s backtesting by comparing each of its most paragraph (b) of this section m ust be based internal m odel m ust use risk factors recent 250 business days’ actual net trading on the total VAR-based figure for the specific sufficient to measure the market risk inherent profit or loss 13 w ith the corresponding daily risk of debt and equity positions, taking in all covered positions. The risk factors must VAR measures generated for internal risk account of any correlations that are built into address interest rate risk,12 equity price risk, measurement purposes and calibrated to a the model. foreign exchange rate risk, and commodity one-day holding period and a 99th (b) VAR-based specific risk capital charge. price risk. percentile, one-tailed confidence level. In all cases w here a bank holding company (d) Q uantitative requirements. For (2) Once each quarter, the organization measures specific risk in its internal model, regulatory capital purposes, VAR measures m ust identify the number of exceptions, that the total capital charge for specific risk (i.e., m ust meet the following quantitative is, the num ber of business days for w hich the the VAR-based specific risk capital charge requirements: magnitude of the actual daily net trading plus the specific risk add-on) m ust equal at (1) The VAR measures must be calculated loss, if any, exceeds the corresponding daily least 50 percent of the standard specific risk on a daily basis using a 99 percent, one-tailed VAR measure. capital charge (this amount is the minim um confidence level w ith a price shock (3) A bank holding company m ust use the specific risk charge). equivalent to a ten-business day movement m ultiplication factor indicated in Table 1 of (1) If the portion of an organization’s VAR in rates and prices. In order to calculate VAR this appendix in determining its capital measure that is attributable to specific risk m easures based on a ten-day price shock, the charge for market risk under section (m ultiplied by the organization’s organization may either calculate ten-day 3(a)(2)(i)(B) of this appendix until it obtains m ultiplication factor if required in section figures directly or convert VAR figures based the next quarter’s backtesting results, unless 3(a)(2) of this appendix) is greater than or on holding periods other than ten days to the the Federal Reserve determines that a equal to the m inim um specific risk charge, equivalent of a ten-day holding period (for different adjustm ent or other action is then the organization has no specific risk instance, by multiplying a one-day VAR appropriate. add-on and its capital charge for specific risk measure by the square root of ten). is the portion included in the VAR measure. T able 1 M ulti pli cati on F a c t o r (2) If the portion of an organization’s VAR 10 An organization’s internal model m ay use any measure that is attributable to specific risk B a s e d o n R e s u l t s o f b a c k t e st in g generally accepted measurement techniques, such (m ultiplied by the organization’s as variance-covariance models, historical Multiplica m ultiplication factor if required in section simulations, or Monte Carlo simulations. However, Number of exceptions tion factor 3(a)(2) of this appendix) is less than the the level of sophistication and accuracy of an organization’s internal model m ust be m inim um specific risk charge, then the 3.00 organization’s specific risk add-on is the commensurate with the nature and size of its 4 or few er.................................... covered positions. An organization that modifies its 3.40 difference between the minim um specific 5 ................................................... existing modeling procedures to comply w ith the 3.50 risk charge and the specific risk portion of 6 ................................................... requirements of this appendix for risk-based capital 3.65 the VAR measure (m ultiplied by the 7 ................................................... purposes should, nonetheless, continue to use the 3.75 m ultiplication factor if required in section 8 ........................................... internal m odel it considers most appropriate in 3.85 3(a)(2) of this appendix). 9 ................................................... evaluating risks for other purposes. 4.00 10 or more .................................. (c) Standard specific risk capital charge. 1 ’ Stress tests provide information about the The standard specific risk capital charge impact of adverse market events on a bank’s covered positions. Backtests provide information equals the sum of the components for Section 5. Specific R isk about the accuracy of an internal model by covered debt and equity positions as follows: (a) Specific risk add-on. For purposes of comparing an organization’s daily VAR measures to (1) Covered debt positions, (i) For purposes section 3(a)(2)(ii) of this appendix, a bank its corresponding daily trading profits and losses. of this section 5, covered debt positions 12 For material exposures in the major currencies m eans fixed-rate or floating-rate debt 13 Actual net trading profits and losses typically and markets, modeling techniques m ust capture instrum ents located in the trading account or include such things as realized and unrealized spread risk and m ust incorporate enough segments instrum ents located in the trading account gains and losses on portfolio positions as well as of the yield curve—at least six—to capture w ith values that react primarily to changes in fee income and commissions associated w ith differences in volatility and less than perfect interest rates, including certain non correlation of rates along the yield curve. trading activities. the requirem ents of this section.10 The Federal Reserve may perm it an organization to use alternative techniques to measure the market risk of de minimis exposures so long as the techniques adequately measure associated market risk. Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations convertible preferred stock, convertible bonds, and instrum ents subject to repurchase and lending agreements. Also included are derivatives (including w ritten and purchased options) for w hich the underlying instrument is a covered debt instrument that is subject to a non-zero specific risk capital charge. (A) For covered debt positions that are derivatives, an organization must risk-weight (as described in paragraph (c)(l)(iii) of this section) the market value of the effective notional am ount of the underlying debt instrum ent or index portfolio. Swaps m ust be included as the notional position in the underlying debt instrum ent or index portfolio, w ith a receiving side treated as a long position and a paying side treated as a short position; and (B) For covered debt positions that are options, w hether long or short, an organization m ust risk-weight (as described in paragraph (c)(l)(iii) of this section) the market value of the effective notional amount of the underlying debt instrum ent or index m ultiplied by the option’s delta. (ii) An organization may net long and short covered debt positions (including derivatives) in identical debt issues or indices. (iii) An organization m ust m ultiply the absolute value of the current market value of each net long or short covered debt position by the appropriate specific risk weighting factor indicated in Table 2 of this appendix. The specific risk capital charge component for covered debt positions is the sum of the weighted values. T a b l e 2 — S p e c if ic R is k W e ig h t in g Fa c t o r s f o r C o v e r e d D e b t Po s i t io n s Category Remaining ma turity (contrac tual) Government ... N/A .................. Qualifying ...... 6 months or less Over 6 months to 24 months. Over 24 months Other .............. N/A .................. Weighting factor (in percent) 0.00 0.25 1.00 1.60 8.00 (A) The governm ent category includes all debt instrum ents of central governments of OECD-based countries 14 including bonds, Treasury bills, and other short-term instrum ents, as well as local currency instrum ents of non-OECD central governments to the extent the organization has liabilities booked in that currency. (B) The qualifying category includes debt instrum ents of U.S. government-sponsored agencies, general obligation debt instruments issued by states and other political subdivisions of OECD-based countries, multilateral development banks, and debt instrum ents issued by U.S. depository institutions or OECD banks that do not qualify as capital of the issuing institution.15 14Organization for Economic Cooperation and Development (OECDJ-based countries is defined in appendix A of this part. 15 U.S. government-sponsored agencies, m ultilateral development banks, and OECD banks are defined in appendix A of this part. This category also includes other debt instrum ents, including corporate debt and revenue instrum ents issued by states and other political subdivisions of OECD countries, that are: (3) Rated investment-grade by at least two nationally recognized credit rating services; (2) Rated investment grade by one nationally recognized credit rating agency and not rated less than investment grade by any other credit rating agency; or (3) Unrated, but deemed to be of comparable investment quality by the reporting organization and the issuer has instrum ents listed on a recognized stock exchange, subject to review by the Federal Reserve. (C) The other category includes debt instrum ents that are not included in the government or qualifying categories. (2) Covered equity positions, (i) For purposes of this section 5, covered equity positions means equity instrum ents located in the trading account and instruments located in the trading account w ith values that react primarily to changes in equity prices, including voting or non-voting common stock, certain convertible bonds, and commitments to buy or sell equity instruments. Also included are derivatives (including written or purchased options) for w hich the underlying is a covered equity position. (A) For covered equity positions that are derivatives, an organization m ust risk weight (as described in paragraph (c)(2)(iii) of this section) the market value of the effective notional am ount of the underlying equity instrum ent or equity portfolio. Swaps m ust be included as the notional position in the underlying equity instrum ent or index portfolio, w ith a receiving side treated as a long position and a paying side treated as a short position; and (B) For covered equity positions that are options, w hether long or short, an organization must risk weight (as described in paragraph (c)(2)(iii) of this section) the market value of the effective notional amount of the underlying equity instrum ent or index m ultiplied by the option’s delta. (ii) An organization may net long and short covered equity positions (including derivatives) in identical equity issues or equity indices in the same m arket.16 (iii)(A) An organization must m ultiply the absolute value of the current market value of each net long or short covered equity position by a risk weighting factor of 8.0 percent, or by 4.0 percent if the equity is held in a portfolio that is both liquid and welldiversified.17 For covered equity positions l6An organization may also net positions in depository receipts against an opposite position in the underlying equity or identical equity in different m arkets, provided that the organization includes the costs of conversion. I7A portfolio is liquid and well-diversified if: (1) it is characterized by a limited sensitivity to price changes of any single equity issue or closely related group of equity issues held in the portfolio; (2) the volatility of the portfolio’s value is not dominated by the volatility of any individual equity issue or by equity issues from any single industry or economic sector; (3) it contains a large num ber of individual equity positions, w ith no single position 47375 that are index contracts comprising a welldiversified portfolio of equity instruments, the net long or short position is to be m ultiplied by a risk weighting factor of 2.0 percent. (B) For covered equity positions from the following futures-related arbitrage strategies, an organization may apply a 2.0 percent risk weighting factor to one side (long or short) of each equity position w ith the opposite side exempt from charge, subject to review by the Federal Reserve: (1) Long and short positions in exactly the same index at different dates or in different market centers; or (2) Long and short positions in index contracts at the same date in different but similar indices. (C) For futures contracts on broadly-based indices that are matched by offsetting positions in a basket of stocks comprising the index, an organization may apply a 2.0 percent risk weighting factor to the futures and stock basket positions (long and short), provided that such trades are deliberately entered into and separately controlled, and that the basket of stocks comprises at least 90 percent of the capitalization of the index. (iv) The specific risk capital charge component for covered equity positions is the sum of the weighted values. By order of the Board of Governors of the Federal Reserve System, August 29,1996. William W. Wiles, Secretary o f the Board. Federal Deposit Insurance Corporation 12 CFR CHAPTER III For the reasons indicated in the pream ble, the FDIC Board of D irectors hereby am ends p art 325 of chapter III of title 12 of th e Code of Federal R egulations as follows. PART 325— [AMENDED] 1. T he au thority citation for part 325 co ntinu es to read as follows: Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b), 1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n), 1828(o), 1831o, 3907, 3909, 4808; Pub. L. 102-233,105 Stat. 1761, 1789, 1790 (12 U.S.C. 1831n note); Pub. L. 102-242, 105 Stat. 2236, 2355, 2386 (12 U.S.C. 1828 note). 2. A p p en d ix A to part 325 is am ended in the introductory text, by adding a new paragraph after th e th ird und esignated paragraph to read as follows: A ppendix A to Part 325—Statement o f Policy on Risk-Based Capital * * * * * In addition, when certain banks that engage in trading activities calculate their risk-based capital ratio under this appendix A, they m ust also refer to appendix C of this representing a substantial portion of the portfolio’s total market value; and (4) it consists mainly of issues traded on organized exchanges or in wellestablished over-the-counter markets. 47376 Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations sum of the VAR-based capital charge, the Section 2. Definitions specific risk add-on (if any), and the capital For purposes of this appendix, the charge for de minimis exposures (if any). following definitions apply: (i) VAR-based capital charge. The VAR(a) Covered positions means all positions based capital charge equals the higher of: in a bank’s trading account, and all foreign (A) The previous day’s VAR measure; or exchange5 and commodity positions, (B) The average of the daily VAR measures w hether or not in the trading account.6 Positions include on-balance-sheet assets and for each of the preceding 60 business days m ultiplied by three, except as provided in liabilities and off-balance-sheet items. section 4(e) of this appendix; Securities subject to repurchase and lending (ii) Specific risk add-on. The specific risk agreements are included as if they are still add-on is calculated in accordance with ow ned by the lender. section 5 of this appendix; and (b) M arket risk means the risk of loss (iii) Capital charge fo r de m inim is 3. A new ap p e n d ix C is ad d e d to part resulting from movements in market prices. exposure. The capital charge for de minimis Market risk consists of general market risk 325 to read as follows: exposure is calculated in accordance with and specific risk components. section 4(a) of this appendix. A ppendix C to Part 325—Risk-Based (1) General m arket risk means changes in (3) M arket risk equivalent assets. Calculate the market value of covered positions Capital for State Non-Member Banks; market risk equivalent assets by multiplying resulting from broad market movements, Market Risk the m easure for market risk (as calculated in such as changes in the general level of Section 1. Purpose, Applicability, Scope, and interest rates, equity prices, foreign exchange paragraph (a)(2) of this section) by 12.5. (4) D enominator calculation. Add market Effective Date rates, or commodity prices. risk equivalent assets (as calculated in (2) Specific risk means changes in the (a) Purpose. The purpose of this appendix paragraph (a)(3) of this section) to adjusted market value of specific positions due to is to ensure that banks w ith significant risk-weighted assets (as calculated in factors other than broad market movements exposure to market risk m aintain adequate paragraph (a)(1) of this section). The resulting and includes such risk as the credit risk of capital to support that exposure.1 This sum is the bank’s risk-based capital ratio an instrum ent’s issuer. appendix supplements and adjusts the riskdenominator. (c) Tier 1 and Tier 2 capital are defined in based capital ratio calculations u nder (b) Risk-based capital ratio numerator. A appendix A of this part. appendix A of this part w ith respect to those bank subject to this appendix shall calculate (d) Tier 3 capital is subordinated debt that banks. its risk-based capital ratio numerator by (b) Applicability. (1) This appendix applies is unsecured; is fully paid up; has an original allocating capital as follows: m aturity of at least two years; is not to any insured state nonmember bank whose (1) Credit risk allocation. Allocate Tier 1 redeemable before maturity w ithout prior trading activity 2 (on a w orldwide and Tier 2 capital equal to 8.0 percent of approval by the FDIC; includes a lock-in consolidated basis) equals: adjusted risk-weighted assets (as calculated clause precluding payment of either interest (1) 10 percent or more of total assets;3 or in paragraph (a)(1) of this section).8 or principal (even at maturity) if the payment (ii) $1 billion or more. (2) Market risk allocation. Allocate Tier 1, w ould cause the issuing bank’s risk-based (2) The FDIC may additionally apply this Tier 2, and Tier 3 capital equal to the capital ratio to fall or remain below the appendix to any insured state nonmember measure for market risk as calculated in m inim um required under appendix A of this paragraph (a)(2) of this section. The sum of bank if the FDIC deems it necessary or part; and does not contain and is not covered Tier 2 and Tier 3 capital allocated for market appropriate for safe and sound banking by any covenants, terms, or restrictions that risk m ust not exceed 250 percent of Tier 1 practices. are inconsistent w ith safe and sound banking capital allocated for market risk. (This (3) The FDIC may exclude an insured state practices. requirem ent means that Tier 1 capital nonmember bank otherwise meeting the (e) Value-at-risk (VAR) means the estimate allocated in this paragraph (b)(2) m ust equal criteria of paragraph (b)(1) of this section of the maximum am ount that the value of at least 28.6 percent of the measure for from coverage under this appendix if it covered positions could decline during a market risk.) determines the bank meets such criteria as a fixed holding period w ithin a stated (3) Restrictions, (i) The sum of Tier 2 consequence of accounting, operational, or confidence level, m easured in accordance capital (both allocated and excess) and Tier sim ilar considerations, and the FDIC deems w ith section 4 of this appendix. 3 capital (allocated in paragraph (b)(2) of this it consistent w ith safe and sound banking section) may not exceed 100 percent o f Tier practices. Section 3. A djustm ents to the Risk-Based 1 capital (both allocated and excess).9 (c) Scope. The capital requirements of this Capital Ratio Calculations. (ii) Term subordinated debt (and appendix support market risk associated w ith (a) Risk-based capital ratio denominator. A intermediate-term preferred stock and related a bank’s covered positions. bank subject to this appendix shall calculate surplus) included in Tier 2 capital (both (d) Effective date. This appendix is its risk-based capital ratio denominator as allocated and excess) may not exceed 50 effective as of January 1,1997. Compliance follows: percent of Tier 1 capital (both allocated and is not mandatory until January 1,1998. (1) A djusted risk-weighted assets. Calculate excess). Subject to supervisory approval, a bank may adjusted risk-weighted assets, w hich equals (4) Num erator calculation. Add Tier 1 opt to comply w ith this appendix as early as risk-weighted assets (as determined in capital (both allocated and excess), Tier 2 January 1 , 1997.4 accordance with appendix A of this part), capital (both allocated and excess), and Tier excluding the risk-weighted am ounts of all 3 capital (allocated under paragraph (b)(2) of 1This appendix is based on a framework covered positions (except foreign exchange this section). The resulting sum is the bank’s developed jointly by supervisory authorities from positions outside the trading account and risk-based capital ratio numerator. the countries represented on the Basle Committee over-the-counter derivative positions).7 on Banking Supervision and endorsed by the Group Section 4. Internal Models (2) Measure fo r market risk. Calculate the of Ten Central Bank Governors. The framework is (a) General. For risk-based capital measure for market risk, w hich equals the described in a Basle Committee paper entitled purposes, a bank subject to this appendix "A m endm ent to the Capital Accord to Incorporate part, w hich incorporates capital charges for certain market risks into the risk-based capital ratio. When calculating their riskbased capital ratio u nder this appendix A, such banks are required to refer to appendix C of this part for supplemental rules to determine qualifying and excess capital, calculate risk-weighted assets, calculate market risk equivalent assets and add them to risk-weighted assets, and calculate riskbased capital ratios as adjusted for market risk. * * * * * Market Risk,” January 1996. 2 Trading activity means the gross sum of trading assets and liabilities as reported in the bank’s most recent quarterly Consolidated Report of Condition and Income (Call Report). 3 Total assets m eans quarter-end total assets as reported in the bank’s most recent Call Report. 4 A bank that voluntarily complies with the final rule prior to January 1,1998, m ust comply with all of its provisions. 5 Subject to FDIC review, a bank may exclude structural positions in foreign currencies from its covered positions. ‘ The term trading account is defined in the instructions to the Call Report. ’ Foreign exchange positions outside the trading account and all over-the-counter derivative positions, w hether or not in the trading account, m ust be included in adjusted risk weighted assets as determ ined in appendix A of this part. 8 A bank may not allocate Tier 3 capital to support credit risk (as calculated under appendix A of this part). ’ Excess Tier 1 capital means Tier 1 capital that has n ot been allocated in paragraphs (b)(1) and (b)(2) of this section. Excess Tier 2 capital means Tier 2 capital that has not been allocated in paragraph (b)(1) and (b)(2) of this section, subject to the restrictions in paragraph (b)(3) of this section. Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations m ust use its internal model to measure its daily VAR, in accordance with the requirements of this section.10 The FDIC may permit a bank to use alternative techniques to measure the market risk of de minimis exposures so long as the techniques adequately measure associated market risk. (b) Qualitative requirements. A bank subject to this appendix m ust have a risk management system that meets the following minim um qualitative requirements: (1) The bank m ust have a risk control unit that reports directly to senior management and is independent from business trading units. (2) The bank’s internal risk measurement model m ust be integrated into the daily management process. (3) The bank’s policies and procedures must identify, and the bank m ust conduct, appropriate stress tests and backtests.11 The bank’s policies and procedures m ust identify the procedures to follow in response to the results of such tests. (4) The bank must conduct independent reviews of its risk measurement and risk management systems at least annually. (c) Market risk factors. The bank’s internal model m ust use risk factors sufficient to measure the market risk inherent in all covered positions. The risk factors must address interest rate risk,12 equity price risk, foreign exchange rate risk, and commodity price risk. (d) Q uantitative requirements. For regulatory capital purposes, VAR measures must meet the following quantitative requirements: (1) The VAR measures must be calculated on a daily basis using a 99 percent, one-tailed confidence level w ith a price shock equivalent to a ten-business day movement in rates and prices. In order to calculate VAR measures based on a ten-day price shock, the bank may either calculate ten-day figures directly or convert VAR figures based on holding periods other than ten days to the equivalent of a ten-day holding period (for instance, by multiplying a one-day VAR measure by the square root of ten). (2) The VAR measures m ust be based on an historical observation period (or effective observation period for a bank using a 10A bank's internal model may use any generally accepted measurement techniques, such as variance-covariance models, historical simulations, or Monte Carlo simulations. However, the level of sophistication and accuracy of a bank’s internal model m ust be commensurate w ith the nature and size of its covered positions. A bank that modifies its existing modeling procedures to comply w ith the requirements of this appendix for risk-based capital purposes should, nonetheless, continue to use the internal model it considers most appropriate in evaluating risks for other purposes. 11 Stress tests provide information about the impact of adverse market events on a bank’s covered positions. Backtests provide information about the accuracy of an internal model by comparing a bank’s daily VAR measures to its corresponding daily trading profits and losses. 12For material exposures in the major currencies and markets, modeling techniques m ust capture spread risk and m ust incorporate enough segments of the yield curve—at least six—to capture differences in volatility and less than perfect correlation of rates along the yield curve. 47377 weighting scheme or other similar method) of covered debt and/or equity positions and that those measures are included in the VARat least one year. The bank m ust update data sets at least once every three months or more based capital charge in section 3(a)(2)(i) of frequently as market conditions warrant. this appendix, then the bank may reduce or (3) The VAR measures must include the eliminate its specific risk add-on under this risks arising from the non-linear price section. The determination as to whether a characteristics of options positions and the model incorporates specific risk must be sensitivity of the market value of the made separately for covered debt and equity positions to changes in the volatility of the positions. underlying rates or prices. A bank with a (1) If a model includes the specific risk of large or complex options portfolio m ust covered debt positions but not covered equity measure the volatility of options positions by positions (or vice versa), then the bank can different maturities. reduce its specific risk charge for the (4) The VAR measures may incorporate included positions under paragraph (b) of empirical correlations w ithin and across risk this section. The specific risk charge for the categories, provided that the bank’s process positions not included equals the standard for measuring correlations is sound. In the specific risk capital charge under paragraph event that the VAR measures do not (c) of this section. incorporate empirical correlations across risk (2) If a model addresses the specific risk of categories, then the bank must add the both covered debt and equity positions, then separate VAR measures for the four major the bank can reduce its specific risk charge risk categories to determine its aggregate VAR for both covered debt and equity positions measure. under paragraph (b) of this section. In this (e) Backtesting. (1) Beginning one year after case, the comparison described in paragraph a bank starts to comply with this appendix, (b) of this section must be based on the total a bank must conduct backtesting by VAR-based figure for the specific risk of debt comparing each of its most recent 250 and equity positions, taking into account any business days’ actual net trading profit or correlations that are built into the model. loss 13 with the corresponding daily VAR (b) VAR-based specific risk capital charge. measures generated for internal risk In all cases where a bank measures specific measurement purposes and calibrated to a risk in its internal model, the total capital one-day holding period and a 99 percent, charge for specific risk (i.e., the VAR-based one-tailed confidence level. specific risk capital charge plus the specific (2) Once each quarter, the bank m ust risk add-on) must equal at least 50 percent identify the number of exceptions, that is, the of the standard specific risk capital charge number of business days for w hich the (this am ount is the minimum specific risk magnitude of the actual daily net trading charge). loss, if any, exceeds the corresponding daily (1) If the portion of a bank’s VAR measure VAR measure. that is attributable to specific risk (multiplied (3) A bank must use the multiplication by the bank’s multiplication factor if required factor indicated in Table 1 of this appendix in section 3(a)(2) of this appendix) is greater in determining its capital charge for market than or equal to the minim um specific ri sk risk under section 3(a)(2)(i)(B) of this charge, then the bank has no specific risk appendix until it obtains the next quarter’s add-on and its capital charge for specific risk backtesting results, unless the FDIC is the portion included in the VAR measure. determines that a different adjustm ent or (2) If the portion of a bank’s VAR measure other action is appropriate. that is attributable to specific risk (multiplied by the bank’s multiplication factor if required T able 1 .— M ultiplication F a c t o r in section 3(a)(2) of this appendix) is less than the minim um specific risk charge, then Ba se d o n R e s u l t s o f B a c k testin g the bank’s specific risk add-on i§ the Multiplica difference between the minimum specific Number of exceptions tion factor risk charge and the specific risk portion of the VAR measure (multiplied by the bank’s 4 or fewer.................................... 3.00 multiplication factor if required in section 5 .................................................. 3.40 3(a)(2) of this appendix). 6 .................................................. 3.50 (c) Standard specific risk capital charge. 7 .................................................. 3.65 The standard specific risk capital charge 8 ..................................... ............. 3.75 equals the sum of the components for 9 .................................................. 3.85 covered debt and equity positions as follows: 10 or more .................................. 4.00 (1) Covered debt positions, (i) For purposes of this section 5, covered debt positions Section 5. Specific Risk means fixed-rate or floating-rate debt instruments located in the trading account (a) Specific risk add-on. For purposes of and instrum ents located in the trading section 3(a)(2)(ii) of this appendix, a bank’s account with values that react primarily to specific risk add-on equals the standard changes in interest rates, including certain specific risk capital charge calculated under non-convertible preferred stock, convertible paragraph (c) of this section. If, however, a bonds, and instrum ents subject to repurchase bank can demonstrate to the FDIC that its and lending agreements. Also included are internal model measures the specific risk of derivatives (including written and purchased options) for w hich the underlying instrum ent 13 Actual net trading profits and losses typically is a covered debt instrum ent that is subject include such things as realized and unrealized to a non-zero specific risk capital charge. gains and losses on portfolio positions as w ell as (A) For covered debt positions that are fee income and commissions associated with derivatives, a bank m ust risk-weight (as trading activities. 47378 Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / Rules and Regulations described in paragraph (c)(l)(iii) of this section) the market value of the. effective notional am ount of the underlying debt instrum ent or index portfolio. Swaps m ust be included as the notional position in the underlying debt instrum ent or index portfolio, w ith a receiving side treated as a long position and a paying side treated as a short position; and (B) For covered debt positions that are options, whether long or short, a bank must risk-weight (as described in paragraph (c)(l)(iii) of this section) the market value of the effective notional am ount of the underlying debt instrum ent or index m ultiplied by the option’s delta. (ii) A bank may net long and short covered debt positions (including derivatives) in identical debt issues or indices. (iii) A bank m ust m ultiply the absolute value of the current market value of each net long or short covered debt position by the appropriate specific risk weighting factor indicated in Table 2 of this appendix. The specific risk capital charge component for covered debt positions is the sum of the weighted values. T a b l e 2 .— S p e c if ic R is k W e ig h t in g Fa c t o r s f o r C o v e r e d D e b t Po s i t io n s Category Government..... Qualifying......... Other ................ Remaining maturity (con tractual) Weighting factor (in percent) N/A .............. 6 months or less. Over 6 months to 24 months. Over 24 months. N/A.............. 0.00 025 1.00 1.60 8.00 (A) The governm ent category includes all debt instrum ents of central governments of OECD-based countries 14 including bonds, Treasury bills, and other short-term instruments, as well as local currency instruments of non-OECD central governments to the extent the bank has liabilities booked in that currency. (B) The qualifying category includes debt instrum ents of U.S. government-sponsored agencies, general obligation debt instruments issued by states and other political subdivisions of OECD-based countries, 14 Organization for Economic Cooperation and Development (OECD)-based countries is defined in appendix A of this part. multilateral development banks, and debt instrum ents issued by U.S. depository institutions or OECD-banks that do not qualify as capital of the issuing institution.15 This category also includes other debt instrum ents, including corporate debt and revenue instrum ents issued by states and other political subdivisions of OECD countries, that are: (3) Rated investment-grade by at least two nationally recognized credit rating services; (2) Rated investment-grade by one nationally recognized credit rating agency and not rated less than investment-grade by any other credit rating agency; or (3) Unrated, but deem ed to be of comparable investment quality by the reporting bank and the issuer has instruments listed on a recognized stock exchange, subject to review by the FDIC. (C) The other category includes debt instruments that are not included in the government or qualifying categories. (2) Covered equity positions, (i) For purposes of this section 5, covered equity positions means equity instrum ents located in the trading account and instrum ents located in the trading account with values that react primarily to changes in equity prices, including voting or non-voting common stock, certain convertible bonds, and commitments to buy or sell equity instruments. Also included are derivatives (including w ritten and purchased options) for w hich the underlying is a covered equity position. (A) For covered equity positions that are derivatives, a bank m ust risk weight (as described in paragraph (c)(2)(iii) of this section) the market value of the effective notional am ount of the underlying equity instrum ent or equity portfolio. Swaps must be included as the notional position in the underlying equity instrum ent or index portfolio, w ith a receiving side treated as a long position and a paying side treated as a short position; and (B) For covered equity positions that are options, w hether long or short, a bank must risk weight (as described in paragraph (c)(2)(iii) of this section) the market value of the effective notional am ount of the underlying equity instrum ent or index m ultiplied by the option’s delta. (ii) A bank may net long and short covered equity positions (including derivatives) in identical equity issues or equity indices in the same market.16 15 U.S. government-sponsored agencies, m ultilateral development banks, and OECD banks are defined in appendix A of this part. 16A bank may also net positions in depository receipts against an opposite position in the (iii)(A) A bank m ust m ultiply the absolute value of the current market value of each net long or short covered equity position by a risk weighting factor of 8.0 percent, or by 4.0 percent if the equity is held in a portfolio that is both liquid and w ell-diversified.17 For covered equity positions that are index contracts comprising a well-diversified portfolio of equity instrum ents, the net long or short position is m ultiplied by a risk weighting factor of 2.0 percent. (B) For covered equity positions from the following futures-related arbitrage strategies, a bank may apply a 2.0 percent risk weighting factor to one side (long or short) of each position w ith the opposite side exem pt from charge, subject to review by the FDIC: (1) Long and short positions in exactly the same index at different dates or in different market centers; or (2) Long and short positions in index contracts at the same date in different but similar indices. (C) For futures contracts on broadly-based indices that are m atched by offsetting positions in a basket of stocks comprising the index, a bank may apply a 2.0 percent risk weighting factor to the futures and stock basket positions (long and short), provided that such trades are deliberately entered into and separately controlled, and that the basket of stocks comprises at least 90 percent of the capitalization of the index. (iv) The specific risk capital charge com ponent for covered equity positions is the sum of the weighted values. By Order of the Board of Directors. Dated at Washington, D.C., this 13th day of August, 1996. Federal Deposit Insurance Corporation. Jerry L. Langley, Executive Secretary. [FR Doc. 96-22546 Filed 9-5-96; 8:45 am] BILLING CODE 4 8 10-33-P ; 6210-01-P ; 6714-01-P underlying equity or identical equity in different markets, provided that the bank includes the costs of conversion. 17A portfolio is liquid and well-diversified if: (1) it is characterized by a limited sensitivity to price changes of any single equity issue or closely related group of equity issues held in the portfolio; (2) the volatility of the portfolio’s value is not dominated by the volatility of any individual equity issue or by equity issues from any single industry or economic sector; (3) it contains a large number of individual equity positions, with no single position representing a substantial portion of the portfolio’s total market value; and (4) it consists mainly of issues traded on organized exchanges or in wellestablished over-the-counter markets.
@FedFRASER