Full text of Federal Reserve Bank of New York Circulars : 10797. Risk-Based Capital Guidelines

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FEDERAL RESERVE BANK
OF NEW YORK

[

Circular No. 10797
August 4, 1995

~1

RISK-BASED CAPITAL GUIDELINES
Requests for Comments on Capital Requirements for Market Risk
Comments Due September 18 and November 1

To All State Member Banks and Bank Holding Companies
in the Second Federal Reserve District, and Others Concerned:

Following is the text of a statement issued by the Board of Governors of the Federal Reserve
System:
The Federal Reserve Board has requested comment on a proposal to amend its risk-based
capital requirements to incorporate a measure for market risk in foreign exchange and
commodity activities and in the trading of debt and equity instruments.
Comment is requested by September 18, 1995.
Under the proposal, state member banks and bank holding companies (institutions) with
relatively large trading activities would calculate their capital charges for market risk using either
their own internal value-at-risk model(s) or, alternatively, risk management techniques that were
developed by supervisors.
The effect of the proposed rules would be that, in addition to existing capital requirements
for credit risk, certain institutions would be required to hold capital based on the measure of their
market risk exposure.
The proposed rule is based on a proposal issued by the Basle Committee on Banking
Supervision in April and would go into effect at the end of 1997.
The Board also is requesting comment on a possible approach to setting capital requirements
for market risk, which, if feasible, might form the basis for future enhancements to supervisory
procedures.
Comment is requested by November 1, 1995.
This approach would require a bank to specify the amount of capital it chose to allocate to
support market risks. If cumulative losses over some subsequent trading interval exceed the
commitment, the bank would be subject to regulatory penalties, such as fines, higher capital
requirements, or restrictions on trading activities. Public disclosure of commitments, results, and
any penalties might also be required, which would bring market discipline to bear on the bank’s
capital allocations.
In theory, the penalties could be calibrated to ensure that capital allocations were consistent
with supervisory objectives.




(OVER)

4

Enclosed — for state member banks and bank holding companies in this District — are the
texts of the Board’s official notices, as published in the Federal Register. (The related proposed
regulatory provisions of the Office of the Comptroller of the Currency and the Federal Deposit
Insurance Corporation are not included in the enclosure.) Additional copies of the enclosure may
be obtained from our Circulars Division (Tel. No. 212-720-5215 or 5216).




Comments on the first proposal — to incorporate a measure for market risk in foreign
exchange and commodity activities and in the trading of debt and equity instruments (pages
38082-38129) — should be submitted by September 18, 1995. Questions on the technical aspects
of this proposal may be directed, at this Bank, to Beverly J. Hirtle, Vice President (212-720-7544)
or Darryll Hendricks, Senior Economist (212-720-6561). Questions relating to the supervisory
implications of the proposal should be directed to Christine M. Cumming, Senior Vice President
(212-720-1830) or John Dearie, Staff Director, Domestic Surveillance Staff (212-720-2053).
Comments on the second notice — a possible approach to setting capital requirements for
market risk (pages 38142-38144) — should be submitted by November 1, 1995.

W illia m J. M c D o n o u g h ,

President.

7 -2 5-9 5
Vol. 60

Tuesday
July 25, 1995

Part II
Market Risk-Based Capital
Standards and Capital
Requirements for Market
Risk; Proposed Rules

[Enc. Cir. No. 10797]




[PRINTED IN NEW YORK]

38082

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

D EPA R T M EN T O F THE T R E A SU R Y

Office of the Comptroller of the
Currency
12 CFR Part 3
[Docket No. 95-19]
RIN 1557-AB14

FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[Regulations H and Y; Docket No. R-0884]

FEDERAL DEPOSIT INSURANCE
CORPORATION
12 CFR Part 325
RIN 3064-AB64

Risk-Based Capital Standards: Market
Risk
AGENCIES: Office of the Comptroller of
the Currency (OCC), Department of the
Treasury; Board of Governors of the
Federal Reserve System (Board), and the
Federal Deposit Insurance Corporation
(FDIC).
ACTION: Joint notice of proposed
rulemaking.
SUMMARY: The Office of the Comptroller
of the Currency (OCC), the Board of
Governors of the Federal Reserve
System (Board), and the Federal Deposit
Insurance Corporation (FDIC) (the
Agencies) are proposing to amend their
risk-based capital requirements to
incorporate a measure for market risk in
foreign exchange and commodity
activities and in the trading of debt and
equity instruments. Under the proposal,
banks and hank holding companies
(institutions) regulated by the OCC, the
Board, and the FDIC with relatively
large trading activities would calculate
their capital charges for market risk
using either their own internal value-atrisk model(s) or, alternatively, risk
measurement techniques that were
developed by supervisors. The effect of
the proposed market risk measure
would be that, in addition to existing
capital requirements for credit risk,
certain institutions would be required to
hold capital based on the measure of
their market risk exposure.
DATES: Comments must be received on
or before September 18,1995.
ADDRESSES: Comments should be
directed to:
OCC: Comments may be submitted to
Docket Number 95-19, Communications
Division, Third Floor, Office of the
Comptroller of the Currency, 250 E
Street, S.W., Washington, DC 20219.




Comments w ill be available for
inspection and photocopying at that
address.
Board: Comments directed to the
Board should refer to Docket No.R-0884
and may be mailed to William W. Wiles,
Secretary, Board of Governors of the
Federal Reserve System, 20th Street and
Constitution Avenue, N.W.,
Washington, D.C. 20551. Comments
may also be delivered to Room B-2222
of the Eccles Building between 8:45 and
5:15 p.m. weekdays, or to the guard
station in the Eccles Building courtyard
on 20th Street, N.W. (between
Constitution Avenue and C Street) at
any time. Comments may be inspected
in Room MP-500 of the Martin Building
between 9 a.m. and 5 p.m. weekdays,
except as provided in 12 CFR 261.8 of
the Board’s rules regarding availability
of information.
FDIC: Written comments should be
sent to Jerry L. Langley, Executive
Secretary, Attention: Room F—402,
Federal Deposit Insurance Corporation,
550 17th Street N.W., Washington, D.C.
20429. Comments may be handdelivered to Room, F—402,1776 F Street
N.W., Washington, D.C. 20429, on
business days between 8:30 a.m. and 5
p.m. (Fax number (202)898-3838;
Internet address: comments@fdic.gov).
Comments w ill be available for
inspection and photocopying in Room
7118, 550 17th Street, N.W.,
Washington, D.C. 20429, between 9 a.m.
and 4:30 p.m. on business days.
FOR FURTHER INFORMATION CONTACT:

OCC: Roger Tufts, Senior Economic
Advisor (202/874—5070), or Christina
Benson, Capital Markets Specialist,
(202/874-5070) Office of the Chief
National Bank Examiner. For legal
issues, Ronald Shimabukuro, Senior
Attorney, Legislative and Regulatory
Activities Division (202/874-5090),
Office of the Comptroller of the
Currency, 250 E Street S.W.,
Washington, D.C. 20219.
Board: Roger Cole, Deputy Associate
Director (202/452-2618), James Houpt,
Assistant Director (202/452-3358),
Barbara Bouchard, Supervisory
Financial Analyst (202/452-3072),
Division of Banking Supervision and
Regulation; or Stephanie Martin, Senior
Attorney (202/452-3J98), Legal
Division. For the hearing impaired only,
Telecommunication Device for the Deaf,
Dorothea Thompson (202/452-3544).
FDIC: William A. Stark, Assistant
Director, (202/898-6972), Kenton Fox,
Senior Capital Markets Specialist, (202/
898-7119), Division of Supervision;
Jamey Basham, Counsel, (202/8987265), Legal Division, FDIC, 550 17th
Street, N.W., Washington, D.C. 20429.

The
Agencies are proposing amendments to
their risk-based capital requirements to
incorporate a measure for market risk.
The proposed amendments would
generally apply only to institutions that
have (1) total assets exceeding $5 billion
and either on-balance-sheet trading
activities representing at least 3.0
percent of total assets or a volume of offbalance-sheet trading activities with
notional amounts exceeding $5 billion,
or (2) total assets of $5 billion or less
and a volume of trading activities
representing at least 10.0 percent of total
assets.
SUPPLEMENTARY INFORMATION:

I. B a c k gro u n d

The Agencies’ risk-based capital
standards are based upon the principles
contained in the agreement on
International Convergence of Capital
Measurement and Capital Standards of
July, 1988 (the Accord) that was agreed
to by the Basle Committee on Banking
Supervision (the Committee) and
endorsed by the central bank governors
of the Group of Ten (G-10) countries.1
That Accord sets forth a framework for
measuring capital adequacy under
which weighted risk assets are
calculated by weighting an institution’s
assets and off-balance-sheet items on the
basis of their perceived credit risk using
a relatively small number of risk
categories.
By focusing on credit risk, the risk
that a loss w ill be incurred due to an
obligor or counterparty default on a
transaction, the Accord generally
excludes coverage of risks arising from
adverse movements in market interest
rates, foreign exchange rates, or
commodity or equity prices. The
potential for loss from such movements
is referred to as market risk. In April
1993, ih e Committee, recognizing the
need to incorporate market risk into the
risk-based capital standard, requested
comments on an initial measurement
framework. The Agencies’ current
proposal reflects substantial revisions to
that 1993 paper and is based upon
revisions to the Accord that were
proposed by the Committee on April 12,
1995.2
The 1993 paper proposed
standardized measurement procedures
for assessing risks in traded debt, equity,
1The Basle Supervisors’ Committee is comprised
of representatives of the central banks and
supervisory authorities from the G-10 countries
(Belgium, Canada, France, Germany, Italy, Japan,
The Netherlands, Sweden, Switzerland, the United
Kingdom, and the United States) plus Luxembourg.
2The Committee's document is entitled “Proposal
to Issue a Supplement to the Basle Capital Accord
to Cover Market Risks" and is available through the
Board’s and the OCC’s Freedom of Information
Office and the FDIC’s Reading Room.

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
a n d fo r e ig n e x c h a n g e a c t iv it ie s a n d
p r o v i d e d o n l y a l i m i t e d r o l e f o r a b a n k ’s
in te r n a l m o d e l(s ) in m e a s u r in g m a rk et
r is k e x p o s u r e fo r r e g u la to r y c a p ita l
p u rp o ses. T h ese p ro ced u res w ere
s tr o n g ly c r it ic iz e d b y c o m m e n t e r s to th e
c o n s u lta tiv e d o c u m e n t, e s p e c ia lly b y
in s t itu t io n s in t h e U n ite d S ta te s. T h e s e
in s t itu t io n s g e n e r a lly b e lie v e d th a t th e
m e a su r e m e n t fr a m e w o r k w a s u n d u ly
c u m b e r s o m e a n d p o t e n t ia lly in a c c u r a te ,
e s p e c i a l ly fo r i n s t i t u t i o n s w i t h
s ig n if ic a n t a n d d iv e r s if ie d tr a d in g
a c t iv itie s .
In lie u o f t h e s ta n d a r d iz e d fr a m e w o r k ,
t h e s e in s t it u t io n s u r g e d t h e C o m m itte e
t o a l l o w g r e a t e r u s e o f a n i n s t i t u t i o n ’s
in te r n a l m a r k e t r is k m o d e ls . T h e y n o te d
t h a t la r g e t r a d i n g b a n k s h a v e m a t e r i a l l y
e x p a n d e d th e s o p h is tic a tio n a n d
c o v e r a g e o f t h e ir m a r k e t r is k tr a d in g
m o d e ls . T h e s e m o d e ls a re ty p ic a lly
d e s c r i b e d a s “ v a l u e - a t - r i s k ” (V A R )
m o d e ls , w h ic h e s tim a te t h e m a x im u m
a m o u n t b y w h i c h a n i n s t i t u t i o n ’s
p o r tfo lio c o u ld d e c lin e in m a rk et v a lu e ,
g iv e n a c e r ta in le v e l o f s t a t is t ic a l
c o n fid e n c e a n d a n a s s u m e d h o ld in g
p e r io d . T h e c o m m e n te r s b e lie v e d th a t
th e s e m o d e ls w o u ld p r o v id e a m o r e
a c c u r a te r is k m e a s u r e a n d w o u l d b e
b e t te r a b le t o in c o r p o r a t e n e w p r o d u c ts
a n d a c tiv itie s th a n w o u ld th e
sta n d a r d iz e d fr a m e w o r k . T h e y a ls o
b e lie v e d th a t im p o s in g a r ig id
su p e r v is o r y m e a s u r e m e n t s y s te m o n
in s t itu t io n s w o u ld r e s u lt in u n n e c e s s a r y
c o s t s a n d c o u l d e n c o u r a g e i m p r o p e r r is k
m a n a g e m e n t p r a c tic e s i f in s t itu t io n s
s o u g h t to m in im iz e t h e c a p ita l
r e q u ir e m e n ts r e s u ltin g fr o m th e
p r o p o s e d r is k m e a s u r e . M a n y la r g e
E u r o p e a n b a n k s a ls o u r g e d th e u s e o f
in te r n a l m o d e ls fo r m e a s u r in g m a r k e t
r is k s fo r r e g u la to r y c a p it a l p u r p o s e s , b u t
w e r e g e n e r a lly le s s c r itic a l, in p a rt
b e c a u se th e E u ro p ea n U n io n h a d
a d o p te d in to E u r o p e a n la w a r e g im e
s im ila r to th e o n e o u t lin e d in t h e 1 9 9 3
p a p e r .3
In r e s p o n s e to t h e s e a n d o th e r
c o m m e n t s a n d c o n c e r n s , th e C o m m itte e
is s u e d a n e w p r o p o s a l o n A p r il 1 2 ,
1 9 9 5 . In a d d it io n to e x p a n d in g th e

a p p r o v a l o f it s a p p r o p r ia te s u p e r v is o r
a n d w o u ld b e c o n tin g e n t u p o n
c o n fo r m a n c e w it h c e r ta in q u a lita t iv e
a n d q u a n tit a tiv e s ta n d a r d s r e g a r d in g t h e
m ea su rem en t a n d m a n a g em en t o f
m a r k e t r is k s . A n in s t it u t io n w h o s e
in te r n a l m o d e l f a ile d to m e e t t h o s e
s ta n d a r d s o r o t h e r w is e f a ile d to g a in
r e g u la to r y a p p r o v a l w o u l d b e r e q u ir e d
t o u s e s t a n d a r d iz e d r is k m e a s u r e m e n t
te c h n iq u e s a s s e t fo r th in th e
C o m m i t t e e ’s A p r i l 1 9 9 5 p r o p o s a l . T h i s
la t t e r a p p r o a c h i s r e f e r r e d t o a s t h e
“ s t a n d a r d iz e d r is k m e a s u r e ” a p p r o a c h ,
a s it a p p lie s s t a n d a r d iz e d a s s u m p t io n s
a n d r i s k f a c t o r s t o a n i n s t i t u t i o n ’s
a c t iv itie s .
T h e A g e n c ie s a re n o w p r o p o s in g
a m e n d m e n t s to t h e ir r is k -b a s e d c a p ita l
sta n d a r d s th a t a re s im ila r to th e
p r o p o sa l r e c e n tly is s u e d b y th e
C o m m i t t e e . 4 *T h e A g e n c i e s w o u l d
e n c o u r a g e in s titu tio n s th a t a re a ffe c te d
b y t h is p r o p o s a l, a n d e s p e c ia lly t h o s e
w it h la r g e tr a d in g a c c o u n t s , to c o m p ly
w it h t h e p r o p o s e d r e q u ir e m e n ts b y
u s in g t h e p r o p r ie ta r y in te r n a l m o d e ls
t h a t t h e y U 6e t o m a n a g e m a r k e t r is k .
T h e A g e n c ie s b e lie v e th a t s u c h
m o d e ls s h o u ld p r o v id e a m o r e a c c u r a te
m e a su r e o f m a r k e t r is k th a n th e
sta n d a r d iz e d r is k m e a s u r e a n d w o u ld
im p o s e fe w e r c o s ts a n d b u r d e n s o n
in s t itu t io n s . B y u s in g in te r n a l m o d e ls
n o t o n ly fo r o p e r a tin g p u r p o s e s , b u t a ls o
a s a b a s i s f o r determining c a p i t a l
r e q u ir e m e n ts , in s t it u t io n s s h o u ld b e
fu r th e r e n c o u r a g e d to c o n t in u e th e ir
e ffo r ts to r e f in e t h e a c c u r a c y o f th e ir
p r o p r ie ta r y m o d e ls , e s p e c i a l ly w it h
r e g a r d to o p t io n s r is k . G iv e n t h e ir
p r e fe r e n c e fo r t h e u s e o f in te r n a l m o d e ls
fo r m e a s u r in g m a r k e t r is k , t h e A g e n c ie s
r e q u e s t c o m m e n t s r e g a r d in g w h e t h e r
in s t itu t io n s s h o u ld b e p e r m itte d a
c h o ic e b e tw e e n th e tw o m e a su r e m e n t
p r o c e d u r e s , o r o n ly b e p e r m itte d to u s e
in te r n a l m o d e ls .

II. Scope: Activities and Institutions
Covered by the Proposal
T h is p r o p o sa l w o u ld e s ta b lis h n e w
c a p ita l r e q u ir e m e n ts fo r g e n e r a l m a r k e t
r is k a n d s p e c if ic r is k a s t h e y p e r ta in to

e a r lie r p r o p o s a l b y p r o v id in g m e a s u r e s
fo r r is k s in c o m m o d it ie s a n d o p tio n s ,

t h e tr a d in g a c t iv it ie s o f a b a n ld n g

t h is la te st p r o p o s a l w o u ld a llo w
in s t it u t io n s to u s e t h e ir in te r n a l m a r k e t

o th e r fo r e ig n e x c h a n g e a n d c o m m o d it ie s

o r g a n i z a t i o n a n d t o t h e o r g a n i z a t i o n ’s
a c tiv itie s . A s s u c h , th e p r o p o s e d

r is k m o d e ls to m e a s u r e t h e le v e l o f th e ir
m a r k e t r is k e x p o s u r e a g a in s t w h i c h t h e y

s ta n d a r d , b y c r e a tin g a r is k -b a s e d

w o u l d b e r e q u ir e d t o h o l d c a p it a l. T h is
a p p r o a c h i s r e fe r r e d to a s t h e “ in te r n a l
m o d e l s a p p r o a c h . ” A n i n s t i t u t i o n ’s u s e

t h r o u g h t h e a d d i t i o n o f a m a r k e t r is k e q u iv a le n t a s s e t s m e a s u r e , is a n

c a p i t a l r a t io a d j u s t e d f o r m a r k e t r i s k

in te g r a te d s u p p le m e n t to e x is t in g

o f th is a p p r o a c h w o u ld b e su b je c t to th e

3
The European Union’s Second Directive sets
forth a capital regime for market risk that applies
to banking and securities firms that operate in EU
member countries. These capital requirements
become effective at the beginning of 1996.




4As set forth in the regulatory text, the Agencies
propose to adopt the market risk requirements as
new appendices to their capital adequacy
standards. The OCC may be required to make
additional conforming amendments to its risk-based
capital guidelines.

38083

s t a n d a r d s t h a t a d d r e s s c r e d i t r is k
th r o u g h th e c u r r e n t w e ig h te d -r is k a ss e ts
m ea su re.

For purposes of this proposal, general
market risk refers to changes in the
market value of the covered transactions
that arise from broad market
movements, such as changing levels of
market interest rates, broad equity
indices, or currency exchange rates.
Specific risk includes the credit risk of
an issuer of a traded security, as well as
other factors that affect the market value
of specific instruments, but that do not
materially alter broad market
conditions. Consequently, instruments
other than over-the-counter (OTC)
derivatives that are covered by this
proposal would, in effect, be removed
from and no longer subject to the credit
risk standard previously established.
OTC derivatives would remain subject
to the counterparty credit risk
requirements set forth in the existing
risk-based capital standard.
This proposal defines trading
activities as the sum of all trading assets
and liabilities as reported in the
quarterly Consolidated Reports of
Condition and Income (call report) and
would apply on a fully consolidated
basis to all national banks, state member
banks, and bank holding companies that
meet the following criteria:
(1 ) T h e in s t i t u t i o n h a s to ta l a s s e t s
e x c e e d i n g $ 5 b i l l i o n , a n d (a ) t h e g r o s s
s u m o f tr a d in g a s s e t s a n d lia b ilit ie s o n
a d a ily a v e r a g e b a s is fo r t h e q u a r te r
a c c o u n t fo r 3 .0 p e r c e n t o r m o r e o f t o ta l
a s s e t s , o r (b ) t h e s u m o f t h e n o t i o n a l
a m o u n t o f in te r e s t r a te , f o r e ig n
e x c h a n g e , e q u ity a n d c o m m o d it y o ffb a la n c e - s h e e t d e r iv a tiv e c o n tr a c ts
r e la t in g to tr a d in g a c t iv it ie s e x c e e d s $ 5
b illio n , or
(2 ) T h e i n s t i t u t i o n h a s t o t a l a s s e t s o f
$ 5 b illio n o r le s s a n d tr a d in g a s s e t s a n d
lia b ilit ie s e x c e e d 1 0 p e r c e n t o f to ta l
a ssets.

The Agencies may also apply the
standard to other institutions for safety
and soundness purposes in limited
circumstances and on a case-by-case
basis.
III. Definition of Capital and the Capital
Requirement

The Agencies are also proposing to
expand the definition and types of
qualifying capital that an institution
could use to meet its market risk capital
requirements. This modification and
others require that the procedures for
calculating an institution’s overall riskbased capital ratio be changed.
Definition o f capital. The Accord
permits institutions to meet regulatory
capital requirements with a combination
of “core” (Tier 1) and “supplementary”

38084

F e d e r a l R eg ister

/ v o l . 6 0 , N o . 142 / T u esd a y , July 25, 19 9 5 /

(Tier 2>c a p i t a l . Tier 1 i n c l u d e s e q u i t y ,
n o n c u m u la t iv e p e r p e tu a l p r eferred
s to c k , a n d m in o r it y in te r e s t in
c o n s o lid a te d su b s id ia r ie s , le s s g o o d w ill,
w h i l e T ie r 2 i n c lu d e s t h e a llo w a n c e fo r
lo a n a n d le a s e lo s s e s , o th e r p r eferred
s to c k , a n d s u b o r d in a te d d e b t th a t h a s a n
o r ig in a l w e ig h t e d a v e r a g e m a tu r ity o f at
le a s t f iv e y e a r s .5
T h is p r o p o s a l w o u ld p e r m it
in s t it u t io n s to u s e a th ir d tie r o f c a p ita l
(T ie r 3 ), c o n s is t in g o f sh o r t-te r m
s u b o r d in a te d d e b t. H o w e v e r , t h is c a p ita l
c o u ld b e u s e d o n ly to m e e t c a p ita l
r e q u i r e m e n t s p e r t a i n i n g t o market

risk

a n d o n ly i f th a t d e b t m e e t s c e r ta in
q u a l i f y i n g c o n d i t i o n s : It m u s t h a v e a n
o r ig in a l m a tu r ity o f at le a s t t w o y e a r s ,
b e u n s e c u r e d a n d f u lly p a id u p , a n d
s u b je c t to a lo c k - in p r o v is io n th a t
p r e v e n ts t h e is s u e r fro m r e p a y in g th e
d e b t e v e n a t m a t u r i t y i f t h e i s s u e r ’s
c a p it a l r a tio s a re, o r w it h r e p a y m e n t
w o u ld b e c o m e , le s s th a n t h e m in im u m
8 .0 p e r c e n t r is k -b a s e d c a p ita l
r e q u ir e m e n t.
T h e a g e n c ie s a re p r o p o s in g to a llo w
th e u s e o f T ie r 3 c a p it a l i n r e c o g n it io n
th a t s u c h sh o r t-te r m s u b o r d in a te d d e b t
c a n h e lp to p r o te c t d e p o s ito r s a n d th e
B a n k In su r a n c e F u n d a g a in s t lo s s .
I n d e e d , b e c a u s e t h e u n d e r w r itin g
a c t i v i t i e s o f s e c u r it ie s fir m s o f te n c r e a te
v o la t ile c a p ita l r e q u ir e m e n ts , s e c u r it ie s
r e g u la to r s in m a n y c o u n t r ie s p e r m it
th e ir in s t itu t io n s t o tr e a t s u c h d e b t a s
c a p it a l, w it h s im ila r q u a lific a t io n s . T h e
A g e n c ie s , h o w e v e r , b e lie v e th a t T ie r 1
in s t r u m e n t s s h o u ld r e m a in a s u b s ta n tia l
p r o p o r t i o n o f a n i n s t i t u t i o n ’s t o t a l
c a p ita l a n d , th e r e fo r e , p r o p o s e th e
f o llo w in g c o n s tr a in ts :
(1 ) T i e r 3 c a p i t a l m a y n o t e x c e e d 2 5 0
p e r c e n t o f th e a m o u n t o f T ie r 1 c a p ita l
a llo c a t e d fo r m a r k e t r is k , a n d
(2 ) T ie r 1 c a p it a l m u s t r e p r e s e n t a t
l e a s t 5 0 p e r c e n t o f a n i n s t i t u t i o n ’s t o t a l
e lig ib le c a p it a l— t h e s u m o f T ie r 1 ,
q u a lif y in g T ie r 2 , a n d T ie r 3 t o t h e
e x t e n t it is p e r m itte d in it e m (1 ), a b o v e .
N o t e th a t a n y e le m e n t o f T ie r 2 c a p ita l
m u s t c o n tin u e to c o n fo r m w ith th e
r e q u ir e m e n ts o f th e o r ig in a l A c c o r d ;
th a t is , T ie r 2 m a y n o t e x c e e d t o ta l T ie r
1 c a p it a l, a n d lo n g -te r m s u b o r d in a te d
debt m ay n ot ex cee d 50 p ercen t o f
T ie r 1.

Calculation o f the capital ratio. A n
in s titu tio n su b je c t to t h is p r o p o sa l
w o u ld r e m a in s u b je c t to t h e A g e n c ie s ’
r is k -b a s e d c a p it a l s ta n d a r d s b a s e d o n
c r e d it r is k , b u t w o u ld a ls o b e r e q u ir e d
to s u p p le m e n t it s r is k -b a s e d c a p ita l
r a t i o t o a d j u s t i t f o r m a r k e t r is k . U n d e r

5
Bank holding companies may include
cumulative perpetual preferred stock in Tier 1
capital, subject to the conditions that are specified
in the Board's capital guidelines.




t h e p r o p o s a l, a n in s t itu t io n w o u ld
a c c o m p lis h t h is b y m u lt ip ly in g its
c a p it a l r e q u ir e m e n t fo r m a r k e t r is k (a s
c a lc u la t e d b y th e in te r n a l m o d e l or
s t a n d a r d iz e d a p p r o a c h ) b y 1 2 .5 (th e
r e c i p r o c a l o f t h e m i n i m u m c a p i t a l r a t io
o f 8 .0 p e r c e n t) a n d a d d in g t h e r e s u ltin g
m a r k e t r is k e q u iv a le n t fig u r e to it s
w e ig h t e d r is k a s s e t s , a s c a lc u la t e d b y
t h e c r e d it r is k s ta n d a r d . T h e
i n s t i t u t i o n ’s T i e r 1 a n d t o t a l r i s k - b a s e d
c a p it a l r a tio s w o u ld b e c a lc u la t e d a s t h e
su m o f th e e lig ib le c a p ita l a s a p e r c e n t
o f th e s u m o f m a r k e t r is k - e q u iv a le n t
a s s e t s a n d w e ig h t e d r is k a s s e t s . T h is
a p p r o a c h a v o id s t h e d is t o r t io n s th a t
c o u ld r e s u lt fr o m a llo c a t in g th e
n e c e s s a r y c a p ita l to e ith e r m a r k e t o r
c r e d it r is k a n d t h e n c a lc u la t in g a n
i n s t i t u t i o n ’s c a p i t a l r a t i o o n t h e b a s i s o f
t h e r e m a i n i n g c a p i t a l . It a l s o
i n c o r p o r a t e s t h e r i s k - b a s e d c a p i t a l r a t io
a d ju s te d fo r m a r k e t r is k i n t o t h e c a p it a l
c a te g o r y d e fin itio n s u n d e r th e A g e n c ie s ’
p r o m p t c o r r e c tiv e a c t io n r e g u la tio n s .
D u e t o th e 2 5 0 p e r c e n t c o n s tr a in t o n
T ie r 3 c a p it a l, a n in s t it u t io n th a t w i s h e s
to u s e T ie r 3 c a p it a l m u s t fir s t c a lc u la t e
it s m in im u m c r e d it r is k r e q u ir e m e n t to
d e t e r m in e th e a m o u n t o f T ie r 1 c a p ita l
t h a t i s a v a i l a b l e t o s u p p o r t m a r k e t r is k .
T h is a m o u n t s e ts a n u p p e r lim it o n th e
a m o u n t o f T ie r 3 c a p it a l th a t t h e
in s t itu t io n m a y h a v e . In c a lc u la t in g it s
a g g r e g a te c a p it a l r a tio , h o w e v e r , o n ly
th a t p o r t io n o f T ie r 3 th a t is a c tu a lly
n e e d e d to m e e t it s m a r k e t r is k
r e q u ir e m e n t m a y b e in c lu d e d a s e lig ib le
c a p it a l. T ie r 3 c a p it a l i n e x c e s s o f t h is
a m o u n t w ill n o t b e c o n s id e r e d a s
e lig ib le c a p ita l a s it is n o t p e r m itte d to
m e e t c r e d i t r is k . E l i g i b l e c a p i t a l w o u l d
b e th e su m o f th e w h o le o f d ie
i n s t i t u t i o n ’s T i e r 1 c a p i t a l , p l u s a l l o f i t s
T ie r 2 c a p it a l u n d e r t h e lim it s im p o s e d
in t h e c r e d it r is k A c c o r d , a n d T ie r 3
c a p it a l s u b j e c t to t h e a b o v e r e s tr ic tio n s .
T h e q u o t e d r a tio w i l l t h u s r e p r e s e n t
c a p it a l th a t i s a v a ila b le t o m e e t b o th
c r e d it r is k a n d m a r k e t r is k .6

IV. Partial Models
W ith s u p e r v is o r y a p p r o v a l,

Proposed Rules

h o w e v e r , s h o u ld b e lim it e d to s itu a tio n s
in w h ic h th e in s titu tio n is in th e p r o c e s s
o f d e v e lo p in g a n d im p le m e n tin g th e
in te r n a l m o d e ls a p p r o a c h fo r a ll o f its
tr a d in g a c t iv it ie s a n d w o u ld b e
p e r m itt e d o n ly o n a te m p o r a r y b a s is . In
a d d itio n , th e c o m b in a tio n o f a p p r o a c h e s
u s e d s h o u ld b e c o n s is te n t w ith th e
m e t h o d th e in s t it u t io n u s e s in m a n a g in g
it s r is k s . F o r e x a m p le , i f a n in s t it u t io n
h a s a c o m p r e h e n s iv e v a lu e -a t-r is k
m o d e l fo r it s in te r e s t r a te e x p o s u r e s in
it s tr a d in g p o r tfo lio b u t n o t fo r it s
e q u itie s e x p o su r e s, th e a g e n c ie s w o u ld
e x p e c t th e in s titu tio n to u s e th e
s ta n d a r d iz e d m e a su r e fo r e q u it ie s a n d
t h e in te r n a l m o d e l fo r in te r e s t ra te
e x p o s u r e s . T h e s e c o n d itio n s are
d e s ig n e d to p r e v e n t in s t it u t io n s fr o m
s e l e c t i n g t h e l o w e r o f a l t e r n a t i v e r is k
m e a s u r e s a n d are a ls o in t e n d e d to
e n c o u r a g e in s titu tio n s to d e v e lo p a n d
i m p r o v e t h e i r r is k m e a s u r e m e n t , a n d
m a n a g e m e n t p r a c tic e s .
W h e n c o m b i n a t i o n s o f t h e t w o r is k
m e a su r e m e n t te c h n iq u e s a re u s e d , th e
in s titu tio n s h o u ld m e a su r e a c o m p le te
r is k c a te g o r y u s in g a s in g le a p p r o a c h
a n d n o t m ix te c h n iq u e s w it h in a g iv e n
c a t e g o r y o f r is k . F o r t h i s p u r p o s e , t h e
r is k c a t e g o r ie s a r e d e f in e d a s in te r e s t
r a te s, f o r e ig n e x c h a n g e , e q u ity p r ic e s ,
a n d c o m m o d it y p r ic e s . 'M o r e o v e r , o n c e
a n in s titu tio n a d o p ts a c o m p r e h e n s iv e
v a lu e - a t- r is k m o d e l th a t i s a c c e p t a b le , it
m a y n o t r e v e r t t o t h e s t a n d a r d iz e d r is k
m e a su r e , e x c e p t in u n u su a l
c ir c u m s ta n c e s a n d o n ly w ith
s u p e r v is o r y c o n s e n t. T h e p r o p o sa l
p r o v i d e s s o m e f l e x i b i l i t y f o r de minimis
p o s it io n s , a c t iv itie s in r e m o te lo c a tio n s ,
in m in o r c u r r e n c ie s , o r i n a c t iv itie s th a t
p r e s e n t n e g lig ib le r is k t o t h e in s titu tio n .

V. Internal Models Approach
T h e A g e n c ie s b e lie v e th a t a n
i n s t i t u t i o n ’s m a r k e t r i s k c a n b e m o s t
a c c u r a te ly m e a s u r e d u s in g d e t a ile d
in fo r m a tio n a v a ila b le o n ly to th e
in s titu tio n a n d p r o c e s s e d b y its o w n
p r o p r ie ta r y r is k m e a s u r e m e n t m o d e l(s ).
A c c o r d in g ly , th e A g e n c ie s w o u ld
e n c o u r a g e a ll in s titu tio n s — e s p e c ia lly
t h o s e w it h s i g n ific a n t tr a d in g

in s t itu t io n s w h o s e in te r n a l m o d e ls d o
n o t c o v e r a ll e le m e n t s o f t h e ir tr a d in g
a c tiv itie s m a y u s e c o m p o n e n ts o f th e

a c tiv itie s — to p u r su e t h is a p p r o a c h . T o
b e m o s t r e lia b le , h o w e v e r , t h e

a lte r n a tiv e s ta n d a r d iz e d a p p r o a c h to

m o d e llin g p r o c e s s m u s t b e fu lly

m e a s u r e m a r k e t r is k s fo r r is k -b a s e d

i n t e g r a t e d i n t o t h e i n s t i t u t i o n ’s b r o a d e r
p r o c e d u r e s fo r m a n a g in g r is k a n d m u s t

c a p ita l p u r p o s e s . S u c h c o m b in a t io n s ,

b e a c tiv e ly s u p p o r te d b y s e n io r

6 For example, if an institution had SI 20 of Tier
1 capital, of which $100 was needed to meet its
minimum 8.0 percent risk-based capital standard
for credit risk, only $20 would be available for
market risk. That $20, in turn, would “support” as
much as $50 of Tier 3 capital ($20 X 250%) for
purposes of meeting the capital requirement for
market risk. If the market risk capital requirement
were $50, the institution could count only $30 of
Tier 3 capital as eligible capital in calculating its
regulatory capital requirements.

m a n a g e m e n t It m u s t a l s o c o n f o r m w i t h
o th e r s p e c if ic q u a lita tiv e a n d
q u a n tit a tiv e s ta n d a r d s th a t t h e A g e n c ie s
b e l i e v e a r e n e c e s s a r y in o r d e r to a c h ie v e
a n a d e q u a t e l e v e l o f r ig o r a n d
c o n s is t e n c y in a c a p ita l sta n d a rd . U n d er
t h i s p r o p o s a l , i n s t i t u t i o n s t h a t p l a n to
u s e i n t e r n a l m o d e l s i n c a l c u l a t i n g t h e ir
c a p i t a l r e q u i r e m e n t s f o r m a r k e t r is k

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
w o u ld n e e d t o c o n t a c t t h e ir a p p r o p r ia te
s u p e r v is o r a n d m a k e a r r a n g e m e n ts fo r
h a v in g t h e ir m o d e l s v a lid a t e d fo r
r e g u la to r y c a p it a l p u r p o s e s .

Modelling Market R isk
In o r d e r t o m e a s u r e e x p o s u r e s w h e n
e v a lu a t in g tr a d in g r is k s , m a n y
in s t it u t io n s c a lc u la t e t h e “ v a lu e -a t-r is k ”
(V A R ), r e p r e s e n t in g t h e m a x im u m
a m o u n t b y w h ic h th e m a r k e t v a lu e o f

38085

h o ld in g p e r io d . J u st a s in s t it u t io n s u s e
d iffe r e n t h is t o r ic a l t im e p e r io d s w h e n
c o m p u tin g p o s s ib le c h a n g e s in m a rk et
r is k fa c to r s , t h e y a ls o u s e d iffe r e n t

s im ila r r is k e x p o s u r e s h a v e s im ila r
c a p it a l r e q u ir e m e n ts .
S in c e in s t it u t io n s u s e V A R to g u id e
t h e m in s e tt in g tr a d in g lim it s , ra th er

c o n fid e n c e le v e ls to e s tim a te p o te n tia l
lo s s e s . S o m e in s titu tio n s u s e a 9 0 o r 9 5

th a n fo r e v a lu a t in g c a p it a l a d e q u a c y ,

p e r c e n t c o n f id e n c e le v e l (o n e -ta il),

a d d r e ss n o rm a l c o n d itio n s . In d e e d , th e
m o d e ls are d e s ig n e d to e n s u r e th a t

w h ile o th e r s u s e a h ig h e r le v e l o f
s t a tis tic a l c o n f id e n c e .
I n s titu tio n s a ls o u s e d iffe r e n t

th e y se t th e ir m o d e l p a r a m e te r s to

a c t u a l t r a d in g r e s u lt s o f t e n e x c e e d t h e
p ro je c te d le v e ls s o th a t m a n a g e m e n t is

m o d e llin g p r o c e d u r e s in c a lc u la t in g
t h e ir m a r k e t r is k e x p o s u r e s . T h e m o s t
c o m m o n m o d e ls are b a se d u p o n

b e t t e r a b l e t o e v a l u a t e t h e m o d e l ’s

v a r ia n c e /c o v a r ia n c e m e th o d o lo g ie s ,
h i s t o r i c a l s i m u l a t i o n s , o r M o n t e C a r lo

g a in s o r lo s s e s . D u r in g a g iv e n y e a r , fo r
e x a m p le , a m o d e l b a s e d o n a 9 0 p e r c e n t
c o n f id e n c e le v e l (o n e t a il) c o u ld b e

t h e ir t r a d in g p o r t f o lio s c o u l d d e c lin e
d u r in g a s p e c if ic p e r io d o f t im e a n d
w it h a c e r ta in d e g r e e o f s t a t is t ic a l
c o n fid e n c e . F o r e x a m p le , a t th e c lo s e o f
b u s in e s s o n d a y o n e a b a n k m ig h t
c a lc u la te its V A R to b e $ 1 0 m illio n ,
in d ic a tin g th a t it h a s o n ly s o m e s m a ll
c h a n c e o f lo s in g m o r e th a n th a t a m o u n t
o n its e x is tin g h o ld in g s , i f th e y w e r e
h e ld th r o u g h th e e n d o f d a y tw o . M o st
in s titu tio n s u s e th is m e a su r e a s a
m a n a g e m e n t t o o l fo r e v a lu a t in g th e ir
t r a d in g p o s it io n s , lim it s , a n d s tr a te g ie s .
B y m e a s u r in g t h e r is k d a ily ,
m a n a g e m e n t c a n q u ic k ly r e v is e its
p o s it io n s , lim it s a n d s tr a te g ie s a s m a rk et
c o n d itio n s c h a n g e .
A v a lu e -a t-r is k m o d e l r e q u ir e s a
v a r ie ty o f in p u ts : (1 ) A c c u r a te a n d
t im e ly in fo r m a tio n a b o u t t h e
i n s t i t u t i o n ’s t r a d i n g p o s i t i o n s , (2 )
in fo r m a tio n a b o u t p a s t m o v e m e n t s o f
r e l e v a n t m a r k e t p r i c e s a n d r a t e s , a n d (3 )
s e v e r a l k e y m e a s u r e m e n t p a r a m e te r s,
s u c h a s th e le n g th o f t h e h is to r ic a l
p e r io d fo r w h i c h m a r k e t c h a n g e s a r e
o b s e r v e d (o b s e r v a tio n p e r io d ) ,
m a n a g e m e n t ’s r e q u i r e d l e v e l o f
c o n fid e n c e , a n d th e a s s u m e d h o ld in g
p e r io d fo r w h i c h t h e v a lu e o f c u r r e n t
t r a d in g p o s it io n s m a y c h a n g e . W h e n

U s in g h is to r ic a l s im u la t io n s , a n
in s titu tio n w o u ld c a lc u la te th e
h y p o th e tic a l c h a n g e in v a lu e o f th e
c u r r e n t p o r tfo lio in t h e fig h t o f a c tu a l
h is t o r ic a l m o v e m e n t s in r is k fa c to r s.
T h is c a lc u la t io n i s d o n e fo r e a c h o f th e
d e f in e d h o ld in g p e r io d s o v e r a g iv e n
h is t o r ic a l m e a s u r e m e n t h o r iz o n to
a r r iv e a t a r a n g e o f s im u la t e d p r o f its a n d
l o s s e s , a n d t h e c o n f id e n c e le v e l, a g a in ,
d e t e r m in e s t h e v a lu e -a t-r is k .

e v a lu a t in g th e ir c u r r e n t p o s it io n s a n d
e s tim a tin g fu tu r e m a r k e t v o la t ilit y ,
in s titu tio n s ty p ic a lly u s e a se r ie s o f
“ m a r k e t r is k fa c to r s ” th a t t h e y h a v e
d e t e r m in e d a ffe c t t h e v a lu e o f th e ir
p o s it io n s a n d t h e r is k s to w h ic h th e y are
e x p o s e d . T h e s e fa c to r s, in tu r n , c a n b e
g r o u p e d in to fo u r c a te g o r ie s , d e p e n d in g
o n t h e n a t u r e o f t h e u n d e r l y i n g r is k :
in te r e s t ra te s, e x c h a n g e r a te s, a n d e q u ity

M o n t e C a r lo t e c h n i q u e s a l s o c o n s i d e r
h is to r ic a l m o v e m e n ts , b u t o n ly to
d e t e r m i n e t h e p r o b a b i l i t y o f p a r t i c u la r
p r ic e a n d r a te c h a n g e s . U s in g t h e s e
p r o b a b ilit ie s , t h e in s t it u t io n w o u ld th e n
c o n s t r u c t a la r g e n u m b e r o f t h e o r e t ic a l
m o v e m e n t s to e v a lu a t e t h e r a n g e o f its
p o r t f o l i o ’s p o t e n t i a l m a r k e t v a l u e s a n d
id e n tif y t h e m a x im u m lo s s c o n s is te n t
w ith th e n e c e s sa r y c o n fid e n c e le v e l.

m o d e ls a s s u m e th a t m a rk et m o v e m e n ts
a re d is t r ib u te d n o r m a lly . W h ile th a t
a s s u m p t io n m a y b e a d e q u a te fo r a
m o d e l ’s i n t e n d e d p u r p o s e , i t p e r m i t s
t h e m o d e l to g r e a tly u n d e r s t a t e th e
l i k e l i h o o d o f a la r g e l o s s . F o r e x a m p l e ,
a s s u m in g a n o r m a l d is t r ib u tio n , th e
lik e lih o o d o f e x p e r ie n c in g a fo u r
sta n d a r d d e v ia t io n e v e n t is
a p p r o x im a t e ly 3 i n 1 0 0 ,0 0 0 — i n t r a d in g
te r m s , a b o u t o n c e i n 1 3 0 y e a r s . In
p r a c tic e , h o w e v e r , s u c h u n u s u a l m a r k e t
m o v e m e n t s a r e s e e n in m o s t m a jo r
m a r k e t s o n a v e r a g e a l m o s t e v e r y y e a r .7
T h e s e c o n d it io n s r e q u ir e th a t
r e g u la to r s im p o s e s o m e c o n s t r a in t s or
o t h e r a d ju s tm e n t s t o t h e V A R fig u r e th a t
e a c h in s titu tio n d e r iv e s in o rd er to
p r o v id e t h e r ig o r a n d c o n s i s t e n c y t h a t a
c a p ita l r e q u ir e m e n t d e m a n d s . A t th e
s a m e tim e , th e A g e n c ie s w a n t to
m in im iz e th e c o s ts a n d d is lo c a tio n s to
a n in te r n a l m o d e llin g s y s t e m th a t
e x te r n a l c o n s tr a in ts c o u ld c r e a te a n d

a n d c o m m o d it y p r ic e s , w it h r e la te d

Proposed Modelling Constraints

h a v e s o u g h t to b a la n c e t h e s e c o n f lic tin g
o b je c tiv e s th r o u g h a c o m b in a tio n o f

T h e A g e n c ie s r e c o g n iz e th a t

q u a lita tiv e a n d q u a n tita tiv e c o n s tr a in ts .

o p t i o n s v o l a t i l i t i e s i n c l u d e d i n e a c h r is k
fa c to r c a te g o r y .

Having determined which risk factors
to use, an institution estimates the
potential future volatility of the factors.
Most often this calculation is based on
the past movements of these factors over
some specified time horizon, with some
institutions using long historical time
periods and others focusing on more
recent market behavior. However
derived, the estimates of potential
market movements are combined with
current position data to calculate an
estimate of the potential loss that may
arise from those positions for a specified

L




s im u la tio n te c h n iq u e s . In t h e c a s e o f th e
v a r ia n c e /c o v a r ia n c e a p p r o a c h , th e
c h a n g e in v a lu e o f th e p o r tfo lio is
c a lc u la t e d b y c o m b in in g t h e r is k fa c to r
s e n s itiv it ie s o f th e in d iv id u a l
p o s it io n s — d e r iv e d fro m v a lu a tio n
m o d e ls — w it h a v a r ia n c e /c o v a r ia n c e
m a tr ix b a s e d o n r is k fa c to r v o la t ilit ie s
a n d c o r r e la t io n s . A n i n s t it u t io n w o u l d
c a lc u la te th e v o la t ilit ie s a n d
c o r r e la t io n s o f t h e r is k fa c to r s o n t h e
b a s is o f th e h o ld in g p e r io d a n d th e
o b s e r v a tio n p e r io d . V a lu e -a t-r is k i s
d e t e r m in e d a c c o r d in g t o t h e d e s ir e d
le v e l o f s ta tis tic a l c o n f id e n c e .

in s t it u t io n s h a v e a d o p te d d iffe r e n t
a s s u m p tio n s a n d m e a su r e m e n t
t e c h n iq u e s in t h e ir in te r n a l m a r k e t r is k
m o d e ls a n d th a t s u c h d iffe r e n c e s o fte n
r e fle c t d is t in c t b u s in e s s s tr a te g ie s a n d
a p p r o a c h e s t o r i s k m a n a g e m e n t . In
d e v e lo p in g a fr a m e w o r k fo r th e u s e o f
in te r n a l m o d e ls fo r r e g u la to r y c a p ita l
p u r p o s e s , t h e A g e n c ie s b e lie v e th a t
s o m e c o n s tr a in ts s h o u ld b e p la c e d o n
m o d e l p a r a m e te r s a n d a s s u m p t io n s .
S u c h r e s tr ic tio n s w o u ld h e lp to e n s u r e
th a t p r u d e n tia l c a p ita l le v e ls are
m a in ta in e d a n d th a t in s titu tio n s w ith

p r e d ic tiv e a c c u r a c y a n d to r e s p o n d to
e v e n t s t h a t g e n e r a t e u n e x p e c t e d l y la r g e

e x p e c te d to u n d e r e s tim a te a c tu a l
tr a d in g lo s s e s m o r e t h a n 2 0 t im e s .
M o r e o v e r , k n o w i n g t h a t a d a y ’s
tr a d in g r e s u lts c o u ld b e e x p e c t e d to
e x c e e d th e

VAR t e n

p e r c e n t, fiv e

p e r c e n t, or e v e n o n ly o n e p e r c e n t o f th e
t i m e , s a y s n o t h i n g a b o u t t h e magnitude
b y w h i c h t h e VAR m i g h t b e e x c e e d e d .
T h e p r o b a b i l i t i e s o f VAR m o d e l s cannot
b e e x te n d e d to e s tim a te th e s iz e o f a
h ig h ly u n lik e ly e v e n t b e c a u s e m o st

Qualitative Standards
T h e q u a lita tiv e sta n d a r d s are
d e s ig n e d to e n s u r e th a t in s titu tio n s
u s i n g i n t e r n a l m o d e l s h a v e m a r k e t r is k
m a n a g e m e n t sy s te m s th a t are
c o n c e p tu a lly s o u n d a n d im p le m e n te d

7 Daily rate or price movements of a half-dozen
major currencies and U.S. Treasury maturities and
of several U.S. equity indices each moved by at
least four standard deviations on average about
once a year during the period 1977-1994. The drop
in the value of the S&P 500 index on October 19.
1987 represented a 20 standard deviation event in
terms of daily price movements.

38086

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

w i t h i n t e g r i t y . 8 T h e i n t e r n a l r is k
m e a su r e m e n t m o d e l s h o u ld b e c lo s e ly
in te g r a te d in t h e d a ily r is k m a n a g e m e n t
p r o c e s s a n d s e r v e a s a b a s i s fo r
r e p o r tin g o f r is k e x p o s u r e s to s e n io r
o ffic e r s . I n s titu tio n s s h o u ld h a v e , fo r
e x a m p le , h ig h ly tr a in e d p e r s o n n e l w h o
c a n e v a l u a t e t h e a d e q u a c y o f t h e r is k
m o d e ls a n d w h o are o r g a n iz a tio n a lly
in d e p e n d e n t o f p e r s o n n e l r e s p o n s ib le
fo r e x e c u t in g tr a d e s. T h e s e in d iv id u a ls
s h o u ld c o m p a r e a c t u a l d a ily tr a d in g
g a in s a n d lo s s e s w it h V A R fig u r e s
g e n e r a te d b y th e m o d e l a s p a rt o f th e ir
o n -g o in g e v a lu a t io n s o f t h e m o d e llin g
p r o c e s s . A t le a s t a n n u a lly , in te r n a l
a u d i t o r s s h o u l d a s s e s s t h e i n s t i t u t i o n ’s
o v e r a ll p r o c e s s fo r m a n a g in g a n d
m e a s u r in g tr a d in g r is k s .
N o tw ith s ta n d in g th e u s e o f V A R a s a
b a s is fo r a r e g u la to r y c a p it a l c h a r g e ,
in s t itu t io n s s h o u ld a ls o r o u t in e ly
e v a lu a t e th e ir e x p o s u r e s to h ig h ly
str e s sfu l e v e n ts , s e le c te d to id e n tify th e
c i r c u m s t a n c e s t o w h i c h t h e i r p a r t i c u la r
tr a d in g p o r t fo lio s a re m o s t v u ln e r a b le .
S u c h a p ro g ra m o f s tr e s s t e s tin g
s u p p le m e n ts t h e c a p ita l sta n d a r d a n d
i l l u s t r a t e s m a n a g e m e n t ’s c o m m i t m e n t t o
e v a lu a t in g tr a d in g r is k s f u lly .
T h e s tr e s s te s t in g p r o c e s s , a lo n g w it h
o th e r r e le v a n t in te r n a l p o lic ie s ,
c o n tr o ls , a n d p r o c e d u r e s , s h o u ld b e
w e l l d o c u m e n t e d a n d a v a ila b le fo r
e x a m in e r s to r e v ie w . E x a m in e r s w i l l
n e e d t h i s in fo r m a tio n , a s w e l l a s
c o m p a r is o n s o f V A R m e a s u r e s w ith
a c t u a l d a ily t r a d in g r e s u lt s , t o ju d g e t h e
a c c e p t a b i l i t y o f t h e i n s t i t u t i o n ’s m o d e l
o n a n in itia l a n d p e r io d ic b a s is . U n d e r
th e p r o p o s a l, i f k e y m a n a g e m e n t
p r o c e d u r e s are m is s in g o r w e a k , or if th e
in te g r ity o f a m o d e l is q u e s t io n a b le , t h e
a p p r o p r ia te s u p e r v is o r m a y e ith e r
d i s a l l o w t h e m o d e l fo r r e g u la to r y
c a p it a l p u r p o s e s o r r e q u ir e c a p it a l a b o v e
th e m in im u m s p e c if ie d in t h e p r o p o s a l.
T h e la tte r m a y b e d o n e b y in c r e a s in g t h e
s iz e o f th e m u ltip lie r th a t w o u ld b e
a p p l i e d t o a n i n s t i t u t i o n ’s V A R
( d is c u s s e d b e lo w u n d e r “ C a p ita l
R e q u i r e m e n t ” ). T y p i c a l l y , t h e A g e n c i e s
w o u ld e x p e c t to se e a n y m a n a g e m en t or
m o d e llin g s h o r tc o m in g s a d d r e s s e d a n d
t h e r is k m e a s u r e im p r o v e d , r a th e r t h a n
s e e k to r e s o lv e th e m a tte r b y a p p ly in g
a la r g e r m u lt ip lie r t o a m a r g in a lly
s a tis fa c to r y o r q u e s t io n a b le m o d e llin g
or m anagem en t approach.

Quantitative Standards
W h e r e a s th e q u a lita tiv e sta n d a r d s
f o c u s o n t h e in te g r ity o f t h e m o d e llin g
p r o c e s s a n d in c o r p o r a te s ta n d a r d s o f

sta n d a r d s are d e s ig n e d to d e v e lo p a
p r u d e n tia l c a p ita l r e q u ir e m e n t b y
a d d r e s s in g t h e l e v e l o f r ig o r in a n
i n s t i t u t i o n ’s m o d e l s a n d t h e c o n s i s t e n c y
o f m o d e l p a r a m e te r s a m o n g in s t itu t io n s .
T h e A g e n c ie s h a v e so u g h t to m in im iz e
th e q u a n tita tiv e c o n s tr a in ts a n d to m a k e
th o s e th a t w e r e d e e m e d n e c e s s a r y a s
c o m p a tib le a s p r a c tic a b le w it h e x is tin g
p r o c e d u r e s o f in s titu tio n s . T h e A g e n c ie s
r e c o g n iz e , h o w e v e r , th a t s o m e o f t h e s e
s ta n d a r d s m a y r e q u ir e a n in s t it u t io n to
m a k e c e r ta in m o d if ic a t io n s t o it s
in te r n a l m o d e l w h e n u s in g it fo r
c o m p u t in g r e g u la to r y c a p it a l
r e q u ir e m e n ts . T h e A g e n c ie s p r o p o s e
th a t a n in s t itu t io n th a t e le c t s to u s e th e
in te r n a l m o d e l a p p r o a c h b e su b je c t to
t h e f o llo w in g sta n d a r d s fo r it s in te r n a l
m o d e l:
(1 ) Value-at-risk s h o u l d b e c o m p u t e d
e a c h b u s in e s s d a y a n d s h o u ld b e b a se d
o n a 9 9 p e r c e n t ( o n e - t a i l e d ) confidence
level o f e s t i m a t e d m a x i m u m l o s s .
( 2 ) T h e a s s u m e d holding period u s e d
fo r t h e V A R m e a s u r e m u s t b e 1 0
b u s in e s s d a y s , a lt h o u g h fo r p o s it io n s
th a t d is p la y lin e a r p r ic e c h a r a c te r is tic s
(n o t o p tio n s , w h ic h d is p la y n o n lin e a r
c h a r a c te r is tic s ) t h e in s t it u t io n m a y u s e
r e s u lts b a se d o n o n e -d a y p e r io d s ,
in c r e a s e d to te n d a y s b y m u ltip ly in g b y
t h e sq u a r e r o o t o f t im e .9
( 3 ) T h e m o d e l m u s t m e a s u r e all
material risks i n c u r r e d b y t h e
in s t itu t io n , a lth o u g h n o s p e c if ic t y p e o f
m o d e l i s p r e s c r ib e d .
(4 ) T h e m o d e l m a y u t i l i z e h is t o r ic a l
correlations w i t h i n b r o a d c a t e g o r i e s o f
r is k fa c to r s ( in t e r e s t r a te s , e x c h a n g e
r a te s, a n d e q u ity a n d c o m m o d ity
p r ic e s ), b u t n o t a m o n g t h e s e c a te g o r ie s .
T h a t is , th e c o n s o lid a t e d v a lu e -a t-r isk is
th e su m o f th e in d iv id u a l V A R s
m e a s u r e d fo r e a c h b r o a d c a te g o r y .
( 5 ) T h e non-linear price
characteristics o f o p t i o n s m u s t b e
a d e q u a te ly a d d r e s s e d , b o th b y e n s u r in g
th a t t h e m o d e l in c o r p o r a t e s p o te n t ia l
n o n -lin e a r p r ic e b e h a v io r a n d b y
e v a l u a t i n g a c t u a l minimum i o d a y
h o ld in g p e r io d s , r a th er th a n m u ltip ly in g
th e r e s u lts b a se d o n o n e -d a y p e r io d s b y
t h e sq u a r e r o o t o f tim e . T h e v o la t ilit y o f
t h e r a te s a n d p r ic e s (v e g a ) u n d e r ly in g
th e o p tio n s m u s t a ls o b e in c lu d e d
a m o n g t h e r is k fa c to r s.

(6) The historical observation period
used to estimate future price and rate
changes must have a minimum length of
one year. The Agencies request specific
comment on whether they should also
require institutions to calculate their
exposures using a shorter observation

s o u n d p r a c tic e , t h e q u a n tit a tiv e

■With respect to the qualitative standards, the
OCC is planning to provide additional guidance
through supplementary banking issuances.




■For example, one can estimate the ten day price
volatility of an instrument by multiplying the
volatility calculated on ene-day changes by the
square root of ten.

p e r i o d ( e .g . l e s s t h a n 6 m o n t h s ) , w i t h
t h e c a p it a l r e q u ir e m e n t b a s e d o n th p
h ig h e r r e s u lt.
( 7 ) D a t a m u s t b e updated n o l e s s
fr e q u e n tly th a n o n c e e v e r y th r e e m o n th s
a n d m o r e fr e q u e n tly i f m a r k e t
c o n d it io n s w a rra n t.
(8 ) E a c h y i e l d c u r v e i n a m a jo r
c u r r e n c y m u s t b e m o d e l e d u s i n g a t least

six risk factors, s e l e c t e d t o r e f l e c t t h e
c h a r a c t e r is tic s o f t h e in te r e s t r a te
s e n s it iv e in s tr u m e n ts th a t t h e
in s titu tio n tra d es. T h e m o d e l m u s t a ls o
t a k e a c c o u n t o f s p r e a d r is k .
S e v e r a l o f th e s e c o n s tr a in ts w a rra n t a
d i s c u s s i o n o f t h e i r u n d e r l y i n g r a t i o n a le :

M inim um holding period (and issues
regarding options). T y p i c a l l y , l o n g e r
h o ld in g p e r io d s le a d t o la r g e r e x p e c t e d
p r ic e c h a n g e s a n d , c o n s e q u e n t ly , to
la r g e r m e a s u r e s o f r is k . W h e n e s t im a t in g
r is k in t r a d in g a c t iv it ie s fo r m a n a g e m e n t
p u r p o se s , m o st in s titu tio n s a s s u m e o n ly
a o n e - d a y h o ld in g p e r io d , s i n c e tr a d in g
d e c is io n s are m a d e c o n s t a n t ly , a n d
s o m e in s tr u m e n ts a re h e ld fo r o n ly
m in u te s or h o u r s. T h is a p p r o a c h m a y b e
f u lly s a tis fa c to r y fo r d a y -to -d a y
m a n a g e m e n t p u r p o se s b u t se e m s le s s
a p p r o p r ia te w h e n d e s ig n in g a p r u d e n t
c a p ita l sta n d a r d .
In p e r io d s o f m a r k e t t u r m o il, w h e n a n
i n s t i t u t i o n ’s c a p i t a l i s m o s t n e e d e d ,
m a n y fin a n c ia l in s tr u m e n ts c o u ld
b e c o m e u n e x p e c te d ly illiq u id , a s m ark et
p a r tic ip a n ts b e c o m e le s s w illin g to
a c c e p t m a r k e t r is k . O n e m e t h o d o f
in c r e a s in g t h e r ig o r o f t h e r is k m e a s u r e
a n d a d d r e s s in g a n u n e x p e c t e d l y la r g e
p r ic e c h a n g e th a t c o u ld r e s u lt fr o m a
d e c lin e in m a rk et liq u id it y w o u ld b e to
a s s u m e a lo n g e r h o ld in g p e r io d . T h e
p r o p o s e d r e q u ir e m e n t th a t in s t it u t io n s
u s e a 1 0 -d a y h o ld in g p e r io d d o e s n o t
im p ly th a t th e A g e n c ie s w o u ld e x p e c t
th e m to p la n fo r th a t e v e n t u a lit y .
In d e e d , so m e p o s itio n s , s u c h a s th o s e
in v o lv in g s p o t fo r e ig n e x c h a n g e
c o n tr a c ts, w ill m a tu r e a n d s e ttle w ith in
th a t tim e fra m e a n d c o u ld n o t b e h e ld
fo r 1 0 d a y s , in a n y e v e n t . T h e r e fo r e , in
t h is c o n te x t, th e 1 0 -d a y p e r io d s h o u ld
b e v ie w e d s im p ly a s a w a y o f p r o d u c in g
a m o re stressfu l m a rk et sh o c k b y
a s s u m i n g a n instantaneous p r i c e
m o v e m e n t o f a s iz e th a t o n e w o u ld
n o r m a lly e x p e c t t o w it n e s s o n ly o v e r
t h e lo n g e r p e r io d o f t im e .
H o w e v e r , in o r d e r to m in im iz e
m o d e llin g c o s t s a n d r e c o g n iz e t h e lin e a r
n a tu r e o f p r ic e m o v e m e n t s o f m a n y
fin a n c ia l in s tr u m e n ts , th e A g e n c ie s
w o u ld p e r m it in s t it u t io n s to e s tim a te a
1 0 - d a y p r ic e o r r a te m o v e m e n t — fo r
in s tr u m e n ts o th e r t h a n o p t io n s — u s in g
t h e r is k fa c to r c h a n g e s c a lc u la t e d o n t h e
b a s is o f o n e -d a y h o ld in g p e r io d s . T h is
a d ju stm e n t c o u ld b e a c c o m p lis h e d
u s in g th e “ sq u a re r o o t o f t im e ” m e th o d

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
b y m u lt ip ly in g t h e o n e -d a y r e s u lts b y
3 . 1 6 ( t h e s q u a r e r o o t o f t e n t r a d in g
d a y s).
T h e p r ic e s o f o p tio n s , h o w e v e r , d o
n o t c h a n g e p r o p o r tio n a te ly w it h th e
p r ic e o f th e u n d e r ly in g in s tr u m e n t, a n d
th e ir p o te n tia l p r ic e v o la t ilit y c a n n o t b e
s o e a s ily e s tim a te d . T h e r e fo r e ,
in s t it u t io n s w o u ld b e r e q u ir e d to ta k e
s t e p s to id e n t if y t h e n o n - lin e a r b e h a v io r
o f o p tio n p r ic e s w it h r e s p e c t to c h a n g e s
i n u n d e r ly in g r a te s o r p r ic e s . In
a d d itio n , in s t it u t io n s w o u ld n o t, fo r
e x a m p le , b e a llo w e d to s c a le t h e p r ic e
v o la t ilit y o f a n o p t io n th a t w a s b a s e d o n
o n e -d a y s e n s itiv itie s u s in g th e sq u a re
r o o t o f te n . H o w e v e r , s in c e t h e p r ic e o r
r a te v o la t ilit y o f t h e in s t r u m e n t o n
w h ic h th e o p tio n is b a s e d is c o n s id e r e d
to in c r e a s e p r o p o r tio n a te ly w it h th e
sq u a r e ro o t o f tim e , in s titu tio n s w o u ld
b e p e r m itte d to u s e t h e sq u a r e r o o t o f
tim e te c h n iq u e to e x p a n d th e o n e -d a y
v o la tility o f th e o p tio n 's u n d e r ly in g
in s tr u m e n t w h e n c a lc u la t in g th e p r ic e
v o la tility o f th e o p tio n its e lf.
A lte r n a tiv e ly , in s titu tio n s c o u ld
e s tim a te th e c h a n g e s in th e v a lu e o f
o p tio n s o n th e b a s is o f a c tu a l
m o v e m e n t s in u n d e r ly in g fa c to r s
m e a s u r e d d u r in g a f u ll 1 0 -d a y p e r io d .
I n s titu tio n s s h o u ld a ls o e v a lu a te t h e
e f fe c t o f c h a n g e s in t h e v o la t ilit y o f ra te
o r p r ic e m o v e m e n t s o f in s t r u m e n t s
u n d e r l y i n g t h e i r o p t i o n p o s i t i o n s [vega)
o n o p tio n v a lu e s . T h is c a n b e d o n e b y
m o d e llin g v o la t ilit ie s a s a d d it io n a l r is k
fa c to r s a n d in c lu d in g th e m in th e
o v e r a ll s e t o f r is k fa c to r s a ffe c tin g t h e
v a l u e o f t h e i n s t i t u t i o n ’s t r a d i n g
p o s it io n s . I n s titu tio n s w it h r e la tiv e ly
la r g e o r c o m p l e x o p t i o n s p o r t f o l i o s
s h o u ld a ls o m e a su r e v o la tilitie s a c r o s s
d iffe r e n t p o in t s a lo n g t h e m a tu r ity y ie ld
cu rve.

Aggregating Exposures
W h e n e v a lu a t in g t h e p o te n t ia l c h a n g e
i n a p o r t f o l i o ’s m a r k e t v a l u e , o n e m u s t
c o n s id e r th e lik e lih o o d th a t p r ic e s o f
c e r ta in in s tr u m e n ts i n t h e p o r tfo lio m a y
m o v e to g e th e r fo r in o p p o s ite
d ir e c tio n s ). H o w e v e r , o b se r v e d

le v e ls o f c o r r e la t io n s c o u ld b e

r e q u ir e m e n ts a t a ll t im e s . W h ile th e
A g e n c ie s b e lie v e s u c h a o n e -y e a r
c o n s tr a in t m a y b e s u f f ic ie n t, th e y a re
a ls o r e q u e s tin g c o m m e n t o n w h e t h e r
in s t it u t io n s s h o u ld b e r e q u ir e d to

r e c o g n iz e d b y a m o d e l. G iv e n th e
im p o r ta n c e — b u t a ls o th e u n c e r ta in ty —

c a lc u la t e th e ir e x p o s u r e s u s in g tw o
o b s e r v a tio n p e r io d s — o n e a s c o n s tr a in e d

o f h is t o r ic a l c o r r e la t io n s , t h e A g e n c ie s
p r o p o s e to p e r m it in s t it u t io n s to u s e
c o r r e la t io n s w i t h i n c a t e g o r ie s o f r is k

a b o v e a n d t h e o th e r r e p r e s e n t in g a
sh o r te r p e r io d , s u c h a s s ix m o n t h s o r
le s s . U n d e r t h is d u a l o b s e r v a tio n

fa c to r s, b u t n o t a m o n g c a te g o r ie s , w h e r e
t h e in te r r e la tio n s h ip s o f m a r k e t fa c to r s

a p p r o a c h , t h e c a p it a l r e q u ir e m e n t
w o u ld b e b a s e d o n t h e p e r io d th a t
i n d i c a t e d t h e g r e a t e r r is k .

r is k fa c to r s ( in t e r e s t r a te s , fo r e ig n
e x c h a n g e , e t c .) .
T h e A g e n c ie s d o n o t w a n t to s p e c ify
c o r r e la t io n s o r t o s e t s t a n d a r d s fo r w h a t

m a y b e m o r e t e n u o u s , e s p e c ia lly d u r in g
p e r i o d s o f m a r k e t s t r e s s . 10*T h u s , t o t a l
V A R w o u ld b e th e s im p le su m o f th e
c a lc u la te d V A R fo r in d iv id u a l
c a te g o r ie s . T h e A g e n c ie s r e c o g n iz e th a t
t h is a p p r o a c h is c o n s e r v a tiv e a n d
b e lie v e t h a t it i s a p p r o p r ia te fo r a c a p it a l
c h a r g e a g a in s t m a r k e t p r ic e m o v e s
d u r in g p e r io d s o f str e s s, w h e n h is t o r ic
c o r r e la t io n s h a v e b e e n o b s e r v e d to
b r e a k d o w n . T h e A g e n c ie s a ls o n o te th a t
it is c o n s is te n t w it h t h e r is k
m e a s u r e m e n t p r a c t ic e s o f m a n y la r g e
tr a d in g b a n k s.

M inimum Observation Period
In m a n a g in g m a r k e t r is k , in s t it u t io n s
d r a w fr o m a b r o a d r a n g e o f h is t o r ic a l
p e r io d s to c a lc u la te h is to r ic a l
v o la t ilit ie s a n d c o r r e la t io n s fo r t h e
p u r p o s e o f e s tim a tin g fu tu r e p r ic e a n d
ra te m o v e m e n t s . S o m e in s t it u t io n s u s e
p e r io d s a s sh o r t a s 3 0 - 6 0 d a y s , w h ile
o th e r s u s e p e r io d s e x te n d in g a s lo n g a s
s e v e r a l y ea r s. A lth o u g h th e c h o ic e o f
h i s t o r ic a l p e r io d s m a y .h a v e l i t t l e e f f e c t
o n a t r a d i n g p o r t f o l i o ’s l e v e l o f e x p e c t e d
V A R o v e r a n e x te n d e d p e r io d o f tim e ,
it c a n h a v e a s ig n ific a n t e ffe c t o n th e
m e a su r e o f e x p o s u r e a t a n y s p e c ific
tim e . V A R s b a s e d o n sh o r t h is to r ic a l
p e r io d s w ill b e m o r e v o la t ile a n d
r e s p o n s iv e t o c h a n g in g m a r k e t
c o n d itio n s th a n m e a su r e s b a se d o n
lo n g e r p e r io d s , p r o d u c in g r e la t iv e ly
la r g e V A R s d u r i n g p e r i o d s o f h i g h
-m a r k e t v o la t ilit y a n d lo w V A R s w h e n
t h e m a r k e ts a re c a lm . C o n v e r s e ly , V A R s
b a s e d o n lo n g e r -p e r io d s w i l l e x h ib it
m o r e s ta b ility , r e f le c t in g a w id e r r a n g e

c o r r e la t io n s a m o n g t h e p r ic e s o f s o m e

o f m a r k e t c o n d it io n s a n d t h e s m a lle r

in s tr u m e n ts a r e t h e m s e lv e s v o la t ile a n d

e ffe c t o f r e c e n t o b s e r v a tio n s .

m a y b e e s p e c ia lly lik e ly t o c h a n g e
d u r in g p e r io d s o f m a r k e t str e ss.
T h e r e fo r e , w h ic h a s s u m p tio n s are
p r u d e n t a n d w h ic h o n e s are n o t c a n n o t
b e d e t e r m in e d in a d v a n c e . M o r e o v e r ,
o n e c o r r e la t io n a s s u m p t io n i s n o t
a lw a y s m o r e c o n s e r v a tiv e th a n a n o th e r ,
s in c e th e o u tc o m e d e p e n d s o n w h e th e r
a n i n s t i t u t i o n ’s p o s i t i o n i n a g i v e n
in s t r u m e n t i s lo n g o r sh o r t. In p r a c tic e ,
m o s t m o d e ls c a lc u la t e t h e c o r r e la t io n s
w it h in r is k fa c to r c a te g o r ie s , b u t d iffe r
in th e ir r e c o g n itio n o f h is to r ic a l
c o r r e la t io n s a c r o s s b r o a d c a t e g o r ie s o f




38087

Since VARs based on short periods
may, at times, produce small estimates
of risk and could also produce a wide
range of risk measures among
institutions having similar portfolios,
the Agencies are proposing a minimum
historical observation period of one
year. That constraint should reduce the
dispersion and help ensure that
institutions have adequate capital
10Use of correlations is permitted provided the
supervisor is satisfied that the calculation of
tx>rrelations within axategory is performed with
integrity.

M inim um Number o f R isk Factors
T h e r is k fa c to r s c o n t a in e d in a n
i n s t i t u t i o n ’s m a r k e t r i s k m e a s u r e m e n t
s y s t e m s h o u ld b e s u f f ic ie n tly
c o m p r e h e n s iv e to c a p tu r e a ll o f th e
m a te r ia l r is k s in h e r e n t in t h e p o r t fo lio
o f it s o n - a n d o ff-b a la n c e s h e e t tr a d in g
p o s it io n s , in c lu d in g in te r e s t a n d
e x c h a n g e r a te s, e q u ity a n d c o m m o d ity
p r ic e s , a n d t h e v o la t ilit ie s r e la te d to
o p tio n p o s itio n s . A lth o u g h in s titu tio n s
w i l l h a v e s u b s ta n tia l f le x ib ilit y in
s p e c if y in g t h e r is k fa c to r s th a t a re m o s t
r e le v a n t to th e ir p o r tfo lio s , t h e A g e n c ie s
e x p e c t th e n u m b e r a n d c o m p o s itio n o f
fa c to r s to b e c o m m e n s u r a te w ith th e
n a t u r e a n d s c o p e o f e a c h i n s t i t u t i o n ’s
r is k s .
In o r d e r to a d e q u a te ly m e a s u r e
e x p o s u r e s t o in te r e s t r a te s a n d t o b r in g
a b o u t g rea ter c o n fo r m ity o f r e s u lts
a m o n g in s titu tio n s , th e A g e n c ie s are
p r o p o s in g a m in im u m o f s i x m a tu r ity
b a n d s (e a c h r e p r e s e n t in g a s e p a r a te r is k
fa c to r ) t o b e u s e d fo r m a te r ia l p o s i t i o n s
in t h e m a jo r c u r r e n c ie s a n d m a r k e ts . A ll
in s titu tio n s w o u ld b e e x p e c te d to
m e a s u r e s p r e a d r is k ( e .g ., t h e d if f e r e n c e
b e t w e e n r a te s o n c o r p o r a t e a n d U .S .
g o v e r n m e n t in str u m e n ts ) a d e q u a te ly ,
w it h t h e r e q u ir e d le v e l o f s o p h is t ic a t io n
b e in g a fu n c tio n o f th e n a tu r e a n d s c o p e
o f t h e i n s t i t u t i o n ’s a c t i v i t i e s a n d
ex p o su res.

Capital Requirement
E x p e r ie n c e h a s s h o w n th a t f in a n c ia l
m a r k e ts c a n h a v e b r ie f p e r io d s o f iiig h
v o la t ilit y p r e c e d e d o r fo llo w e d b y
e x t e n d e d p e r io d s o f c a lm . U n d e r s o m e
m o d e l l i n g p r o c e d u r e s , t h e la r g e n u m b e r
o f s m a ll d a ily m ark et c h a n g e s c a n
s u b s ta n t ia lly o ffs e t t h e in fr e q u e n t
p e r io d s o f h ig h v o la t ilit y . E v e n w h e n
c o n s tr a in e d a n d c a lc u la te d a s p r o p o s e d ,
th e re a re sev era l rea so n s w h y an
i n s t i t u t i o n ’s n e e d f o r c a p i t a l m i g h t
s o m e t i m e s e x c e e d t h i s f ig u r e :
(1 ) T h e p a s t i s n o t a lw a y s a g o o d
g u id e to t h e fu tu r e ;
(2 ) T h e a s s u m p t io n s a b o u t s t a t is t ic a l
“ n o r m a lit y ” b u ilt in t o s o m e m o d e ls m a y
n o t b e ju s t if ie d b e c a u s e o f t h e r e la t iv e ly
h i g h f r e q u e n c y o f la r g e m a r k e t
m o v em e n ts;

38088

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

(3 ) T h e c o r r e la t io n s a s s u m e d in th e
m o d e l m a y p r o v e to b e in c o r r e c t;
(4 ) M a r k e t liq u id it y m a y b e c o m e
in a d e q u a te to c lo s e o u t p o s itio n s ; a n d
(5 ) T h e in s t it u t io n m a y fa c e m u lt ip le
str e s s fu l e v e n ts o v e r sh o r t p e r io d s o f
tim e .
C o n s e q u e n tly , t h e A g e n c ie s b e lie v e
t h a t i n o r d e r f o r a n i n s t i t u t i o n ’s V A R
fig u r e t o s e r v e a s a n a d e q u a te b a s is fo r
a c a p it a l r e q u ir e m e n t, it s h o u ld b e
m u lt ip lie d b y a n a p p r o p r ia te p r u d e n tia l
fa c to r . T h e A g e n c ie s a r e p r o p o s in g a
m in im u m m u ltip le o f th r e e , w h ic h
c o u ld b e in c r e a s e d i f t h e r e s u lts o f
“ b a c k -te s tin g ” a re n o t s u f f ic ie n tly
s a t i s f a c t o r y . 11
T h e A g e n c ie s a ls o r e c o g n iz e th a t
in s t it u t io n s m a y c h a n g e t h e ir tr a d in g
p o s it io n s r a p id ly a n d m a y s u b s ta n t ia lly
in c r e a s e th e ir e x p o s u r e s fo r b r ie f
p e r io d s in o rd er to r e s p o n d to p e r c e iv e d
o p p o r tu n itie s o r m a rk et c o n d itio n s . A t
s u c h t i m e s , a n i n s t i t u t i o n ’s e x p o s u r e t o
m a r k e t r is k m a y b e la r g e r t h a n it s
a v e r a g e V A R t im e s th r e e . In o r d e r to
a d d r e ss s u c h c ir c u m s ta n c e s , th e
A g e n c ie s are p r o p o s in g th a t in s t itu t io n s
m a in ta in c a p ita l o n a d a ily b a s is to
s u p p o r t t h e la r g e r o f e i t h e r ( 1 ) t h e
a v e r a g e V A R fig u r e fo r t h e la s t 6 0
b u s in e s s d a y s, c a lc u la te d u n d e r th e
p r o p o s e d c r ite r ia a n d in c r e a s e d b y t h e
a s s i g n e d m u lt ip le , o r ( 2 ).t h e p r e v io u s
d a y ’s V A R , s i m i l a r l y c a l c u l a t e d b u t
w it h o u t th e m u lt ip le . B y c o n s id e r in g
n o t o n ly a n a v era g e V A R b u t a ls o a
s i n g l e d a y ’s m e a s u r e , t h e A g e n c i e s
e x p e c t in s t itu t io n s to h o ld c a p ita l
s u f f ic ie n t to c o v e r p e a k le v e ls o f m a rk et
v o la t ilit y a n d to m a n a g e th e ir a c t iv itie s
a c c o r d in g ly .
M a n y V A R m o d e ls fo c u s p r in c ip a lly
o n m e a s u r in g g e n e r a l m a r k e t r is k s a n d
in c o r p o r a t e o n l y p a r tia l e l e m e n t s o f
s p e c i f i c r is k . T h e r e f o r e , i n s t i t u t i o n s
w o u ld r e m a in s u b je c t t o s e p a r a te c a p ita l
r e q u ir e m e n ts to c o v e r s p e c i f i c r is k o n
e q u itie s a n d tra d ed d e b t, to th e e x te n t
it i s n o t a d d r e s s e d b y th e ir V A R m o d e ls .
T h is se p a r a te c h a rg e w o u ld b e a d d e d
a fte r t h e V A R fig u r e is in c r e a s e d b y t h e
m u ltip lie r a n d w o u ld , in n o c a s e , b e le s s

VI. Standardized Risk Measure
T h e s t a n d a r d i z e d r is k , m e a s u r e
c a lc u la t e s se p a r a te c a p ita l r e q u ir e m e n ts
fo r s p e c i f i c a n d g e n e r a l m a r k e t r is k s a n d
u s e s d iffe r e n t t e c h n iq u e s to m e a s u r e a n
i n s t i t u t i o n ’s r i s k e x p o s u r e , d e p e n d i n g
u p o n its so u r c e : d e b t in s tr u m e n ts ,
e q u it ie s , fo r e ig n c u r r e n c ie s , a n d
c o m m o d it ie s , in c lu d in g th e ir r e s p e c t iv e
o p t i o n s . 12

Debt instruments held in trading
portfolios
T h e m a r k e t r is k c a p it a l r e q u ir e m e n t
fo r d e b t in s t r u m e n t s in a tr a d in g
a c c o u n t c o n s i s t s o f s e p a r a te c h a i'g e s fo r
g e n e r a l m a r k e t a n d s p e c if ic r is k s .
a . General market risk. T h e g e n e r a l
m a r k e t r is k c a p it a l r e q u ir e m e n t fo r d e b t
in s tr u m e n ts ( in c lu d in g o ff-b a la n c e -s h e e t
d e r iv a t iv e s ) th a t a re p a r t o f tr a d in g
a c tiv itie s is d e s ig n e d to c a p tu r e th e
p o t e n t ia l lo s s th a t m a y a r is e fr o m
m o v e m e n ts in m a r k e t in te r e st ra tes. A n
in s t it u t io n m a y d e t e r m in e t h is
c o m p o n e n t o f it s c a p it a l r e q u ir e m e n t
e it h e r b y u s in g s t a n d a r d iz e d r is k
w e ig h t s th a t a p p r o x im a te t h e p r ic e
s e n s it iv it y o f v a r io u s in s t r u m e n t s o r b y
c a lc u la t in g , it s e lf , t h e p r e c is e d u r a tio n
o f e a c h in s t r u m e n t , w e ig h t e d b y a
s p e c ifie d c h a n g e in in te r e s t ra tes.
B o th m e th o d s u s e a m a tu r ity -la d d e r
a p p r o a c h th a t e m p lo y s a s e r ie s o f tim e
b a n d s a n d z o n e s , d e s ig n e d to ta k e in to
a c c o u n t d iffe r e n c e s in p r ic e s e n s it iv it ie s
a n d in te r e s t r a te v o la t ilit ie s a c r o s s
v a r io u s m a tu r itie s . U n d e r e it h e r
m e t h o d , t h e i n s t i t u t i o n ’s c a p i t a l c h a r g e
fo r g e n e r a l m a r k e t r is k w o u l d b e th e
s u m o f a b a s e c h a r g e th a t r e s u lt s fr o m
f u lly n e ttin g v a r io u s r is k -w e ig h te d
p o s i t i o n s ( i.e ., lo n g s v e r s u s s h o r t s ) a n d
a s e r ie s o f a d d itio n a l c h a r g e s (a d d -o n s)
th a t e f fe c tiv e ly d is a llo w p a rt o f th e
p r e v io u s fu ll n e ttin g in o r d e r to a d d r e ss
b a s is a n d y i e l d c u r v e r is k . T h e c a p it a l
c h a r g e s w o u ld b e se p a r a te ly c o m p u t e d
fo r e a c h c u r r e n c y in w h i c h a n
in s titu tio n h a s s ig n ific a n t p o s itio n s . N o
n e ttin g o f p o s it io n s o r c h a r g e s w o u ld b e
a llo w e d a c r o s s d iffe r e n t c u r r e n c ie s .
W h e n u s in g t h e fir s t a p p r o a c h ,
r e fe r r e d to a s t h e “ m a tu r ity ” m e th o d , a n
in s t it u t io n w o u ld fir s t d is t r ib u te it s o n a n d o ff-b a la n c e -s h e e t p o s it io n s in e a c h
c u r r e n c y a m o n g a r a n g e o f tim e -b a n d s

b a s e d o n t h e m a tu r ity o r n e a r e s t in te r e s t
r a te r e s e t d a te o f t h e in s t r u m e n t . L o n g
p o s it io n s w o u ld b e trea ted a s p o s itiv e
a m o u n ts a n d sh o r t p o s itio n s w o u ld b e
tr e a te d a s n e g a tiv e a m o u n ts. T h e
in s t it u t io n w o u ld th e n c a lc u la t e its n e t
lo n g o r s h o r t p o s it io n fo r e a c h tim e b a n d a n d w o u ld m u ltip ly th a t n e t
p o s i t i o n b y t h e r is k w e ig h t p r o v id e d b y
t h e s u p e r v is o r fo r th a t tim e -b a n d . T h e
r e s u ltin g r is k -w e ig h te d p o s it io n
r e p r e se n ts th e a m o u n t b y w h ic h th e
m a r k e t v a lu e o f th a t d e b t p o s it io n is
e x p e c t e d to c h a n g e fo r a s p e c if ie d
m o v e m e n t i n i n t e r e s t r a t e s . T h e r is k
w e i g h t s a n d a s s o c ia t e d in te r e s t ra te
c h a n g e s a r e s h o w n i n e a c h A g e n c y ’s
p r o p o s e d r e g u l a t o r y l a n g u a g e (O C C —
T a b l e 2 ; B o a r d — T a b l e I, a n d F D IC —
T a b l e l ) . 13 A d d i n g t h e s u m o f a l l r is k w e ig h t e d p o s it io n s (lo n g o r sh o r t) a c r o s s
a ll t im e - b a n d s r e s u lt s in a f in a l n e t r is k w e ig h t e d p o s itio n . T h is a m o u n t w o u ld
b e t h e b a s e c a p ita l c h a r g e fo r g e n e r a l
m a r k e t r i s k . 14*
T h e b a s e c h a r g e is c a lc u la te d
d iffe r e n tly u n d e r th e s e c o n d , o r
a lt e r n a tiv e “ d u r a tio n ” m e t h o d . In t h is
c a s e , a n in s titu tio n w o u ld c a lc u la te th e
e s t im a t e d p r ic e m o v e m e n t fo r a s p e c if ic
in s tr u m e n t b y m u ltip ly in g th e
i n s t r u m e n t ’s m o d i f i e d d u r a t i o n b y a
s p e c if ie d in te r e s t r a te s h o c k th a t is
b a s e d o n t h e i n s t r u m e n t ’s d u r a t i o n a s
s h o w n in t h e p r o p o s e d r e g u la to r y
l a n g u a g e . 13 T h a t p r o d u c t , r e p r e s e n t i n g
th e a m o u n t o f e x p e c te d p r ic e c h a n g e o f
t h e in s tr u m e n t, is th e n d is tr ib u te d in to
t h e a rra y o f tim e -b a n d s o n t h e b a s is o f
t h e i n s t r u m e n t ’s d u r a t i o n ( s e e p r o p o s e d
T a b l e 4 — O C C , T a b l e III— B o a r d , T a b l e
3 — F D IC ). F o r e x a m p le , a n in s t r u m e n t
w it h a m a tu r ity o f 4 y e a r s a n d 3 m o n t h s
m i g h t h a v e a m o d i f i e d d u r a t i o n o f 3 .5
y e a r s . B a s e d o n it s d u r a tio n , it w o u ld b e
“ s h o c k e d ” b y 7 5 b a s is p o in ts , r e s u ltin g
i n a n e x p e c t e d p r ic e c h a n g e o f 2 .6 2 5
p e r c e n t ( 3 .5 x 0 . 7 5 p e r c e n t ) . T h a t
e s t i m a t e d 2 .6 2 5 p e r c e n t c h a n g e ,
m u lt ip lie d b y th e c u r r e n t v a lu e o f th e
in s tr u m e n t, w o u ld b e p la c e d in to th e
3 .3 t o 4 .0 y e a r t im e - b a n d fo r

13 In the case of securities backed by fixed rate
mortgages, an institution would slot the
th a n o n e - h a lf th e s p e c if ic r is k c h a r g e
instruments into time bands on the basis of their
current expected weighted average lives (reflecting
c a lc u la t e d u s in g th e sta n d a r d iz e d
the effect of expected prepayments at current
a p p r o a c h . T h e A g e n c ie s s p e c ific a lly
12
Several techniques are offered for measuring market interest rates), rather than by their
r e q u e s t c o m m e n ts o n w h ic h fe a tu r e s to
contractual maturities.
the price risJuin options (see “ Options", discussed
c o n s id e r w h e n r e v ie w in g m o d e ls in
,4Since the price sensitivity of zero coupon and
below or in the proposed regulatory language for
low coupon instruments can be materially greater
each agency). Under one approach, called the
o r d e r to e v a lu a te th e ir c o v e r a g e o f
“ delta-plus" approach, an institution would
than that of instruments with higher coupons,
s p e c i f i c r is k .
include the delta-equivalent value of the underlying institutions would be required to assign higher risk
weights to low coupon instruments as shown in the
instrument when evaluating the market risk of each
11
Back-testing refers to the process of comparing category of instruments (debt, equity, etc.). Under
proposed Tables.
calculated daily VARs with actual daily trading
the two other approaches, the underlying
lsThe duration of an instrument indicates its
results to determine how effectively the risk
instrument of an option may be “carved-out” , not
approximate percentage change in price for a small
measure identified the boundaries of gains or losses subject to the prescribed risk measure for the
parallel shift in the yield curve assuming that its
consistent with the predetermined level of
underlying, and evaluated together with its option
cash flow does not change when the yield curve
statistical confidence.
according to the procedures described for options.
shifts.




Federal Register / Vol. 60, No. 142 4 Tuesday, July 25, 1995 / Proposed Rules
d e t e r m in in g t h e c h a r g e fo r g e n e r a l
m a r k e t r is k .
A s in t h e m a tu r ity m e th o d , t h e b a s e
c a p ita l c h a r g e fo r g e n e r a l m a r k e t r is k is
th e s u m o f t h e e s tim a te d p r ic e c h a n g e s
a c r o ss a ll t im e b a n d s. If th a t s u m is
n e g a tiv e , t h e b a s e c h a r g e w o u ld b e it s
a b s o lu t e v a lu e . D iffe r e n t t im e - b a n d s a re
u s e d fo r th e t w o m e th o d s b e c a u s e a n
i n s t r u m e n t ’s d u r a t i o n c a n b e
s u b s ta n t ia lly d iffe r e n t fr o m i t s m a tu r ity .
In a d d itio n t o th e b a se c a p ita l c h a r g e
fo r g e n e r a l m a r k e t r is k , a s r e f le c t e d b y
t h e i n s t i t u t i o n ’s n e t r i s k - w e i g h t e d
p o s itio n , a n in s titu tio n w o u ld b e su b je c t
to a s e r ie s o f c a p ita l “ a d d -o n s ” th a t a re
d e s ig n e d to ta k e in to a c c o u n t im p e r fe c t
a n d u n c e r t a in c o r r e la t io n s a m o n g
in s t r u m e n t t y p e s a n d m a tu r itie s . T h e s e
a d d -o n s r e c o g n iz e th a t lo n g a n d sh o r t
p o s it io n s m ig h t n o t, in p r a c tic e , o ffs e t
e a c h o th e r b y t h e f u ll a m o u n t th a t th e ir
r is k -w e ig h tin g s w o u ld su g g e s t, a n d
th e r e fo r e , s o m e p o r tio n o f t h e h e d g e d or
o ffs e ttin g p o s it io n s h o u ld b e
d is a llo w e d .
T h e fir s t d i s a llo w a n c e (r e fe r r e d t o a s
t h e v e r tic a l d is a llo w a n c e ) is in t e n d e d to
a d d r e s s t h e b a s is r is k th a t e x is t s
b e t w e e n in s t r u m e n t s w it h t h e s a m e o r
s im ila r m a tu r itie s a n d a ls o t h e p o s s ib ly
d iffe r e n t p r ic e m o v e m e n t s th a t m a y b e
e x p e r ie n c e d b y d iffe r e n t in s t r u m e n t s
w it h in t h e s a m e tim e -b a n d d u e to th e
r a n g e o f m a t u r it ie s (o r r e p r ic in g p e r io d s )
th a t m a y e x is t w it h in a tim e -b a n d . T o
c a p tu r e t h is r is k , a v e r t ic a ^ d is a llo w a n c e
is a p p lie d to t h e sm a lle r o f th e o ffs e ttin g
(lo n g o r sh o r t) p o s it io n s w it h in a tim e b a n d . 16 T h i s d i s a l l o w a n c e i s 1 0 p e r c e n t
u n d e r t h e m a tu r ity m e th o d , a n d 5
p e r c e n t u n d e r t h e d u r a tio n m e th o d . F o r
e x a m p le , u n d e r t h e m a tu r ity m e t h o d , i f
th e s u m o f w e ig h t e d lo n g p o s it io n s
within a t i m e - b a n d e q u a l s $ 1 0 0 m i l l i o n
a n d th e s u m o f w e ig h te d sh o r t p o s itio n s
e q u a ls $ 9 0 m illio n , t h e v e r tic a l
d is a llo w a n c e fo r th e tim e -b a n d w o u ld
b e 1 0 p e r c e n t o f $ 9 0 m illio n , or $ 9
m illio n . T h is a m o u n t w o u ld b e a d d e d to
t h e i n s t i t u t i o n ’s b a s e c a p i t a l c h a r g e . T h e
u s e o f t w o d iffe r e n t v e r tic a l
d is a llo w a n c e s r e c o g n iz e s th a t b e c a u s e
th e d u r a tio n m e th o d ta k e s in to a c c o u n t
a n i n s t r u m e n t ’s s p e c i f i c c h a r a c t e r i s t i c s
(m a tu r ity a n d c o u p o n ) , t h e r e i s l e s s
o p p o r t u n i t y f o r m e a s u r e m e n t e r r o r .17

16If the offsetting amounts (long and short) are
equal, the disallowance can be applied to either
figure.
17In the case of cash positions and transactions
conducted on an exchange (e.g. futures) an
institution has the opportunity to adjust its market
risk either by acquiring a new position or selling an
existing one. However, that is not typically the case
with interest rate swaps, for which an institution
almost always adjusts its position by entering into
a new or offsetting swap, rather than by selling or
unwinding one that it already holds. This
procedure, required partly because of the lack of




38089

T h e s e c o n d d i s a l l o w a n c e (o r
h o r iz o n ta l d is a llo w a n c e ) a d d r e s s e s t h e
r is k th a t in t e r e s t r a te s a lo n g t h e y i e l d
c u r v e a r e n o t p e r f e c t ly c o r r e la t e d a n d
th a t r is k - w e ig h t e d p o s it io n s th a t m ig h t
h a v e b e e n e x p e c te d to o ffse t w ill n o t

r a n g in g fr o m 0 .2 5 p e r c e n t to 1 .6 p e r c e n t
i f t h e y a r e i s s u e d b y qualifying
b o r r o w e r s. S e c u r itie s o f n o n q u a lify in g
is s u e r s a r e c h a r g e d a s p e c if ic r is k o f 8 .0
p e r c e n t. T o b e c o n s id e r e d a s q u a lify in g ,
th e s e c u r ity m u s t b e r a te d a s in v e s tm e n t

f u lly o ffs e t, in p r a c tic e . T h e h o r iz o n t a l
d is a llo w a n c e a p p lie s to th e s m a lle r o f
th e o ffs e ttin g p o s it io n s a c r o s s d iffe r e n t

g ra d e b y at le a s t t w o n a tio n a lly
r e c o g n iz e d c r e d it r a tin g f ir m s o r , i f t h e
is s u e r h a s s e c u r itie s lis t e d o n a

tim e -b a n d s . T h e a m o u n t o f t h is '
d is a llo w a n c e v a r ie s in s iz e b y z o n e (th a t

r e c o g n iz e d s to c k e x c h a n g e , it m u s t b e
d e e m e d to b e o f c o m p a r a b le in v e s t m e n t
q u a lity b y t h e r e p o r tin g in s t itu t io n .
T h is la tte r c o n d i t i o n i s p r o v id e d to
a c c o m m o d a te th e fa ct th a t in s o m e
c o u n t r ie s c r e d it r a tin g s a n d t h e c o v e r a g e
o f c r e d it r a tin g f ir m s a r e n o t a s
e x t e n s iv e a s in th e U n ite d S ta te s.
C o n s e q u e n tly , th e s e c u r itie s o f m a n y
la r g e a n d w e ll- e s t a b lis h e d fo r e ig n
c o m p a n ie s m a y n o t b e ra ted . In s u c h
c a s e s , a c o m p a n y ’s l i s t i n g o n a n
o r g a n iz e d e x c h a n g e m a y b e a n
a c c e p t a b le s u b s tit u te fo r c r e d it r a tin g s i f
s u c h lis t in g s a re lim ite d to fin a n c ia lly
s tr o n g a n d w e ll- e s t a b lis h e d fir m s . In
th e se c a se s, a n d in th e a b se n c e o f
in d e p e n d e n t c r e d it r a tin g s , t h e
se c u r itie s o f a lis te d c o m p a n y m a y
q u a lify fo r a lo w e r c a p ita l c h a r g e i f th e
tr a d in g i n s t it u t io n a n d it s a p p r o p r ia te
su p e r v is o r b e lie v e th e s e c u r itie s are
e q u iv a le n t to in v e s tm e n t g ra d e.
H o w e v e r , t h e A g e n c ie s are p r o p o s in g
th a t, g iv e n th e p r e s e n c e a n d w id e
c o v e r a g e in t h e U n ite d S ta te s o f c r e d it
r a tin g f ir m s , i n s t it u t io n s w o u l d n o t b e
a llo w e d to q u a lify th e s e c u r itie s o f a
U .S . fir m o n t h e b a s i s o f a l i s t i n g o n a n
o r g a n iz e d e x c h a n g e .
D u r in g t h e e x a m in a t io n p r o c e s s , t h e
A g e n c ie s w o u ld a ls o c o n s id e r th e e x te n t
to w h ic h a n in s titu tio n tr a d e s n o n ­
in v e s t m e n t g r a d e in s tr u m e n ts
(s o m e tim e s c a lle d h ig h y ie ld d e b t) th a t
d o n o t q u a lify fo r r is k w e ig h t s l e s s t h a n
8 .0 p e r c e n t b e c a u s e o f t h e la c k o f
in v e s t m e n t g r a d e r a tin g s . I f t h e s e
h o ld in g s a re n o t w e l l d iv e r s if ie d o r i f
t h e y o t h e r w is e r e p r e s e n t m a te r ia l
e x p o s u r e s to th e in s titu tio n , th e
A g e n c ie s m a y p r e v e n t a n in s titu tio n
fr o m n e t t in g t h e e x p o s u r e s a r is in g fr o m

is , a g r o u p in g o f c o n t ig u o u s t im e b a n d s ),
w it h g rea te r n e t tin g a llo w e d fo r
p o s it io n s i n d iff e r e n t tim iT b a n d s b u t
w ith in t h e s a m e z o n e th a n i s a llo w e d
fo r p o s it io n s th a t a r e in d iff e r e n t z o n e s
( T a b le 3 — O C C , T a b l e II— B o a r d , T a b l e
2 — F D IC i n t h e p r o p o s e d r e g u la t o r y
la n g u a g e ). T h e h o r iz o n t a l d is a llo w a n c e s
r a n g e fr o m 3 0 p e r c e n t t o 1 0 0 p e r c e n t o f
t h e s m a lle r fig u r e in a p a ir o f o f fs e tt in g
t r a n s a c t i o n s . 18
In c a lc u la t in g t h e s e d is a llo w a n c e s , a n
in s t it u t io n w o u l d fir s t d e t e r m in e i t s
o ffs e ttin g p o s it io n s w it h in a z o n e a n d
th e a s s o c ia te d “ w it h in z o n e ”
d is a llo w a n c e a m o u n ts. O n c e th e
in s t itu t io n h a s n e tte d -its p o s it io n s
w it h in a z o n e , it w o u ld d e t e r m in e th e
a m o u n t o f o ffs e ttin g a n d a s s o c ia t e d
d is a llo w a n c e s a c r o s s z o n e s . A n
i n s t i t u t i o n ’s g e n e r a l m a r k e t r i s k
r e q u ir e m e n t fo r d e b t in s t r u m e n t s w it h in
a g iv e n c u r r e n c y w o u ld b e th e s u m o f
(1 ) t h e v a l u e o f i t s n e t r i s k - w e i g h t e d
p o s itio n (b a se c h a rg e) a n d (2 ) a ll o f its
v e r tic a l a n d h o r iz o n t a l d is a llo w a n c e s .
b.
Specific risk. U n d e r t h e p r o p o s a l ,
g e n e r a lly e v e r y tr a d e d s e c u r ity , w h e t h e r
lo n g o r sh o r t, w o u ld b e a s s e s s e d a
c a p it a l c h a r g e fo r s p e c if ic m a r k e t r is k .
In t h e d e b t p o r tfo lio t h is c h a r g e i s b a s e d
o n t h e id e n t it y o f th e o b lig o r a n d , i n t h e
c a s e o f c o r p o r a te s e c u r itie s , o n th e
c r e d it r a tin g a n d m a tu r ity o f t h e
in s tr u m e n t. C o n s is te n t w it h t h e o r ig in a l
A c c o r d , d e b t in s tr u m e n ts o f n a tio n a l
g o v e r n m e n ts o f O E C D c o u n tr ie s are
a s s ig n e d z e r o s p e c i f i c r is k . O th e r
s e c u r itie s a re a s s ig n e d r is k w e ig h t s

standardization in the terms and credit risk
characteristics of swaps, can produce large swap
portfolios and potentially large disallowances under
the standardized approach.
Consequently, the Agencies’ proposal would
allow institutions with large swap books to use
alternative procedures for calculating the amounts
that would be distributed into the maturity or
duration time bands. One approach would be to
convert the payments requited by a swap into their
present values using zero coupon yields and then
to place those amounts into their appropriate time
bands using the procedures that apply to zero (or
low) coupon bonds. The net amounts for each time
band would then be weighted and subject to the
disallowances of the general market risk framework
as if they were bonds. The Agencies would also
consider other procedures.
18
Since the disallowance is applied to only one
side of an offsetting transaction, a 100 percent
disallowance effectively treats the hedge as being 50
percent effective.

t h e s e in s t r u m e n t s w it h o t h e r w is e
o ffs e ttin g e x p o s u r e s r e s u ltin g fr o m
p o s it io n s in q u a lify in g in s tr u m e n ts .

Equities Held in Trading Portfolios
T h e s t a n d a r d iz e d m e a s u r e o f m a r k e t
r is k in tr a d e d e q u it ie s a ls o c o n s i s t s o f
s e p a r a te c h a r g e s fo r s p e c if ic a n d g e n e r a l
m a r k e t r is k . T h e s e c h a r g e s w o u l d a p p l y
n o t o n ly to d ir e c t h o ld in g s o f e q u ity
s e c u r itie s , b u t a ls o to e q u ity d e r iv a tiv e s
a n d o ff-b a la n c e -s h e e t p o s it io n s w h o s e
m a rk et v a lu e s are d ir e c tly a ffe c te d b y
e q u ity p r ic e s .
a.
General m arket risk. A n
i n s t i t u t i o n ’s g e n e r a l m a r k e t r i s k c a p i t a l
c h a r g e w o u ld b e 8 .0 p e r c e n t o f it s n e t

38090

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

-e q u ity p o s it io n — t h e d if f e r e n c e b e t w e e n
t h e s u m o f it s lo n g a n d t h e s u m o f it s
sh o r t p o s itio n s . T h e n e t lo n g o r sh o r t
p o s it io n a g a in s t w h ic h a g e n e r a l m a r k e t
r is k c h a r g e w o u ld b e a s s e s s e d m u s t b e
c a lc u la t e d o n a m a r k e t-b y -m a r k e t b a s is ,
i.e ., a s e p a r a te c a lc u la t io n m u s t b e
c o m p u t e d fo r e a c h n a tio n a l m a r k e t in
w h ic h th e in s titu tio n h o ld s e q u itie s .
I n s titu tio n s w o u ld n o t, fo r e x a m p le , b e
a b le t o n e t a lo n g p o s i t i o n in U .S .
c o m p a n ie s tra d ed o n th e N e w Y o rk
S to c k E x c h a n g e a g a in s t a s h o r t p o s it io n
in J a p a n e se c o m p a n ie s tr a d e d o n th e

tr a d in g a c c o u n t . N e t p o s it io n s , i n tu r n ,
i n c l u d e a n i n s t i t u t i o n ’s n e t s p o t a n d
fo rw a rd p o s itio n s ; a n y g u a r a n te e s th a t
a re c e r ta in t o b e c a lle d a n d lik e ly to b e
i r r e c o v e r a b le ; n e t f u t u r e i n c o m e a n d
e x p e n s e s th a t are n o t y e t a c c r u e d , b u t
th a t a re a lr e a d y f u lly h e d g e d ; a n d a n y
o t h e r i t e m s r e p r e s e n t in g a p r o fit o r l o s s
in fo r e ig n c u r r e n c ie s . F o r w a r d a n d
fu tu re p o s it io n s w o u ld b e c o n v e r te d
in to th e r e p o r tin g c u r r e n c y a t s p o t
m a r k e t ra tes.
I n s titu tio n s m a y , su b je c t to
s u p e r v is o r y a p p r o v a l, e x c lu d e fr o m t h is
c a lc u la t io n a n y str u c tu r a l p o s it io n s in
T o k y o S to c k E x c h a n g e.
b.
Specific risk. T h e c a p i t a l c h a r g e f o rf o r e i g n c u r r e n c i e s . F o r t h i s p u r p o s e ,
s u c h stru ctu ra l p o s itio n s are lim ite d to
s p e c if ic r is k i s b a s e d o n t h e r e p o r tin g
i n s t i t u t i o n ’s g r o s s e q u i t y p o s i t i o n s ( i . e . ,
tr a n s a c tio n s d e s ig n e d to h e d g e a n
th e a b s o lu te s u m o f a ll lo n g e q u ity
i n s t i t u t i o n ’s c a p i t a l r a t i o s a g a i n s t t h e
p o s it io n s a n d o f a ll sh o r t e q u ity
e f fe c t o f a d v e r s e e x c h a n g e ra te
p o s it io n s , w it h n e ttin g a llo w e d o n ly
m o v e m e n t s o n (1 ) su b o r d in a te d d e b t,
w h e n th e in s titu tio n h a s lo n g a n d sh o r t
e q u ity , o r m in o r it y in te r e s t s in
p o s itio n s in e x a c tly th e sa m e
c o n s o lid a te d su b s id ia r ie s a n d d o ta tio n
in s tr u m e n t). T h is c h a r g e w o u ld a ls o b e
c a p ita l a s s ig n e d to f o r e ig n b r a n c h e s t h a t
8 .0 p e r c e n t, u n le s s th e p o r t fo lio i s b o th
a re d e n o m in a t e d in fo r e ig n c u r r e n c ie s ,
liq u id a n d w e ll- d iv e r s if ie d o r th e
a n d (2 ) a n y p o s i t i o n s r e l a t e d t o
p o s it io n r e la te s to a n in d e x c o m p r is in g
u n c o n s o lid a te d s u b s id ia r ie s a n d to
a d iv e r s if ie d p o r tfo lio o f e q u it ie s .
o th e r ite m s th a t a re d e d u c te d fro m a n
E x a m in e r s w i l l v e r ify th a t a n y
i n s t i t u t i o n ’s c a p i t a l w h e n calculating i t s
p o r tfo lio d e s ig n a t e d a s “ liq u id a n d w e llc a p ita l b a s e . In a n y e v e n t , s u c h
d iv e r s ifie d ” b y a n in s titu tio n is
s tr u c tu r a l fo r e ig n c u r r e n c y p o s it io n s
c h a r a c te r iz e d b y a lim it e d s e n s it iv it y to
s h o u ld r e fle c t lo n g -te r m p o lic ie s o f t h e
p r ic e c h a n g e s o f a n y s in g le e q u it y is s u e
in s t it u t io n a n d n o t r e la te to tr a d in g
o r c lo s e ly r e la te d g r o u p o f e q u it y is s u e s
p o s itio n s .
h e l d i n t h e p o r t f o l i o . I n p a r t i c u la r , t h e
T h e sta n d a r d iz e d a p p r o a c h a s s u m e s
v o la t ilit y o f th e v a lu e o f t h e p o r tfo lio
th e sa m e v o la t ilit y fo r a ll c u r r e n c ie s a n d
s h o u ld n o t b e d o m in a te d b y t h e
r e q u ir e s a n in s t it u t io n to h o ld c a p it a l
v o la t ilit y o f a n y in d iv id u a l e q u ity is s u e
e q u a l t o 8 . 0 p e r c e n t o f t h e s u m o f (a ) i t s
o r b y e q u ity is s u e s fr o m a n y s in g le
n e t p o s i t i o n i n g o l d a n d (b ) t h e s u m o f
in d u s tr y o r e c o n o m ic s e c to r . In g e n e r a l,
th e n e t sh o r t p o s itio n s o r th e su m o f th e
s u c h p o r tfo lio s s h o u ld b e c h a r a c te r iz e d
n e t lo n g p o s it io n s i n e a c h fo r e ig n
b y a la r g e n u m b e r o f i n d iv id u a l e q u it y
c u r r e n c y , w h ic h e v e r i s g r e a te r . W ith
p o s itio n s , w ith n o s in g le p o s itio n
su p e r v is o r y a p p r o v a l, a n in s t itu t io n
r e p r e s e n t in g a la r g e p o r t io n o f t h e
m a y b e e x e m p t fr o m t h is c a p it a l
p o r t f o l i o ’s t o t a l m a r k e t v a l u e . I n
r e q u ir e m e n t i f t h e s u m o f it s g r o s s lo n g
a n d sh o rt p o s itio n s d o e s n o t e x c e e d 1 0 0
a d d it io n , it w o u ld g e n e r a lly b e t h e c a s e
th a t a s iz e a b le p r o p o r tio n o f t h e
p e r c e n t o f it s e lig ib le c a p ita l a n d it s
o v e r a ll n e t fo r e ig n e x c h a n g e p o s it io n
p o r tfo lio w o u ld b e c o m p r is e d o f i s s u e s
tr a d e d o n o r g a n iz e d e x c h a n g e s .
d o e s n o t e x c e e d 2 .0 p e r c e n t o f t h i s
F o r s u c h liq u id a n d w e ll- d iv e r s if ie d
c a p it a l, a s d e f in e d a b o v e in S e c t io n D .
p o r t fo lio s , th e s p e c if ic r is k c h a r g e
Commodities
w o u l d b e 4 .0 p e r c e n t. A s p e c i f i c r is k
T h e c a p it a l r e q u ir e m e n t fo r
c h a r g e o f 2 .0 p e r c e n t w o u l d a p p l y t o t h e
c o m m o d it ie s r is k a p p lie s to h o ld in g s o r
n e t lo n g o r sh o r t p o s it io n in a b r o a d p o s itio n s ta k e n in c o m m o d itie s ,
b a s e d , d iv e r s if ie d e q u ity in d e x a n d is
in c lu d in g p r e c io u s m e ta ls , b u t
v ie w e d a s n e c e s s a r y to p r o v id e fo r t h e
e x c lu d in g g o ld ( w h ic h i s tr e a te d a s a
r is k th a t t h e p e r fo r m a n c e o f t h e in d e x

r o u g h i n d ic a t io n o f t h e r is k e x p o s u r e
a n d i s a p p r o p r ia te o n l y fo r i n s t i t u t i o n s
w ith r e la tiv e ly s m a ll a m o u n ts o f
c o m m o d itie s a c tiv ity .
W ith in t h e sta n d a r d iz e d a p p r o a c h ,
t w o a lte r n a tiv e m e a s u r e s a re a v a ila b le ,
referred to a s th e “ s im p le ” a n d th e
“ m a tu r ity ” m e th o d s . B o th m e a s u r e s
a d d r e s s d ir e c t io n a l r is k , w h i c h i s t h e
r i s k t h a t a c o m m o d i t y ’s s p o t p r i c e w i l l
in c r e a s e o r d e c r e a s e , a s w e ll a s b a s is
r is k , in t e r e s t r a te r is k , a n d fo r w a r d g a p
r is k , w h i c h a r e a ls o im p o r ta n t r is k s ,
e s p e c ia lly fo r in s t itu t io n s th a t e n g a g e in
fo r w a r d o r d e r iv a tiv e c o n tr a c ts. T h e s e
in s t it u t io n s c a n fa c e s ig n if ic a n t l o s s e s in
th e ir p o s it io n s a s a r e s u lt o f a d v e r s e
c h a n g e s in th e r e la tio n s h ip b e tw e e n
p r ic e s o f sim ila r c o m m o d itie s , in c r e a s e s
in th e c o s t o f fin a n c in g fo rw a rd
p o s itio n s , o r c h a n g e s in fo rw a rd p r ic e s
p r o d u c e d b y a n y n u m b er o f e c o n o m ic or
m a rk et c o n d itio n s .
B o th th e s im p le a n d m a tu r ity
a p p r o a c h e s r e q u ir e a n in s t it u t io n t o
c a lc u la te its n e t p o s it io n in e a c h
c o m m o d ity o n th e b a s is o f s p o t ra te s.
L o n g a n d sh o rt p o s itio n s in th e sa m e
c o m m o d ity m a y b e n e tte d , b u t p o s itio n s
in d iffe r e n t c o m m o d it ie s w o u ld
g e n e r a lly n o t b e a llo w e d to o ffs e t,
e x c e p t w h e r e d iffe r e n t su b -c a te g o r ie s o f
c o m m o d it ie s a r e d e liv e r a b le a g a in s t
e a c h o th e r .
U n d e r th e sim p le a p p ro a ch , a n
i n s t i t u t i o n ’s c a p i t a l c h a r g e f o r
d ir e c t io n a l r is k w o u ld e q u a l 1 5 p e r c e n t
o f its n e t p o s it io n , lo n g o r sh o r t, i n e a c h
c o m m o d ity . A s u p p le m e n ta l c h a r g e o f
3 .0 p e r c e n t o f t h e g r o s s p o s it io n in e a c h
c o m m o d ity w o u ld b e a d d e d to c o v e r
b a s is , in t e r e s t r a te a n d fo r w a r d g a p r is k .
T h e c a p it a l c h a r g e u s in g t h e m a tu r ity
m e th o d r e fle c ts n o t o n ly th e n e t a n d
g r o ss p o s it io n s in e a c h c o m m o d ity , b u t
a ls o t h e m a tu r ity o f e a c h c o m m o d it y
c o n tr a c t. F o r e a c h c o m m o d ity , p o s it io n s
w o u l d fir s t b e d is t r ib u t e d a m o n g s e v e n
tim e b a n d s. P h y s ic a l h o ld in g s o f
c o m m o d itie s w o u ld b e a llo c a te d to th e
fir s t b a n d . T h e m a t c h e d lo n g p o s it io n
p lu s th e m a tc h e d sh o r t p o s itio n w ith in
e a c h tim e -b a n d w o u ld th e n b e
m u l t i p l i e d b y a “ s p r e a d r a t e ,” ( p r o p o s e d
a t a u n i f o r m 1 .5 p e r c e n t r a t e ) t o c a p t u r e
fo r w a r d g a p a n d in te r e s t r a te r is k . N e t

fo r e ig n c u r r e n c y b e c a u s e o f it s m a r k e t

p o s it io n s fro m o n e tim e -b a n d m u s t b e
u s e d to o ffs e t o p p o s it e p o s it io n s in

m e a s u r e s a n d a ls o fo r p o te n t ia l

liq u id it y ). A s w it h fo r e ig n c u r r e n c ie s ,

a n o th e r tim e -b a n d a n d w o u ld in c u r a

d if f ic u lt ie s th a t c o u ld a r is e in e x e c u t in g

t h e c o v e r a g e e x t e n d s to a ll c o m m o d it ie s

“ s u r c h a r g e ” e q u a l t o 0 .6 p e r c e n t o f t h e

tr a n s a c tio n s at e x p e c t e d p r ic e s .

p o s itio n s o f th e in s titu tio n , n o t o n ly to

n e t p o s it io n fo r e v e r y t im e - b a n d it i s

t h o s e b o o k e d i n tr a d in g a c c o u n t s . F o r

c a r r ie d fo r w a r d in r e c o g n it io n th a t s u c h

w i l l d iffe r fr o m t h o s e o f o th e r m a r k e t

Foreign Exchange

th is p u r p o s e , a c o m m o d ity is d e fin e d a s

o ffs e ttin g m a y n o t b e p e r fe c t. T h is

a p h y s ic a l p r o d u c t w h ic h is or c a n b e

p r o c e s s u ltim a te ly p r o d u c e s a n o v e r a ll

r is k o f h o l d i n g o r t a k i n g p o s i t i o n s i n

tr a d e d o n a s e c o n d a r y m a r k e t, e .g .,

n e t p o s it io n fo r e a c h c o m m o d it y . A 1 5

fo r e ig n c u r r e n c ie s , i n c lu d in g g o ld , a n d

a g r ic u ltu r a l p r o d u c ts , m in e r a ls , a n d

i s b a s e d o n a n i n s t i t u t i o n ’s n e t p o s i t i o n s
in in d iv id u a l c u r r e n c ie s , w h e t h e r o r n o t
th o s e p o s itio n s are b o o k e d in th e

p r e c io u s m e ta ls . T h e s ta n d a r d iz e d
a p p r o a c h fo r m e a s u r in g g e n e r a l m a r k e t

p e r c e n t c a p ita l c h a r g e w o u ld b e a p p lie d
to th a t n e t p o s it io n . T h e to ta l c a p ita l

T h is c a p it a l r e q u ir e m e n t c o v e r s t h e




r is k in c o m m o d it ie s p r o v id e s o n ly a

c h a r g e fo r a n y g iv e n c o m m o d it y w o u ld
b e t h e s u m o f (a ) t h e i n i t i a l 1 .5 p e r c e n t

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
c h a r g e fo r t h e m a t c h e d p o s i t i o n s i n e a c h
t i m e b a n d , (b ) a n y s u r c h a r g e , a n d ( c ) t h e
c h a rg e o n th e o v e r a ll n e t p o s itio n .

Options
T h e A g e n c ie s r e c o g n iz e t h e d iv e r s it y
o f a c tiv itie s in o p tio n s a n d th e
d i f f i c u l t i e s i n m e a s u r i n g a n o p t i o n ’s
p r i c e r is k . A c c o r d i n g l y , t h e p r o p o s a l
p r o v id e s th r e e a lt e r n a tiv e r is k m e a s u r e s
fo r in s t itu t io n s th a t d o n o t a d o p t th e
in te r n a l m o d e ls a p p r o a c h . T h e s e
a l t e r n a t i v e s a r e : (a ) a “ s i m p l i f i e d ”
m e th o d , w h ic h is a v a ila b le to
in s titu tio n s th a t o n ly p u r c h a se tra d ed
o p t i o n s , (b ) a “ s c e n a r i o a n a l y s i s ”
m e th o d th a t e v a lu a te s o p tio n v a lu e s
u n d e r a r a n g e o f m a r k e t s c e n a r io s , a n d
(c ) a “ d e lt a - p lu s ” m e t h o d th a t p r o v id e s
s p e c ific m e a s u r e s o f in d iv id u a l
c o m p o n e n t s o f a n o p t i o n ’s r i s k . T h e
m e th o d u s e d s h o u ld b e c o m m e n s u r a te
w it h a n d a p p r o p r ia te fo r t h e n a tu r e a n d
s c o p e o f t h e i n s t i t u t i o n ’s o p t i o n s
a c tiv itie s . I n s titu tio n s th a t h a v e
e x te n s iv e d e a lin g s in o p tio n s m u s t h a v e
a p p r o p r ia te ly a c c u r a te m e a s u r e s o f r is k .
S e v e r a l v a r ia b le s d e t e r m in e a n
o p t i o n ’s p r i c e :
(1 ) T h e c u r r e n t p r ic e o f t h e
u n d e r ly in g a sset;
(2 ) T h e s tr ik e p r ic e o f t h e o p t io n ,
w h ic h is t h e p r ic e o f t h e u n d e r ly in g
s e c u r ity a t w h ic h th e o p tio n h a s v a lu e ;
(3 ) T h e v o la t ilit y o f t h e p r ic e o f t h e
u n d e r ly in g se c u r ity ;
(4 )
t im e r e m a in in g b e fo r e t h e
o p t io n e x p ir e s ; a n d
(5 ) T h e p r e v a ilin g “ r is k f r e e ” in te r e s t
ra te.
T h e e ffe c t o f t h e s e v a r ia b le s o n a n
o p t i o n ’s v a l u e a r e r e p r e s e n t e d b y a
s e r i e s o f G r e e k l e t t e r s : delta ( t h e p r i c e
s e n s it iv it y o f a n o p tio n r e la tiv e to p r ic e
c h a n g e s in t h e u n d e r ly in g s e c u r ity , ra te,
o r i n d e x — t h e “ u n d e r l y i n g ” ) , gamma
(th e c h a n g e in d e lta fo r a g iv e n c h a n g e
i n t h e u n d e r l y i n g ) , vega ( t h e e f f e c t o f
c h a n g e s in th e v o la t ilit y o f th e
u n d e r l y i n g ) , theta ( t h e e f f e c t g i v e n t h e
p a s s a g e o f t i m e ) , a n d rho ( h o w t h e
o p t io n p r ic e c h a n g e s fo r a g iv e n c h a n g e
in r is k fr e e in te r e s t r a te s). D e lta i s a
f r e q u e n t l y u s e d i n d i c a t o r o f a n o p t i o n ’s

The

v o lu m e o f p u r c h a s e d o p tio n s . T h is
a p p r o a c h p e r m its a n in s t itu t io n e ith e r to
“ c a r v e o u t” b o th th e o p tio n a n d a
c o r r e s p o n d in g u n d e r ly in g p o s it io n fr o m
o th e r e le m e n ts o f t h e sta n d a r d iz e d
a p p r o a c h o r to v ie w t h e o p tio n a s
“ n a k e d ”— th a t is , w it h o u t a m a tc h in g
c a s h p o s itio n . In o r d e r to a v o id
p o te n tia lly p e n a liz in g a n in s titu tio n fo r
p u r c h a s in g a n o p tio n , in s t it u t io n s c o u ld
a v o id lin k in g (a n d s u b s e q u e n t ly
c a r v in g -o u t) a p u r c h a s e d o p t io n a n d a
c o r r e s p o n d in g c a s h p o s it io n i f d o in g s o
w o u ld crea te a n e x p o s u r e w ith in th e
u n d e r ly in g p o s it io n a n d p r o d u c e a
c a p it a l r e q u ir e m e n t t h a t e x c e e d e d t h e
v a lu e o f th e p u r c h a se d o p tio n .
C o n s e q u e n tly , th e r e a re t w o
p o s s ib ilit ie s :
(1 ) I f a c a r v e -o u t i s m a d e , t h e c a p it a l
ch a rg e is e q u a l to th e s p e c ific a n d
g e n e r a l m a r k e t r is k c h a r g e o n t h e
u n d e r ly in g p o s itio n , le s s th e a m o u n t th e
o p tio n is in th e m o n e y , b o u n d e d a t zero .
(2 ) I f t h e p u r c h a s e d o p t io n i s v ie w e d
b y it s e lf , t h e c h a r g e fo r t h e o p tio n i s t h e
s m a l l e r o f (a ) i t s m a r k e t v a l u e o r ( b ) t h e
su m o f th e s p e c ific a n d g e n e r a l m a rk et
r is k c h a r g e th a t w o u ld a p p ly to its
u n d e r ly in g in s tr u m e n t. A n y e x is t in g
r e la t e d (b u t n o t lin k e d ) c a s h p o s it io n
w o u ld c o n tin u e to r e c e iv e th e fu ll
s p e c if ic a n d g e n e r a l m a r k e t r is k c h a r g e
p r o d u c e d b y o th e r e le m e n ts o f th e
s ta n d a r d iz e d a p p r o a c h .
In b o th c a s e s , th e m e th o d is r e la tiv e ly
c o n s e r v a tiv e , c r e a tin g a n in c e n t iv e fo r
in s titu tio n s to u s e a m o r e a c c u r a te
m e a s u r e o f r is k . I n s t it u t io n s th a t w a n t a
m o r e a c c u r a te m e a s u r e o f o p t io n r is k o r
w h o s e tr a d in g a c t iv it ie s in c lu d e t h e
w r it in g (s e llin g ) o f o p t io n s m u s t u s e

either the scenario or the delta-plus
m e th o d s o ffe r e d u n d e r t h e sta n d a r d iz e d
a p p r o a c h , o r t h e p r e v io u s ly d e s c r ib e d
in te r n a l m o d e ls a p p r o a c h .

Scenario Analysis

38091

o p tio n s w o u ld b e c o n s is te n t w ith th e
a s s u m e d p r ic e o r ra te c h a n g e a p p lie d to
th e ir u n d e r ly in g c a s h p o s itio n s : 8
p e r c e n t fo r f o r e ig n e x c h a n g e , 1 2 p e r c e n t
fo r in d iv id u a l e q u it ie s , 8 p e r c e n t fo r
e q u it y in d ic e s , a n d 1 5 p e r c e n t fo r
c o m m o d it ie s . In a ll c a s e s , t h e r a n g e
w o u ld c o v e r b o th a n in c r e a s e a n d
d e c r e a s e fro m c u r r e n t v a lu e s o f th e
u n d e r ly in g s e c u r ity (o r ra te) b y t h e s e
p e r c e n ta g e s a n d w o u ld b e d iv id e d in to
a t le a s t 1 0 e q u a lly s p a c e d in te r v a ls
c e n t e r e d b y t h e c u r r e n t r a te o r p r ic e .
G iv e n t h e n e a r -lin e a r r e la t io n s h ip
b e t w e e n v o la t ilit y a n d o p tio n v a lu e s fo r
m a n y o p t io n s , t h e A g e n c ie s b e l i e v e it
w o u ld b e s u f f ic ie n t in m o s t c a s e s to
e v a lu a te th e o p tio n p o r tfo lio a s s u m in g a
2 5 p e r c e n t in c r e a s e a n d d e c r e a s e in t h e
le v e l o f v o la tility fro m th a t im p lie d b y
c u r r e n t m a rk et p r ic e s . I f w a r r a n te d ,
h o w e v e r , t h e A g e n c ie s m a y r e q u ir e a
d iffe r e n t c h a n g e in v o la t ilit y a n d th e
c o n s id e r a tio n o f in te r m e d ia te p o in ts .
A n in s t it u t io n w o u l d d e t e r m in e t h e
m a r k e t v a lu e o f e a c h o p tio n a n d a n y
r e la te d h e d g in g p o s it io n o r g r o u p o f
o p t i o n s a r id r e l a t e d h e d g i n g p o s i t i o n s
f o r e a c h s c e n a r i o . 19 S u c h o p t i o n s a n d
p o s it io n s b a s e d o n d e b t in s tr u m e n ts in
th e s a m e z o n e , o r o n th e s a m e e q u ity ,
e q u ity in d e x , e x c h a n g e ra te, or
c o m m o d ity m a y b e g r o u p e d to g e th e r
a n d e v a lu a te d o n a p o r t fo lio b a s is w h e n
e v a lu a t in g t h e e f fe c t o f a g iv e n s c e n a r io .
T h e m a r k e t r is k c a p ita l c h a r g e fo r a
p o r tfo lio w o u ld b e t h e la r g e s t lo s s
e s tim a te d fo r th a t p o r t f o lio fr o m a m o n g
t h e e v a lu a te d s c e n a r io s . T h e c h a r g e fo r
a ll o p tio n p o r tfo lio s w o u ld b e th e s u m
o f th e c h a r g e s o n th e in d iv id u a l
p o r tfo lio s . T h e A g e n c ie s r e c o g n iz e th a t
t h is a p p r o a c h is c o n s e r v a tiv e , s in c e it
a s s u m e s th a t t h e la r g e s t l o s s w i l l o c c u r
w it h in e a c h s e g m e n t o f t h e o p tio n
p o r tfo lio s im u lta n e o u s ly .

The delta-plus m ethod

U s in g s c e n a r io a n a ly s is , in s t it u t io n s
w o u ld e v a lu a te t h e m a r k e t v a lu e s o f
t h e ir o p tio n s a n d r e la te d h e d g in g
p o s it io n s b y c h a n g in g t h e u n d e r ly in g
r a te o r p r ic e o v e r a s p e c if ie d r a n g e a n d

I n s titu tio n s th a t w r ite o p tio n s w o u ld
b e a llo w e d to in c lu d e d e lta -w e ig h te d
o p tio n s p o s itio n s w it h in th e
s ta n d a r d iz e d m e th o d o lo g y . S u c h

b y a ls o a s s u m in g d iffe r e n t le v e ls o f

r is k , b u t o th e r s — p a r t ic u la r ly g a m m a —

v o la t ilit y fo r th a t ra te o r p r ic e . E a c h

o p tio n s s h o u ld b e r e p o r te d a s a p o s itio n
e q u a l to th e m a rk et v a lu e o f th e

s h o u ld b e s p e c ific a lly a d d r e sse d b y

c o m b in a tio n o f a s s u m e d v o la t ilit ie s a n d

u n d e r ly in g in str u m e n t m u ltip lie d b y th e

in s titu tio n s th a t tra d e o p tio n s to a n y

d o e s n o t s u f f ic ie n t ly a d d r e s s o th e r r is k s

s h o u ld n o t r e ly m e r e ly o n lin e a r

ra te o r p r ic e c h a n g e s w o u ld r e p r e s e n t a
s c e n a r io .
T h e r a n g e o f ra te o r p r ic e m o v e m e n t s

a p p r o x im a tio n s o f p r ic e m o v e m e n t s , b u t

w o u ld b e b a se d o n th e n a tu r e o f th e

v a lu e , in s t itu t io n s w o u ld a ls o b e
r e q u i r e d t o m e a s u r e t h e o p t i o n ’s

m a te r ia l e x t e n t. S u c h in s t it u t io n s

s h o u ld u n d e r ta k e to c a p tu r e th e n o n ­

o p tio n . F o r o p tio n s b a s e d o n d e b t

lin e a r r e la tio n b e t w e e n c h a n g e s in t h e

in s t r u m e n t s o r in te r e s t r a te s , t h e r a n g e

d e l t a . H o w e v e r , s i n c e a n o p t i o n ’s d e l t a
a s s o c i a t e d w i t h t h e o p t i o n ’s m a r k e t

gamma

o p t i o n ’s p r i c e a n d c h a n g e s i n t h e

w o u ld b e c o n s is te n t w it h t h e m a x im u m

a n d v e g a in o rd er to c a lc u la te th e to ta l
c a p it a l c h a r g e fo r th e o p tio n . T h e s e

u n d e r ly in g r a te o r p r ic e .

ra te m o v e m e n t in d ic a te d in th e p r o p o sa l

s e n s itiv it ie s w o u ld b e c a lc u la te d b y a n

d e a lin g w it h tr a d e d d e b t: 1 0 0 b a s is

a p p r o v e d e x c h a n g e m o d e l o r b y th e

Sim plified Approach
T h e s im p lifie d a p p r o a c h fo r o p tio n s
m a y o n ly b e u s e d b y in s titu tio n s w h o s e
o p tio n s a c tiv itie s a re c o n fin e d to a s m a ll




p o in t s fo r u n d e r ly in g in s t r u m e n t s in
z o n e 1 , 9 0 b a s is p o in t s fo r t h o s e in z o n e
2 , a n d 7 5 b a s is p o in t s fo r t h o s e in z o n e
3 . S im ila r ly , th e r a n g e s u s e d fo r o th e r

19 For this purpose, a single option and any
related hedging position and a group of ootions and
any related hedging positions are all referred to as
an "options portfolio."

38092

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

i n s t i t u t i o n ’s p r o p r i e t a r y o p t i o n s p r i c i n g
m o d e l, s u b je c t to o v e r s ig h t b y th e
a p p r o p r ia te s u p e r v is o r .
D e lta -w e ig h te d p o s it io n s o f o p t io n s
b a s e d -o n d e b t s e c u r itie s o r in te r e s t ra tes
w o u ld b e s lo t t e d in to t h e d e b t s e c u r itie s
tim e -b a n d s , a s s e t o u t a b o v e fo r d e b t
in s tr u m e n ts , u n d e r th e f o llo w in g
p r o c e d u r e . A tw o -le g g e d a p p r o a c h
w o u l d b e u s e d a s fo r o t h e r d e r iv a t iv e s ,
- r e q u ir in g o n e e n t r y a t t h e t i m e t h e
u n d e r ly in g c o n tr a c t ta k e s e ffe c t a n d a
s e c o n d a t th e tim e th e u n d e r ly in g
c o n tr a c t m a tu r e s. F o r in s ta n c e , a b o u g h t
c a ll o p tio n o n a Ju n e th r e e -m o n th
in te r e s t-r a te fu tu r e w i l l in A p r il b e
c o n s id e r e d , o n th e b a s is o f its “d e lt a ”
e q u iv a le n t v a lu e , to b e a lo n g p o s it io n
w it h a m a tu r ity o f f iv e m o n t h s a n d a
s h o r t p o s it io n w it h a m a tu r ity o f t w o
m o n th s . T h e w r itte n o p tio n w o u ld b e
s im ila r ly s lo t t e d a s a lo n g p o s it io n w it h
a m a tu r ity o f t w o m o n t h s a n d a s h o r t
p o s it io n w it h a m a tu r ity o f f iv e m o n t h s .
F lo a t in g r a te in s t r u m e n t s w it h c a p s o r
flo o r s w o u ld b e tr e a te d a s a c o m b in a t io n
o f flo a tin g ra te s e c u r itie s a n d a s e r ie s o f
E u r o p e a n -sty le o p tio n s . F o r e x a m p le ,
t h e h o ld e r o f a th r e e -y e a r f lo a t in g ra te
b o n d in d e x e d to s ix m o n th L IB O R w it h
a c a p o f 15 p e r c e n t w o u ld trea t th e
i n s t r u m e n t a s : (1 ) A d e b t s e c u r i t y t h a t
r e p r ic e s in s i x m o n th s ; a n d (2 ) a s e r ie s
o f f iv e w r it te n c a ll o p t io n s o n a f lo a tin g
r a te a s s e t (F R A ) w i t h a b a s is o f 1 5
p e r c e n t, e a c h w it h a n e g a tiv e s ig n a t th e
t im e th e u n d e r ly in g F R A ta k e s e ffe c t
a n d a p o s it iv e s ig n a t th e t im e th e
u n d e r ly in g F R A m a tu r e s.
In a d d it io n to th e a b o v e c a p it a l
c h a r g e s a r is in g fro m d e lta r is k , t h e
p r o p o s a l r e q u ir e s c a p ita l fo r g a m m a a n d
v e g a r is k s . I n s t it u t io n s u s in g t h is
m e th o d w o u ld b e r e q u ir e d to c a lc u la t e
th e g a m m a a n d v e g a fo r e a c h o p t io n
p o s it io n . T h e r e s u lts w o u ld b e s lo t t e d
in t o s e p a r a te m a tu r ity la d d e r s b y
c u r r e n c y . F o r o p tio n s s u c h a s c a p s a n d
flo o r s w h o s e u n d e r ly in g in s t r u m e n t is
a n in te r e s t r a te , th e d e lta a n d g a m m a
w o u ld b e e x p r e s s e d in te r m s o f a
h y p o th e t ic a l u n d e r ly in g s e c u r ity .
S u b s e q u e n tly :
(1 ) F o r g a m m a r is k , fo r e a c h t im e b a n d , n e t g a m m a s w h ic h are n e g a tiv e
w o u ld b e m u lt ip lie d b y th e r is k w e ig h t s
s e t o u t in t h e p r o p o s e d r e g u la to r y
l a n g u a g e (O C C — T a b l e 5 , B o a r d — T a b l e

in d iv id u a l c a p ita l c h a r g e s fo r n e t
n e g a t iv e g a m m a s p lu s t h e a b s o lu te
v a lu e o f th e su m o f th e in d iv id u a l
c a p it a l c h a r g e s fo r v e g a r is k fo r e a c h
tim e - b a n d .
T h e c a p ita l c h a r g e fo r o p t io n s o n
e q u itie s w o u ld a ls o b e b a s e d o n th e
d e lta w e ig h t e d p o s it io n s o f t h e o p tio n s
b y in c o r p o r a tin g t h o s e w e ig h t e d
p o s it io n s in to t h e m a rk et r is k m e a s u r e
fo r e q u it ie s d e s c r ib e d a b o v e . F o r
p u r p o s e s o f t h is c a lc u la t io n in d iv id u a l
e q u ity is s u e s a n d in d ic e s a re to b e
tr e a te d a s s e p a r a te u n d e r ly in g s . In
a d d it io n to t h e c a p it a l c h a r g e fo r d e lta
r is k , in s t it u t io n s w o u ld a p p ly a fu r th e r
c a p i t a l c h a r g e f o r g a m m a a n d v e g a r is k :
(1 ) F o r g a m m a r is k , t h e n e t n e g a t iv e
g a m m a s fo r e a c h u n d e r ly in g in s t r u m e n t
w o u ld b e m u lt ip lie d b y 0 .7 2 p e r c e n t
w h e n th a t in s t r u m e n t i s a n in d iv id u a l
e q u it y a n d b y 0 .3 2 p e r c e n t w h e n it i s a n
i n d e x . 20 T h a t p r o d u c t w o u l d t h e n b e
m u ltip lie d b y th e sq u a re o f th e m ark et
v a lu e o f t h e u n d e r ly in g ;
(2 ) F o r v o la t ilit y r is k , in s t it u t io n s
w o u ld b e r e q u ir e d to c a lc u la t e t h e
c a p it a l c h a r g e s fo r v e g a s fo r e a c h
u n d e r ly in g in s t r u m e n t a s s u m in g a
p r o p o r tio n a L s h if t in v o la t ilit y o f p l u s o r
m in u s 2 5 p e r c e n t;
(3 ) T h e c a p it a l c h a r g e w o u l d b e t h e
a b s o lu te v a lu e o f th e su m o f th e
in d iv id u a l c a p ita l c h a r g e s fo r n e t
n e g a t iv e g a m m a s p lu s t h e a b s o lu te
v a lu e o f th e s u m o f th e in d iv id u a l
c a p i t a l c h a r g e s f o r v e g a r is k .
T h e c a p ita l c h a r g e fo r o p tio n s o n
f o r e ig n e x c h a n g e a n d g o ld p o s it io n s
w o u ld b e b a se d o n th e sh o rth a n d
m e t h o d s e t o u t e a r l i e r . F o r d e l t a r is k ,
t h e n e t d e lta (o r d e lta -b a s e d ) e q u iv a le n t
o f t h e to ta l b o o k o f fo r e ig n c u r r e n c y a n d
g o ld o p tio n s w o u ld b e in c o r p o r a te d in to
th e m e a su r e m e n t o f th e e x p o s u r e in a
sin g le , c u r r e n c y p o s itio n . T h e g a m m a
a n d v e g a r is k s w o u ld b e m e a s u r e d a s
f o llo w s :
(1 ) F o r g a m m a r is k , fo r e a c h
u n d e r ly in g e x c h a n g e ra te n e t g a m m a s
w h ic h are n e g a tiv e w o u ld b e m u lt ip lie d
b y 0 .3 2 p e r c e n t a n d b y th e sq u a r e o f th e
m a r k e t v a l u e o f t h e p o s i t i o n ; 21
(2 ) F o r v o la t ilit y n s k , in s t it u t io n s
w o u ld b e r e q u ir e d to c a lc u la t e th e
c a p it a l c h a r g e s fo r v e g a s fo r e a c h
c u r r e n c y p a ir a n d g o ld a s s u m in g a

th e m a rk et v a lu e o f th e u n d e r ly in g s (n et

p r o p o r t io n a l s h ift in v o la t ilit y o f p lu s o r
m in u s 2 5 p e rcen t;
(3 ) T h e c a p it a l c h a r g e w o u ld b e th e

g a m m a s w h ic h are p o s itiv e w o u ld b e

a b s o lu te v a lu e o f th e su m o f th e

d is r e g a r d e d );
(2 ) F o r v o l a t i l i t y r i s k , i n s t i t u t i o n s

in d iv id u a l c a p ita l c h a r g e s fo r n e t

w o u l d b e r e q u ir e d t o c a lc u la t e t h e

20Using the Taylor expansion, the risk weights
are calculated as follows: Risk weight for gamma
=0.5x (assumed price change of underlying)2 For an
individual equity, 0.5x0.122= 0.72%. In the case of
an index as the underlying, the assumed price
change of the underlying equals 8.0 percent.
21 The assumed price change is 8.0 percent.

IV , F D IC — T a b l e 4 ) a n d b y t h e s q u a r e o f

c a p ita l c h a r g e s fo r v e g a s in e a c h tim e b a n d a s s u m in g a p r o p o r tio n a l s h if t in
v o la t ilit y o f 2 5 p e r c e n t;
(3 ) T h e c a p ita l c h a r g e w o u ld b e th e
a b s o lu te v a lu e o f th e s u m o f th e




n e g a t iv e g a m m a s p lu s t h e a b s o lu te
v a lu e o f t h e s u m o f th e in d iv id u a l
c a p i t a l c h a r g e s f o r v e g a r is k .
T h e c a p it a l c h a r g e fo r o p t i o n s o n
c o m m o d itie s w o u ld b e b a se d o n th e
s a m e a p p r o a c h s e t o u t a b o v e fo r
c o m m o d it ie s . T h e d e lta w e ig h t e d
p o s it io n s w o u ld b e in c o r p o r a te d in to
o n e o f t h e t w o m e a s u r e s d e s c r ib e d in
th a t s e c t io n . In a d d itio n to t h e c a p ita l
c h a r g e fo r d e lt a r is k , i n s t it u t io n s w o u l d
in c u r a fu r th e r c a p ita l c h a r g e f o r g a m m a
a n d v e g a r is k :
(1 ) F o r g a m m a r is k , n e t n e g a t iv e
g a m m a s fo r e a c h u n d e r ly in g w o u ld b e
m u l t i p l i e d b y 1 .1 2 5 p e r c e n t a n d b y t h e
sq u a r e o f th e m a rk et v a lu e o f th e
c o m m o d i t y ; 22
(2 ) F o r v o l a t il i t y r is k , i n s t i t u t i o n s
w o u ld b e r e q u ir e d t o c a lc u la t e t h e
c a p it a l c h a r g e s fo r v e g a s fo r e a c h
c o m m o d ity a s d e fin e d a b o v e in th e
s e c tio n d e a lin g w ith c o m m o d itie s ,
a s s u m in g a p r o p o r tio n a l sh ift in
v o la t ilit y o f p lu s or m in u s 2 5 p e r c e n t;
(3 ) T h e c a p it a l c h a r g e w o u l a b e t h e
a b s o lu te v a lu e o f th e s u m o f th e
in d iv id u a l c a p ita l c h a r g e s fo r n e t
n e g a tiv e g a m m a s p lu s th e a b s o lu te
v a lu e o f d ie su m o f th e in d iv id u a l
c a p i t a l c h a r g e s f o r v e g a r is k .
A w o r k e d e x a m p le o f th e d e lta -p lu s
m e th o d fo r c o m m o d it ie s i s s e t o u t in
A t t a c h m e n t I V o f t h e B o a r d ’s a n d t h e
F D I C ’s p r o p o s e d r e g u l a t o r y l a n g u a g e . In
th e c a s e o f o p tio n s b a se d o n d e b t
s e c u r it ie s o r in te r e s t r a te s a n d w it h t h e
a p p r o v a l o f t h e a p p r o p r ia te s u p e r v is o r ,
in s titu tio n s th a t are s ig n ific a n t tra d ers
in o p tio n s c o u ld b e a llo w e d to n e t
p o s it iv e a n d n e g a tiv e g a m m a s a n d v e g a s
a c r o s s tim e -b a n d s to a lim ite d e x te n t.
H o w e v e r , s u c h n e ttin g w o u ld b e
p e r m i t t e d o n l y i f it i s b a s e d o n p r u d e n t
a n d c o n s e r v a tiv e a s s u m p tio n s a n d th e
in s t it u t io n m a te r ia lly s a t is f ie s th e
q u a lita tiv e sta n d a r d s o u tlin e d u n d e r th e
in te r n a l m o d e ls a p p r o a c h .
In a d d it io n , in s t e a d o f a p p ly in g a
u n ifo r m r e la t iv e c h a n g e in v o la t ilit y to
m e a s u r e v e g a r is k , in s t it u t io n s m a y b a s e
t h e c a lc u la t io n o n a v o la t ilit y la d d e r in
w h ic h t h e im p lie d c h a n g e in v o la t ilit y
v a r ie s w it h t h e m a tu r ity o f t h e o p tio n .
W h e n u s in g s u c h a v o la t ilit y la d d e r th e
a s s u m e d p r o p o r tio n a l sh ift in v o la t ilit y
s h o u ld b e at le a s t 2 5 p e r c e n t at th e sh o r t
e n d o f t h e m a tu r ity s p e c tr u m . T h e
p r o p o r t io n a l s h if t in v o la t ilit y fo r lo n g e r
m a tu r it ie s s h o u ld b e a t le a s t a s s tr in g e n t
in s ta tis tic a l te r m s a s th e 2 5 p e r c e n t
s h ift at th e sh o r t e n d . U s e o f th is
a lte r n a tiv e w o u ld b e su b je c t to
v a lid a tio n b y th e su p e r v is o r , a n d to th e
q u a lita tiv e sta n d a r d s lis te d in th e
in te r n a l m o d e ls s e c t io n th a t a re r e le v a n t
t o t j r is a s p e c t o f t h e i n s t i t u t i o n ’s

22The assumed price change is 15 percent.

Federal Register / VoL 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
b u s in e s s . In th e lo n g te r m , in s titu tio n s
u s in g t h i s a lte r n a tiv e w o u ld b e e x p e c t e d
t o m o v e t o h illy a r tic u la te d v a lu e -a t-r is k
m o d e ls , s u b je c t t o t h e f u ll q u a lita tiv e
a n d q u a n tita tiv e sta n d a r d s fo r m o d e ls .
B e s id e s t h e o p tio n s r is k s m e n tio n e d
a b o v e , t h e A g e n c ie s r e c o g n iz e th a t th e re
a re o th e r r is k s a s s o c ia t e d w it h o p tio n s ,
e .g ., r h o a n d t h e t a . W h ile t h e y a r e n o t
p r o p o s in g a m e a s u r e m e n t s y s t e m fo r
t h o s e r is k s a t p r e s e n t , in s t it u t io n s
u n d e r ta k in g s ig n if ic a n t o p t io n s b u s in e s s
w o u ld s t ill b e e x p e c t e d to m o n ito r s u c h
r is k s c lo s e ly .
V II. Q u e s t io n s o n W h ic h t h e A g e n c ie s
S p e c if ic a lly R e q u e st C o m m e n t

General Topics
1 . T h e A g e n c ie s p r o p o s e to a p p ly
t h e s e sta n d a r d s to a r e la t iv e ly s m a ll
n u m b e r o f in s titu tio n s th a t h a v e
m a te r ia l tr a d in g a c t iv it ie s . A s t h e
c r ite r ia a r e p r o p o s e d , a b o u t 2 5 “ la r g e ”
in s t it u t io n s a n d a fe w o th e r s m a lle r
in s titu tio n s w ith r e la tiv e ly m o r e
s ig n if ic a n t t r a d in g a c t iv it ie s w o u l d m e e t
t h e r e q u ir e m e n ts a n d b e s u b je c t to th e
n e w c a p ita l sta n d a r d s. Is t h e e x e m p tio n
o f s m a lle r in s t it u t io n s a p p r o p r ia te ,
g iv e n t h e ir r is k p r o f ile a n d t h e i m p lie d
r e g u la to r y b u r d e n , or d o e s it p r o v id e
th e m w ith a n u n d u e c o m p e titiv e
a d v a n ta g e ? O n th e o th e r h a n d , w o u ld
t h e a m e n d m e n t a ffe c t t o o m a n y
in s t it u t io n s , g iv e n t h e n a tu r e o f th e ir
tr a d in g a c t iv it ie s a n d m a r k e t r is k
p r o f ile s ?
2 . C o n s is te n t w it h th e ir p r o c e d u r e s
fo r e x is t in g c a p ita l s ta n d a r d s , t h e
A g e n c ie s w o u ld a p p ly th e p r o p o s e d
sta n d a r d to a n y n a tio n a l b a n k , sta te
m e m b e r b a n k a n d b a n k h o ld in g
c o m p a n y th a t m e e t s t h e c r ite r ia o n a
c o n s o lid a t e d b a s is . W h a t a r e t h e b u r d e n
im p lic a t io n s o f a p p ly in g t h e sta n d a r d to
b o th b a n k s a n d b a n k h o ld in g
c o m p a n ie s ?
3 . T h e B o a r d c u r r e n tly e v a lu a t e s th e
c a p ita l a d e q u a c y o f b a n k h o ld in g
c o m p a n ie s th a t h a v e S e c tio n 2 0
su b s id ia r ie s o n a fu lly c o n s o lid a te d
b a s is a n d a ls o w ith o u t th e a s s e ts a n d
c a p ita l o f th e S e c tio n 2 0 s u b s id ia r ie s .
S h o u ld it c o n t in u e t h is p r a c t ic e
r e g a r d in g m a r k e t r is k , o r s h o u ld it f o c u s

w it h t h e s c a lin g fa c to r , c o u ld r e s u lt i n
c a p ita l r e q u ir e m e n ts th a t o n a v e r a g e a r e
significantly d i f f e r e n t ( f o r e x a m p l e ,
h ig h e r ) t h a n t h o s e r e q u ir e d u n d e r t h e
s ta n d a r d iz e d a p p r o a c h .
6 . T h e A g e n c ie s p r o p o se to a llo w
in s t it u t io n s t o u s e t h e sta n d a r d iz e d
m e th o d fo r m e a s u r in g s o m e c a te g o r ie s

38093

a re th e c o s ts a n d b u r d e n im p lic a tio n s o f
r e q u ir in g s u c h a d u a l c a lc u la t io n ?
2 . A ll in s titu tio n s a ffe c te d b y th e
p r o p o s a l w o u ld b e r e q u ir e d t o h a v e
c a p ita l c o v e r in g b o th g e n e r a l m a rk et
a n d s p e c i f i c r is k s . I n s t it u t io n s u s in g th e
in te r n a l m o d e l a p p r o a c h w o u ld b e
r e q u ir e d t o a p p ly t h e s p e c if ic r is k

S h o u ld in s titu tio n s b e g iv e n t h is

c h a r g e (o r a p o r tio n th e r e o f) c a lc u la t e d
u s in g t h e s t a n d a r d iz e d a p p r o a c h , i f th e ir
m o d e ls d o n o t a d e q u a te ly c a p tu r e

f le x ib ilit y , o r s h o u ld t h e y b e r e q u ir e d to
u s e o n e a p p r o a c h th r o u g h o u t?

te c h n iq u e s s h o u ld th e A g e n c ie s

o f r is k (e .g ., d e b t, e q u it ie s , e t c .) , a n d
in t e r n a l m o d e l s fo r o t h e r c a t e g o r ie s .

7. T h e A g e n c ie s p r o p o se a r e d u c e d
c a p ita l c h a r g e fo r s p e c if ic r is k in
e q u i t i e s i f a n i n s t i t u t i o n ’s e q u i t i e s
p o r t fo lio is “ liq u id a n d w e lld iv e r s if ie d ,” a c o n c e p t th a t is d e fin e d in
q u a lita tiv e te r m s in th e p r o p o s a l.
S h o u ld t h is c o n c e p t b e d e s c r ib e d m o r e
s p e c i f i c a l l y a n d , i f s o , w h a t c r ite r ia
s h o u ld b e a p p lie d ?

Questions on the Standardized M ethod
1 . U n d e r t h e p r o p o s a l, in s t it u t io n s
w o u ld b e a llo w e d to n e t o ffs e ttin g
p o s it io n s in d iffe r e n t c o m m o d it ie s o n ly
if th e c o m m o d itie s w e r e d e liv e r a b le
a g a in s t e a c h o th e r . T o w h a t e x t e n t, i f
a n y , s h o u ld t h e A g e n c ie s a llo w n e ttin g
o n t h e b a s is o f t h e h is t o r ic a l c o r r e la t io n s
o f p r ic e m o v e m e n t s o f d iffe r e n t
c o m m o d it ie s w it h in t h e sta n d a r d iz e d
a p p r o a c h ? If n e ttin g is a llo w e d o n th e
b a s is o f p a s t c o r r e la t io n s , w h a t s p e c if ic
c r it e r ia s h o u l d b e r e q u ir e d ?
2 . O n e o f t h e a lte r n a tiv e w a y s o f
m e a s u r in g t h e m a r k e t r is k o f o p t io n s in
t h e s ta n d a r d iz e d a p p r o a c h is to
c a lc u la t e se p a r a te c h a r g e s fo r a n
o p t i o n ’s d e l t a , g a m m a , a n d v e g a r i s k
(se e th e d e lta -p lu s m e th o d ). T h is
a p p r o a c h p e r m its a n in s t itu t io n to
m e a s u r e t h e r is k o f it s o p t io n s p o s it io n s
w h i l e m e a s u r in g t h e r is k o f it s o th e r
p o s it io n s a n d , th e r e b y , to e v a lu a te th e m
m o r e f u l l y o n a p o r t f o lio b a s is . It a ls o
p e r m its a n in s t it u t io n t o a v o id in c u r r in g
t h e w o r s t - c a s e c h a r g e fo r t h e o p t io n
u n d e r t h e s c e n a r io m e th o d . T h e d e lta p lu s c a lc u la t io n s , h o w e v e r , a re c o m p le x
a n d p o te n t ia lly in a c c u r a te s in c e t h e y d o
n o t p e r m it f u ll u s e o f a r e v a lu a t io n
m o d e l. Is t h e m e th o d s u f f ic ie n t ly u s d f u l
t o w a r r a n t i t s c o m p l e x i t y , a n d d o e s it

s p e c if ic r is k . W h a t m o d e llin g
c o n s id e r w h e n e v a lu a t in g a n
i n s t i t u t i o n ’s m o d e l a n d determining t h e
e x te n t to w h ic h th e m o d e l in c lu d e s
s p e c ific r is k in its V A R m e a su r e ?
3 . A s p a r t o f a n o n -g o in g p r o c e s s o f
e v a lu a t in g t h e a c c u r a c y o f a n
i n s t i t u t i o n ’s i n t e r n a l m o d e l , a c t u a l d a i l y
tr a d in g p r o f its a n d lo s s e s w o u ld b e
c o m p a r e d w it h th e m e a su r e d V A R (so c a l l e d “ b a c k - t e s t i n g ” ). T h e A g e n c i e s
w o u l d e x p e c t t h is b a c k -t e s tin g n o r m a lly
to r e ly u p o n t h e V A R s a c t u a lly u s e d b y
t h e in s t it u t io n fo r n o n r e g u la to r y
p u r p o se s, w h ic h in m o st c a s e s w o u ld
r e f l e c t a c o n f i d e n c e l e v e l l e s s than t h e
9 9 p e r c e n t le v e l o n w h ic h t h e c a p ita l
r e q u ir e m e n t w o u ld b e b a s e d . W o u ld
th is a p p r o a c h b e le s s b u r d e n so m e to th e
in s t it u t io n th a n r e q u ir in g a s e p a r a te
c a lc u la t io n fo r t h e 9 9 p e r c e n t
c o n f id e n c e le v e l, a n d w o u ld it p r o v id e
a m o r e s t a t is t ic a lly r e lia b le b a s is fo r
e v a lu a t in g t h e r e s u lts ? P le a s e c o m m e n t
o n th e s e p r o c e d u r e s a n d a n y o th e r
c o n s id e r a tio n s th e F e d e r a l R e se r v e
s h o u ld ta k e in to a c c o u n t in r e v ie w in g
b a c k -te sts.
4 . T h e A g e n c ie s r e c o g n iz e th a t d a ily
V A R i s u s e d b y in s t itu t io n s fo r s e ttin g
d a ily tr a d in g lim it s , r a th e r th a n fo r
e v a lu a t in g c a p ita l a d e q u a c y . T h e
r e g u la to r y u s e o f V A R a s a b a s is fo r a
c a p it a l r e q u ir e m e n t i s p r e d ic a t e d o n th e
s p e c ific a t io n o f se v e r a l c o n s tr a in ts o n
m o d e llin g p a r a m e te r s, a s w e ll a s th e u se
o f a m u lt ip lic a t io n fa c to r . D o t h e s e
c o n s t r a in t s p r o v id e s u f f ic i e n t c a p it a l fo r
t h e u n d e r ly in g a c tiv itie s ?
5 . T o q u a lify fo r t h e u s e o f th e
in te r n a l m o d e ls a p p r o a c h , a n in s titu tio n
m u s t h a v e a r ig o r o u s s tr e s s t e s t in g
p ro g ra m w h ic h w o u ld b e su b je c t to

o n o n ly th e c o n s o lid a te d h o ld in g
com pany?
4 . S h o u ld th e A g e n c ie s p e r m it

p r o v id e a s u f f ic ie n tly c o n s e r v a tiv e

s u p e r v is o r y r e v ie w . W h a t s tr e s s t e s t s fo i

m e a s u r e o f r is k fo r in s t it u t io n s th a t

m a r k e t r is k s h o u ld in s t it u t io n s b e

w r ite o p tio n s b u t d o n o t h a v e o p tio n s

e x p e c t e d t o p e r fo r m a s p a rt o f th e ir

in s titu tio n s th e c h o ic e o f th e

p r i c i n g m o d e l s i n t e g r a t e d i n t o t h e i r r is k
m e a su r e m e n t sy stem s?

in te r n a l m a n a g e m e n t p r o c e s s ?

s t a n d a r d iz e d o r in te r n a l m o d e l
a p p r o a c h e s , o r s h o u ld it p e r m it o n ly th e
in te r n a l m o d e l a p p r o a c h o n t h e b a s is

Questions on the Internal Model Method

Vin.

R e g u la to r y F le x ib ilit y A c t
A n a ly s is

OCC Regulatory Flexibility A ct Analysis

t h a t t h e i n s t i t u t i o n ’s t r a d i n g a c t i v i t i e s
a re s u f f ic ie n t to w a rra n t t h e m o r e
a c c u r a t e m e a s u r e o f r is k ?
5 . T h e A g e n c ie s are in te r e s te d in
c o m m e n t s o n w h e th e r t h e in te r n a l

w h e t h e r t o r e q u ir e in s t it u t io n s to
c a lc u la t e t h e ir V A R s u s in g t w o

R e g u la to r y F le x ib ilit y A c t , th e

o b s e r v a tio n p e r io d s (o n e lo n g , o n e
sh o r t) a n d b a s in g t h e c a p ita l

th a t th is p r o p o sa l w o u ld n o t h a v e a

m o d e l q u a n tita tiv e s ta n d a r d s , to g e th e r

r e q u i r e m e n t o n t h e la r g e r f i g u r e . W h a t

s ig n if ic a n t im p a c t o n a s u b s ta n tia l




1.

T h e A g e n c ie s a re c o n s id e r in g

P u r su a n t to s e c tio n 6 0 5 (b ) o f th e
C o m p tr o lle r o f th e C u r r e n c y c e r t if ie s

38094

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

n u m b e r o f s m a ll b u s in e s s e n t it ie s in
a c c o r d w it h t h e s p ir it a n d p u r p o s e s o f

w h ic h c o n tr ib u te to in c r e a s e d s a f e t y a n d
s o u n d n e s s i n t h e b a n k in g s y s t e m .

th e O C C h a s n o t p r e p a r e d a b u d g e ta r y
im p a c t s ta te m e n t or s p e c ific a lly

t h e R e g u l a t o r y F l e x i b i l i t y A c t (5 U .S .C .

Board Paperwork Reduction A ct and
Regulatory Burden

c o n s id e r e d . A s d is c u s s e d in th e

6 0 1 et seq.). A c c o r d i n g l y , a r e g u l a t o r y
f le x ib ilit y a n a ly s is is n o t r e q u ir e d . T h e
im p a c t o f t h is p r o p o s e d r u le o n b a n k s

T h e B o a r d h a s d e t e r m in e d th a t t h i s

a d d r e s s e d Jtie r e g u l a t o r y a l t e r n a t i v e s
p r e a m b le , t h is p r o p o s e d r u le m a y
r e q u ir e a d d it io n a l c a p it a l fo r m a r k e t

r e g a r d le s s o f s iz e is e x p e c t e d to b e

p r o p o s a l w o u ld n o t in c r e a s e t h e

r is k s . H o w e v e r , th e a p p lic a tio n o f t h is

m in im a l. F u r th e r , t h is p r o p o s e d r u le

r e g u la to r y p a p e r w o r k b u r d e n o f b a n k in g

p r o p o s e d r u le w o u ld b e g e n e r a lly

g e n e r a lly w o u l d a p p ly to la r g e r b a n k s

o r g a n iz a tio n s p u r s u a n t to th e p r o v is io n s

lim it e d to b a n k s w it h s ig n if ic a n t tr a d in g

w it h s ig n if ic a n t t r a d in g a c c o u n t
a c t iv it ie s a n d w o u l d c o v e r o n ly tr a d in g

o f th e P a p e r w o r k R e d u c tio n A c t (4 4

a c c o u n t a c tiv itie s a n d w o u ld c o v e r o n ly

U .S .C . 3 5 0 1

a c t iv it ie s a n d fo r e ig n e x c h a n g e a n d

R ie g le C o m m u n it y D e v e lo p m e n t a n d

et seq.).

S e c tio n 3 0 2 o f th e

fo r e ig n e x c h a n g e a n d c o m m o d it y
p o s itio n s th r o u g h o u t th e b an k .

c o m m o d ity p o s it io n s th r o u g h o u t th e

R e g u la to r y I m p r o v e m e n t A c t o f 1 9 9 4

C u r r e n tly , t h e O C C e s t im a t e s th a t l e s s

bank.

(P u b . L . 1 0 3 - 3 2 5 ,1 0 8 S ta t 2 1 6 0 )

th a n 2 5 n a tio n a l b a n k s w ill b e s u b je c t

Board Regulatory Flexibility A ct
Analysis

p r o v id e s th a t t h e fe d e r a l b a n k in g

to t h e r e q u ir e m e n ts o f t h is p r o p o s e d

a g e n c ie s m u s t c o n s id e r th e

r u le . In a d d it io n , a n y b u r d e n i m p o s e d

P u r su a n t to s e c tio n 6 0 5 (b ) o f th e
R e g u la to r y F le x ib ilit y A c t , t h e B o a r d
d o e s n o t b e lie v e th is p r o p o sa l w o u ld
h a v e a s ig n if ic a n t im p a c t o n a
s u b s ta n tia l n u m b e r o f s m a ll b u s in e s s
e n t itie s in a c c o r d w ith th e sp ir it a n d
p u r p o s e s o f t h e R e g u la to r y F le x ib ilit y
A c t (5 U .S .C . 6 0 1 et seq.). A c c o r d i n g l y ,
a r e g u la to r y f le x ib ilit y a n a ly s is i s n o t
r e q u ir e d . In a d d it io n , b e c a u s e t h e r is k b a se d c a p it a l sta n d a r d s g e n e r a lly d o n o t
a p p ly to b a n k h o ld in g c o m p a n ie s w it h
c o n s o lid a te d a s s e ts o f le s s th a n $ 1 5 0
m illio n , t h is p r o p o s a l w o u ld n o t a ffe c t
s u c h c o m p a n ie s .

FDIC Regulatory Flexibility A ct A nalysis
P u r su a n t to s e c tio n 6 0 5 (b ) o f th e

a d m in is tr a tiv e b u r d e n s a n d b e n e f its o f

o n t h is s m a ll g r o u p o f n a tio n a l b a n k s

a n y n e w r e g u la tio n s th a t im p o s e

w o u ld b e le s s e n e d to th e e x te n t th a t a

a d d itio n a l r e q u ir e m e n ts o n in s u r e d

b a n k m a y u s e it s o w n q u a lify in g

d e p o s ito r y in s titu tio n s . A s n o te d a b o v e ,

in te r n a l m a r k e t r is k m o d e l.

t h e p r o p o s e d m a r k e t r is k m e a s u r e
w o u ld a ffe c t o n ly a s m a ll n u m b e r o f

List _of Subjects

in s titu tio n s . T h e B o a rd b e lie v e s th a t a n y

12 CFR Part 3

a d d itio n a l b u r d e n p la c e d o n th e s e
in s titu tio n s is o u tw e ig h e d b y th e
a d v a n ta g e s o f g r e a te r a c c u r a c y i n r is k
m e a s u r e m e n t a n d c a p ita l a llo c a tio n ,
w h ic h c o n tr ib u te to in c r e a s e d s a fe ty a n d

r e q u ir e m e n t s . R is k .

s o u n d n e s s in t h e b a n k in g s y s t e m .

12 CFR Part 2 08

FDIC Paperwork Reduction A ct
T h e F D IC h a s d e t e r m in e d th a t h i s
p r o p o s e d r u le m a k in g d o e s n o t c o n t a in
a n y c o lle c t io n s o f in fo r m a tio n a s
d e f in e d b y th e P a p e r w o r k R e d u c tio n
A c t ( 4 4 U .S .C . 3 5 0 1 et seq.).

R e g u la to r y F le x ib ilit y A c t (P u b . L . 9 6 3 5 4 , 5 U . S .C . 6 0 1 et seq.), i t i s c e r t i f i e d
th a t t h e p r o p o s e d r u le w o u ld n o t h a v e
a s ig n if ic a n t im p a c t o n a s u b s ta n tia l
n u m b e r o f s m a ll e n titie s .
IX . P a p e r w o r k R e d u c t io n A c t a n d
R e g u la to r y B u r d e n

OCC Regulatory Burden
S e c t io n 3 0 2 o f th e R ie g le C o m m u n ity
D e v e lo p m e n t a n d R e g u la to r y
Im p rovem en t A ct o f 1 9 94, P ub. L. 1 0 3 3 2 5 ,1 0 8 S ta t. 2 1 6 0 ( S e p t e m b e r 2 3 ,
1 9 9 4 ) , p r o v id e s th a t t h e f e d e r a l b a n k in g
a g e n c ie s m u s t c o n s id e r th e
a d m in is tr a tiv e b u r d e n s a n d b e n e fits o f
a n y n e w r e g u la tio n s th a t im p o s e
a d d itio n a l r e q u ir e m e n ts o n in s u r e d
d e p o s ito r y in s titu tio n s . A s d is c u s s e d ,

X . O C C E x e c u tiv e O r d e r 1 2 8 6 6
D e te r m in a tio n
T h e C o m p tr o lle r o f t h e C u r r e n c y h a s
d e t e r m in e d th a t t h is n o t ic e o f p r o p o s e d
r u le m a k in g i s n o t a s ig n if ic a n t
r e g u la to r y a c t io n u n d e r E x e c u t iv e O r d e r
12866.
X I. O C C U n fu n d e d M a n d a te s R efo rm
A c t o f 1 9 9 5 D e te r m in a tio n
S e c tio n 2 0 2 o f th e U n fu n d e d
M a n d a te s R efo rm A c t o f 1 9 9 5
(U n fu n d e d M a n d a te s A c t), P u b . L . 1 0 4 —
4 , 1 0 9 S ta t. 4 8 (M a r c h 2 2 ,1 9 9 5 ) r e q u ir e s
th a t a n a g e n c y p r e p a r e a b u d g e ta r y
im p a c t s ta t e m e n t b e fo r e p r o m u lg a tin g a
r u le th a t in c lu d e s a F e d e r a l m a n d a te
th a t m a y r e s u lt in th e e x p e n d itu r e b y
s t a t e , l o c a l , a n d tr ib a l g o v e r n m e n t s , i n

th is p r o p o s e d r u le w o u ld a ffe c t o n ly a

t h e a g g r e g a te , o r b y t h e p r iv a te s e c to r , o f

s m a ll n u m b e r o f b a n k s a n d g e n e r a lly

$ 1 0 0 m illio n o r m o r e in a n y o n e y e a r .

w o u ld c o v e r o n l y tr a d in g a c c o u n t

If a b u d g e ta r y im p a c t s ta te m e n t is

a c t iv it ie s a n d fo r e ig n e x c h a n g e a n d

r e q u ir e d , s e c t io n 2 0 5 o f th e U n f u n d e d

c o m m o d ity p o s it io n s th r o u g h o u t th e

M a n d a te s A c t a ls o r e q u ir e s a n a g e n c y to

b an k . A d d itio n a lly , a n y b u r d e n im p o s e d

id e n t if y a n d c o n s id e r a r e a s o n a b le

w o u ld b e le s s e n e d to th e e x te n t th a t a

n u m b e r o f r e g u la to r y a lt e r n a tiv e s b e f o r e
p r o m u lg a tin g a r u le . B e c a u s e t h e O C C

b a n k m a y u s e its o w n q u a lify in g
in te r n a l m a r k e t r is k m o d e l. T h e O C C

h a s d e t e r m in e d th a t t h is n o t ic e o f

b e lie v e s th a t a n y a d d itio n a l b u r d e n

p r o p o s e d r u le m a k in g w i l l n o t r e s u lt in

p la c e d o n a b a n k is o u tw e ig h e d b y th e

e x p e n d it u r e s b y s t a t e , lo c a l a n d tr ib a l

a d v a n ta g e s o f g r e a te r a c c u r a c y i n r is k

g o v e r n m e n ts , o r b y t h e p r iv a te s e c to r , o f

m a n a g e m e n t a n d c a p ita l a llo c a t io n ,

m o r e th a n $ 1 0 0 m illio n in a n y o n e y ea r.




A d m in is tr a t iv e p r a c tic e a n d
p r o c e d u r e , C a p ita l, N a t io n a l b a n k s ,
R e p o r tin g a n d r e c o r d k e e p in g

A c c o u n t in g , A g r ic u ltu r e , B a n k s ,
b a n k in g . C o n f id e n t ia l b u s in e s s
in f o r m a t io n , C r im e , C u r r e n c y , F e d e r a l
R e s e r v e S y s t e m , M o r tg a g e s , R e p o r tin g
a n d r e c o r d k e e p in g r e q u ir e m e n ts ,
S e c u r itie s .

12 CFR Part 2 25
A d m in is tr a t iv e p r a c tic e a n d
p r o c e d u r e , B a n k s , b a n k in g , F e d e r a l
R e s e r v e S y s te m , H o ld in g c o m p a n ie s ,
R e p o r tin g a n d r e c o r d k e e p in g
r e q u ir e m e n ts , S e c u r itie s .

12 CFR Part 3 25
A d m in is t r a t iv e p r a c tic e a n d
p r o c e d u r e . B a n k s , b a n k in g . C a p ita l
a d e q u a c y , R e p o r tin g a n d r e c o r d k e e p in g
r e q u ir e m e n ts , S a v in g s a s s o c ia tio n s ,
S ta te n o n -m e m b e r b a n k s.
A u th o r ity a n d I s s u a n c e

38102




Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

FEDERAL RESERVE BOARD
12 CFR Chapter II
F o r th e r e a s o n s se t o u t in th e
p r e a m b le , p a r ts 2 0 8 a n d 2 2 5 o f t itle 12
o f t h e C o d e o f F e d e r a l R e g u la tio n s are
p r o p o s e d t o b e a m e n d e d a s s e t fo r th
b e lo w .

PART 208— MEMBERSHIP OF STATE
BANKING INSTITUTIONS IN THE
FEDERAL RESERVE SYSTEM
(REGULATION H)
1.

T h e a u th o r it y c it a tio n fo r p a rt 2 0 8

is r e v is e d to r e a d a s f o llo w s :

Authority: 12 U.S.C. 36, 248(a), 248(c),
321-338a, 37ld ,461,481-486, 601, 611,
1814, 1823(j), 1828(o), 1831o, 1831p-l, 3105.
3310, 3331-3351, and 3905-3909; 15 U.S.C.29
29The OCC generally expect banks with
significant trading positions to use internal market
risk models for the purposes of this appendix B.

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
78b, 781(b), 781(g), 78l(i), 78o-4(c)(5), 78q,
78q—1 and 78w; 31 U.S.Q 5318; 42 U.S.C.
4012a, 4104a, 4104b, 4106, and 4128.
2 . In P a r t 2 0 8 , § 2 0 8 .1 3 i s r e v is e d to
r e a d a s fo llo w s ;

§208.13 Capital adequacy.
T h e sta n d a r d s a n d g u id e lin e s b y
w h ic h t h e c a p ita l a d e q u a c y o f sta te
m e m b e r b a n k s w i l l b e e v a lu a te d b y th e
B o a r d a r e s e t fo r th in a p p e n d ix A a n d
a p p e n d ix E t o p a r t 2 0 8 fo r r is k -b a s e d
c a p ita l p u r p o s e s , a n d , w it h r e s p e c t to
t h e r a tio s r e la tin g c a p ita l to to ta l a s s e ts ,
in a p p e n d ix B to p art 2 0 8 a n d in
a p p e n d i x B t o t h e B o a r d ’s R e g u l a t i o n Y ,
12 CFR part 22 5 .
3 . In P a r t 2 0 8 , § 2 0 8 .3 1 i s a m e n d e d b y
r e v i s i n g p a r a g r a p h s ( e ) , ( h ) , a n d (j) t o
r e a d a s fo llo w s :

§208.31
*

Definitions.

*

*

*

*

( e ) Risk-weighted assets m e a n s t o t a l
w e ig h t e d r is k a s s e t s , a s c a lc u la t e d in
a c c o r d a n c e w i t h t h e B o a r d ’s C a p i t a l
A d e q u a c y G u id e lin e s fo r S ta te M e m b e r
B a n k s; R is k -B a s e d M e a s u r e ( a p p e n d ix A
to t h is p a rt 2 0 8 ) a n d a d ju s te d fo r m a rk et
r i s k i n a c c o r d a n c e w i t h t h e B o a r d ’s
C a p ita l A d e q u a c y G u id e lin e s f o r S ta te
M e m b e r b a n k s : M a r k e t R is k M e a s u r e
(a p p e n d ix E to t h is p art 2 0 8 ).
*
*
*
*
*
(h )
Tier 1 risk-based capital ratio
m e a n s t h e r a tio o f T ie r 1 c a p it a l to
w e ig h t e d r is k a s s e t s , a s c a lc u la t e d in
a c c o r d a n c e w i t h t h e B o a r d ’s C a p i t a l
A d e q u a c y G u id e lin e s fo r S ta te M e m b e r
B a n k s: R is k -B a s e d M e a s u r e ( a p p e n d ix A
to t h is p a rt 2 0 8 ) a n d a d ju s te d fo r m a rk et
r i s k i n a c c o r d a n c e w i t h t h e B o a r d ’s
C a p ita l A d e q u a c y G u id e lin e s fo r S ta te
M e m b e r B a n k s: M a rk et R is k M e a s u r e
(a p p e n d ix E to th is p art 2 0 8 ).
*
*
*
*
*
(j)
Total risk-based capital ratio
m e a n s t h e r a tio o f q u a lif y in g to ta l
c a p it a l t o w e ig h t e d r is k a s s e t s , a s
c a lc u la te d in a c c o r d a n c e w ith th e
B o a r d ’s C a p i t a l A d e q u a c y G u i d e l i n e s
fo r S ta te M e m b e r B a n k s: R is k -B a s e d
M e a su r e (a p p e n d ix A to th is p a rt 2 0 8 )
a n d a d ju s te d fo r m a r k e t r is k i n
a c c o r d a n c e w i t h t h e B o a r d ’s C a p i t a l
A d e q u a c y G u id e lin e s fo r S ta te M e m b e r
B a n k s : M a r k e t R is k M e a s u r e ( a p p e n d ix
E to t h is p a rt 2 0 8 ).
4 . In p a rt 2 0 8 , A p p e n d ix A is
a m e n d e d b y r e v is in g t h e fir s t a n d
s e c o n d p a r a g r a p h s o f s e c t i o n I. t o r e a d
a s f o llo w s :

Appendix A to Part 208—Capital
Adequacy Guidelines for State Member
Banks: Risk-Based Measure
I. O v e r v ie w

The Board of Governors of the Federal
Reserve System has adopted a risk-based




38103

For this purpose, market risk is defined as
the risk of losses in a bank’s on- and offbalance-sheet positions arising from
movements in market prices. The market
risks subject to these capital requirements are
those associated with debt and equity
instruments held in the bank’s trading
account, as well as foreign exchange risk and
commodities risk throughout the bank,
including options and other derivative
contracts in each risk category.
2. Effective December 31 ^1997, the market
risk measure will be applied to all state
member banks that, on a consolidated basis:
a. Have total assets in excess of $5 billion;
and either have a total volume of trading
activities (measured as the sum of the bank’s
trading assets and liabilities2 on a daily
average basis for the quarter) that is 3.0
percent or more of the total assets of the
bank, or have interest rate, foreign exchange,
equity, and commodity off-balance-sheet
derivative contracts relating to trading
activities whose total notional amounts
exceed $5 billion; or
b. Have total assets of $5 billion or less;
and have trading activities exceeding 10.0
percent of the total assets of thd bank.
*
*
*
*
*
3. Such banks are still subject to the risk5.
I n P a r t 2 0 8 , a n e w A p p e n d i x E i s based capital measure set forth in appendix
A of this part, subject to the exclusion of
a d d e d t o r e a d a s f o llo w s :
certain assets specified in this appendix E.
However, these banks must calculate their
Appendix E to Part 208—Capital
Adequacy Guidelines for State Member market risk-equivalent assets and determine
risk-based capital ratios adjusted for market
Banks: Market Risk Measure
risk in accordance with this appendix E.3
/. Introduction
4. The market risk measure provides two
ways for a bank to determine its exposure to
A. Overview
market risk. A bank may use its internal risk
1.
The Board of Governors of the Federal measurement model, subject to the
Reserve System has adopted a framework for conditions and criteria set forth in section m.
determining capital requirements for the
of this appendix E (referred to as the internal
market risk exposure of state member banks.1 models approach), or when appropriate, a
bank may use all or portions of the
1Some banks are also subject to capital
alternative measurement system described in
requirements for market risk as set forth in
section IV. of this appendix E (referred to as
appendix E of this part. Banks that are subject to
the standardized approach).
the market risk measure are required to follow the
a.
With prior approval from the Federal
guidelines set forth in appendix E of this part for
Reserve, for regulatory capital purposes, a
determining qualifying and eligible capital,
bank may use its internal risk measurement
calculating market risk-equivalent assets and
model to measure its value-at-risk4 for each
adding them into weighted-risk assets, and
calculating risk-based capital ratios adjusted for
of the following risk factor categories; interest
market risk. Supervisory ratios that relate capital to
rates, exchange rates, equity prices, and
total assets for state member banks are outlined in
commodity prices. The value-at-risk amount
appendix B of this part and in appendix B to part
for each risk factor category should include
225 of the Board’s Regulation Y, 12 CFR part 225.
volatilities of related options. The value-at2The risk-based capital measure is based upon a
risk amount for each risk factor category is
framework developed jointly by supervisory
capital measure to assist in the assessment of
the capital adequacy of state member banks.1
The principal objectives of this measure are
to (i) make regulatory capital requirements
more sensitive to differences in risk profiles
among banks; (ii) factor off-balance-sheet
exposures into the assessment of capital
adequacy; (iii) minimize disincentives to
holding liquid, low-risk assets; and (iv)
achieve greater consistency in the evaluation
of the capital adequacy of major banks
throughout the world.
The risk-based capital guidelines include
both a definition of capital and a framework
for calculating weighted risk assets by
assigning assets and off-balance-sheet items
to broad risk categories.2 A bank’s risk-based
capital ratio is calculated by dividing its
qualifying capital (the numerator of the ratio)
by its weighted risk assets (the
denominator).* The definition of qualifying
capital is outlined below in section II. of this
appendix A, and the procedures for
calculating weighted risk assets are discussed
in section JH. of this appendix A. Attachment
I to this appendix A illustrates a sample
calculation of weighted risk assets and the
risk-based capital ratio.

authorities from the countries represented on the
Basle Committee on Banking Regulations and
Supervisory Practices (Basle Supervisors’
Committee) and endorsed by the Group of Ten
Central Bank Governors. The framework is
described in a paper prepared by the Basle
Supervisors’ Committee entitled “International
Convergence of Capital Measurement,” July 1988.
3Banks generally are expected to utilize periodend amounts in calculating their risk-based capital
ratios. When necessary and appropriate, ratios
based on average balances may also be calculated
on a case-by-case basis. Moreover, to the extent
banks have data on average balances that can be
used to calculate risk-based ratios, the Federal
Reserve will take such data into account
1
The market risk measure is based on a
framework developed jointly by supervisory
authorities from the countries represented on the
Basle Committee on Banking Supervision (Basle
Supervisors Committee) and endorsed by the Group

of Ten Central Bank Governors. The framework is
described in a paper prepared by the Basle
Supervisors Committee entitled "[Proposal to issue
a] Supplement to the Basle Capital Accord to Cover
Market Risks.” (April) 1995.
2 As reflected in the bank’s quarterly Consolidated
Reports of Condition and Income (call report).

3The Federal Reserve may apply all or portions
of this Appendix E to other banks when deemed
necessary for safety and soundness purposes.
4 A bank evaluates its current positions and
estimates future market volatility through a valueat-risk measure, which is an estimate representing,
with a certain degree of statistical confidence, the
maximum amount by which the market value of
trading positions could decline during a specific
period of time. The value-at-risk is generated
through an internal model that employs a series of
market risk factors (for example, market rates and
prices that affect the value of trading positions).

38104

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

i. Assets acquired with the intent to resell
summed to determine the aggregate value-atrisk for the bank.
to customers;
b.
The standardized approach uses a set of ii. Positions in financial instruments
standardized calculations and assumptions to arising from matched principal brokering and
market making; or
measure market risk exposure depending on
iii. Positions taken in order to hedge other
its source; debt instruments, equities, foreign
elements of the trading account (that is,
currenties, and commodities, including
reduce risk by offsetting other positions that
volatilities of related options.
have exposure to changes in market rates or
5. The Board generally expects any bank
prices).6 Trading activities may include
that is subject to the market risk measure,
especially those with large trading accounts, positions in debt instruments, equities,
to comply with the measure by using internal foreign currencies, and commodity
instruments, or related derivative 7 or other
risk-measurement models. A bank may not
off-balance-sheet contracts.
change its measurement approach for the
b. Debt instruments in the trading account
In limited instances, on a case-by-case basis, are all fixed-rate and floating-rate debt
securities and instruments that behave like
the Federal Reserve may permit a bank that
debt, including non-convertible preferred
has internal models to incorporate risk
stock. Convertible bonds, i.e., preferred stock
measures of negligible exposures, for
or debt issues that are convertible, at a stated
example, de minimis positions, activities in
price, into common shares of the issuer,
remote locations, minor exposures in a
currency, or activities that present negligible should be treated as debt instruments if they
risk to the bank, in an alternative manner, so trade like debt instruments and as equities if
they trade like equities. Also included are
long as it adequately captures the risk.
6. The risk-based capital ratios adjusted for derivative contracts of debt instruments and
other off-balance-sheet instruments in the
market risk determined in accordance with
trading account that react to changes in
this appendix E are minimum supervisory
interest rates. A security that has been sold
ratios. Banks generally are expected to
operate with capital positions well above the subject to a repurchase agreement or lent
subject to a securities lending agreement is
minimum ratios. In all cases, banks should
treated as if it were still owned by the lender
hold capital commensurate with the level
of the security. Such transactions remain
and nature of the risks to which they are
subject to capital requirements for credit risk
exposed.
for the off-balance-sheet portion of the
7. The Federal Reserve will monitor the
implementation and effect of these guidelines transaction as set forth in section III.D. of
appendix A of this part
in relation to domestic and international
c. Equities in the trading account are equity
developments in the banking industry. When
instruments that behave like equities. The
necessary and appropriate, the Board will
consider the need to modify this appendix E instruments covered include common stocks
(whether voting or non-voting), convertible
in light of any significant changes in the
securities that behave like equities, and
economy, financial markets, banking
commitments to buy or sell equity securities.
practices, or other relevant factors.
Also included are derivative contracts of
B. Market Risks Subject to a Capital
equity instruments and other off-balanceRequirement
sheet instruments in the trading account that
1. General Market Risk and Specific Risk.
are affected by changes in equity prices.
A bank must hold capital against exposure to However, non-convertible preferred stock is
general m arket risk and specific risk arising
included in debt instruments.
from its trading and other foreign exchange
3.
Foreign Exchange and Commodities
and commodity activities. For this purpose,
Risk. Foreign exchange or commodities
general market risk refers to changes in the
positions, whether or not included in a
market value of covered transactions
bank’s trading account, are subject to a
resulting from market movements, such as
capital requirement for the market risk of
changing levels of market interest rates,
those positions.
broad equity indices, or currency exchange
a.
The capital requirement for foreign
rates. Specific risk refers to credit risk, that
exchange risk applies to a bank’s total
is, the risk that the issuer of a debt or equity
currency and gold positions. This includes
instrument might default, as well as to other
spot positions (that is, asset items and
factors that affect the market value of specific liability items, including accrued interest and
instruments but that do not materially alter
expenses, denominated in each currency);
market conditions.3
forward positions (that is, forward foreign
2. Trading Activities, a. The general market exchange transactions, including currency
risk and specific risk capital requirements for
trading activities are based on on- and off6At a bank’s option, when non-trading account
balance-sheet positions in a bank’s trading
instruments are hedged with instruments in the
account. For this purpose, trading account
trading account, on- or off-balance-sheet, the non­
trading account instruments may be included in the
means positions in financial instruments
measure for general market risk Such non-trading
acquired with the intent to resell in order to
account instruments remain subject to the credit
profit from short-term price movements (or
risk capital requirements of appendix A of this part.
other price or interest-rate variations),
7In general terms, a derivative is a financial
including, but not limited to:
contract whose value is derived from the values of
5
This appendix E does not impose specific risk
capital requirements for foreign exchange risk and
commodities positions because they do not have the
type of issuer-specific risk associated with debt and
equity instruments in the trading account.




one or more underlying assets or reference rates or
indexes of asset values (referred to as “the
underlying”). Derivatives include standardized
contracts that are traded on exchanges and
customized, privately negotiated contracts known
as over-the-counter (OTC) derivatives.

futures and the principal on currency swaps
not included in the spot position); and
certain guarantees. It includes future income
and expenses from foreign currency
transactions not yet accrued but already fully
hedged (at the discretion of the reporting
bank), foreign exchange derivative and other
off-balance-sheet positions that are affected
by changes in exchange rates, and any other
item representing a profit or loss in foreign
currencies.
b. A bank may, subject to approval by the
Federal Reserve, exclude from its foreign
exchange positions any structural positions
in foreign currencies. For this purpose, such
structural positions are limited to
transactions designed to hedge a bank’s
capital ratios against the effect of adverse
exchange rate movements on subordinated
debt, equity, or minority interests in
consolidated subsidiaries and dotation
capital assigned to foreign branches that are
denominated in foreign currencies. Also
included are any positions related to
unconsolidated subsidiaries and to other
items that are deducted from a bank’s capital
when calculating its capital base. In any
event, such structural foreign currency
positions must reflect long-term policies of
the institution and not relate to trading
positions.
c. A bank doing negligible business in
foreign currency and that does not take
foreign exchange positions for its own
account may be exempted fromthe capital
requirement for foreign exchange risk
provided that:
i. Its foreign currency business, defined as
the greater of the sum of its gross long
positions and the sum of its gross short
positions in all foreign currencies, does not
exceed 100 percent of eligible capital as
defined in section ELof this appendix E; and
ii. Its overall net open foreign exchange
position as determined in section IV.C2. of
this appendix E does not exceed 2.0 percent
of its eligible capital.
d. The capital requirement for commodities
risk applies to a bank’s total commodities
positions, including commodity futures,
commodity swaps, and all other commodity
derivatives or other off-balance-sheet
positions that are affected by changes in
commodity prices. A commodity is defined
as a physical product that is or can be traded
on a secondary market (such as agricultural
products, minerals (including oil), and
precious metals), but excluding gold (which
is treated as foreign exchange).
C. Capital Requirements
1.
Capital Requirements. The m in im u m
capital requirement for a state member bank
subject to the market risk measure is the sum
of:
a. The capital requirement for credit risk as
determined in accordance with appendix A
of this part, excluding debt and equity
instruments in the trading book and positions
in commodities, but including the
counterparty credit risk requirements on all
over-the-counter derivative activities whether
in the bank’s trading account or not; and
b. The capital requirement for market risk
as determined by the internal models
approach, the standardized approach, or a

Federal Register

J

Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

combination of the two approaches deemed
to be appropriate by the Federal Reserve.
2. Internal Models, a. For a bank approved
to use the internal models approach, the
capital requirement for market risk is the
higher of:
i. The bank’s previous day’s aggregate
value-at-risk amount calculated subject to
certain supervisory requirements set forth in
section m. of this appendix E; or
ii. An average of the daily aggregate valueat-risk amounts, calculated subject to the
same restrictions, measured on each of the
preceding sixty (60) business days,
multiplied by a minimum “multiplication
factor” of three (3).8
b.
A bank approved to use the internal
models approach may also be subject to a
separate capital requirement for specific
market risk of traded debt and equity
instruments to the extent that the specific
market risk associated with these instruments
is not captured by the bank’s models.
However, for all banks using internal models,
the total specific risk charge should in no
case be less than one-half the specific risk
charges calculated according to the
standardized approach.
3. Standardized approach. A bank whose
model has not been approved by the Federal
Reserve must use the standardized approach
for measuring its market risk. For a bank
using this approach, the capital requirement
for market risk is the sum of the market risk
capital requirementfor debt and equity
instruments in the trading account, foreign
exchange and commodities risk throughout
the bank, and options and other derivative
positions in each risk category as set forth in
sections IV.A. to IV.E. of this appendix E.9
4. Partial models, a. With approval from
the Federal Reserve, a bank whose internal
model does not cover all risk factor categories
may use the standardized approach to
measure market risk exposure arising from
the risk factor categories that are not covered.
The Federal Reserve will approve combining
the two approaches only on a temporary
basis in situations where the bank is
developing, but has not fully implemented, a
comprehensive value-at-risk measurement
system. When a bank uses both approaches,
each risk factor category (that is, interest
rates, exchange rates, equity prices, and
commodity prices) must be measured using
one or the other approach. The methods may
not be combined within a risk factor
8The Federal Reserve may adjust the
multiplication factor for a bank to increase its
capital requirement based on an assessment of the
quality and historic accuracy of the bank’s risk
management system.
9 Section IV.E. of this appendix E provides several
alternatives for measuring the market risk of
options. Under two of the alternatives, the
simplified and scenario methods, the underlying
position of an option is “carved-out,” and is not
included in the prescribed risk measure for the
underlying. Instead it is evaluated together with the
related option according to the procedures
described for options to determine the capital
requirement Under the third alternative, the "deltaplus” approach, the delta-equivalent value of each
position is included in the measurement framework
for the appropriate risk category (that is, debt or
equity instruments in the trading account, foreign
exchange or commodities risk).




category. Once a bank adopts an acceptable
value-at-risk model for a particular risk factor
category, it may not revert to the
standardized approach except in unusual
circumstances and with prior approval of the
Federal Reserve.
b.
For a bank using a combination of
approaches, the capital requirement for
market risk is the sum of (i) the appropriate <
value-at-risk amount (as determined under
section I.G2.a. of this appendix E), and (ii)
the capital requirement for each risk category
that is calculated using the standardized
approach.
5. Application. The capital requirements
for market risk apply to state member banks
on a worldwide consolidated basis. The
Federal Reserve may, however, evaluate
market risk on an unconsolidated basis when
necessary. For example, when there are
obstacles to the repatriation of profits from a
foreign subsidiary or where management
structure does not allow timely management
of risk on a consolidated basis.
6. Other considerations. All transactions,
including forward sales-and purchases,
should be included in the calculation of
market risk capital requirements from the
date on which they were entered into. The
Federal Reserve expects a bank to meet its
capital requirements for market risk on a
continuous basis (that is, at a minimum, at
the close of each business day).
n. Qualifying Capital and the Market RiskAdjusted Capital Ratio
A. Qualifying and Eligible Capital
1. The principal forms of qualifying capital
for market risk are Tier 1 capital and Tier 2
capital as defined in section n. of appendix
A of this part and subject to the conditions
and limitations of appendix A of this part. A
bank may use Tier 3 capital for the sole
purpose of meeting a portion of the capital
requirements for market risk.10
2. Tier 3 capital consists of short-term
subordinated debt that is subject to a lock-in
clause providing that neither interest nor
principal payment is due (even at maturity)
if such payment would cause the issuing
bank to fell or remain below the minimum
8.0 percent risk-based capital requirement as
set forth in appendix A and adjusted for
market risk.
3. In order to qualify as Tier 3 capital, the
short-term debt must be unsecured,
subordinated, and fully paid up; it must have
an original maturity of at least two years; and
it may not be redeemed before maturity
without prior approval by the Federal
Reserve. In addition, it may not contain or be.,
covered by any covenants, terms, or
restrictions that are inconsistent with safe
and sound banking practices.
4. Eligible Tier 3 capital may not exceed
250 percent of a bank’s Tier 1 capital
allocated for market risk and the maximum
eligible amount of Tier 2 and Tier 3 capital
together is limited to 100 percent of Tier 1

38105

capital. (Examples of how to calculate these
limits are set forth in Attachment 1to this
appendix E.) Tier 2 elements may be
substituted for Tier 3 up to the same limit of
250 percent, so long as the overall limits for
Tier 2 capital set fourth in appendix A of this
part are not exceeded, that is, Tier 2 capital
may not exceed total Tier 1 capital, and long­
term subordinated debt may not exceed 50
percent of Tier 1 capital.

B. Calculation of Eligible Capital and the
Capital Ratio
1. In order to calculate eligible capital, a
bank must first/calculate its minimum capital
requirement for credit risk in accordance
with appendix A of this part and then its
capital requirement for market risk. Eligible
capital is the sum of the “bank’s qualifying
Tier 1 capital, its qualifying Tier 2 capital
subject to the limits stated above, and its
eligible Tier 3 capital subject to the
conditions set out under section II. of this
appendix E.
2. A bank that is subject to the market risk
measure must calculate its risk-based capital
ratios as follows:
a. Determine total weighted-risk assets
using the procedures and criteria set forth in
appendix A of this part, excluding debt and
equity instruments in the trading book and .
positions in commodities, but including all
over-the-counter derivative activities whether
in the bank’s trading account or not
b. Calculate the measure for market risk
using the internal models approach,The
standardized approach, or an approved
combination of these two approaches.
c. Multiply the measure for market risk by
12.5 (i.e., the reciprocal of the 8.0 percent
minimum risk-based capital ratio). The
resulting product is referred to as “market
risk-equivalent assets.”
d. Add market risk-equivalent assets to th
weighted-risk assets compiled for credit risk
purposes (section n.B.2.a. of this appendix
E). The sum of these two amounts is the
denominator of risk-based capital ratios
adjusted for market risk. The numerator of
the total risk-based capital ratio is eligible
capital and the numerator of the Tier 1 riskbased capital ratio is Tier 1 capital.
m . The Internal Models Approach
A. Use of Models
1.
With prior approval of the Federal
Reserve, a bank may use its internal risk
measurement model(s) for purposes of
measuring value-at-risk and determining the
associated regulatory capital requirements for
market risk exposure.
a. Requests for approval under section
m.A.l. of this appendix E should include, at
a minimum, a complete description of the
bank’s internal modeling and risk
management systetlis and how these systems
conform to the criteria set forth in this
section m., an explanation of the policies and
procedures established by the bank to ensure
continued compliance with such criteria, a
discussion of internal and external validation
10
A bank may not use Tier 3 capital to satisfy any
procedures, and a description of other
capital requirements for counterparty credit risk
relevant policies and procedures consistent
under appendix A of this part, including
with sound practices.
counterparty credit risk associated with derivative
transactions in either trading or non-trading
b. The Federal Reserve will approve an
accounts.
internal model for regulatory capital

38106

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

identify the effect of low-probability events
purpcwes only after determining that the
on the bank’s trading portfolio. Senior
bank’s internal model and risk management
systems meet the criteria in section m. of this management must routinely review the
results of stress-testing in the context of the
appendix E. Such a determination may
potential effect of the events on bank capital
require on-site examinations of the systems.
and the appropriate procedures the bank
The Federal Reserve may require
modification to an internal model as deemed should take to minimize losses. The policies
of die bank set by management and the board
necessary to ensure compliance, on a
of directors should identify appropriate
continuingbasis, with the provisions of this
stress-tests and the procedures to follow in
appendix E. A bank’s internal model will be
response to the test results.
subject tocontinuingreview, both on- and
d. The bank musthave established
off-site, by the Federal Reserve.11
2.
A bank should ensure that the level of -procedures for ensuring compliance with a
.documented set of internal policies and
sophistication of its internal model is
commensurate with the nature and volume of controls, as well as for monitoring the overall
operation of the risk measurement system.
the bank’s trading activity in the risk factor
e. Not less than once a year, the bank must
categories covered by this appendix E and
measures market risk as accurately as
conduct, as part of its regular internal audit
process, an independent review of the risk
-possible. In addition, the model should be
adjusted to reflect changing portfolio
measurement system. This review must
composition and changing market
include both the activities of the business
conditions.
trading units and of the independent risk
control unit of the bank.
B. Qualitative Criteria
f. Not less than once a year, the bank must
1. A bank using the internal models
conduct a review of its overall risk
approach should have market risk
management process. The review piust
management systems that are conceptually
consider
sound and implemented with integrity.
L The adequacy of the documentation of
Internal risk measurement models must be
the risk management system and process and
closely integrated into the day-to-day risk
the organization of the risk control unit;
management process of the bank. For
ii. The integration of market risk measures
example, the risk measurement model must
into daily risk management and the integrity
be used in conjunction with internal trading
of the management information system;
and exposure limits.
iii. The process the bank employs for
2. A bank must meet the following
approving risk pricing models and valuation
minimum qualitative criteria before using its systems that are used by front- and backinternal model to measure its exposure to
office personnel;
market risk.12
iv. The scope of market risks captured by
a. A bank must have a risk control unit that the risk measurement model and die
is independent from business trading units
validation of any significant changes in the
and reports directly to senior management of risk measurement process;
the bank. The unit must be responsible for
v. The accuracy and completeness of
designing and implementing the bank’s risk
position data, the accuracy and
management system and analyzing daily
appropriateness of volatility and correlation
reports on the output of the bank’s risk
assumptions, and the accuracy of valuation
measurement model in the context of trading and risk sensitivity calculations;
limits. The unit must conduct regular back­
vi. The verification process the bank
testing.13
employs to evaluate the consistency,
b. Senior management must be actively
timeliness, and reliability of data sources
involved in the risk control process. The
used to run internal models, including the
daily reports produced by the risk
independence of such data sources; and
management unit must be reviewed by a
vii. The verification process the bank uses
level of management with sufficient authority
to evaluate back-testing that is conducted to
to enforce both reductions in positions taken /assess
the model’s accuracy.by individual traders, as well as in the bank’s
overall risk exposure.
C. Market Risk Factors
c. The bank must have a routine and
1. Overview. For regulatory capital
rigorous program of stress-testing14*to
purposes, a bank’s internal risk measurement
system(s) must use sufficient risk factors to
•■Banksthatneedtomodifytheirexisting
capture the risks inherent in the bank’s
modelingprocedurestoaccommodatethe
portfolio of on- and off-balance-sheet trading
requirementsofthisappendixEshould,
-positions and must, subject to the following
nonetheless,continuetousetheinternalmodels
theyconsidermostappropriateinevaluatingrisks guidelines, cover interest rates, equity prices,
exchange rates, commodityprices, and
forotherpurposes.
I2lftheFederalReserveisqptsatisfiedwiththe volatilities related to options positions in
each risk factor category. The level of
extenttowhichabankmeetsthesecriteria,the
FederalReservemayadjustthemultiplication
sophistication of the bank’s risk factors must
factorusedtocalculatemarketriskcapital
be commensurate with the nature and scope
requirementsorotherwise-increasecapital
of the riskstaken by the hank.
requirements.
2. Interest Rates, a. A bank must use a set
13Back-testingincludesex po st comparisonsof
of market risk factors corresponding to
theriskmeasuresgeneratedbythemodelagainst
interest rates in each currency in which it has
theactualdailychangesinportfoliovalue.
material interest rate-sensitive cm- or off14Bankstress-testingshouldcoverarangeof

balance-sheet positions. The risk
measurement system must model the yield
curve13 using one of a number of generally
accepted approaches, for example, by
estimating forward rates of zero coupon
yields. The yield curve must be divided into
various maturity segments in order to capture
variation in the volatility of rates along the
yield curve; there will typically be one risk
factor corresponding to each maturity
segment
b.
For material exposures to interest rate
movements in the major currencies and
markets, a bank must model the yield curve
using a minimum of six risk factors.
However, the number of risk factors used
should ultimately be driven by the nature of
the bank’s trading strategies.16The risk
measurement system must incorporate
separate risk factors to capture spread risk.17
3. Exchange rates. A bank must use market
risk factors corresponding to the exchange
rate between the domestic currency and each
foreign currency in which the bank has a
significant exposure. The risk measurement
system must incorporate market risk factors
corresponding to the individual foreign
currencies in which the bank’s positions are
denominated.
4. Equity prices. A bank must use market
risk factors corresponding to each of the
equity markets in which it holds significant
positions. The sophistication and nature of
the modeling technique for a given market
must correspond to the bank’s exposure to
the overall market as well as to the bank’s
concentration in individual equity issues in
that market At a minimum, there must be a
risk factor designed to capture market-wide
movements in equity prices (such as a market
index), but additional risk factors could track
various sectors or individual issues.
5. Commodity prices. A bank must use
market risk factors corresponding to each of
the commodity markets in which it holds
significant positions. The internal model
must encompass directional risk, forward gap
and interest rate risk, and basis risk.1* The

13Generally,■yieldcurveisagraphshewingthe
termstructure.ofinterestratesbyplottingtheyields
ofallinstrumentsofthesamequalitybymaturities
rangingfromtheshortesttothelongestavailable.
The resultingcurveshows-whethershort-term
interest-ratesarehigherorlowerthanlong-term
interestrates.
16Forexample,abankthathasaportfolioof
varioustypesofsecuritiesacrossmany pointsofthe
yieldcurveandthatengagesincomplexarbitrage
strategieswouldrequiresgreaternumberofrisk
factorstocaptureinterest-rateriskaccurately.
17Spreadrisk.referstothepotentialchangesin
valueofan instrumentorportfolioarisingfrom
differencesinthebehaviorofbaselineyieldcurves,
suchasthosefarU-S.'Treasurysecurities,andyield
curvesreflectingsector,quality,orinstrument
specific-factors.A varietyofapproachesmay be
usedtocapturethespreadriskarisingfromless
thanperfectlycorrelatedmovementsbetween
governmentandotherinterestrates,suchas
-specifyingacompletelyseparateyieldcurvefor
non-governmentinstruments(forexample.swaps or
municipalsecurities)orestimatingthespreadover
goveramentratesatvariouspointsahmgtheyield
curve.
"Directionalriskisthe-riskthataspotpricewill
factorsthatcancreateextraordinarylossesorgains
increaseordecrease.Forwardgapriskreferstothe
intradingportfoliosormake thecontrolofriskin
probabilityeventsofalltypes,includingthevarious effectsofowningaphysicalcommodityversus
thoseportfoliosdifficult.Thesefactorsincludelow- componentsofmarket,credit,and operationalrisks. owningaforwardpositioninacommodity.Interest




Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

38107

foreach riskcategorymust be added together features,etc.,mean thatpricesmay diverge
intheshortrun. The categoriesand factors
on a simple sum basistodetermine the
are:
aggregatevalue-at-riskamount
3.A bank’smodels must accuratelycapture
Factor
the unique risksassociatedwith options
Remaining ma­
D. Q u a n tita tiv e S ta n d a r d s
Category
turity (contrac­
(In per­
within each ofthemarket riskfactor
cent)
tual)
1.A hank may use one ofa number of
categories.The followingminimum criteria
generallyaccepted measurement techniques apply tothe measurement ofoptions risk:
G overnm ent....... N /A ......................
0.00
including, forexample, an internalmodel
a.A bank’sinternalmodel must capture
0.25
based on variance-covariancematrices,
the non-linearpricecharacteristicsofoption Q ualifying............ 6 months or less
6 to 12 months
1.00
historicalsimulations,orMonte Carlo
positionsusing an options pricingtechnique.
Over 12 months
1.60
simulations so longasthemodel employed
The bank must apply aminimum ten-day
O th e r.................... N /A ......................
8.00
capturesallthematerialmarket risks.*
19The
holding period tooption positionsor
followingminimum standardsapply for
positionsthatdisplayoption-like
b.The g o v e r n m e n t category includes all
purposes ofusing an internalmodel for
characteristics. Banks may not scale-upthe
forms ofdebt instruments ofcentral
calculatingmarket riskcapitalrequirements: dailyvalue-at-risknumbers by the square
governments oftheOECD-based group of
a.Value-at-riskmust be calculated on a
rootoftime.
countries23includingbonds, Treasurybills
dailybasisusing a 99th percentile,oneb.A bank’sinternalmodel must capture
tailedconfidence interval20and the holding the volatilitiesoftheratesand prices(thatis, and other short-term instruments, aswell as
localcurrency instruments ofnon-OECD
periodmust be ten tradingdays. For
thevega) underlying option positionsand a
centralgovernments totheextent thatthe
positionsthatdisplay linearprice
bank should measure thevolatilitiesofthe
bank has liabilitiesbooked inthatcurrency.
characteristics,abank may use value-at-risk underlying instruments broken down by
c.The q u a lify in g category includes
numbers calculatedaccording toshorter
differentoption maturities.
holdingperiods scaledup toten days by the
4.The accuracy ofabank’sinternalmodel securitiesofU.S. government-sponsored
squarerootoftime.21
willbe reviewed periodicallyby the Federal agencies,generalobligationsecuritiesissued
by statesand otherpoliticalsubdivisions of
b.Value-at-riskmust be calculatedusing
Reserve. Such review, duringwhich, when
theOECD-based group ofcountries,
an observationperiod ofatleastone yearto appropriate, theFederal Reservemay take
multilateraldevelopment banks, and debt
measure historicalchanges inratesand
intoconsiderationreportsand opinions
instruments issuedbyTJ.S. depository
prices.
generatedby externalauditors orqualified
institutionsorOECD-banks thatdo not
c.A bank must update itshistoricalrates
consultants,will include, ataminimum:
and pricesatleastonce every threemonths
• a.Verificationthatthe internalvalidation qualifyascapitalofthe issuinginstitution.24
and must reassessthem whenever market
processesdescribed insectionm.B.2. ofthis Italsoincludes othersecurities, including
revenue securitiesissuedby statesand other
conditions change materially.
Appendix E areoperating inasatisfactory
politicalsubdivisions oftheOECD-based
2.A bank may use discretion in
manner;
group ofcountries,thatarerated investmentrecognizingempirical correlationswithin
b.Affirmation thatthe formulae used in
each market riskfactorcategory.22However, thecalculationprocess and forthepricingof gradeby atleasttwo nationallyrecognized
creditratingservices,orratedinvestmentempiricalcorrelationsamong riskcategories options and othercomplex instruments, are
grade by one nationallyrecognized credit
arenot recognized. The value-at-riskmeasure validatedby a qualifiedunitofthebank,
which inallcasesmust be independent from ratingagency and not lessthan investmentgradeby any other creditratingagency, or,
the tradingareas;
rateriskistheriskofachangeinthecostof
with theexception ofsecuritiesissuedby
c.Confirmation thatthestructureofthe
carryingforwardpositionsand options.Basisrisk
U.S. firms and subjecttoreviewby the
istheriskthattherelationshipbetweentheprices internalmodel isadequate with respectto
Federal Reserve,unrated but deemed tobe of
ofsimilarcommoditieschangesovertime.
thebank’sactivitiesand geographical
comparable investment qualityby the
19Inavariance/covarianceapproach,thechange coverage;
invalueoftheportfolioiscalculatedbycombining
reporting bank a n d the issuerhas securities
d.Confirmation thattheresultsofthe
theriskfactorsensitivitiesoftheindividual
listedon a recognized stockexchange.
bank’sback-testingofitsinternal
positions— derivedfromvaluationmodels— witha measurement system (thatis,comparing
d.The o th e r category includes debt
variance/covariancematrixbasedonriskfactor
s
e
c
uritiesnot qualifyingasgovernment or
v
a
l
u
e
a
t
r
i
s
k
e
s
t
i
m
a
t
e
s
with
a
c
t
u
a
l
p
r
o
f
i
t
s
and
volatilitiesandcorrelations.A bankusingthis
qualifyingsecurities.This would include
losses)arebeingused effectivelytomonitor
approachwouldcalculatethevolatilitiesand
reliabilityofthemodel’sestimates overtime; non-OECD centralgovernment securitiesthat
correlationsoftheriskfactorsonthebasisofthe
do notmeet thecriteriaforthegovernment
holdingperiodandtheobservationperiod.A bank and
orqualifyingcategories.This category also
usingahistoricalsimulationwouldcalculatethe
e.Affirmation that,forregulatorycapital
includes instruments thatqualifyascapital
hypotheticalchangeinvalueofthecurrent
purposes, themodel processesallrelevant
portfoliointhelightofhistoricalmovements inrisk dataand thatthemodeling procedures
issuedby otherbanking organizations.
factors.Thiscalculationwouldbedoneforeachof conform with the parameters and
e.The Federal Reservewillconsiderthe
thedefinedholdingperiodsoveragivenhistorical specificationssetforthinthisappendix E.
extentofa bank’sposition innon-investment
measurementhorizontoarriveatarangeof
grade instruments (sometimes referredtoas
simulatedprofitsand losses.A bankusingaMonte IV. The Standardized Approach
high yield debt).Ifthoseholdings arenot
Carlotechniquewouldconsiderhistorical
well-diversifiedorotherwise representa
A. D e b t I n s tr u m e n ts
movementstodeterminetheprobabilityof
materialposition tothe institution,the
particularpriceandratechanges.
1.
Specific Risk. a.The capitalrequirementFederal Reservemay preventa bank from
20A one-tailedconfidenceintervalof99percent forspecificriskisbased on the identityof
offsettingpositions inthese instruments with
meansthatthereisa1percentprobabilitybasedon t
heobligorand, inthe caseofcorporate
otherpositions inqualifyinginstrumentsthat
historicalexperiencethatthecombinationof
positionsinabank’sportfoliowould resultinaloss securities,on the creditratingand maturity
may be offsetwhen calculatingitsgeneral
oftheinstrument The specificriskcapital
higherthanthemeasuredvalue-at-risk.
marketriskrequirement Inaddition,the
requirement
i
s
c
a
l
c
u
l
a
t
e
d
by
weighting
t
h
e
21Thistransformationentailsmultiplyinga
Board may impose a specificriskcapital
currentmarket value ofeach individual
bank’svalue-at-riskbythesquarerootoftheratio
requirement as high as 16.0percent
oftherequiredholdingperiod(tendays)tothe
position,whether longorshort,by the
2. General Market Risk. a.A bank may
holdingperiodembodiedinthevalue-at-riskfigure. appropriatecategoryfactoras setforthbelow measure
itsexposure togeneral marketrisk
Forexample,thevalue-at-riskcalculatedaccording and summing theweighted values. In
toaone-dayholdingperiodwouldbescaled-upby measuring specificrisk,thebank may offset using, on a continuous basis,eitherthe
the“squarerootoftime”bymultiplyingthevalueat-riskby3.16(thesquarerootoftheratioofaten- and exclude from itscalculationsany
23TheOECD-basedgroupofcountriesisdefined
matched positionsinthe identical issue
dayholdingperiodtoaone-dayholdingperiod).
insectionIILB.l.ofappendix A ofthispart
(
i
n
c
l
u
d
i
n
g
p
o
s
i
t
i
o
n
s
i
n
d
e
r
i
v
a
t
i
v
e
s
)
.
Even
i
f
22Whileabankhasflexibilitytousecorrelations,
24U.S.government-sponsored agencies,
the issueristhesame, no offsettingis
theFederalReservemustbesatisfiedthatthereis
multilateraldevelopmentbanks, and OECD
permittedbetween differentissuessince
integrityinthebank’sprocessforcalculating
aredefinedinsectionIfi.C.2.ofappendixA ofthis
correlations.
differences in coupon rates,liquidity,call
part.
model should alsotakeintoaccount the
market characteristics,forexample, delivery
datesand thescope provided totradersto
closeoutpositions.




Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

38108

maturitymethod (which uses standardized
riskweight* thatapproximate theprice
sensitivityofvarious instruments) orthe
durationmethod (where theinstitution
calculatesthe precisedurationofeach
instrument,weightedby a specifiedchange
ininterestrates).
b.Both methods use amaturity-ladderthat
incorporatesa seriesof“time-bands” and
“zones” togroup togethersecuritiesof
similarmaturitiesand thataredesigned to
takeintoaccountdifferencesin mice
sensitivitiesand interestratevolatilities
acrossdifferentmaturities. Under either
method, thecapitalrequirement forgeneral
market riskisthesum ofabasecharge that
resultsfrom fullynettingvariousriskweighted positionsand aseriesofadditional
charges (add-ons),which effectively
“disallow”partofthe previousfullnetting
toaddressbasisand yieldcurverisk.

c.Foreach currency inwhich abank has
significantpositions,e separatecapital
requirementmust be calculated.No netting
ofpositionsispermittedacrossdifferent
currencies. Offsettingpositionsofthe same
amount inthesame issues^whether actualor
notional,may be excluded fromthe
calculation,aswell ascloselymatched
swaps,forwards, futures,and forward rate
agreements (FRAs) thatmeet theconditions
setout insection IV.A.3.ofthisAppendix E.
d.Inthem a tu r ity -m e th o d , thebank
distributeseach longorshortposition (at
currentmarket value)ofadebtinstrument
intothetime-bands ofthematurity ladder.
Fixed-rateinstruments areallocated
accordingtotheremaining term tomaturity
and floating-rateinstrumentsaccordingtothe
nextrepricingdate.A callablebond trading
abovepar isslottedaccording toitsfirstcall
date,while acallablebond pricedbelow par

Table 1.—Maturity Method: Time-Bands

and

isslottedaccordingtoremainingmaturity.
Fixed-ratemortgage-backed securities,
includingcollateralizedmortgage obligations
(CMOs) and realestatemortgageinvestment
conduits (REMICs), are slottedaccordingto
theirexpected weighted averagelives.
e. Once alllongand shortpositionsare
slottedintothe appropriate time-band, the
long positionsineach time-bandaresummed
and theshortpositions in each time-band are
summed. The summed longand/or short
positionsaremultiplied by theappropriate
risk-weight factor(reflectingtheprice
sensitivityofthe positions tochanges in
interestrates)todetermine therisk-weighted
longand/or shortposition foreach timeband. The riskweights foreach time-band are
setout inTable Ibelow:

Weights

Zone

Coupon 3% or more

Coupon less than 3% and zero coupon bonds

1 ........

up to 1 month ................................................................................
1 up to 3 months ......... ...................- .........„................ ..............
3 up to 6 months .................................. ....................„.................
6 up to 12 months ................................................... „...... ...........
1 up to 2 years .............................................................................
2 up to 3 years ....... - ................................................ .... ..............
3 up to 4 years ....... ......................................................................
4 up to 5 years .......................................... ..................................
5 up to 7 years ............................................................... „ .......
7 up to 10 years ...........................................................................
10 up to ‘15 years .........................................................................
15 up to 20 years ........ ...................„ .............. „..........................
Over 20 years ............- ...................................„ ..... ......................

up to 1 month
....................... .............. ......................................
1 up to 3 months .............................................. „ ..........................
3 up to 6 months ........... _............................. .................„ ............
6 up to 12 months ..................„ .........„.........................................
1 up to 1.9 years ...... ....................................................................
1.9 up to 2.8 yrs ............................................................................
2 .8 up to 3.6 yrs ................................ ....................... „ .................
3.6 up to 4.3 yrs ............................„ .............................................
4.3 up to 5.7 yrs ...................................................................„.......
5.7 up to 7.3 yrs ..................................„ ................... „ ..................
7.3 up to 9.3 yrs .............. „ ..... .............................................. ......
9.3 up to 10.6 yrs ................................ .........................................
10.6 up to 12 yrs .............. ............................................................
12 up to 20 yrs .............................................................................
Over 20 years ................................................................................

2 ........

3

f. Within each time-band forwhich there
arerisk-weighted longand shortpositions,
therisk-weighted long and shortpositions
arethen netted,resultinginasinglenetriskweighted longorshortpositionforeach timeband. Sincedifferentinstruments and
differentmaturitiesmay be included and
nettedwithin each time-band, a capital
requirement,referredtoasthevertical
disallowance, isassessed toallow forbasis
risk.The verticaldisallowance capital
requirement is10.0 percentofthe position
eliminated by the intra-time-bandnetting,
thatis,10.0percentofthe smallerofthenet
risk-weighted longornetrisk-weighted short
position,orifthe positionsareequal, 10.0
percentofeitherposition.25The vertical
disallowances foreach time-band are
absolutevalues, thatis,neitherlongnor
short The verticaldisallowances foralltimebands inthematurity ladderaresummed and
included asan elementofthegeneralmarket
riskcapitalrequirement

g. Within each zone forwhich there are
risk-weighted longand shortpositions in
differenttime-bands, theweighted longand
shortpositionsinallofthe time-bands
within the zone are then netted,resultingin
a singlenet longorshortposition foreach
zone. Since differentinstruments and
differentmaturities may be included and
netted within each zone, acapital
requirement,referredtoasthe horizontal
disallowance, isassessed toallow forthe
imperfectcorrelationofinterestratesalong
theyield curve.The horizontal disallowance
capitalrequirement iscalculated asa
percentageofthe positioneliminatedby the
intra-zonenetting,thatis,a percentage ofthe
smallerofthe netrisk-weighted longornet
risk-weighted shortposition,or ifthe
positionsareequal, apercentage ofeither
position.26The percent disallowancefactors
forintra-zonenettingare setout inTable II
insectionIV.A.2.h. ofthisAppendix E.The
horizontaldisallowances, likethe vertical
disallowances, areabsolutevalues thatare

25 Forexample,ifthesum oftheweightedlongs disallowanceforthetime-bandis10.0percentof
$90million,or$9million.
inatime-bandis$100 millionandthesum ofthe
weightedshortsis$90million,thevertical
20Forexample,ifthesum oftheweightedlongs
inthe1-3month time-bandinZone 1is$8million




Risk
weights
[percent]
0.00
0.20
0.40
0.70
1.25
1.75

225
2.75
3.25
3.75
4.50
5.25
6.00
8.00
12.50

summed and included asan element ofthe
general market riskcapitalrequirement
h. Risk-weighted longand shortpositions
indifferentzones arethen nettedbetween
the zones. Z o n e 1 and zone 2arenetted if
possible,reducing oreliminatingthe net long
orshortposition inzone 1 orzone 2 as
appropriate.Zone 2 and zone 3 arethen
netted ifpossible,reducing oreliminating the
netlongor shortposition inzone 2 orzone
3 asappropriate. Zone 3 and zone 1 arethen
netted ifpossible, reducingoreliminating the
longorshortposition inzone 3 and zone 1
as appropriate. A horizontal disallowance
capitalrequirement isthen assessed,
calculatedas a percentage oftheposition
eliminatedby the inter-zonenetting.The
horizontaldisallowance capitalrequirements
foreach zone arethen summed asabsolute
valuesand included inthegeneralmarket
riskcapitalcharge.The percent disallowance
factors forinter-zonenettingare setout in
Table IIbelow:

andthesum oftheweightedshortsinthe3-6
month time-handis$10million,thehorizontal
disallowanceforthezoneiffortypercentof$8
million,or$3.2million.

38109

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
Table II.— Horizontal D isallowances

1

2

3 ........

Within the
zone (per­
cent)

Time-band

Zone

D-1 month
.........................................................................................................................
1-3 months
3 -6 months
6-12 months
1—
? years ........................................................................................................................................
2 - 3 years
3 - 4 years
1-5 years ............................................................................... .........................................................
67 years
710 years
6-1 5 years
5-20 years
over 20 years

Between
adjacent
zones (per­
cent)

Between
zones 1-3
(percent)

40

40

100

30

40

100

30

40

100

i. Finally, the net risk-weighted long or net
risk-weighted short positions remaining in
the zones are summed to reach a single net
risk-weighted long or net risk-weighted short
position for the bank’s portfolio. The sum of
the absolute value of this position and the
vertical and horizontal disallowances is the
capital requirement for general market risk.
An example of the calculation of general
market risk under the maturity method is in
Attachment II to this appendix E.
j. In the duration method, the bank, after
calculating each instrument’s modified
duration 27 using a formula that is subject to
supervisory review, multiplies that modified
duration by the interest rate shock specified
for an instrument of that duration in Table
III in section IV.A.2.k. of this appendix E.

Table II).29As with the maturitymethod, the
sum oftheabsolute value ofthefinalnet
position and the vertical and horizontal
disallowances isthegeneral market risk
capitalrequirement:

27 The duration of an instrument is its
approximate percentage change in price for a 100
basis point parallel shift in the yield curve
assuming that its cash flow does not change the
yield curve shifts. Modified duration is duration
divided by a factor of 1 plus the interest rate.

treatment discussed in section IV.E. of this
30For example, a long position in a June threeAppendix E). A summary of the treatment for
month interest rate future (taken in April) is
debt derivatives is set out in Attachment III
reported as a long position in a government security
to this Appendix E.
b.
Derivatives are converted into positions with a maturity of five months an a short position
in a government security with a maturity to two
in the relevant underlying instrument and are months.
included in the calculation of specific and
3'For example, an interest rate swap under which
general market risk capital charges as
a bank is receiving floating-rate interest and paying
described above. The amount to be included
fixed is treated as a long position in a floating rate
is the market value of the principal amount
instrument with a maturity equivalent to the period

ofthe.underlying orofthe notional
underlying. For instruments where the
apparent notional amount differsfrom the
effectivenotional amount, abank must use
the effectivenotional amount.
c.Futures and forward contracts (including
Table III.— Duration Method: T ime- FRAs) arebroken down intoacombination
Bands and Assum ed - C hanges in ofa long position and short position inthe
notional security. The maturity ofa future or
Y ield
a FRA isthe period until delivery orexercise
ofthecontract, plus the lifeofthe underlying
Assumed
instrument.30Where a.range ofinstruments
Time-band
Zone
change in
may be delivered tofulfillthecontract,the
yield
bank may chose which deliverable
instrumentgoes into the maturity orduration
1 ........ Up to 1 month............
1.00
1 up to 3 months .....
1.00 ladder as the notional underlying. In the case
ofa futureon a corporate bond index,
3 up to 6 months ......
1.00
6 up to 12 months ....
1.00 positions are included atthe market value of
The resultingproduct (representingthe
2 ....... 1.0 up to 1.8 years ....
0.90 the notional underlying portfolioof
expected percentage change inthepriceof
1.8 up to 2.6 years ....
0.80 securities.
the instrument forthegiven interestrate
d. Swaps are treated as two notional
2.6 up to 3.3 years ....
0.75
shock) isthen multiplied by thecurrent
3 ........ 3.3 up to 4.0 years ....
0.75 positions in the relevant instruments with
market value ofthe instrument. The resulting
4.0 up to 5.2 years ....
0.70 appropriate maturities. The receiving side is
amount isthen slottedas a long orshort
5 2 up to 6.8 years ....
0.65 treated as the long position and the paying
position intoatime-band inthe maturity
6.8 up to 8.6 years ....
0.60 side istreated as the short position.31The
ladderinTable IIIon thebasisofthe
8.6 up to 9.9 years ....
0.60 separate sidesofcross-currency swaps or
instrument’smodified duration.28
9.9 up to 11.3 years ..
0.60 forward foreignexchange transactionsare
k. Once all of the bank’s traded debt
11.3 up to 16.6 years
0.60 slottedinthe relevantmaturity ladders for
instruments have been slotted into the
Over 16.6 years........
0.60 the currencies concerned. For swaps thatpay
orreceive a fixed or floating interest rate
maturity ladder, the bank conducts the same
against some other reference price, for
rounds of netting and disallowances
3.
Interest rate derivatives, a. Debt
example, an equity index, the interestrate
described in sections IV.A.2.f. through
derivatives and other off-balance-sheet
component isslotted into the appropriate
IV.A.2.h. of this appendix E for the maturity
positions that are affected by changes in
repricingmaturity category, with the longor
method, with the exception that the vertical
interest rates are included in the
shortposition attributabletothe equity
disallowance requirement for the duration
measurement system under section IV.A. of
component being included inthe equity
method is 5.0 percent (horizontal
this Appendix E (except for options and the
framework setout insection IV.B. ofthis
disallowances continue to be those set out in associated underlyings, which are included
Appendix E.32*
in the measurement system under the

28For example, an instrument held by a bank
with a maturity of 4 years and 3 months and a
current market value of $1,000 might have a
modified duration of 3.5 years. Based on its
modified duration, it would be subjected to the 75basis point interest rate shock, resulting in an
expected price change of 2.625 percent (3.5 x 0.75).
The corresponding expected change in price of
$26.25, calculated as 2.625 percent of $1,000,
would be slotted as a long position in the 3.3 to 4.0
year time-band of the maturity ladder.




29Two different vertical disallowances are used
since the duration method takes into account an
instrument’s specific characteristics (maturity and
coupon) and there is less opportunity for
measurement error.

until the next interest reset date and a short
position in a fixed-rate instrument with a maturity
equivalent to the remaining life of the swap.
32A bank with a large swap book may, with prior
approval of the Federal Reserve, use alternative
Continued

38110

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

e.A bank may offsetlong and short
positions (bothactual and notional) in
identical derivativeinstruments with exactly
the same issuer,coupon, currency, and
maturitybefore slottingthese positions into
time-bands. A matched position ina future
and itscorresponding underlying may alsobe
fullyoffsetand, thus,excluded from the
calculation, except when the future
comprises a range ofdeliverable instruments.
However, incaseswhere, among therangeof
deliverable instruments, there isareadily
identifiableunderlying instrument thatis
most profitable forthe traderwith a short
position todeliver,positionsin the futures
contractand the instrument may be offset.No
offsettingisallowed between positions in
differentcurrencies.
f.Offsettingpositions inthe same category
ofinstruments can incertaincircumstances
be regarded asmatched and treatedby the
bank as a singlenet position which should
be entered intotheappropriate time-band. To
qualifyforthistreatment the positionsmust
be based on the same underlying instrument,
be ofthe same nominal value, and be
denominated inthe same currency. The
separate sidesofdifferentswaps may alsobe
“matched” subjecttothe same conditions. In
addition:
i.For futures,offsettingpositions inthe
notional orunderlying instruments towhich
the futurescontractrelatesmust be for
identical instruments and the instruments
must mature within seven days ofeach other;
ii.For swaps and FRAs, thereferencerate
(forfloatingratepositions) must be identical
and the coupon closelymatched (i.e.,within
15 basis points);and
iii.For swaps, FRAs and forwards, the next
interestresetdate,orforfixedcoupon
positions or forwards theremaining maturity,
must correspond within the following limits:
Ifthereset(remainingmaturity) dates occur
within one month, then theresetdatesmust
be on the same day;ifthe resetdates occur
between one month and one year later,then
the resetdates must occur within seven days
ofeach other,oriftheresetdates occur over
one year later,then theresetdatesmust
occur within thirtydays ofeach other.
g.Interestrateand currency swaps, FRAs,
forward foreignexchange contractsand
interestrate futuresarenot subjecttoa
specificriskcharge. This exemption also
applies tofutureson a short-term (e.g.,
LIBOR) interestrateindex. However, in the
case offuturescontractswhere the
underlying isadebt security,oran index
representingabasketofdebt securities,a
specificriskcharge willapply accordingto
formulae to calculate the positions to be included
in the maturity or duration ladder. For example, a
bank could first convert the payments required by
the swap into present values. For that purpose, each
payment would be discounted using zero coupon
yields, and the payment’s present value entered
into the apprioriate time-band using procedures
that apply to zero (or low) coupon bonds. The net
amounts would then be treated as bonds, and
slotted into the general market risk framework.
Such alternative treatments will, however, only be
allowed if: (i) the Federal Reserve is fully satisified
with the accuracy of the system being used, (ii) the
positions calculated fully reflect the sensitivity of
the cash flows to interest rate changes; and (iii) the
positions are denominated in the same currency.




thecategory ofthe issuerassetout insection Futures relatingtoequity indices should be
IV.A.1. ofthisAppendix E.
reported as themarked-to-market valueofthe
notional underlying equity portfolio.Equity
B. E q u itie s
swaps aretreatedas two notional positions,
1.S p e c ific risk. The measure ofspecific
with thereceivingside asthe longposition
riskiscalculatedon thebasis ofthe bank’s
and the paying side astheshort position.*
36
gross equitypositions,thatis,theabsolute
Ifone ofthe legsinvolves receiving/paying
sum ofalllongequitypositions and ofall
a fixedorfloatinginterestrate,the exposure
shortequity positionsatcurrentmarket
shouldbe slottedintothe appropriate
value.33The specificriskcapitalrequirement repricingmaturityband fordebt securities.
is8.0percentofthatsum, unless the
stockindex iscoveredby theequity
portfolioisboth liquidand well-diversified, The
treatment.
inwhich casethe specificriskcapital
c.In the case offutures-relatedarbitrage
requirementis4.0 percent ofthegross equity
position.A specificriskcharge of2.0percent strategies,the 2.0percent specificriskcharge
applicable tobroad diversifiedequity indices
appliestothe net longorshortpositionin
may be applied toonly one index. The
abroad, diversifiedequity index and is
opposite position isexempt from a specific
viewed as necessarytoprovide forrisks
riskcharge. The strategiesqualifyingforthis
associated with contractexecution.34
treatment are:
2. G en era l M a rk e t risk. The measure of
i.When thebank takes an opposite
general market riskisbased on the difference
position inexactly the same index at
between the sum ofthe long positions and
different dates;and
the sum ofthe shortpositions (i.e.,the
ii.When thebank has an opposite position
overallnetposition inan equitymarket) at
currentmarket value. An overall net position in differentbut similarindicesatthe same
date, subjecttosupervisoryoversight
must be separatelycalculated foreach
d.Ifabank engages inadeliberate
national market inwhich thebank holds
equities.The capitalrequirement forgeneral arbitrage strategy,inwhich a futurescontract
market riskis8.0percent ofthe net position on abroad diversifiedequityindex matches
a basketofsecurities,itmay exclude both
ineach equitymarket
3.E q u ity d e riva tive s, a.Equityderivatives positions from thestandardized approach on
and otheroff-balance-sheetpositionsthatare condition thatthe tradehas been deliberately
affected by changes in equity pricesare
entered intoand separatelycontrolledand
included inthemeasurement system under
the composition ofthebasket ofstocks
sectionFV.B. ofthisAppendix E (except for
represents atleast90 percentofthe market
equityoptions,equityindex options, and the value ofthe index. In such acase, the
associated underlying, which areincluded in minimum capitalrequirement is4.0percent
the measurement system under the treatment (thatis,2.0 percent ofthegrossvalue ofthe
discussed in sectionIV.E.ofthisAppendix
positionson each side)toreflectrisk
E).33This includes futuresand swaps on both associated with executing thetransaction.
individual equitiesand on equity indices.
This applieseven ifallofthesecurities
Equity derivatives should be converted into
comprising the index areheld in identical
notional equity positions inthe relevant
proportions. Any excess value ofthe
underlying. A summary oftherules for
securitiescomprising thebasketover the
equityderivatives issetout inAttachment HI value ofthe futures contractorexcess value
tothisAppendix E.
ofthe futures contractover thevalue ofthe
b. Futures and forward contractsrelatingtobasket istreated asan open longor short
individual equities should be reported at
position.
currentmarket pricesofthe underlying.
e.Ifabank takesapositionin depository
receipts37againstan opposite position inthe
33Matched positions in each additional equity in
underlyingequity,itmay offsetthe position.
each national market may be treated as offsetting
and excluded from the capital calculation, with any
remaining position included in the calculations for
specific and general market risk. For example, a
future in a given equity may be offset against an
opposite cash position in the same equity.
34A portfolio that is liquid and well-diversified
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. The
volatility of the portfolio’s value should not be
dominated by the volatility of any individual equity
issue or by equity issues Grom any single industry
or economic sector. In general, such portfolios
should be characterized by a large number of
individual equity positions, with no single position
representing a large portion of the portfolio’s total
market value. In addition, it would generally be the
case that a sizeable proportion of the portfolio
would be comprised of issues traded on organized
exchanges or in well-established over-the-counter
markets.
33Where equities are part of a forward contract
(both equities to be received or to be delivered), any
interest rate or foreign currency exposure from the
other side of the contract should be appropriately
included in the measurement systems in sections
IV.A. and IV.C. of this Appendix E.

C. F o reign E x c h a n g e R is k

1. The capitalrequirement forforeign
exchange riskcovers the riskofholding or
taking positions in foreigncurrencies,
includinggold,and isbased on abank’snet
open long positions ornetopen short
positions ineach currency,whether ornot
those positions are inthetradingportfolio,
plus the net open position ingold, regardless
ofsign.38*
38For example, an equity swap in which a bank
is receiving an amount based on the change in value
of one particular equity or equity index and paying
a different index will be trated as a long position
in the former and a short position in the latter.
37Depository receipts are instruments issued by
a trust company or other depository institution
evidencing the deposit of foreign securities and
facilitating trading in such instruments on U.S.
stock exchanges.
38Gold is treated as a foreign exchange position
rather than a commodity because its volatility is
more in line with foreign currencies and banks
manage it in a manner similar to foreign currencies.

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
each currency may be used asa proxy forthe
positions,provided there isadequate ex post
monitoring ofactual positions complying
gumming:
a.The netspotposition (i.e.,allassetitems with such limits.In thesecircumstances, the
limitsshould be added, regardlessofsign,to
lessallliabilityitems, including accrued
the netopen position ineach currency.
Interestearned but notyetreceived and
accruedexpenses, denominated inthe
D. Commodities Risk
currency inquestion);
1.Measurement methods. This section
b.All foreignexchange derivative
provides a m inim um capitalrequirement to
instruments and otheroff-balance-sheet
covertheriskofholding ortakingpositions
positionsthatareaffectedby changes in
incommodities. There aretwo methods
exchange ratesareincluded inthe
under the standardized approach for
measurement system under sectionIV.C. of
commodity market risk— the
thisAppendix E (except foroptions and their measuring
simplifiedmethod and the maturity method.
associatedunderlyings, which areincluded
These methods are only appropriate for
inthemeasurement system under the
banks thatconduct a limited amount of
treatment discussed insection IV.E.ofthis
commodities business.All otherbanks must
Appendix E).Forward currency positions
adopt an internalmeasurement system
should be valued atcurrentspotmarket
conforming tothecriteriainsectionIII.of
exchange rates.For abank inwhich the basis thisAppendix E.
ofitsnormal management accountingisto
2.Base capital requirement Under both
use net presentvalues, forward positions
the simplifiedand maturitymethods, each
may be discounted tonetpresentvalues as
long and shortcommodity position (spotand
an acceptableway ofmeasuring currency
forward) isexpressed in terms ofthe
positions forregulatorycapital purposes;
standard unitofmeasurement (such as
c.Guarantees (and similarinstruments)
barrels,kilos,orgrams). The open positions
thatarecertain tobe called and are likelyto ineach categoryofcommodities arethen
be irrevocable;
converted atcurrent spot ratesinto U.S.
d.Net future income/expenses notyet
currency, with long and shortpositionsoffset
accrued but already fullyhedged (atthe
toarriveatthenet open position ineach
discretionofthebank). A bank thatincludes commodity. Positions indifferentcategories
future income and expenses must do so on
ofcommodities may not,generally, be
aconsistentbasiswithout selectingexpected offset.41Under eithermethod, thebase
future flows inordertoreduce the bank’s
capitalrequirement is15.0 percent ofthe net
position;and
open position, long orshort,ineach
e.Any otheritem representingaprofitor
commodity.42
loss in foreigncurrencies.
3.Simplified method. To protectabank
3.For measurings bank’sopen positions, againstbasisrisk,interestraterisk,and
positionsincomposite currencies,such as
forward gap risk,each category ofcommodity
the ECU, may be eithertreatedasacurrency isalsosubjecttoa 3.0percent capital
in theirown rightorsplitintotheir
requirementon thebank’sgross positions,
component partson aconsistentbasis.
longplus short, inthe particularcommodity.
Positions ingold aremeasured inthe same
In valuinggross positions incommodity
manner asdescribed insection IV.D. ofthis
derivatives forthispurpose, a bank should
Appendix E.39
use the currentspot price. The totalcapital
4.The capitalrequirement isdetermined
requirement forcommodities riskisthe sum
by converting the nominal amount (ornet
ofthe 15.0percentbase charges foreach net
present value)ofthe netopen position in
commodity position and the 3.0 percent
each foreigncurrency (and gold) atspotrates requirements on thegrosscommodity
intothereportingcurrency. The capital
positions.
requirement is8.0 percent ofthe sum of:
4.Maturity method, a.Under thismethod,
a.The greaterofthe sum ofthe net short
a bank must sloteach long and short
open positionsorthe sum ofthe net long
commodity position (converted intoU.S.
open positions (absolutevalues);and
currency atcurrent spotrates)intoamaturity
b.The netopen position ingold, regardless ladder. The time-bands forthematurity
ofsign.40
ladderare;from zero toone month, one up
5. Where a hank isassessing itsforeign
tothree months, three up tosixmonths, six
exchange riskon aconsolidated basis,itmay up totwelve months, one up totwo years,
be technicallyimpractical inthe case ofsome two up tothree years,and over threeyears.
marginal operations toinclude the currency A separate maturity ladder isused foreach
positionsofa foreignbranch orsubsidiaryof category ofcommodity. Physical
thebank. Insuch cases, the internal limitin
2.A bank’snetopen position ineach
currency (andgold) iscalculatedby

39Where gold is part of a forward contract
(quantity of gold to be received or to be delivered),
any interest rate or foreign currency exposure from
the other side of the contract should be included
in measurement system in section IV.A. (as a zero
coupon instrument) and IV.C. of this Appendix E.
40 For example, a bank has the following net
currency positions: Yen=+50, DM=+100, GB=+150,
FFR= - 20, USS= -180, and gold= - 35. The bank
would sum its long positions (total=+300) and sum
its short positions (total= - 200). The bank’s capital
requirement for foreign exchange market risk would
be: (300 (the larger of the summed long and short
positions) +35 (gold)) x8.0%=$26.80.




41 However, offsetting is permitted between
different sub-categories of the same commodity in
cases where the sub-categories are deliverable
against each other.
42 When the funding of a commodity position
opens a bank to interest rate or foreign exchange
exposure the relevant positions should be included
in the measures of interest rate and foreign
exchange risk described in sections IV.A. and IV.C.
of this Appendix E. When a commodity is part of
a forward contract, any interest or foreign currency
exposure from the other side of the contract should
be appropriately included in the measurement
systems in sections IV.A. and IV.C. of this
Appendix E.

38111

commodities areallocated tothe firsttimeband.
b.Inorder tocapture forward gap and
interestrateriskwithin a time-band (together
sometimes referred toas curvature/spread
risk),offsettinglong and short positions in
each time-band aresubjecttoan additional
capitalrequirement. Beginning with the
shortest-termtime-band and continuingwith
subsequent time-bands, the amount ofthe
matched short position plus the amount of
the matched long position ismultipliedby a
spread rateof1.5 percent.
c.The unmatched net position from
shorter-term time-bands must be carried
forward tooffsetexposures inlonger-term
time-bands. A capitalrequirement of0.6
percent ofthe net positioncarried forward is
added foreach time-band thatthe net
position iscarried forward.43The total
capitalrequirement forcommodities riskis
the sum ofthe 15.0 percent base capital
requirement foreach net commodity position
and theadditional requirements formatched
positions and forunmatched positions
carried forward. An example ofthis
calculation isinAttachment IV tothis
Appendix E.
5. Commodity derivatives. Commodity
derivativesand otheroff-balance-sheet
positionsthatareaffected by changes in
commodity pricesare included inthe
measurement system under sectionTV.D. of
thisAppendix E (except foroptions and the
associatedunderlying, which areincluded in
the measurement system under the treatment
discussed insection IV.E. ofthisAppendix
E).Commodity derivativesare converted into
notional commodity positions. Under the
maturity method, the positions areslotted
intomaturity time-bands as follows:
a. Futures and forward contracts relating to
individual commodities are incorporated in
the measurement system as notional amounts
(of, for example, barrels or kilos) that are
converted to U.S. dollars at current spot rates
and are assigned a maturity according to
expiration date;

b.Commodity swaps where one sideofthe
contractisafixed price and the other side
isthe currentmarket price are incorporated
asa seriesofpositions equal tothe notional
amount ofthe contract atcurrent spot rates,
with one position corresponding toeach
payment on the swap and slotted in the
maturity ladderaccordingly. The positions
are long positions ifthe bank ispaying a
fixedpriceand receivinga floatingprice, and
short positions ifthe bank isreceivinga fixed
price and paying a floatingprice;44*and
c. Commodity swaps where the sides of the
transaction are in different commodities are
included in the relevant reporting ladder. No
offsetting is allowed unless the commodities
are in the same sub-category.
43 For example, if S200 short is carried forward
from the 3-6 month time-band to the 1-2 year timeband, the capital charge would be
S200x.006x2=S2.40.
44 If one of the sides of the transaction involves
receiving/paying a fixed or floating interest rate,
that exposure should be slotted into the appropriate
repricing maturity band in section IV.A. of this
Appendix E.

38112

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

E47*49), less the amount the option is in the
E. Options
money (if any) bounded at zero.4®
1. Three alternatives are available for a
b. For a bank with a long call or a long put,
Bank to use in measuring its market risk for
the capital charge is the lesser of:
options activities. A bank that only has
i. The market value of the underlying
purchased options may use the simplified
security multiplied by the sum of specific
method set forth in section IV.E.2. of this
and general market risk requirements for the
underlying (that is, the specific and general
Appendix E. A bank that also writes options
market risk requirements that would have
may use the scenario method described in
applied to the underlying directly under
section IV.E.3. of this Appendix E or the
delta-plus method set forth in section IV.E.4. sections IV.A. through IV.D. of this Appendix
E40); or
of this Appendix E.45 These methods may
ii. The market value of the option.
only be used by banks which, in relative
c. Under this measure, the capital
terms, have limited options activities. Banks
requirement for currency options is 8.0
with more significant options business are
percent of the market value of the underlying
expected to adopt an internal measurement
and for commodity options is 15.0 percent of
system conforming to the criteria in section
the market value of the underlying.
III. of this Appendix E. Regardless of the
4.
Under the scenario approach, a bank
revalues its options and related hedging
method used, specific risk related to the
positions by changing the underlying rate or
issuer of an instrument still applies to
price over a specified range and by assuming
options positions for equities, equity indices
different levels of volatility for that rate or
and corporate debt securities as set forth in
price.
sections IV.A. and IV.B. of this Appendix E.
a. For each of its option portfolios, a bank
There remains a separate capital requirement constructs
a grid based on a fixed range of
for counterparty credit risk as set forth in
changes in the portfolio’s risk factors and
appendix A to this part
calculates changes in the value of the option
2. Under the simplified and scenario
portfolio at each point within the grid. For
methods, the positions for the options and
this purpose, an option portfolio consists of
the associated underlying, cash or forward,
an option and any related hedging positions
or multiple options and related hedging
are not included in the measurement
positions that are grouped together according
framework for debt securities, equities,
to their remaining maturity or the type of
foreign exchange or commodities risk as set
underlying.
forth in sections IVA. through IV.D. of this
b. Options based on interest rates and debt
Appendix E. Rather, they are subject to
instruments are grouped into portfolios
capital requirements as calculated in this
according to the maturity zones that are set
section IV.E. The capital requirements
forth in section IVA. of this Appendix E.
calculated under this section IV.E. should
(Zone 1 instruments have a remaining
then be added to the capital requirements for maturity of up to 1 year, zone 2 instruments
debt securities, equities, foreign exchange,
have a remaining maturity from 1 year up to
and commodities risk as appropriate. Under
4 years, and zone 3 instruments have a
remaining maturity of 4 years or more.) These
the delta-plus method, the delta equivalent
position 46 for each option is included in the options and the associated hedging positions
should be evaluated under the assumption
measurement frameworks set forth in
sections IV.A. through IV.D. of this Appendix that the relevant interest rates move
simultaneously. For options based on
E.
equities, separate grids are constructed for
3. A bank that has only a limited amount
each individual equity issue and index. For
and range of purchased options may use the
options based on exchange rates, separate
following simplified approach to measure its grids are constructed for individual exchange
market risk exposure.
rates. For options based on commodities,
a.
For a bank with a long cash position andseparate grids are constructed for each
a long put or with a short casj^position and
category of commodity (as defined in
a long call, the capital requirement is the
sections I.B.3. and IVJD. of this Appendix E).
c. For option portfolios with options based
market value of the underlying instrument
on equities, exchange rates, and
multiplied by the sum of the specific and
commodities, the first dimension of the grid
general market risk requirements for the
consists of rate or price changes within a
underlying (that is, the specific and general
market risk requirements that would have
47Some options (e.g., where the underlying is an
applied to the underlying directly under
interest rate, a currency, or a commodity) bear no
sections IV.A. through IV.D. of this Appendix specific
risk but specific risk will be present in the
43 Unless all their written option positions are
hedged by perfectly matched long positions in
exactly the same options, in which case there is no
capital requirement for market risk.
46The delta equivalent of an option is the
option’s delta value multiplied by its principal or
notional value. The delta value of an option
represents the expected change in the option’s price
as a proportion of a small change in the price of
the underlying instrument For example, an option
whose price changes $1 for every $2 dollar change
in the price of the underlying instrument has a delta
of 0.50.




case of options on corporate debt securities and for
options on equities and equity indices.

44 For example, if a holder of 100 shares currently
valued at S10 each has an equivalent put option.
with a strike price of SI 1, the capital charge would
be: $1,000 x 16.0 percent (e.g., 8.0 percent specific
plus 8.0 percent general market risk)*$160, less the
amount the option is in the money
($11-S10)xl00=$100, i.e., the capital charge
would be $60. A similar methodology applies for
options whose underlying is a foreign currency, a
debt security or a commodity.
49 See footnote 47 in section IV.E.3.a. of this
appendix £.-

specified range above and below the current
market value of the underlying; for equities,
the range is ±12.0 percent (or in the case of
an index ±8.0 percent), for exchange rates the
range is ±8.0 percent, and for commodities
the range is ±15.0 percent. For option
portfolios with options based on interest
rates, the range for the first dimension of the
grid depends on the remaining maturity
zone. The range for zone 1 is ±100 basis
points, the range for zone 2 is ±90 basis
points, and the range for zone 3 is ±75 basis
points. For all option portfolios, the range is
divided into at least ten equally spaced
intervals. The second dimension of each grid
is a shift in the volatility of the underlying
rate or price equal to ±25.0 percent of the
current volatility.50*25
d. For each assumed volatility and rate or
price change (a scenario), the bank revalues
each option portfolio. The market risk capital
requirement for the portfolio is the largest
loss in value from among the scenario
revaluations. The total market risk capital
requirement for all option portfolios is the
stun of the individual option portfolio capital
requirements.
e. The Federal Reserve will review the
application of the scenario approach,
particularly regarding the precise way the
analysis is constructed. A bank using the
scenario approach should meet the
appropriate qualitative criteria set fortfi in
section HT.B. of this Appendix E.
5.
Under the delta-plus method, a bank that
writes options may include delta-weighted
options positions within each measurement
framework as set forth in eections IV.A
through IV.D. of this Appendix E.
a. Options positions should be measured as
a position equal to the market value of the
underlying instrument multiplied by the
delta. In addition, a bank must measure the
sensitivities of the option’s gamma (the
change of the delta for a given change in the
price of the underlying) and vega (the
sensitivity of the option price with respect to
a change in volatility) to calculate the total
capital requirement. These sensitivities may
be calculated according to an exchange
model approved by the Federal Reserve or to
the bank’s own options pricing model,
subject to review by the Federal Reserve.
b. For options with debt instruments or
interest rates as the underlying instrument,
delta-weighted options positions should be
slotted into the debt instrument time-bands
in section IV.A.of this Appendix E using a
two-legged approach (as is used for other
derivatives), requiring one entry at the time
the underlying contract takes effect and one
at the time the underlying contract
matures.51 Floating rate instruments with
50 For example, if the underlying of an equity
instrument has a current market value of $100 and
a volatility of 20 percent, the first dimension of the
grid would range from $88 to $112, divided into ten
intervals of $2.40 and the second dimension would
assume volatilities of 15 percent, 20 percent, and
25 percent.
31 For example, in April, a purchased call option
on a June three-month interest-rate future would be
considered on the basis of its delta-equivalent value
to be a long position with a maturity of five months
and a short position with a maturity of two months.
The written option would be slotted as a long

38113

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
caps or floors should be treated as a
combination of floating rate securities and a
series of European-style options.*52 A bank
must also calculate the gamma and vega for
each such option position (including hedge
positions). The results should be slotted into
separate maturity ladders by currency. For
options such as caps and floors whose
underlying instrument is an interest rate, the
delta and gamma should be expressed in

terms of a hypothetical underlying security.
Subsequently:
i. For gamma risk, for each time-band, net
gammas that are negative are multiplied by
the risk weights set out in Table IV in section
IV.E.5.b.iv. of this Appendix E and by the
square of the market value of the underlying
instrument (net positive gammas may be
disregarded);
ii. For volatility risk, a bank calculates the
capital requirements for vega in each time-

band assuming a proportional shift in
volatility of ±25.0 percent;
iii. The capital requirement is the absolute
value of the sum of the individual capital
requirements for net negative gammas plus
the absolute value of the sum of the
individual capital requirements for vega risk
for each time-band; and
iv. The delta plus method risk weights are:

Table IV — D elta P lus Method R isk W eights
Modified duration
(average assumed
for time band)

Time-band
Under 1 month ..........................................................................................................
1 up to 3 months......................................................................................................
3 up to 6 months.......................................................................................................
6 up to 12 months....................................................................................................
1 up to 2 ye ars.........................................................................................................
2 up to 3 ye ars.........................................................................................................
3 up to 4 ye ars.........................................................................................................
4 up to 5 y e ars.........................................................................................................
5 up to 7 ye ars.........................................................................................................
7 up to 10 ye ars.......... ............................................................................................
10 up to 15 years......................................................... ............................................
15 up to 20 years.....................................................................................................
Over 20 years ............................................................................................ ..............
1According to the Taylor expansion, the risk weights are calculated as

Risk-weight for
gamma1

1.00
1.00
1.00
1.00
0.90
0.80
0.75
0.75
0.70
0.65
0.60
0.60
0.60

0.00000
0.00020
0.00080
0.00245
0.00794
0.01549
0.02531
0.03747
0.05298
0.07106
0.10125
0.13781
0.18000

(modified duration x assumed interest rate change) 2/100.

c. For options with equities as the
underlying, delta-weighted option positions
should be incorporated in the measure of
market risk set forth in section IV.B. of this
Appendix E. Individual equity issues and
indices should be treated as separate
underlyings. In addition to the capital
requirement for delta risk, a bank must apply
a further capital charge for gamma and vega
risk:
i. For gamma risk, the net gammas that are
negative for each underlying are multiplied
by 0.72 percent (in the case of an individual
equity) or 0.32 percent (in the case of an
index as the underlying) and by the square
of the market value of the underlying;
ii. For volatility risk, a bank calculates the
capital requirement for vega for each
underlying, assuming a proportional shift in
volatility of ±25.0 percent; and
iii. The capital requirement is the absolute
value of the sum of the individual capital
requirements for net negative gammas plus
the absolute value of the individual capital
requirements for vega risk.
d. For options of foreign exchange and gold
positions, the net delta (or delta-based)
equivalent of the total book of foreign
currency and gold options is incorporated
into the measurement of the exposure in a
single currency position as set forth in
section IV.C. of this Appendix E. The gamma
and vega risks are measured as follows:
i.
For gamma risk, for each underlying
exchange rate, net gammas that are negative

are multiplied by 0.32 percent and by the
square of the market value of the positions;
ii. For volatility risk, a bank calculates the
capital requirements for vega for each
currency pair and gold assuming a
proportional shift in volatility of ±25.0
percent; and
iii. The capital requirement is the absolute
value of the sum of the individual capital
requirements for net negative gammas plus
the absolute value of the sum of the
individual capital requirements for vega risk.
e. For options on commodities, the deltaweighted positions are incorporated in one of
the measures described in section IV.D. of
this Appendix E. In addition, a bank must
apply a capital requirement for gamma and
vega risk:
i. For,gamma risk, net gammas that are
negative for each underlying are multiplied
by 1.125 percent and by the square of the
market value of the commodity;
ii. For volatility risk, a bank calculates the
capital requirements for vega for each
commodity assuming a proportional shift in
volatility of ±25.0 percent; and
iii. The capital requirement is the absolute
value of the sum of the individual capital
requirements for net negative gammas plus
the absolute value ofthe sum of the
individual capital requirements for vega risk.
f. Under certain conditions and to a limited
extent, the Federal Reserve may permit banks
that are significant traders in options with
debt securities or interest rates as the
underlying to net positive and negative

position with a maturity of two months and short
position with a maturity of five months.
S2For example, the holder of a three-year floating
rate bond indexed to six-month LIBOR with a cap
of 15 percent would treat the bond as a debt

security that reprices in six months, and a series of
five written call options a FRA with a strike rate
of 15 percent, each slotted as a short position at the
expiration date of the option and as a long position
at the time the FRA matures.




0.00
0.20
0.40
0.70
1.40
2.20
3.00
3.65
4.65
5.80
7.50
8.75
10.00

Assumed interest
rate change (%)

gammas and vegas across time-bands. Such
netting must be based on prudent and
conservative assumptions and the bank must
materially meet the qualitative standards set
forth in section m.B. of this Appendix E.
g. A bank may base the calculation of vega
risk on a volatility ladder in which the
implied change in volatility varies with the
maturity of the option. The assumed
proportional shift in volatility must be at
least ±25.0 percent at the short end of the
maturity spectrum. The proportional shift for
longer maturities must be at least as stringent
in statistical terms as the 25.0 percent shift
at the short end.
h. A bank should also monitor the risks of
rho (the rate of change of the value of the
option with respect to the interest rate) and
theta (the rate of change of the value of the
option with respect to rime).
Attachments to Appendix E
Attachment I—Sample Calculation of
Eligible Tier 1, Tier 2, and Tier 3
Capital for the Risk-Based Capital Ratio
Adjusted for Market Risk
a.
In each example the weighted-risk assets
are $8000 and the market risk-adjusted assets
are $625 (capital requirement for market
risk=$50 $50x12.5=$625):
Example 1: A bank has the following
qualifying capital:
Tier 1=$600 Tier 2=$100 Tier 3=$1000

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

38114

(1) The m in im u m capital requirement for
credit risk is $640 ($8000x8.0%). This
requirement could be satisfied with $540 of
Tier 1 capital and $100 of Tier 2 capital.
(2) The remaining capital available for
-market risk would be:
Tier 1=$60, Tier 2=0, and Tier 3=$1000. The
m inim um capital requirement for market
risk is $50 ($625x8.0%). Eligible Tier 3
capital would be limited to $125
($50x2.5).
(3) The Tier 1 capital required to support
market risk could be satisfied by allocating
$14 ($50x.285), with eligible Tier 3 capital
used for market risk being $36 ($50 - $14).
(4) Total qualifying and eligible capital
would be:
$540 (Tier 1)+$100 (Tier 2}+$60 (Tier 1,
comprising $14 allocated for market risk
and $46 unallocaled)+$36 (Tier 3)=$736.
The bank’s ratio of qualifying and
eligible capital to weighted-risk assets
adjusted for market risk would be: $736/
$8,625)=8.5%.

Example 2: A bank has the following
qualifying capital:
Tier 1=$500 Tier 2=5140 Tier 3=$600
(1) The minimum capital requirement for
credit risk is $640 ($8000x8.0%). This
requirement could be satisfied with $500 of
Tier 1 capital and $140 of Tier 2 capital.
(2) The remaining capital available for
market risk would be: Tier 1=0, Tier 2=$0,
and Tier 3=$600. Eligible Tier 3 capital
would be limited to $0 ( 0x2.5). Because
there is no Tier 1 capital required to support
market risk, no eligible Tier 3 capital may be
used for market risk.
(3) Total qualifying and eligible capital
would be: $500 (Tier 1)+$140 (Tier 2)=$640.
The bank’s ratio of qualifying and eligible
capital to weighted-risk assets adjusted for
market risk would be: $640/$8,625)=7.4%.
b.
In both of the examples described in
paragraph a. of this attachment the total of
Tier 2 and Tier 3 capital for credit and
market risk is not greater than 100 percent of
Tier 1 capital for credit and market risk and
the total of Tier 2 capital for credit risk is not

Zone

Time-band and position

1 ..............

0-1 m th ................................... „........................
1-3 mth Long 75 Gov. bond .................- ...............
3-6 m th ____________________________ ______ ____
Short 50 Future
6-12 mths ................................................. ........
Long 150 Swap
1—2 yrs ................................................................
2-3 yrs ..............................................................
3 - 4 yrs ............................................................ .
Long 50 Future
4 - 5 yrs ..............................................................
5 - 7 yrs .................................................. ...........
7—10 yes ...................................- ............... - .......
Short 150 Swap
Long 13.33 Quai Bond
10—15 yrs .................. ............... ....... ................
15-20 yrs ................................................ - .........
Over 2 yrs ....... - ........................................... - ...

2 ..............

3 ... ...........

b. A vertical disallowance would be
calculated for time-band 7-10 years. It would
be 10 percent of the matched positions in the
time-band—10.0x0.5=0.05 ($50,000).
c. A horizontal disallowance would be
calculated for zone 1. It would be 40 percent
of the matched positions in the zone—
40:0x0.20=0.80 ($80,000). The remaining net
position in Zone 1 would be +1.00.
d. A horizontal disallowance would be
calculated for adjacent zones 2 and 3. It
would be 40 percent of the matched positions
between the zones—40.0x1.125=0.45

Risk wght

greater than 100 percent of Tier 1 capital for
credit risk.

Attachment II—Sample Calculation of
General Market Risk lor Debt
Instruments Using the Maturity Method
a.
A bank with the following positions
would slot them into a maturity ladder as
shown below:
i. Qualifying bond, $13.33mn market value,
remaining maturity 8 years, coupon 8%;
ii. Government bond, $75mn market value,
remaining maturity 2 months, coupon 7%;
iii. Interest rate swap, $150 mn, bank
receives floating rate interest and pays fixed,
next interest reset after 12 months, remaining
life of swap is 8 years (assumes the current
interest rate is identical to the one the swap
is based on); and
iv. Long position in interest rate future,
$50mn, delivery date after 6 months, life of
underlying government security is 3.5 years
(assumes the current interest rate is identical
to the one the swap is based on).

Risk-weighted
position

Net time-band
positions

0.00
0.20
0.40

Long 0.15.......
Short 0 .2 0 ____

Long 0 .1 5 ____
Short 0 .2 0 ____

0.70

Long 1.05____

Long 1.05 - ......

1.25
1.75
2.25

Long 1.125......

Long 1.125___

Long 1.125

2.75
3.25
3.75

ShorL5.625____

Short 5.125____

Short 5.125

Net zone
positions
Long 1.00.

Long 0.50
4.50
5.25
6.00

(450,000). The remaining position in zone 3
Horizontal disallowance in
would be —4.00.
zone 1 '....... ..........................
80,000
e. A horizontal disallowance would
Horizontal disallowance—
zones 2 and 3 .....................
450,000
be calculated between zones 1 and 3. It
Horizontal disallowance—
would be 100'percent of the matched
zones 1 and 3 ....... .... .........
1,000,000
positions between the zones—
Overall net open position ......
3,000,000
100X1.00=1.00 (1,000,000).
f. The remaining net open position for
Total requirement for gen­
the bank would be 3.00 ($3,000,000).
eral market risk _____ _
4,580,000
The total capital requirement for general
market risk for this portfolio would be:
Attachment III—Summary of
The vertical disallowance ......
$50,000 Treatment for Interest Rate and Equity.

Derivatives

Summary of Treatment for Interest Rate Derivatives
Instrument
Exchange-Traded Future
G o v ern m erit security ........................................ ...... ...................„.......................„...............
C o rp o ra te d e h t s e c u rity ...................................... ................................................................................................

Index on short-term interest rates (e.g. LIBOR)....................................................................
OTC Forward
Government security................................................................................ ............... .............




Specific
risk charge

General market risk charge

N o ...........
Yes
N o ...........

Yes, as two positions.
Yes, as two positions.
Yes, as two positions.

N o ...........

Yes, as two positions.

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

38115

Summary of Treatment for Interest Rate Derivatives—Continued
Instrument

Specific
risk charge

General market risk charge

Y es..........
N o ...........
No ...........
N o ...........

Yes, as two positions.
Yes, as two positions.
Yes, as two positions.
Yes, as one position in each
currency.
For each type of transaction, ei­
ther
(a) Carve out together with
the associated hedging
positions
—simplified method
—scenario analysis
—internal models, or
(b) General market risk
charge according to the
Delta-plus
method
(gamma and vega receive
separate capital charges)

Options:
Government security.............................................................................................. .......... ..

No ...........

Y es..........

Index on short-term interest rates .........................................................................................

No ...........

Note: Specific risk charges relate to the issuer of the instrument There remains a separate capital requirement for counterparty credit
risk.
Summary of Treatment for Equity Derivatives
Instrument

Specific
risk charge

Exchange-Traded or OTC Future:
Individual equity ..............................................................................................................
Index ..................................................................................................................................
Options:

Y es..........
2.0% ___

Individual equity ...............................................................................................................

Index...............................................................................................................................

General market risk charge

Yes, as underlying.
Yes, as underlying.
For each type of transactions ei­
ther
ves ..........
(a) Carve out together with
the associated hedging
positions
—simplified method
—scenario approach
—internal models, or
2.0% ....... (b) General market risk require­
ment according to the Deltaplus method (gamma and
vega receive separate capital
charges).

Note: Specific risk charges relate to the issuer of the instrument. There remains a separate capital requirement for counterparty credit
risk.
Attachment IV—Sam ple Calculation o f Standardized Approach for Commodities Risk
Time-band

Position

0 up to 1 month.............
1 up to 3 m onths.............
3 up to 6 m onths.............

None
None
Long 800 ......................
Short 1000 ....................

6 up to 12 m onths____ __
1 up to 2 y r s .... ............ .

None
lo n g fiflO

2 up to 3 y r s ................. .' None
Over 3 years ................. Short 600 .....................

Spread
rate

1.5%

Capital calculation

Capital
charge

800 long+800 short (matched)x1.5%=......................
200 short carried forward to 1—2 yrs, capital charge:
200x2x0.6%=.

24
2.4

200 long+200 short (m atched)x1.5%*......................
400 long carried forward to over 3 yrs capital charge:
400x2x0.6%=.

6
4.8

400 long+400 short (m atohed)x1.5%x......................
Net position: 200 capital charge: 200x15.0% =............

12
30

Note: Assume aN positions are in the same commodity and converted at current spot rates into U.S. dollars. The total capital requirement
would be $79.2.




38116

Federal Register / Vol. 60, No. 142 / Tuesday, July .25, 1995 / Proposed Rules

Appendix A to Part 225—Capital
Adequacy Guideline! for Bank Holding
Companies: Risk Baaed Measure
a. Assume a bank has a European short call

Attachment V—Sample Calculation for
Delta-Plus Method for Options

Appendix E to Part 225—Capital
Adequacy Guidelines for B ulk Holding
Companies: Market Risk Measure

I. Introduction
option on a commodity with an exercise
I. Overview
price of 490 and a market value of the
A. Overview
The Board of Governors of the Federal
underlying 12 months from the expiration of Reserve System has adopted a risk-based
1. The Board of Governors of the Federal
the option at 500; a risk-free interest rate at
capital measure to assist in the assessment of Reserve System has adopted a framework for
8% per annum, and the volatility at 20
determining capital requirements for the
the capital adequacy of bank holding
percent. The current delta for this position is companies (banking organizations).121The
market risk exposure of bank holding
according to the Black-Scholes formula
principal objectives of this measure are to (i) companies (banking organizations).1For this
purpose, market risk is defined as the risk of
-0.721 (that is, the price of the option
make regulatory capital requirements more
losses in a banking organization’s on- and offchanges by -0.721 if the price of the
sensitive to differences in risk profiles among balance-sheet positions arising from
underlying moves by 1). The gamma is
banking organizations; (ii) factor off-balance- movements in market prices. The market
-0.0034 (that is, the delta changes by
sheet exposures into the assessment of
risks subject to these capital requirements are
-0.0034 from -0.721 to -0.7244 if the
capital adequacy; (iii) minimize disincentives those associated with debt and equity
price of the underlying moves by 1). The
instruments held in the banking
to holding liquid, low-risk assets; and (iv)
current value of the option is 65.48.
achieve greater consistency in the evaluation organization’s trading account, as well as
b. The first step under the delta-plus
foreign exchange risk and commodities risk
of the capital adequacy of major banking
method is to multiply the market value of the organizations throughout the world.
throughout the organization, including
options and other derivative contracts in
commodity by the absolute value of the delta.
The risk-based capital guidelines include
each risk category.
500 x 0.721 = 360.5. The delta-weighted
both e definition of capital and a framework
2. Effective December 31,1997, the market
position is then incorporated into the
for calculating weighted risk assets by
risk measure will be applied to all bank
measure described in section IV.D. of this
assigning assets and off-balance-sheet items
holding companies that, on a consolidated
Appendix E. If the bank uses the maturity
to broad risk categories.2An institution’s
basis:
approach and no other positions exist, the
risk-based capital ratio is calculated by
a. Have total assets in excess of $5 billion;
delta-weighted position is multiplied by 0.15 dividing its qualifying capital (the numerator and have a total volume of trading activities
to calculate the capital requirement for delta. of the ratio) by its weighted risk assets (the
(measured as the sum of the banking
360.5 x 0.15 = 54.075.
organization’s trading assets and liabilities 2
denominator).3*The definition of qualifying
c. The capital requirement for gamma is
capital is outlined below in section II. of this on a daily average basis for the quarter) that
is 3.0 percent or more of the total assets of
calculated according to the Taylor expansion appendix A, and the procedures for
the banking organization, or have interest
by multiplying the absolute value of the
calculating weighted risk assets are discussed rate, foreign exchange, equity, and
assumed gamma of -0.0034 by 1.125% and
in section III. of this appendix A. Attachment commodity off-balance-sheet derivative
by the square of the market value of the
I to this appendix A illustrates a sample
contracts relating to trading activities whose
underlying. -0.0034 x 0.0125 x 5002 =
calculation of weighted risk assets and the
total notional amounts exceed $5 billion; or
10.625.
risk-based capital ratio.
b. Have total assets of $5 billion or less;
d. The capital requirement for vega is
*
*
*
*
*
and have trading activities exceeding 10.0
calculated next. The assumed current
percent of the total assets of the banking
(implied) volatility is 20%. Since only an
3.
In Part 225 a new appendix E is
organization.
increase in volatility carries a risk of loss for added to read as follows:
3. Such banking organizations are still
a short call option, the volatility has to be
subject to the risk-based capital measure set
forth in appendix A of this part, subject to
increased by a relative shift of 25%. This
1 Some banking organizations are also subject to
the exclusion of certain assets specified in
means that the vega capital requirement has
capital requirements for market risk as set forth in
this appendix E. However, these banking
to be calculated on the basis of a change in
organizations must calculate their market
volatility of 5 percentage points from 20% to appendix E of this part. Banking organizations that
subject to the market risk measure ara required
risk-equivalent assets and determine risk25% in this example. According to the Black- are
to follow the guidelines set forth in appendix E of
based
capital ratios adjusted for market risk
Scholes formula used here, the vega equals
this part for determining qualifying and eligible
in accordance with this appendix E.3
168. Thus, a 1% or 0.01 increase in volatility capital, calculating market risk-equivalent assets
4. The market risk measure provides two
increases the value of the option by 1.68.
and adding them into weighted-risk assets, and
ways for a banking organization to determine
Accordingly, a change in volatility of 5
calculating risk-based capital ratios adjusted for
its exposure to market risk. A banking
percentage points increases the value of 5 x
market risk. Supervisory ratios that relate capital to
organization may use its internal risk
1.68 = 8.4. This is the capital requirement for total assets for bank holding companies are outlined measurement model, subject to the
in appendices B and D of this part.
vega risk. The total capital requirement
conditions and criteria set forth in section Iff.
2The risk-based capital measure is based upon a
would be $73.10 (54.075 + 10.625 + 8.4).
of this appendix E (referred to as the internal
framework developed jointly by supervisory
models approach), or when appropriate, a
PART 225— BANK HOLDING
COMPANIES AND CHANGE IN BANK
CONTROL (REGULATION Y)

1. The authority citation for part 225
continues to read as follows:
Authority: 12 U.S.C. 1817(j)(13), 1818,
1828(o), 1831i, 1831p-l, 1843(c)(8), 1844(b),
1972(1), 3106, 3108, 3310, 3331-3351, 3907,
and 3909.
2. In part 225, appendix A to part 225
is amended by revising the first and
second paragraphs of section I. to read
as follows:




authorities from the countries represented on the
Basle Committee on Banking Regulations and
Supervisory Practices (Basle Supervisors’
Committee) and endorsed by the Group of Ten
Central Bank Governors. The framework is
described in a paper prepared by the Basle
Supervisors’ Committee entitled “International
Convergence of Capital Measurement,” July 1988.
*Banking organizations generally are expected to
utilize period-end amounts in calculating their riskbased capital ratios. When necessary and
appropriate, j-atios based on average balances may
also be calculated on a case-by-case basis.
Moreover, to the extent banking organizations have
data on average balances that can be used to
calculate risk-based ratios, the Federal Reserve will
take such data into account

1The market risk measure is based on a
framework developed jointly by supervisory
authorities from the countries represented on the
Basle Committee on Banking Supervision (Basle
Supervisors Committee) and endorsed by the Group
of Ten Central Bank Governors. The framework is
described in a paper prepared by the Basle
Supervisors Committee entitled “(Proposal to issue
a) Supplement to the Basle Capital Accord to Cover
Market Risks." (April) 1995.
2 As reflected in the Consolidated Financial
Statements for Bank Holding Companies (FR Y-9C
Report).
3The Federsl Reserve may apply all or portions
of this appendix E to other banking organizations
when deemed necessary for safety and soundness
purposes.

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
banking organization may use all or portions
of the alternative measurement system •
described in section IV. of this appendix E
(referred to as the standardized approach).
a. With prior approval from the Federal
Reserve, for regulatory capital purposes, a
banking organization may use its internal risk
measurement model to measure its value-atrisk4 for each of the following risk factor
categories; interest rates, exchange rates,
equity prices, and commodity prices. The
value-at-risk amount for each risk factor
category should include volatilities of related
options. The value-at-risk amount for each
risk factor category is summed to determine
the aggregate value-at-risk for the banking
organization.
b. The standardized approach uses a set of
standardized calculations and assumptions to
measure market risk exposure depending on
its source; debt instruments, equities, foreign
currencies, and commodities, including
volatilities of related options.
5. The Board generally expects any banking
organization that is subject to the market risk
measure, especially those with large trading
accounts, to comply with the measure by
using internal risk-measurement models. A
banking organization may not change its
measurement approach for the purpose of
minimizing capital requirements. In limited
instances, on a case-by-case basis, the Federal
Reserve may permit a banking organization
that has internal models to incorporate risk
measures of negligible exposures, for
example, de minimis positions, activities in
remote locations, minor exposures in a
currency, or activities that present negligible
risk to the banking organization, in an
alternative manner, so long as it adequately
captures the risk.
6. The risk-based capital ratios adjusted for
market risk determined in accordance with
this appendix E are minimum supervisory
-ratios. Banking organizations generally are
expected to operate with capital positions
well above the minimum ratios. In all cases,
banking organizations should hold capital
commensurate with the level and nature of
the risks to which they are exposed.
7. The Federal Reserve will monitor the
implementation and effect of these guidelines
in relation to domestic and international
developments in the banking industry. When
necessary and appropriate, tie Board will
considerthe need to modify this appendix E
in light of any significant changes in the
economy, financial markets, banking
practices, or other relevant factors.
B. Market Risks Subject to a Capital
Requirement.
1. General Market Risk and Specific Risk.
A banking organization must hold capital
against exposure to general market risk and
specific risk arising from its trading and other
4
A banking organization evaluates its current
positions and estimates future market volatility
through a value-at-risk measure, which is an
estimate representing, with a certain degree of
statistical confidence, the maximum amount by
which the market value of trading positions could
decline during a specific period of time. The valueat-risk is generated through an internal model that
employs a series of market risk factors (for example,
market rates and princes that affect the value of
trading positions).




38117

foreign exchange and commodity'activities.
risk for the off- balance-sheet portion of the
transaction as set forth in section III.D. of
For this purpose, general market risk refers
appendix A of this part.
to changes in the market value of covered
c. Equities in the trading account are equity
transactions resulting from market
instruments that behave like equities. The
movements, such as changing levels of
market interest rates, broad equity indices, or instruments covered include common stocks
(whether voting or non-voting), convertible
currency exchange rates. Specific risk refers
securities that behave like equities, and
to credit risk, that is, the risk that the issuer
commitments to buy or sell equity securities.
of a debt or equity instrument might default,
Also included are derivative contracts of
as well as to other factors that affect the
market value of specific instruments but that equity instruments and other off-balancesheet instruments in the trading account that
do not materially alter market conditions.3
2.
Trading Activities, a. The general marketare affected by changes in equity prices.
risk and specific risk capital requirements for However, non-convertible preferred stock is
included in debt instruments.
trading activities are based on on- and off3.
Foreign Exchange and Commodities
balance-sheet positions in a banking
Risk. Foreign exchange or commodities
organization’s trading account. For this
positions, whether or not included in a
purpose, trading account means positions in
banking organization’s trading account, are
financial instruments acquired with the
subject to a capital requirement for the
intent to resell in order to profit from short­
market risk of those positions.
term price movements (or other price or
a. The capital requirement for foreign
interest-rate variations), including, but not
exchange risk applies to a banking
limited to:
organization's total currency and gold
i. Assets acquired with the intent to resell
positions. This includes spot positions (that
to customers;
is, asset items and liability items, including
ii. Positions in financial instruments
arising from matched principal brokering and accrued interest and expenses, denominated
in each currency); forward positions (that is,
market making; or
iii. Positions taken in order to hedge other forward foreign exchange transactions,
including currency futures and the principal
elements of the trading account (that is,
on currency swaps not included in the spot
reduce risk by offsetting other positions that
position); and certain guarantees. It includes
have exposure to changes in market rates or
future income and expenses from foreign
prices).*6 Trading activities may include
currency transactions not yet accrued but
positions in debt instruments, equities,
already fully.hedged (at the discretion of the
foreign currencies, and commodity
reporting bank), foreign exchange derivative
instruments, or related derivative 7*or other
and other off-balance-sheet positions that are
off-balance-sheet contracts.
affected by changes in exchange rates, and
b. Debt instruments in the trading account
any other item representing a profit or loss
are all fixed-rate and floating-rate debt
in foreign currencies.
securities and instruments that behave like
b. A banking organization may, subject to
debt, including non-convertible preferred
stock. Convertible bonds, i.e., preferred stock approval by the Federal Reserve, exclude
or debt issues that are convertible, at a stated from its foreign exchange positions any
structural positions in. foreign currencies. For
price, into common shares of the issuer,
this purpose, such structural positions are
should be treated as debt instruments if they
trade like debt instruments and as equities if limited to transactions designed to hedge a
hanking organization’s capital ratios against
they trade like equities. Also included are
the effect of adverse exchange rate
.derivative contracts of debt instruments and
movements on subordinated debt, equity, or
other off-balance-sheet instruments in the
minority interests in consolidated
trading account that react to changes in
subsidiaries and dotation capital assigned to
interest rates. A security that has been sold
foreign branches that are denominated in
subject to a repurchase agreement or lent
foreign currencies. Also included are any
subject to a securities lending agreement is
positions related to unconsolidated
treated as if it were still owned by the lender subsidiaries
and to other items that are
of the security. Such transactions remain
deducted
from
a banking organization’s
subject to the capital requirements for credit
capital when calculating its capital base. In
any event, such structural foreign currency
9 This Appendix E does not impose specific risk
positions must reflect long-term policies of
capital requirements for foreign exchange risk and
the institution and not relate to trading
commodities positions because they do not have the
positions.
type of issuer-specific risk associated with debt and
c. A banking, organization doing negligible
equity instruments in the trade account.
business in foreign currency and that does
6 At a banking organization’s option, when non­
not take foreign exchange positions for its
trading account instruments are hedged with
own account may be exempted from the
instruments in the trading account, on- or offbalance-sheet, the non-trading account instruments
capital requirement for foreign exchange risk
may be included in the measure for general market
provided that:
risk. Such non-trading account instruments remain
i. Its foreign currency business, defined as
subject to the credit risk capital charges of appendix the greater of the sum of its gross long
A of this part.
positions and the sum of its gross short
7In general terms, a derivative is a financial
positions in all foreign-currencies, does not
contract whose value is derived from the values of
exceed 100 percent of eligible capital as
one or more underlying assets or reference rates or
defined in section II. of this appendix E; and
indexes of asset values (referred to as “the
ii. Its overall net open foreign exchange
underlying”). Derivatives include standardized
position as determined in section IV.C.2. of
contracts that are traded on exchanges and
customized, privately negotiated contracts known
this appendix E does not exceed 2.0 percent
as over-the-counter (OTC) derivatives.
of its eligible capital.

38118

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

II. Qualifying Capital and the Market Riskd.
The capital requirement for commoditiesother derivative positions in each risk
Adjusted Capital Ratio
risk applies to a banking organization’s total
category as set forth in sections IV.A to IV.E.
commodities positions, including commodity of this appendix E.9
A. Qualifying and Eligible Capital
futures, commodity swaps, and all other
4. Partial models, a. With approval from
1. The principal forms of qualifying capital
commodity derivatives or other off-balancethe Federal Reserve, a banking organization
for market risk are Tier 1 capital and Tier 2
sheet positions that are affected by changes
whose internal model does not cover all risk capital as defined in section n. of appendix
in commodity prices. A commodity is
factor categories may use the standardized
A of this part and subject to the conditions
defined as a physical product that is or can
and limitations of appendix A of this part. A
approach to measure market risk exposure
be traded on a secondary market (such as
arising from the risk factor categories that are banking organization may use Tier 3 capital
agricultural products, minerals (including
for the sole purpose of meeting a portion of
oil), and precious metals), but excluding gold not covered. The Federal Reserve will
approve combining the two approaches only the capital requirements for market risk.10*
(which is treated as foreign exchange).
2. Tier 3 capital consists of short-term
on a temporary basis in situations where the
C. Capital Requirements
subordinated debt that is subject to a lock-in
banking organization is developing, but has
clause providing that neither interest nor
1. Capital Requirements. The minimum
not fully implemented, a comprehensive
principal payment is due (even at maturity)
capital requirement for a bank holding
value-at-risk measurement system. When a
if such payment would cause the issuing ■
company subject to the market risk measure
banking organization uses both approaches,
banking organization to fall or remain below
is the sum of:
the minimum 8.0 percent risk-based capital
a. The capital requirement for credit risk as each risk factor category (that is, interest
requirement as set forth in appendix A of this
rates, exchange rates, equity prices, and
. determined in accordance with appendix A
part and adjusted for market risk.
commodity prices) must be measured using
of this part, excluding debt and equity
3. In order to qualify as Tier 3 capital, the
instruments in the trading book and positions one or the other approach. The methods may
short-term debt must be unsecured,
in commodities, but including the
not be combined within a risk factor
counterparty credit risk requirements on all
category. Once a banking organization adopts subordinated, and fully paid up; it must have
an original maturity of at least two years; and
over-the-counter derivative activities whether an acceptable value-at-risk model for a
it may not be redeemed before maturity
in the banking organization’s trading account particular risk factor category, it may not „
without prior approval by the Federal
or not; and
revert to the standardized approach except in Reserve. In addition, it may not contain or be
b. The capital requirement for market risk
unusual circumstances and with prior
covered by any covenants, terms, or
as determined by the internal models
approval of the Federal Reserve.
restrictions that are inconsistent with safe
approach, the standardized approach, or a
and sound hanking practices.
b. For a banking organization using a
combination of the two approaches deemed
4. Eligible Tier 3 capital may not exceed
combination of approaches, the capital
to be appropriate by the Federal Reserve.
250 percent of a banking organization’s Tier
requirement for market risk is the sum of (i)
2. Internal Models, a. For a banking
1 capital allocated for market risk and the
the appropriate value-at-risk amount (as
organization approved to use the internal
maximum eligible amount of Tier 2 and Tier
models approach, the capital requirement for determined under section I.C.2.a. of this
3 capital together is limited to 100 percent of
market risk is the higher of:
appendix E, aggregating the value-at-risk
1 capital. (Examples of how to calculate
i. The banking organization’s previous
amount for each risk factor category included Tier
these limits are set forth in Attachment I to
day’s aggregate value-at-risk amount
in the internal model), and.(ii) the capital
this appendix E.) Tier 2 elements may be
calculated subject to certain supervisory
requirement for each risk category that is
substituted for Tier 3 up to the same limit of
requirements set forth in section HI. of this
calculated using the standardized approach.
250 percent, so long as the overall limits for
appendix E; or
5. Application. The capital requirements
Tier 2 capital set forth in appendix A of this
ii. An average of the daily aggregate valuefor market risk apply to bank holding
part are.not exceeded, that is, Tier 2 capital
at-risk amounts, calculated subject to the
may not exceed total Tier 1 capital, and long­
companies on a worldwide consolidated
same restrictions, measured on each of the
term subordinated debt may not exceed 50
basis. The Federal Reserve may, however,
preceding sixty (60) business days,
percent of Tier 1 capital.
evaluate market risk on an unconsolidated
multiplied by a minimum “multiplication
basis when necessary. For example, when
factor” of three (3).8
B. Calculation of Eligible Capital and the
Capital Ratio
b. A banking organization approved to use there are obstacles to the repatriation of
the internal models approach may also be
profits from a foreign subsidiary or where
1. In order to calculate eligible capital, a
subject to a separate capital requirement for
management structure does not allow timely banking organization must first calculate its
specific market risk of traded debt and equity management of risk on a consolidated basis.
minimum capital requirement for credit risk
instruments to the extent that the specific
6. Other Considerations. All transactions,
in accordance with appendix A of this part
market risk-associated with these instruments including forward sales and purchases,
and then its capital requirement for market
is not captured by the banking organization’s should be included in the calculation of
risk. Eligible capital is the sum of the hanking
models. However, for all banking
organization’s qualifying Tier 1 capital, its
market
risk
capital
requirements
from
the
organizations using internal models, the total
qualifying Tier 2 capital subject to the limits
specific risk charge should in no case be less date on which they were entered into. The
stated above, and its eligible Tier 3 capital
Federal Reserve expects banking
than one-half the specific risk charges
subject to the conditions set out under
organizations to meet their capital
calculated according to the standardized
section II. of this appendix E.
requirements for market risk on a continuous
approach.
2. A banking organization that is subject to
basis (that is, at a minimum, at the close of
3. Standardized approach. A banking
the market risk measure must calculate its
each business day).
organization whose model has not been
risk-based capital ratios as follows:
approved by the Federal Reserve must use
a.
Determine total weighted-risk assets
the standardized approach for measuring its
•Section IV.E. provides several alternatives for
using the procedures and criteria set forth in
market risk. For a hanking organization using measuring the market risk of options. Under two of appendix A of this part, excluding debt and
this approach, tBe capital requirement for
the alternatives, the simplified and scenario
equity instruments in the trading book and
market risk is the sum of the market risk
methods, the underlying position of an option is
positions in commodities, but including all
“carved-out,” and is not included in the prescribed
capital requirement for debt and equity
over-the-counter derivative activities whether
risk measure for the underlying. Instead it is
instruments in the trading account, foreign
in the banking organization’s trading account
evaluated
together
with
the
related
option
exchange and commodities risk throughout
or not.
according to the procedures described for options
the banking organization, and options and
to determine the capital requirement Under the
•The Federal Reserve may adjust the
multiplication factor for a banking organization to
increase its capital requirement based on an
assessment of the quality and historic accuracy of
the banking organization’s risk management system.




third alternative, the “delta-plus” approach, the
delta-equivalent value of each position is included
in the measurement framework for the appropriate
risk category (that is, debt or equity instruments in
the trading account, foreign exchange or
commodities risk).

10 A banking organization may not use Tier 3
capital to satisfy any capital requirements for
counterparty credit risk under appendix A of this
part, including counterparty credit risk associated .
with derivative transactions in either the trading or
non-trading accounts.

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
b. Calculate the measure for market risk
using the internal models approach, the
standardized approach, or an approved
combination of these two approaches.
c. Multiply the measure for market risk by
12.5 (i.e., the reciprocal of the 8.0 percent
m inim um ' risk-based capital ratio). The
resulting product is referred to as “market
risk-equivalent assets.'’
d. Add market risk-equivalent assets to the
weighted-risk assets compiled for credit risk
purposes (section n.B.2.a. of this appendix
E). The sum of these two amounts is the
denominator of the risk-based capital ratios
adjusted for market risk. The numerator of
the total risk-based capital ratio is eligible
capital and the numerator of the Tier 1 riskbased capital ratio is Tier 1 capital.
m. The Internal Models Approach
A. Use of Models
1. With prior approval of the Federal
Reserve, a banking organization may use its
internal risk measurement model(s) for
purposes of measuring value-at-risk and
determining the associated regulatory capital
requirements for market risk exposure.
a. Requests for approval under section
QI.A.1. of this appendix E should include, at
a minimum, a complete description of the
hanking organization’s internal modeling and
risk management systems and how these
systems conform to the criteria set forth in
this section ED., an explanation of the policies
and procedures established by the banking
organization to ensure continued compliance
with such criteria, a discussion of internal
and external validation procedures, and a
description of other relevant policies and
procedures consistent with sound practices.
b. The Federal Reserve will approve an
internal model for regulatory capital
purposes only after determining that the
banking organization’s internal model and
risk management systems meet the criteria in
section m. of this appendix E. Such a
determination may require on-site
examinations of the systems. The Federal
Reserve may require modification to an
internal model as deemed necessary to
ensure compliance, on a continuing basis,
with the provisions of this appendix E. A
banking organization’s internal model will be
subject to continuing review, both on-and off­
site, by the Federal Reserve.11
2. A banking organization should ensure
that the level of sophistication of its internal
model is commensurate with the nature and
volume of the banking organization’s trading
activity in the risk factor categories covered
by this appendix E and measures market risk
as accurately as possible. In addition, the
model should be adjusted to reflect changing
portfolio composition and changing market
conditions.
B. Qualitative Criteria
1.
A banking organization using the
internal models approach should have
market risk management systems that are

conceptually sound and implemented with
integrity. Internal risk measurement models
must be closely integrated into the day-to-day
risk management process of the banking
organization. For example, the risk
measurement model must be used in
conjunction with internal trading and
exposure limits.
2.
A banking organization must meet the
following minimum qualitative criteria
before using its internal model to measure its
exposure to market risk.12
a. A banking organization must have a risk
control unit that is independent from
business trading units and reports directly to
senior management of the banking
organization. The unit must be responsible
for designing and implementing the banking
organization’s risk management system and
analyzing daily reports on the output of the
banking organization’s risk measurement
model in the context of trading limits. The
unit must conduct regular back-testing.13
b. Senior management must be actively
involved in the risk control process. The
daily reports produced by the risk
management-unit must be reviewed by a
level of management with sufficient authority
to enforce both reductions in positions taken
by individual traders, as well as in the
banking organization’s overall risk exposure.
c. The banking organization must have a
routine and rigorous program of stresstesting14 to identify the effect of lowprobability events on the banking
organization’s trading portfolio. Senior
management must routinely review the
results of stress-testing in the context of the
potential effect of the events on bank capital
and the appropriate procedures the banking
organization should take to minimize losses.
The policies of the banking organization set
by management and the board of directors
should identify appropriate stress-tests and
the procedures to follow in response to the
test results.
d. The banking organization must have
established procedures for ensuring
compliance with a documented set of
internal policies and controls, as well as for
monitoring the overall operation of the risk
measurement system.
e. Not less than once a year, the hanking
organization must conduct, as part of i{s
regular internal audit process, an
independent review of the risk measurement
system. This review must include both the
activities of the business trading units and of
the independent risk control unit of the
banking organization.
f. Not less than once a year, the banking
organization must conduct a review of its

12If the Federal Reserve is not satisfied with the
extent to which a banking organization meets these
criteria, the Federal Reserve may adjust the
multiplication factor used to calculate market risk
capital requirements or otherwise increase capital
requirements.
13Back-testing includes ex post comparisons of
the risk measures generated by the model against
the actual daily changes in portfolio value.
11
Banking organizations that need to modify their 14Stress-testing should cover a range of factors
that can create extraordinary losses or gains in
existing modeling procedures to accommodate the
trading portfolios or make the control of risk in
requirements of this appendix £ should,
nonetheless, continue to use the internal models
those portfolios difficult. These factors include lowthey consider most appropriate in evaluating risks
probability events of all types, including the various
for other purposes.
components of market, credit, and operational risks.




38119

overall risk management process. The review
must consider
i. The adequacy of the documentation of
the risk management system and process and
the organization of the risk control unit;
ii. The integration of market risk measures
into daily risk management and the integrity
of the management information system;
iii. The process the banking organization
employs for approving risk pricing models
and valuation systems that are used by frontand back-office personnel;
iv. The scope of market risks captured by
the risk measurement model and the
validation of any significant changes in the
risk measurement process;
v. The accuracy and completeness of
position data, the accuracy and
appropriateness of volatility and correlation
assumptions, and the accuracy of valuation
and risk sensitivity calculations;
vi. The verification process the banking
organization employs to evaluate the
consistency, timeliness, and reliability of
data sources used to run internal models,
including the independence of such data
sources; and
vii. The verification process the banking
organization uses to evaluate back-testing,
that is conducted to assess the model’s
accuracy.
C. Market Risk Factors
1. Overview. For regulatory capital
purposes, a banking organization’s internal
risk meesurement system(s) must use
sufficient risk factors to capture the risks
inherent in the banking organization’s
portfolio of on- and off-balance-sheet trading
positions and must, subject to the following
guidelines, cover interest rates, equity prices,
exchange rates, commodity prices, and
volatilities related to options positions in
each risk factor category. The level of
sophistication of the banking organization’s
risk factors must be commensurate with the
nature and scope of the risks taken by the
banking organization.
2. Interest Rates, a. A banking organization
must use a set of market risk factors
corresponding to interest rates in each
currency in which it has material interest
rate-sensitive on- or off-balance-sheet
positions. The risk measurement system must
model the yield curve15*using one of a
number of generally accepted approaches, for
example, by estimating forward rates of zero
coupon yields. The yield curve must be
divided into various maturity segments in
order to capture variation in the volatility of
rates along the yield curve; there will
typically be one risk factor corresponding to
each maturity segment.
b. For material exposures to interest rate
movements in the major currencies and
markets, a banking organization must model
the .yield curve using a minimum of six risk
factors. However, the number of risk factors
used should ultimately be driven by the
“ Generally, a yield curve is a graph showing the
term structure of interest rates by plotting the yields
of all instruments of the same quality by maturities
ranging from the shortest to the longest available.
The resulting curve shows whether short-term
interest rates are higher or lower than long-term
interest rates.

38120

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

nature of the hanking organization’s trading
strategies.16 The risk measurement system
must incorporate separate risk factors to
capture spread risk.17
3. Exchange rates. A banking organization
must use market risk factors corresponding to
the exchange rate between the domestic
currency and each foreign currency in which
the banking organization has a significant
exposure. The risk measurement system must
incorporate market risk factors corresponding
to the individual foreign currencies in which
the hanking organization’s positions are
denominated.
4. Equity prices. A banking organization
must use risk factors corresponding to each
of the equity markets in which it holds
significant positions. The sophistication and
nature of the modeling technique for a'given
market must correspond to the banking
organization’s exposure to the overall market
as well as to the banking organization’s
concentration in individual equity issues in
that market. At a minimum, there must be a
risk factor designed to capture market-wide
movements in equity prices (such as a market
index), but additional risk factors could track
various sectors or individual issues.
5. Commodity prices. A banking
organization must use market risk factors
corresponding to each of the commodity
markets in which it holds significant
positions. The internal model must
encompass directional risk, forward gap and
interest rate risk, and basis risk.16 The model
should also take into account the market
characteristics, for example, delivery dates
and the scope provided to traders to close out
positions.
D. Quantitative Standards
1.
A hanking organization may use one of
a number of generally accepted measurement
techniques including, for example, an
internal model based on variance-covariance
matrices, historical simulations, or Monte
Carlo simulations so long as the model
employed captures all the material market
risks.19 The following minimum standards

apply for purposes of using an internal model positions that display option-like
characteristics. Banking organizations may
for calculating market risk capital
not scale-up the daily value-at-risk numbers
requirements:
by the square root of time.
a. Value-at-risk must be calculated on a
b. A banking organization's internal model
daily basis using a 99th percentile, one-tailed
confidence interval20 and the holding period must capture the volatilities of the rates and
must be ten trading days. For positions that
prices (that is, the vega) underlying option
display linear price characteristics, a banking positions and a banking organization should
organization may use value-at-risk numbers
measure the volatilities of the underlying
calculated according to shorter holding
instruments broken down by different option
periods scaled up to ten days by the square
maturities.
root of time.21
4.
The accuracy of a banking organization’s
b. Value-at-risk must be calculated using
internal model will be reviewed periodically
an observation period of at least one year to
by the Federal Reserve. Such review, during
measure historical changes in rates and
which, when appropriate, the Federal
prices.
Reserve may take into consideration reports
c. A banking organization must update its
and opinions generated by external auditors
historical rates and prices at least once every or qualified consultants, will include, at a
three months and must reassess them
minimum:
whenever market conditions change
a. Verification that the internal validation
materially.
processes described in section m.B.2. of this
2. A banking organization may use
appendix E are operating in a satisfactory
discretion in recognizing empirical
manner;
correlations within each market risk factor
b. Affirmation that the formulae used in
category.22*However, empirical correlations
the calculation process and for the pricing of
among risk categories are nbt recognized. The options and other complex instruments, are
value-at-risk measure for each risk category
validated by a qualified unit of the banking
must be added together on a simple sum
organization, which in all cases must be
basis to determine the aggregate value-at-risk independent from the trading areas;
amount.
c. Confirmation that the structure of the
3. A banking organization’s models must
internal model is adequate with respect to
accurately capture the unique risks
the banking organization’s activities and
associated with options within each of the
geographical coverage;
market risk factor categories. The following
d. Confirmation that the results of the
minimum criteria apply to the measurement
banking organization’s back-testing of its
of options risk:
internal measurement system (that is,
a. A banking organization’s internal model comparing value-at-risk estimates with actual
must capture the non-linear price
profits and losses) are being used effectively
characteristics of option positions using an
to monitor reliability of the model’s estimates
options pricing technique. The banking
over time; and
organization must apply a minimum ten-day
e. Affirmation that, for regulatory capital
holding period to option positions or
purposes, the model processes all relevant
data and that the modeling procedures
the risk factor sensitivities of the individual
conform with the parameters and
positions—derived from valuation models—with a
specifications set forth in this appendix E.
variance/covariance matrix based on risk factor

volatilities and correlations. A banking organization
using this approach would calculate the volatilities
and correlations of the risk factors on the basis of
the holding period and the observation period. A
18
For example, a banking organization that has abanking organization using a historical simulation
would calculate the hypothetical change in value of
portfolio of various types of securities across many
the current portfolio in the light of historical
points of the yield curve and that engages in
complex arbitrage strategies would require a greater movements in risk factors. This calculation would
be doneJor each of the defined holding periods
number of risk factors to accurately capture interest
over a given historical measurement horizon to
rate risk.
arrive at a range of simulated profits and losses. A
17 Spread risk refers to the potential changes in
banking organization using a Monte Carlo technique
value of an instrument or portfolio arising from
would consider historical movements to determine
differences in the behavior of baseline yield curves,
such as those for U.S. Treasury securities, and yield the probability of particular price and rate changes.
curves reflecting sector, quality, or instrument
20A one-tailed confidence interval of 99 percent
specific factors. A variety of approaches may be
means that there is a 1 percent probability based on
used to capture the spread risk arising from less
historical experience that the combination of
than perfectly correlated movements between
positions in a banking organization’s portfolio
government and other interest rates, such as
would result in a loss higher than the measured
specifying a completely separate yield curve for
value-at-risk.
non-government instruments (for example, swaps or
21 This transformation entails multiplying a
municipal securities) or estimating the spread over
banking organization’s value-at-risk by the square
government rates at various points along the yield
root of the ratio of the required holding period (ten
curve.
days) to the holding period embodied in the valueat-risk figure. For example, the value-at-risk
18Directional risk is the risk that a spot price will
calculated according to a one-day holding period
increase or decrease. Forward gap risk refers to the
effects of owning a physical commodity versus
would be scaled-up by the “square root of time’’ by
owning a forward position in a commodity. Interest
multiplying the value-at-risk by 3.16 (the square
rate risk is the risk of a change in the cost of
root of the ratio of a ten-day holding period to a
carrying forward positions and options. Basis risk
one-day holding period).
is the risk that the relationship between the prices
22 While a banking organization has flexibility to
of similar commodities changes over time.
use correlations, the Federal Reserve must be
19In a variance/covariance approach, the change
satisfied that there is integrity in the banking
in value of the portfolio is calculated by combining
organization's process for calculating correlations.




IV. The Standardized Approach
A. Debt Instruments
1.
Specific Risk. a. The capital requirement
for specific risk is based on the identity of
the obligor and, in the case of corporate
securities, on the credit rating and maturity
of the instrument. The specific risk capital
requirement is calculated by weighting the
current market value of each individual
position, whether long or short, by the
appropriate category factor as set forth below
and summing the weighted values. In
measuring specific risk, the banking
organization may offset and exclude from its
calculations any matched positions in the
identical issue (including positions in
derivatives). Even if the issuer is the same,
no offsetting is permitted between different
issues since differences in coupon rates,
liquidity, call features, etc., mean that prices
may diverge in the short run. The categories
and factors are:
Category
Government ...
Qualifying ......

Remaining ma­
turity [contrac­
tual]
N/A ..............
6 months or
less.

Factor
[In per­
cent]
0.00
0.25

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

Category

Other ............

Remaining ma­
turity [contrac­
tual]
6 to 12 months
over 12 months
N/A ..............

Factor
[In per­
cent]
V.00
1.60
8.00

b. The government category includes all
forms of debt instruments of central
governments of the OECD-based group of
countries23 including bonds, Treasury bills
and other short-term instruments, as well as
local currency instruments of non-OECD
central governments to the extent that the
subsidiary depository institutions have
liabilities booked in that currency.
c. The qualifying category includes
securities of U.S. government-sponsored
agencies, general obligation securities issued
by states and other political subdivisions of
the OECD-based group of countries,
multilateral development banks, and debt
instruments issued by U.S. depository
institutions or OECD-banks that do not
qualify as capital of the issuing institution.24
It also includes other securities, including
revenue securities issued by states and other
political subdivisions of the OECD-based
group of countries, that are rated investmentgrade by at least two nationally recognized
credit rating services, or rated investmentgrade by one nationally recognized credit
rating agency and not less than investmentgrade by any other credit rating agency, or,
with the exception of securities issued by
U.S. firms and subject to review by the
Federal Reserve, unrated but deemed to be of
comparable investment quality by the
reporting banking organization and the issuer
has securities listed on a recognized stock
exchange.

“disallow” part of the previous full netting
to address basis and yield curve risk.
c. For each currency in which a banking
organization has significant positions, a
separate capital requirement must be
calculated. No netting of positions is
permitted across different currencies.
Offsetting positions of the same amount in
the same issues, whether actual or notional,
may be excluded from the calculation, as
well as closely matched swaps, forwards,
futures, and forward rate agreements (FRAs)
that meet the conditions set out in section
IV.A.3. of this appendix E.
d. In the maturity method, the banking
organization distributes each long or short
position (at current market value) of a debt
instrument into the time bands of the
maturity ladder. Fixed-rate instruments are
allocated according to the remaining term to
maturity and floating-rate instruments
according to the next repricing date. A
callable bond trading above par is slotted
according to its first call date, while a
callable bond priced below par is slotted
according to remaining maturity. Fixed-rate
mortgage-backed securities, including
collateralized mortgage obligations (CMOs)
and real estate mortgage investment conduits
(REMICs), are slotted according to their
expected weighted average lives.
e. Once all long and short positions are
slotted into the appropriate time band, the
long positions in each time-band are summed
and the short positions in each time-band are
summed. The summed long and/or short
positions are multiplied by the appropriate
risk-weight factor (reflecting the price
sensitivity of the positions to changes in
interest rates) to determine the risk-weighted
long and/or short position for each timeband. The risk weights for each time-band are
set out in Table I below:

d. The other category includes debt
securities not qualifying as government or
qualifying securities. This would include
non-OECD central government securities that
do not meet the criteria for the government
or qualifying categories. This category also
includes instruments that qualify as capital
issued by other banking organizations.
e. The Federal Reserve will consider the
extent of a banking organization’s position in
non-investment grade instruments
(sometimes referred to as high yield debt). If
those holdings are not well-diversified or
otherwise represent a material position to the
institution, the Federal Reserve may prevent
a banking organization from offsetting
positions in these instruments with other
positions in qualifying instruments that may
be offset when calculating its general market
risk requirement In addition, the Board may
impose a specific risk capital requirement as
high as 16.0 percent.
2.
General Market Risk. a. A banking
organization may measure its exposure to
general market risk using, on a continuous
basis, either the maturity method (which uses
standardized risk weights that approximate
the price sensitivity of various instruments)
or the duration method (where the institution
calculates the precise duration of each
instrument, weighted by a specified change
in interest rates).
b. Both methods use a maturity-ladder that
incorporates a series of “time-bands” and
“zones” to group together securities of
similar maturities and that are designed to
take into account differences in price
sensitivities and interest rate volatilities
across different maturities. Under either
method, the capital requirement for general
market risk is the sum of a base charge that
results from fully netting various riskweighted positions and a series of additional
charges (add-ons), which effectively

T a b l e I.— M a t u r it y M

etho d:

T im e -B a n d s

and

W

e ig h t s

Coupon less than 3% and zero coupon bonds

1
2
3

Up to 1 m onth.... .
1 up to 3 months ..
3 up to 6 months ..
6 up to 12 months
1 up to 2 years .....
2 up to 3 years .....
3 up to 4 years .....
4 up to 5 years .....
5 up to 7 years ...
7 up to 10 years ...
10 up to 15 years
15 up to 20 years
Over 20 years ...*...

Up to 1 m onth......
1 up to 3 months ....
3 up to 6 months ....
6 up to 12 months ..
1 up to 1.9 years ....
1.9 up to 2.8 years .
2.8 up to 3.6 years .
3.6 up to 4.3 years .
4.3 up to 5.7 years .
5.7 up to 7.3 years .
7.3 up to 9.3 years .
9.3 up to 10.6 years
10.6 up to 12 years
12 up to 20 years ...
Over 20 y e a rs......

38121

Risk
weights
[percent]

0.00
0.20
0.40
0.70
1.25
1.75
2.25
2.75

325
3.75
4.50
5.25
6.00

8.00
12.50

f.
Within each time-band for which there are then netted, resulting in a single net risk- different maturities may be included and
are risk-weighted long and short positions,
weighted long or short position for each time- netted within each time, a capital
the risk-weighted long and short positions
band. Since different instruments and
requirement, referred to as the vertical
23
The OECD-based group of countries is defined 24 U.S. government-sponsored agencies,
multilateral development banks, and OECD banks
in section m.B.1 of appendix A of this part.
are defined in section m.C.2. of appendix A of this
part.




38122

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

disallowance, is assessed to allow for basis
risk. The vertical disallowance capital
requirement is 10.0 percent of the position
eliminated by the intra-time-band netting,
that is, 10.0 percent of the smaller of the net
risk-weighted long or net risk-weighted short
position, or if the positions are equal, 10.0
percent of either position.25 The vertical
disallowances for each time-band are
absolute values, that is, neither long nor
short. The vertical disallowances for all timebands in the maturity ladder are summed and
included as an element of the general market
risk capital requirement
g.
Within each zone for which there are
risk-weighted long and short positions in
different time-bands, the weighted long and
short positions in all of the time-bands
within the zone are then netted, resulting in
a single net long or short position for each
zone. Since different instruments and

different maturities may be included and
netted within each zone, a capital
requirement, referred to as the horizontal
disallowance, is assessed to allow for the
imperfect correlation of interest rates along
the yield curve. The horizontal disallowance
capital requirement is calculated as a
percentage of the position eliminated by the
intra-zone netting, that is, a percentage of the
smaller of the net risk-weighted long or net
risk-weighted short position, or if the
positions are equal, a percentage of either
position.26 The percent disallowance factors
for intra-zone netting are set out in Table Q
in section IV.A.2.h. of this appendix E. The
horizontal disallowances, like the vertical
disallowances, are absolute values that are
summed and included as an element of the
general market risk capital requirement.
h.
Risk-weighted long and short positions
in different zones are then netted between

the zones. Zone 1 and zone 2 are netted if
possible, reducing or eliminating the net long
or short position in zone 1 or zone 2 as
appropriate. Zone 2 and zone 3 are then
netted if possible, reducing or eliminating the
net long or short position in zone 2 or zone
3 as appropriate. Zone 3 and zone 1 are then
netted if possible, reducing or eliminating the
long or short position in zone 3 and zone 1
as appropriate. A horizontal disallowance
capital requirement is then assessed,
calculated as. a percentage of the position
eliminated by the inter-zone netting. The
horizontal disallowance capital requirements
for each zone are then summed as absolute
values and included in the general market
risk capital charge. The percent disallowance
factors for inter-zone netting are set out in
Table II below:

Table I I — Horizontal Disallowances

1

2

3

Between
zones 1-3

Time-band

Within the zone

0-1 m onth..................................
1-3 months.
3-6 months.
6-12 months.
1-2 y e a rs...................................
2 - 3 years.
3 - 4 years.
1-5 years.
5-7 years.
7-10 years.
10-15 years.
15-20 years.
Over 20 years.

40 percent...................................

4(1 percent .......

......................

100 percent

30 percent...................... ............

40 percent.................... ..............

100 percent

30 percent........................ .........

40 percent..................................

100 percent

Zone

Between adjacent zones

i. Finally, the net risk-weighted long or net
risk-weighted short positions remaining in
the zones are summed to reach a single net
risk-weighted long or net risk-weighted short
position for the banking organization’s
portfolio. The sum of the absolute value of
this position and the vertical and horizontal
disallowances is the capital requirement for
general market risk. An example of the
calculation of general market risk under the
maturity method is in Attachment II to this
appendix E.
j. In the duration method, the banking
organization, after calculating each
instrument’s modified duration27 using a
formula that is subject to supervisory review,
multiplies that modified duration by the
interest rate shock specified for an
instrument of that duration in Table III in
section IV.A.2.L of this appendix E. The
resulting product (representing the expected
percentage change in the price of the

instrument for the given interest rate shock)
Table III— Duration M ethod: T imeis then multiplied by the current market
Bands and Assumed Changes in
value of the instrument The resulting
Y ield
amount is then slotted as a long or short
position into a time-band in the maturity
Assumed
ladder in Table m on the basis of the
Zone
Time-band
change in
instrument’s modified duration.28*
yield
k.
Once all of the banking organization’s
traded debt instruments have been slotted
1 ...... Up to 1 month__
1.00
into the maturity ladder, the banking
1 up to 3 months ___
1.00
organization conducts the same rounds of
3 up to 6 m onth s___
1.00
netting and disallowances described in
6 up to 12 m onths...
1.00
sections IV.A.2.f. through IV.A.2.h: of this
0.90
appendix E for the.maturity method, with the 2 ..... 1.0 eg) to 1.8 years ....
1.8 up to 2.6 years ....
0.80
exception that the vertical disallowance
2.6 up to 3.3 years ....
0.75
requirement for the duration method is 5.0
3 ...... 3.3 up to 4.0 years ....
0/75
percent (horizontal disallowances continue
4.0 up to 5.2 years ....
0.70
to be those set out in Table II).20 As with the
5.2 up to 6.8 years ....
0.65
maturity method, the sum of the absolute
6.8 up to 8.6 years ....
value of the final net position and the vertical
0.60
and horizontal disallowances is the general
8.6 up to 9.9 years :...
0.60
market risk capital requirement:
9.9 up to 11.3 yrs ....
0.60

25 For example, if the sum of the weighted longs
in a time-band is $100 million and the sum of the
weighted shorts is $90 million, the vertical
disallowance for the time-band is 10.0 percent of
$90 million, or $9 million.
28For example, if the sum of the weighted longs
in the 1-3 month time-band in Zone 1 is $8 million
and the sum of the weighted shorts in the 3-6
month time-band is $10 million, the horizontal
disallowance for the zone is forty percent of $8
million, or $3.2 million.

27The duration of an instrument is its
-approximate percentage change in price for a 100
basis point parallel shift in the yield curve
assuming that its cash flow does not change when
the yield curve shifts. Modified duration is duration
divided by a factor of 1 plus the interest rate.
28 For example, an instrument held by a banking
organization with a maturity of 4 years and 3
months and a current market value of $1,000 might
have a modified duration of 3.5 years. Based on its
modified duration, it would be subjected to the 75-




basis point interest rate shock, resulting in an
expected price change of 2.625 percent (3.5x0.75).
the corresponding expected change in price of
$26.25, calculated as 2.625 percent of $1,000,
would be slotted as a long position in the 3.3 to 4.0
year time-band of the maturity ladder.
28Two different vertical disallowances are used
since the duration method takes into account an
instrument’s specific characteristics (maturity and
coupon) and there is less opportunity for
measurement error.

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
Table III— Duration Method: T imeBands and Assumed Changes in
Y ield— Continued
Zone

Time-band
11.3 up to 16.6 yrs ....
Over 16.6 y e a rs......

Assumed
change in
yield
0.60
0.60

38123

interest rate futures are not subject to a
component is slotted into the appropriate
repricing maturity category, with the long or specific risk charge. This exemption also
applies to futures on a short-term (e.g.,
short position attributable to the equity
LIBOR) interest rate index. However, in the
component being included in the equity
case of futures contracts where the
framework set out in section IV.B. of this
underlying is a debt security, or an index
appendix E.32
representing a basket of debt securities, a
e. A banking organization may offset long
and. short positions (both actual and notional) specific risk charge will apply according to
the category of the issuer as set out in section
in identical derivative instruments with
exactly the same issuer, coupon, currency,
IV.A.2. of this appendix E.
and maturity before slotting these positions
B. Equities
into time-bands. A matched position in a
1. Specific risk. The measure of specific
future and its corresponding underlying may
risk is calculated on the basis of the banking
also be fully offset and, thus, excluded from
organization’s gross equity positions, that is,
the calculation, except when the future
comprises a range of deliverable instruments. the absolute sum of all long equity positions
However, in cases where, among the range of *and of all short equity positions at current
market value.33 The specific risk capital
deliverable instruments, there is a readily
requirement is 8.0 percent of that sum, unless
identifiable underlying instrument that is
the portfolio is both liquid and wellmost profitable for the trader with a short
diversified, in which case the specific risk
position to deliver, positions in the futures
contract and the instrument may be offset. No capital requirement is 4.0 percent of the gross
equity position. A specific risk charge of 2.0
offsetting is allowed between positions in
percent applies to the net long or short
different currencies.
f. Offsetting positions in the same category position in a broad, diversified equity index
of instruments can in certain circumstances
and is viewed as necessary to provide for
be regarded as matched and treated by the
risks associated with contract execution.34
banking organization as a single net position
2. General Market risk. The measure of
which should be entered into the appropriate - general market risk is based on the difference
time-band. To qualify for this treatment the
between the sum of the long positions and
positions must be based on the same
the sum of the short positions (i.e., the
underlying instrument, be of the same
overall net position in an equity market) at
nominal value, and be denominated in the
current market value. An overall net position
same currency. The separate sides of
must be separately calculated for each
different swaps may also be “matched”
national market in which the banking
subject to the same conditions. In addition:
organization holds equities. The capital
i. For futures, offsetting positions in the
requirement for general market risk is 8.0
notional or underlying instruments to which percent of the net position in each equity
the futures contract relates must be for
market.
identical instruments and the instruments
3. Equity derivatives, a. Equity derivatives
must mature within seven days of each other; and other off-balance-sheet positions that are
ii. For swaps and FRAs, the reference rate
affected by changes in equity prices are
(for floating rate positions) must be identical
included in the measurement system under
and the coupon closely matched (i.e., within section IV.B. of this appendix E (except for
15 basis points); and
equity options, equity index options, and the
iii. For swaps, FRAs and forwards, the next associated
underlying, which are included in
interest reset date, or for fixed coupon
positions or forwards the remaining maturity, the measurement system under the treatment
must correspond within the following limits: discussed in section IV.E. of this appendix
E).35*This includes futures and swaps on both
If the reset (remaining maturity) dates occur
within one month, then the reset dates must
33 Matched positions in each identical equity in
be on the same day; if the reset dates occur
each national market may be treated as offsetting
between one month and one year later, then
excluded from the capital calculation, with any
the reset dates must occur within seven days and
remaining position included in the calculations for
of each other, or if the reset dates occur over
specific and general market risk. For example, a
one year later, then the reset dates must
future in a given equity may be offset against an
occur within thirty days of each other.
opposite cash position in the same equity.
g. Interest rate and currency swaps, FRAs,
34A portfolio that is liquid and well-diversified
forward foreign exchange contracts and
is characterized by a limited sensitivity to price

3.
Interest rate derivatives, a. Debt
derivatives and other off-balance-sheet
positions that are affected by changes in
interest rates are included in the
measurement system under section IV.A. of
this appendix E (except for options and the
associated underlyings, which are included
in the measurement system under the
treatment discussed in section IV.E. of this
appendix E). A summary of the treatment for
debt derivatives is set out in Attachment III
to this appendix E.
b. Derivatives are converted into positions
in the relevant underlying instrument and are
included in the calculation of specific and
general market risk capital charges as
described above. The amount to be included
is the market value of the principal amount
of the underlying or of the notional
underlying. For instruments where the
apparent notional amount differs from the
effective notional amount, a banking
organization must use the effective notional
amount.
c. Futures and forward contracts (including
FRAs) are broken down into a combination
of a long position'and short position in the
notional security. The maturity of a future or
a FRA is the period until delivery or exercise
of the contract, plus the life of the underlying
instrument.30 Where a range of instruments
may be delivered to fulfill the contract, the
banking organization may chose which
deliverable instrument goes into the maturity
or duration ladder as the notional
underlying. In the case of a future on a
corporate bond index, positions are included
at the market value of the notional
underlying portfolio of securities.
d. Swaps are treated as two notional
positions in the relevant instruments with
appropriate maturities. The receiving side is
treated as the long position and the paying
side is treated as the short position.31 The
separate sides of cross-currency swaps or
forward foreign exchange transactions are
slotted in the relevant maturity ladders for
changes of any single equity issue or closely related
the currencies concerned. For swaps that pay
32
A banking organization with a large swap bookgroup of equity issues held in the portfolio. The
or receive a fixed or floating interest rate
volatility of the portfolio’s value should not be
may, with prior approval of the Federal Reserve,
against some other reference price, for
dominated by the volatility of any individual equity
use alternative formulae to calculate the positions
example, an equity index, the interest rate
issue or by equity issues from any single industry
30For example, a long position in a June threemonth interest rate future (taken in April) is
reported as a long position in a government security
with a maturity of five months and a short position
in a government security with a maturity of two
months.
31 For example, an interest rate swap under which
a banking organization is receiving floating-rate
interest and paying fixed is treated as a long
position in a floating rate instrument with a
maturity equivalent to the period until the next
interest reset date and a short position in a fixedrate instrument with a maturity equivalent to the
remaining life of the swap.




to be included in the maturity or duration ladder.
For example, a banking organization could first
convert the payments required by the swap into
present values. For that purpose, each payment
would be discounted using zero coupon yields, and
the payment’s present value entered into the
appropriate time-band using procedures that apply
to zero (or low) coupon bonds. The net amounts
would then be treated as bonds, and slotted into the
general market risk framework. Such alternative
treatments will, however, only be allowed if: (i) the
Federal Reserve is fully satisfied with the accuracy
of the system being used, (ii) the positions
calculated fully reflect the sensitivity of the cash
flows to interest rate changes; and (iii) the positions
are denominated in the same currency.

or economic sector. In general, such portfolios
should be characterized by a large number of
individual equity positions, with no single position
representing a large portion of the portfolio’s total
market value. In addition, it would generally be the
case that a sizable proportion of the portfolio would
be comprised of issues traded on organized
exchanges or in well-established over-the-counter
markets.
35Where equities are part of a forward contract
(both equities to be received or to be delivered), any
interest rate or foreign currency exposure from the
other side of the contract should be appropriately
included in the measurement system in sections
IV.A. and IV.C. of this appendix E.

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Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

individual equities and on equity indices.
Equity derivatives should be converted into
notional equity positions in the relevant
underlying. A su m m a ry of the rules for
equity derivatives is set out in Attachment IQ
to this appendix E.
fa. Futures and forward contracts relating to
individual equities should he reported at
current market prices of the underlying.
Futures relating to equity indices should be
reported as the marked-to-market value of the
notional underlying equity portfolio. Equity
swaps are treated as two notional positions,
with the receiving side as the long position
and the paying side as the short position.36
If one of the legs involves receiving/paying
a fixed or floating interest rate, the exposure
should be slotted into the appropriate
repricing maturity band for debt securities.
The stock index is covered by the equity
treatment.
c. In the case of futures-related arbitrage
strategies, the 2.0 percent specific risk charge
applicable to broad diversified equity indices
may be applied to only one index. The
opposite position is exempt from a specific
risk charge. The strategies qualifying for this
treatment are:
i. When the banking organization takes an
opposite position in exactly the same index
at different dates; and
ii. When the banking organization has an
opposite position in different but similar
indices at the same date, subject to
supervisory oversight.
d. If a banking organization engages in a
deliberate arbitrage strategy, in which a
futures contract on a broad diversified equity
index matches a basket of securities, it may
exclude both positions from the standardized
approach on condition that the trade has
been deliberately entered into and separately
controlled and the composition of the basket
of stocks represents at least 90 percent of the
market value of the index. In such a case, the
minimum capital requirement is 4.0 percent
(that is, 2.0 percent of the gross value of the
positions on each side) to reflect risk
associated with executing the transaction.
This applies even if all of the securities
comprising the index are held in identical
proportions. Any excess value of the
securities comprising the basket over the
value of the futures contract or excess value
of the futures contract over the value of the
basket is treated as an open long or short
position.
e. If a banking organization takes a position
in depository receipts37 against an opposite
position in the underlying equity, it may
offset the position.
C. Foreign Exchange Risk
1.
The capital requirement for foreign
exchange risk covers the risk of holding or
38 For example, an equity swap in which a
banking organization is receiving an amount based
on the change in value of one particular equity or
equity index and paying a different index will be
treated as a long position in the former and a short
position in the latter.
37 Depository receipts are instruments issued by
a trust company or other depository institution
evidencing the deposit of foreign securities and
facilitating trading in such instruments on U.S.
stock exchanges.




taking positions in foreign currencies,
including gold, and is based on a banking
organization’s net open long positions or net
open short positions in each currency,
whether or not those positions are in the
trading portfolio, plus the net open position
in gold, regardless of sign.38
2. A banking organization’s net open
position in each currency (and gold) is
calculated by summing:
•a. The net spot position (i.e., all asset items
less all liability items, including accrued
interest earned but not yet received and
accrued expenses, denominated in the
currency in question);
b. All foreign exchange derivative
instruments and other off-balance-sheet
positions that are affected by changes in
exchange rates are included in the
measurement system under section IV.C. of
this appendix E (except for options and their
associated underlyings, which are included
in the measurement system under the
treatment discussed in section IV.E. of this
appendix E). Forward currency positions
should be valued at current spot market
exchange rates. For a banking organization in
which the basis of its normal management
accounting is to use net present values,
forward positions may be discounted to net
present values as an acceptable way of
measuring currency positions for regulatory
capital purposes;
c. Guarantees (and similar instruments)
that are certain to be called and are likely to
be irrevocable;
d. Net future income/expenses not yet
accrued but already fully hedged (at the
discretion of the banking organization). A
banking organization that includes future
income and expenses must do so on a
consistent basis without selecting expected
future flows in order to reduce the banking
organization’s positiom-and
e. Any other item representing a profit or
loss in foreign currencies.
3. For measuring a banking organization’s
open positions, positions in composite
currencies, such as the ECU, may be either
treated as a currency in their own right or
split into their component parts on a
consistent basis. Positions in gold are
measured in the same manner as described
in section IV.D. of this appendix E.39
4. The capital requirement is determined
by converting the nominal amount (or net
present value) of the net open position in
each foreign currency (and gold) at spot rates
into the reporting currency. The capital
requirement is 8.0 percent of the sum of:
a. The greater of the sum of the net short
open positions or, the sum of the net long
open positions; and
38 Gold is treated as a foreign exchange position
rather than a commodity because its volatility is
more in line with foreign currencies and banking
organizations manage it in a manner similar to
foreign currencies.
39Where gold is part of a forward contract
(quantity of gold to be received or to be delivered),
any interest rate or foreign currency exposure from
the other side, of the contract should be included
in the measurement system in section IV.A. (as a
zero coupon instrument) and IV.C of this appendix
E.

b. The net open position in gold, regardless
of sign.40
5.
Where a banking organization is
assessing its foreign exchange risk on a
consolidated basis, it may be technically
impractical in the case of some marginal
operations to include the currency positions
of a foreign branch or subsidiary of the
banking organization. In such cases, the
internal limit in each currency may be used
as a proxy for the positions, provided there
is adequate ex post monitoring of actual
positions complying with such limits. In
these circumstances, the limits should be
added, regardless of sign, to the net open
position in each currency.
D. Commodities Risk.
1. Measurement methods. This section
provides a minimum capital requirement to
cover the risk of holding or taking positions
in commodities. There are two methods
under the standardized approach for
measuring commodity market risk—the
simplified method and the maturity method.
These methods are only appropriate for
banking organizations that conduct a limited
amount of commodities business. All other
banking organizations must adopt an internal
measurement system conforming to the
criteria in section 01. of this appendix E.
2. Base capital requirement. Under both
the simplified and maturity methods, each
long and short commodity position (spot and
forward) is expressed in terms of the
standard unit of measurement (such as
barrels, kilos, or grams). The open positions
in each category of commodities are then
converted at current spot rates into U.S.
currency, with long and short positions offset
to arrive at the net open position in each
commodity. Positions in different categories
of commodities may not, generally, be
offset.41 Under either method, the base
capital requirement is 15.0 percent of the net
open position, long or short, in each
commodity.42
3. Simplified method. To protect a banking
organization against basis risk, interest rate
risk, and forward gap risk, each category of
commodity is also subject to a 3.0 percent
capital requirement on the banking
organization’s gross positions, long plus
short, in the particular commodity. In
40For examples, a banking organizations has the
following net currency positions: Yen=+50,
DM=+100, GB=+150, FFR=- 20, US$* -1 8 0 , and
gold= - 35. The banking organization would sum its
long positions (total=+300) and sum its short
positions (totals-200). The banking organization’s
capital requirement for foreign exchange market
risk would be: (300 (the larger of the summed long
and short positions) + 35 (gold))x8.0%=26.80.
41However, offsetting is permitted between
different sub-categories of the same commodity in
cases where the sub-categories are deliverable
against each other.

42 When the funding of a commodity position
opens a banking organization to interest rate or
foreign exchange exposure the relevant positions
should be included in the measures of interest rate
and foreign exchange risk described in section IV.A.
and IV.C of this appendix E. When a commodity is
part of a forward contract, any interest or foreign
currency exposure from the other side of the
contract should be appropriately included in the
measurement systems in sections IV.A. and IV.C. of
this appendix E.

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

38125

sections IV.A. through IV.D. of this appendix
amount of the contract at current spot rates,
valuing gross positions in commodity
E.
with one position corresponding to each
derivatives for this purpose, a banking
3. A banking organization that has only a
payment on the swap and slotted in the
organization should use the current spot
limited amount and range of purchased
maturity ladder accordingly. The positions
price. The total capital requirement for
are long positions if the banking organization options may use the following simplified
commodities risk is the sum of the 15.0
approach to measure its market risk
percent base charges for each net commodity is paying a fixed price and receiving a
exposure.
position and the 3.0 percent requirements on floating price, and short positions if the
a. For a banking organization with a long
han k ing organization is receiving a fixed
the gross commodity positions.
cash position and a long put or with a short
price and paying a floating price;44 and
4. Maturity method, a. Under this method,
c.
Commodity swaps where the sides of thecash position and a long call, the capital
a banking organization must slot each long
requirement is the market value of the
transaction are in different commodities are
and short commodity position (converted
included in-the relevant reporting ladder. No underlying instrument multiplied by the sum
into U.S. currency at current spot rates) into
of the specific and general market risk
offsetting is allowed unless the commodities
a maturity ladder. The time-bands for the
requirements for the underlying (that is, the
maturity ladder are; from zero to one month, are in the same sub-category.
specific and general market risk requirements
one up to three months, three up to six
E. Options
that would have applied to the underlying
months, six up to twelve months, one up to
1. Three alternatives are available for a
directly under sections IV.A. through IV.D. of
two years, two up to three years, and over
banking organization to use in measuring its
this appendix E.47), less the amount the
three years. A separate maturity ladder is
market risk for options activities. A banking
option is in the money (if any) bounded at
used for each category of commodity.
organization that only has purchased options zero.48
Physical commodities are allocated to the
may use the simplified method set forth in
b. For a banking organization with a long
first time-band.
section IV.E.2. of this appendix E. A banking call or a long put, the capital charge is the
b. In order to capture forward gap and
organization that also writes options may Use lesser of:
interest rate risk within a time-band (together the scenario method described in section
i. The market value of the underlying
sometimes referred to as curvature/spread
IV.E.3. of this appendix E or the delta-plus
security multiplied by the sum of specific
risk), offsetting long and short positions in
method set forth in section IV.E.4. of this
and general market risk requirements for the
each time-band are subject to an additional
appendix E.45 These methods may only be
underlying (that is, the specific and general
capital requirement. Beginning with the
used by hanking organizations which, in
market risk requirements that would have
shortest-term time-band and continuing with relative terms, have limited options
applied to the underlying directly under
subsequent time-bands, the amount of the
activities. Banking organizations with more
sections IV.A. through IV.D. of this appendix
matched short positions plus the amount of
significant options business are expected to
E49); or
the matched long position is multiplied by a adopt an internal measurement system
ii. The market value of the option.
spread rate of 1.5 percent.
conforming to the criteria in section III. of
c. Under this measure, the capital
c. The unmatched net position from
this appendix E. Regardless of the method
requirement for currency options is 8.0
shorter-term time-bands must be carried
used, specific risk related to die issuer of an
percent of the market value of the underlying
forward to offset exposures in longer-term
instrument still applies to options positions
and forcommodity options is 15.0 percent of
time-bands. A capital requirement of 0.6
for equities, equity indices and corporate
the market value of the underlying.
percent of the net position carried forward is debt securities as set forth in sections IV.A.
4. Under the scenario approach, a banking
added for each time-band that the net
and IV.B. of this appendix E. There remains
organization revalues its options and related
position is carried forward.43 The total
a separate capital requirement for
hedging positions by changing the
capital requirement for commodities risk is
counterparty credit risk as set forth in
underlying rate or price over a specified
the sum of the 15.0 percent base capital
appendix A to this part.
range and by assuming different levels of
requirement for each net commodity position
2. Under the simplified and scenario
volatility for that rate or price.
and the additional requirements for matched methods, the positions for the options and
a. For each of its option portfolios, a
positions and for unmatched positions
the associated underlying, cash or forward,
banking organization constructs a grid based
carried forward. An example of this
on a fixed range of changes in the portfolio’s
are not included in the measurement
calculation is in Attachment IV to this
risk factors and calculates changes in the
framework for debt securities, equities,
appendix E.
foreign exchange or commodities risk as set
value of the option portfolio at each point
5. Commodity derivatives. Commodity
within the grid. For this purpose, an option
forth in sections IV.A. through IV.D. of this
derivatives and other off-balance-sheet
portfolio consists of an option and any
appendix E. Rather, they are subject to
positions that are affected by changes in
related hedging positions or multiple options
capital requirements as calculated in this
commodity prices are included in the
and related hedging positions that are
section. The capital requirements calculated
measurement system under section IV.D. of
under this section IV.E. should then be added grouped together according to their
this appendix E (except for options and the
remaining maturity or the type of underlying.
to the capital requirements for debt
associated underlying, which are included in securities, equities, foreign exchange and
b. Options based on interest rates and debt
the measurement system under the treatment commodities risk as appropriate. Under the
instruments are grouped into portfolios
discussed in section IV.E. of this appendix
according to the maturity zones that are set
delta-plus method, the delta equivalent
E). Commodity-derivatives are converted into position 46 for each option is included in the
forth in section IV.A. of this appendix E.
notional commodity positions. Under the
(Zone 1 instruments have a remaining
measurement frameworks set forth in
maturity method, the positions are slotted
maturity of up to 1 year, zone 2 instruments
into maturity time-bands as follows:
44 If one of the sides of the transaction involves
a. Futures and forward contracts relating to receiving/paying a fixed or floating interest rate,
47Some options (e.g., where the underlying is an
individual commodities dre incorporated in
that exposure should be slotted into the appropriate interest rate, a currency, or a commodity) bear no
the measurement system as notional amounts repricing maturity band in section IVA. of this
specific risk bat specific risk will be present in the
appendix E.
(of, for example, barrels or kilos) that are
case of options on corporate debt securities and for
options on equities and equity indices.
43 Unless all their written option positions are
converted to U.S. dollars at current spot rates
hedged by perfectly matched long positions in
-“ For example, if a holder of 100 shares currently
and are assigned a maturity according to
exactly the same options, in which case there is no
valued at $10 each has an equivalent put option
expiration date;
with a strike price of $11, the capital charge would
b. Commodity swaps where one side of the capital requirement for market risk.
be: $1,000x16.0 percent (e.g., 8.0 percent specific
44 The delta equivalent of an option is the
contract is a fixed price and the other side
plus 8.0 percent general market risk) = $160, less
option’s delta value multiplied by its principal or
is the current market price are incorporated
the amount the option is in the money
notional value. The delta value of an option
as a series of positions equal to the notional
represents the expected change in the option’s price ($11 -$10)xl00 = $100, Le., the capital charge
43
For example, if $200 short is carried forward
from the 3-6 month time-band to the 1-2 year timeband, the capital charge would be $200 x .006 x 2
= $2.40.




as a proportion o f a small change in the price of
the underlying instrument For example, an option
whose price changes $1 for every $2 dollar change
in the price of the underlying instrument has a delta
of 0.50.

would be $60. A similar methodology applies for
-options whose underlying is a foreign currency, a
debt security or a commodity.
“ See footnote 47 in section IV.E.3.a of this
appendix E.

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Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

have a remaining maturity from 1 year up to
4 years, and zone 3 instruments have a
remaining maturity of 4 years or more.) These
options and the associated hedging positions
should be evaluated under the assumption
that the relevant interest rates move
simultaneously. For options based on
equities, separate grids are constructed for
each individual equity issue and index. For
options based on exchange rates, separate
grids are constructed for individual exchange
rates. For options based on commodities,
separate grids are constructed for each
category of commodity (as defined in
sections I.B.3. and IV.D. of this appendix E).
c. For option portfolios with options based
on equities, exchange rates, and
commodities, the first dimension of the grid
consists of rate or price changes within a
specified range above and below the current
market value of the underlying; for equities,
the range is ± 12.0 percent (or in the case of
an index ± 8.0 percent), for exchange rates
the range is ± 8.0 percent, and for
commodities the range is ± 15.0 percent. For
option portfolios with options based on
interest rates, the range for the first
dimension of the grid depends on the
remaining maturity zone. The range for zone
1 is ± 100 basis points, the range for zone 2
is ± 90 basis points, and the range for zone
3 is ± 75 basis points. For all option
portfolios, the range is divided into at least
ten equally spaced intervals. The second
dimension of each grid is a shift in the
volatility of the underlying rate or price equal
to ± 25.0 percent of the current volatility.30
d. For each assumed volatility and rate or
price change (a scenario), the banking

slotted into the debt instrument time-bands
organization revalues each option portfolio.
in section IV.A. of this appendix E using a
The market risk capital requirement for the
portfolio is the largest loss in value from
two-legged approach (as is used for other
among the scenario revaluations. The total
derivatives), requiring one entry at the time
market risk capital requirement for all option the underlying contract takes effect and one
portfolios is the sum of the individual option at the time the underlying contract matures.3*
portfolio capital requirements.
Floating rate instruments with caps or floors
e.
The Federal Reserve will review the
should be treated as a combination of floating
application of the scenario approach,
rate securities and a series of European-style
particularly regarding the precise way the
options.32 A banking organization must also
analysis is constructed. A banking
calculate the gamma and vega for each such
organization using the scenario approach
option position (including hedge positions).
should meet the appropriate qualitative
The results should be slotted into separate
criteria set forth in section m.B. of this
maturity ladders by currency. For options
appendix E.
such as caps and floors whose underlying
5.
Under the delta-plus method, a banking instrument is an interest rate, the delta and
organization that writes options may include
delta-weighted options positions within each gamma should be expressed in terms of a
hypothetical underlying security.
measurement framework as set forth in
sections IV.A. through IV.D. of this appendix Subsequently:
i. For gamma risk, for each time-band, net
E.
a. Options positions should be measured as gammas that are negative are multiplied by
the risk weights set out in Table IV in section
a position equal to the market value of the
IV.E.5.b.iv. of this appendix E and by the
underlying instrument multiplied by the
square of the market value of the underlying
delta. In addition, a banking organization
must measure the sensitivities of the option's instrument (net positive gammas may be
disregarded);
gamma (the change of the delta for a given
ii. For volatility risk, a banking
change in the price of the underlying) and
organization calculates the capital
vega (the sensitivity of the option price with
requirements for vega in each time-band
respect to a change in volatility) to calculate
assuming a proportional shift in volatility of
the total capital requirement. These
± 25.0 percent;
sensitivities may be calculated according to
iii. The capital requirement is the absolute
an exchange model approved by the Federal
Reserve or to the banking organization’s own value of the sum of the individual capital
requirements for net negative gammas plus
options pricing model, subject to review by
the absolute value of the sum of the
the Federal Reserve.
b. For options with debt instruments or
individual capital requirements for vega risk
interest rates as the underlying instrument,
for each time-band; and
delta-weighted options positions should be
iv. The delta plus method risk weights are:

T a b l e IV .— D e l t a P l u s M

eth o d

R

is k

W

e ig h t s

Time-band

Under 1 month ....

1 up to 3 months .
3 up to 6 months .
6 up to 12 months
1 up to 2 years_
2 up to 3 years.....
3 up to 4 years.—
4 up to 5 years ....
5 up to 7 years —
7 up to 10 years ..
10 up to 15 years
15 up to 20 years
Over 20 years ....

Modified du­
ration (aver­
age as­
sumed for
time band)

Assumed
interest rate
change (%)

Risk-weight
for gamma1

0.00
0.20
0.40
0.70
1.40
2.20
3.00
3.65
4.65
5.80
7.50
8.75
10.00

1.00
1.00
1.00
1.00
0.90
0.80
0.75
0.75
0.70
0.65
0.60
0.60
0.60

0.00000
0.00020
0.00080
0.00245
0.00794
0.01549
0.02531
0.03747
0.05298
0.07106
0.10125
0.13781
0.18000

1According to the Taylor expansion, the risk weights are calculated as Vfe (modified duration x assumed interest rate change)2 100

c.
For options with equities as the
underlying, delta-weighted option positions
should be incorporated in the measure of

market risk set forth in section IV.B. of this
appendix E. Individual equity issues and
indices should be treated as separate

underlyings. In addition to the capital
requirement for delta risk, a banking

50 For example, if the underlying in an equity
instrument with a current market value of $100 and
a volatility of 20 percent, the first dimension of the
grid would range from $88 to $112, divided into ten
intervals of $2.40 and the second dimension would
assume volatilities of 15 percent, 20 percent, and
25 percent.

31For example, in April, a purchased call option
on a June three-month interest-rate future would be
considered on the basis of its delta-equivalent value
to be a long position with a maturity of five months
and a short position with a maturity of two months.
The written option would be slotted as a long
position with a maturity of two months and a short
position with a maturity of five months.

32 For example, the holder of a three-year floating
rate bond indexed to six-month LIBOR with a cap
of 15 percent would treat the bond as a debt
security that reprices in six months, and a series of
five written call options on a FRA with a strike rate
of 15 percent, each slotted as a short position at the
expiration date of the option and as a long position
at the time the FRA matures.




Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 19 9 5 / Proposed Rules
organization should apply a further capital
charge for gamma and vega risk:
i. For gamma risk, the net gammas that are
negative for each underlying are multiplied
by 0.72 percent (in the case of an individual
equity) or 0.32 percent (in the case of an
index as the underlying) and by the square
of the market value of the underlying;
ii. For volatility risk, a banking
organization calculates the capital
requirement for vega for each underlying,
assuming a proportional shift in volatility of
±25.0 percent; and
iii. The capital requirement is the absolute
value of the sum of die individual capital
requirements for net negative gammas plus
the absolute value of the individual capital
requirements for vega risk.
d. For options of foreign exchange and gold
positions, the net delta (or delta-based)
equivalent of the total book of foreign
currency and gold options is incorporated
into the measurement of the exposure in a
single currency position as set forth in
section 1V.G of this appendix E. The gamma
and vega risks should be measured as
follows:
i. For gamma risk, for each underlying
exchange rate, net gammas that are negative
are multiplied by 0.32 percent and by the
square of the market value of the positions;
ii. For volatility risk, a banking
organization calculates the capital
requirements for vega for each currency pair
and gold assuming a proportional shift in
volatility of ± 25.0 percent; and
iii. The capital requirement is the absolute
value of the sum of the individual capital
requirements for net negative gammas plus
the absolute value of the sum of the
individual capital requirements for vega risk.
e. For options on commodities, the deltaweighted positions are incorporated in one of
the measures described in section IV.D. of
this appendix E. In addition, a banking
organization must apply a capital
requirement for gamma and vega risk:
i. For gamma risk, net gammas that are
negative for each underlying are multiplied
by 1.125 percent and by the square of the
market value of the commodity;
ii. For volatility risk, a banking
organization calculates the capital
requirements for vega for each commodity
assuming a proportional shift in volatility of
+/ - 25.0 percent; and
iii. The capital requirement is the absolute
value of the sum of the individual capital
requirements for net negative gammas plus
Zone
1 ..............

2 ...................

3 ...................

the absolute value of the sum of the
individual capital requirements for vega risk.
f. Under certain conditions end to a limited
extent, the Federal Reserve may permit .
banking organizations that are significant
traders in options with debt securities or
interest rates as the underlying to net positive
and negative gammas and vegas across timebands. Such netting must be based on
prudent and conservative assumptions and
the banking organization must materially
meet the qualitative standards set forth in
section m.B. of this appendix E.
g. A banking organization may base the
calculation of vega risk on a volatility ladder
in which the implied change in volatility
varies with the maturity of the option. The
assumed proportional shift in volatility must
be at least +/- 25.0 percent at the short end
of the maturity spectrum. The proportional
shift for longer maturities must be at least as
stringent instatistical terms as the 25.0
percent shift at the short end.
h. A banking organization should also
monitor the risks of rho (the rate of change
of the value of the option with respect to the
interest rate) and theta (the rate of change of
the value of the option with respect to time).
A tta c h m e n ts to A p p e n d ix E
A t t a c h m e n t I— S a m p l e C a l c u l a t i o n o f
E lig ib le T ie r 1 , T ie r 2 , a n d T ie r 3
C a p ita l fo r t h e R is k - B a s e d C a p ita l R a tio
A d ju ste d fo r M a r k e t R is k

(Tier 1, comprising $14 allocated for market
risk and $46 unallocated) + $36 (Tier 3) =
$736. The banking organization’s ratio of
qualifying and eligible capital to weightedrisk assets adjusted for market risk would be:
$736/$8,625) = 8.5%.
Example 2: A banking organization has the
following qualifying capital: Tier 1 = $500,
Tier 2 = $140, Tier 3 = $600.
(1) The minimum capital requirement for
credit risk is $640 ($8000 x 8.0%). This
requirement could be satisfied with $500 of
Tier 1 capital and $140 of Tier 2 capital.
(2) The remaining capital available for
market risk would be: Tier 1 = 0, Tier 2 =
$0, and Tier 3 = $600. Eligible Tier 3 capital
would be limited to $0 (0 x 2.5). Because
there is no Tier 1 capital required to support
market risk, no eligible Tier 3 capital may be
used for market risk.
(3) Total qualifying and eligible capital
would be: $500 (Tier 1) + $140 (Tier 2) =
$640. The banking organization’s ratio of
qualifying and eligible capital to weightedrisk assets adjusted for market risk would be:
$640/$8,625) = 7.4%.
b. In both of the examples described in
paragraph a. of this attachment the total of
Tier 2 and Tier 3 capital for credit and
market risk is not greater than 100 percent of
Tier 1 capital for credit and market risk and
the total of Tier 2 capital for credit risk is not
greater than 100 percent of Tier 1 capital for
credit risk.

a. In each example the weighted-risk assets
are $8000 and the market risk-adjusted assets A t t a c h m e n t I I — S a m p l e C a l c u l a t i o n o f
are $625 (capital requirement for market risk G e n e r a l M a r k e t R i s k f o r D e b t
I n s tr u m e n ts U s in g t h e M a tu r ity M e th o d
= $50, $50 x 12.5 = $625):
Example 1: A banking organization has the
a. A banking organization with the
following qualifying capital: Tier 1 = $600,
following positions would slot them into a
Tier 2 = $100, Tier 3 = $1000.
maturity ladder as shown below:
(1) The minimum capital requirement for
i. Qualifying bond, $13.33mn market value,
credit risk is $640 ($8000 x 8.0%). This
remaining maturity 8 years, coupon 8%;
requirement could be satisfied with $540 of
ii. Government bond, $75mn market value,
Tier 1 capital and $100 of Tier 2 capital.
remaining maturity 2 months, coupon 7%;
(2) The remaining capital available for
iii. Interest rate swap, $150mn, banking
market risk would be: Tier 1 = $60, Tier 2
organization receives floating rate interest
= 0, and Tier 3 = $1000. The minimum
and pays fixed, next interest reset after 12
capital requirement for market risk is $50
months, remaining life of swap is 8 years
($625 x 8.0%). Eligible Tier 3 capital would
(assumes the current interest rate is identical
be limited to $125 ($50 x 2.5).
to the one the swap is based on); and
(3) The Tier 1 capital required to support
iv. Long position in interest rate future,
market risk could be satisfied by allocating
$50mn, delivery date after 6 months, life of
$14 ($50 x .285), with eligible Tier 3 capital
underlying government security is 3.5 years
used for market risk being $36 ($50 - $14).
(4) Total qualifying and eligible capital
(assumes the current interest rate is identical
would be: $540 (Tier 1) + $100 (Tier 2) + $60 to the one the swap is based on).

Time-band and position

Risk wght
(%)

10-1 mth ................................................................................
1-3 mth Long 75 Gov.bond..................................................
3 -6 mt Short 50 Future ........................................................
6-12 mths Long 150 Sw ap...................................................
1-2 yrs ...................................................................................
2 -3 yrs ...................................................................................
3 -4 yrs Long 5 0 .....................................................................
Future
4 -5 yrs .......................... „......................................................
5 -7 yrs ...................................................................................
7-10 yrs Short 150 Swap Long 13.13 Qual Bond .............

2.75
3.25
3.75

10-15 yrs ...............................................................................

4.50




38127

0.00
0.20
0.40
0.70
1.25
1.75
2.25

Risk-weighted
position

Net time-band
positions

Long 0 .1 5 ..........
Short 0 .2 0 .........
Long 1 .0 5 ..........

Long 0 .1 5 ..........
Short 0 .2 0 .........
Long 1.05.

Long 1.00

Long 1 .1 2 5 ........

Long 1.1 2 5 ........

Long 1.125

Short 5.625 .......
Long 0 .5 0 ..........

Short 5.125 ......

Short 5.125

Net zone posi­
tions

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

38128

Risk wght
(%)

Time-band and position

Zone

S ummary

(450.000). The remaining position in zone 3
would be -4.00.
e. A horizontal disallowance would be
calculated between zones 1 and 3. It would
be 100 percent of the matched positions
between the zones—100x1.00=1.00
(1.060.000)
.
f. The remaining net open position for the
hanking organization would be 3.00
($3,000,000).
The total capital requirement for general
market risk for this portfolio would be:
The vertical disallowance ......
$50,000
of

T reatment

for Interest

Exchange-Traded Future:
Government security ................................................................
Corporate debt security............................................................
Index on short-term interest rates (e.g. LIBOR) ....................
OTC Forward:
Government security ................................................................
Corporate debt security............................................................
Index on short-term interest ra te s ...........................................
FRAs, Sw aps.............................................................................
Forward foreign exchange .......................................................
Options:
Government security ................................................................
Corporate debt security............................................................
Index on short-term interest ra te s ...........................................

Net zone posi­
tions

Horizontal disallowance in
zone 1 .................................
Horizontal disallowance be­
tween zones 2 and 3 ...........
Horizontal disallowance be­
tween zones 1 and 3 ...........
The overall net open position
Total requirement for gen­
eral market risk............

80,000
450,000
1,000,000
3,000,000
4,580,000

A tta c h m e n t m — S u m m a r y o f
T r e a t m e n t f o r I n t e r e s t R a t e a n d E q u ity
D e r iv a tiv e s

Rate Derivatives

Specific
risk charge

Instrument

Net time-band
positions

5.25
6.00

15-20 yrs ...............................................................................
over 20 y rs .............................................................................

b. A vertical disallowance would be
calculated for time-band 7-10 years. It would
be 10 percent of the matched positions in the
time-band—10.0x0.5=0.05 ($50,000).
c. A horizontal disallowance would be
calculated for zone 1. It would be 40 percent
of the matched positions in the zone—
40.0x0.20=0.80 ($80,000). The remaining net
position in Zone 1 would be +1.00 .
d. A horizontal disallowance would be
calculated for adjacent zones 2 and 3. It
would be 40 percent of the matched positions
between the zones—40.0x1.125=0.45

Risk-weighted
position

General market risk charge

No ............
Y e s ...........
No ............

Yes, as two positions.
Yes, as two positions.
Yes, as two positions.

No ............
Y e s ...........
No ............
No ............
No ............

Yes,
Yes,
Yes,
Yes,
Yes,

No ............
Y e s ...........
No ............

For each type of transaction, either
(a) Carve out together with the associated hedging positions
—simplified method— scenario analysis— internal models, or
(b) General market risk charge according to the Delta-plus
method (gamma and vega receive separate capital charges)

as
as
as
as
as

two positions.
two positions.
two positions.
two positions.
one position in each'currency.

No te : Specific risk charges relate to the issuer of the instrument. There remains a separate capital requirement for counterparty credit risk.

S ummary of T reatment for Equity D erivatives
Specific
risk charge

Instrument
Exchange-Traded or OTC Future:
Individual equity.........................................................................
Index ...........................................................................................
Options:
Individual equity.........................................................................
Index...........................................................................................

General market risk charge

Y e s .......
2 .0 % .........

Yes, as underlying.
Yes, as underlying.

yes ...........
2 .0 % .........

For each type of transactions either
(a) Carve out together with the associated .hedging positions
—simplified method— scenario approach— internal models, or
(b) General market risk requirement according to the Delta-plus
method (gamma and vega receive separate capital charges).

Note : Specific risk charges relate to the issuer of the instrument. There remains a separate capital requirement for counterparty credit risk.
A tta c h m e n t IV — S a m p le C a lc u la t io n o f S ta n d a r d iz e d A p p r o a c h fo r C o m m o d it ie s R is k

Time band

Position

0 up to 1 m onth....................
1 up to 3 months ..................
3 up to 6 months ..................

None
None
Long 800 ...............................
Short 1000 ...........................

6 up to 12 months ................
1 up to 2 yrs ..........................

None.
Long 600 ...............................




Spread
rate

1.5%

Capital calculation

Capital
charge

800 long+800 short (matched)x1.5%= ...............................
200 Short carried forward to 1-2 yrs, capital charge:
200x2x0.6%=.

24
24

200 long+200 short (matched)x 1.5%= ...............................

6

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
Time band

2 up to 3 yrs .........................
over 3 years .........................

Position

None
Short 600 ..............................

Spread
rate

Capital calculation

38129
Capital
charge

400 long carried forward to over 3 yrs capital charge:
400x2x0.6%=.

4.8

400 long+400 short (matched)+1.5%- ...............................
Net position: 200 capital charge: 2 0 0 x 1 5 .0 % -..................

12
30

Note : Assume all positions are in the same commodity and converted at current spot rates into U.S. dollars. The total capital requirement
would be $79.2.

A tta c h m e n t V — S a m p le C a lc u la t io n fo r
D e lta -P lu s M e th o d fo r O p tio n s

a. Assume a banking organization has a
European short call option on a commodity
with an exercise price of 490 and a market
value of the underlying 12 months from the
expiration of the option at 500; a risk-free
interest rate at 8% per annum, and the
volatility at 20 percent. The current delta for
this position is according to the BlackScholes formula -0.721 (that is, the price of
the option changes by -0.721 if the price of
the underlying moves by 1). The gamma is
-0.0034 (that is, the delta changes by
-0.0034 from -0.721 to -0.7244 if the
price of the underlying moves by 1). The
current value of the option is 65.48.
b. The first step under the delta-plus
method is to multiply the market value of the
commodity by the absolute value of the delta.
500x0.721=360.5. The delta-weighted
position is then incorporated into the
measure described in section IV.D. of this
Appendix E. If the banking organization uses
the maturity approach and no other positions
exist, the delta-weighted position is
multiplied by 0.15 to calculate the capital
requirement for delta. 360.5x0.15=54.075.
c. The capital requirement for gamma is
calculated according to the Taylor expansion
by multiplying the absolute value of the
assumed gamma of -0.0034 by 1.125% and
by the square of the market value of the
underlying. 0.0034x0.0125x5002=10.625
d. The capital requirement for vega is
calculated next. The assumed current
(implied) volatility is 20%. Since only an
increase in volatility carries a risk of loss for
a short call option, the volatility has to be
increased by a relative shift of 25%. This
means that the vega capital requirement has
to be calculated on the basis of a change in
volatility of 5 percentage points from 20% to
25% in this example. According to the BlackScholes formula used here, the vega equals
168. Thus, a 1% or 0.01 increase in volatility
increases the value of the option by 1.68.
Accordingly, a change in volatility of 5
percentage points increases the value of
5x1.68=8.4. This is the capital requirement
for vega risk. The total capital requirement
would be $73.10 (54.075+10.625+8.4).
By Order of the Board of Governors of the
Federal Reserve System, July 12,1995.
W illia m W . W ile s ,

Secretary of the Board.




38142

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
a c tiv itie s . In th e o r y , th e p e n a ltie s c o u ld
b e c a lib r a te d to e n s u r e th a t c a p ita l
a llo c a t io n s w e r e c o n s is t e n t w it h
su p e r v is o r y o b je c tiv e s .

DATES: C o m m e n t s m u s t b e s u b m i t t e d o n
or b efo re N o v e m b e r 1 ,1 9 9 5 .

to W illia m W . W ile s , S e c r e ta r y , B o a r d o f

T h e B o a r d b e lie v e s th a t p u b lic

G overnors o f th e F ed eral R eserve

c o m m e n ts w o u ld b e o f grea t a s s is ta n c e
in e v a lu a t in g t h e o v e r a ll fe a s ib ility o f

S y s te m , 2 0 th S tr e e t a n d C o n s titu tio n
A v e n u e , N W . , W a s h i n g t o n , D .C . 2 0 5 5 1 .

t h e a p p r o a c h a n d in id e n tify in g th e

C o m m e n ts a ls o m a y b e d e liv e r e d to

m o s t p r a c tic a l a n d e ffe c tiv e m e a n s o f

R o o m B —2 2 2 2 o f t h e E c c l e s B u i l d i n g

im p le m e n t in g it. P u b lic c o m m e n t s

b e t w e e n 8 : 4 5 a .m . a n d 5 : 1 5 p .m .

w o u ld a ls o b e o f v a lu e in a s s e s s in g

w e e k d a y s , o r to th e g u a r d s ta tio n in th e

w h e th e r fu tu r e im p le m e n ta tio n o f th e
p r o p o sa l m ig h t h a v e u n in te n d e d

N W . (b e tw e e n C o n s titu tio n A v e n u e a n d

c o n s e q u e n c e s o n b a n k s o r o n fin a n c ia l

C S tr e e t) a t a n y t im e . C o m m e n t s

m a r k e ts.

r e c e iv e d w i l l b e a v a ila b le fo r in s p e c t io n

I. D e s c r ip t io n o f t h e P r e -C o m m itm e n t
A pproach.

in R o o m M P - 5 0 0 o f t h e M a r tin B u ild in g
b e t w e e n 9 a .m . a n d 5 p .m . w e e k d a y s ,
e x c e p t a s p r o v id e d in 1 2 C F R 2 6 1 .8 o f
t h e B o a r d ’s r u l e s r e g a r d i n g a v a i l a b i l i t y
o f in fo r m a tio n .

FOR FURTHER INFORMATION CONTACT:
P a tr ic k P a r k in s o n , A s s o c ia t e D ir e c t o r
( 2 0 2 - 4 5 2 - 3 5 2 6 ) , o r P a u l K u p ie c , S e n io r
E c o n o m is t ( 2 0 2 - 4 5 2 - 3 7 2 3 ) , o r J a m e s
O ’B r i e n , S e n i o r E c o n o m i s t ( 2 0 2 - 4 5 2 2 3 8 4 ), D iv is io n o f R esea rch a n d
S ta tis tic s ; fo r u s e r s o f t h e
T e le c o m m u n ic a tio n s D e v ic e fo r t h e D e a f
(T D D ) o n l y , D o r o t h e a T h o m p s o n ( 2 0 2 4 5 2 -3 5 4 4 ); B oard o f G overn ors o f th e
F e d e r a l R e s e r v e S y s te m , W a s h in g to n ,
D .C . 2 0 5 5 1 .

SUPPLEMENTARY INFORMATION: T h e B o a r d
is r e q u e s tin g c o m m e n t o n a p r o p o s e d

[Docket No. R-0886]
Capital Requirements for Market Risk

“ p r e - c o m m i t m e n t ” a p p r o a c h . W h i l e in
th e o r y t h is a p p r o a c h m ig h t o ffe r
significant a d v a n t a g e s o v e r e x i s t i n g
a lte r n a tiv e s , m a n y o f t h e p r a c tic a l
d e t a ils h a v e n o t y e t b e e n w o r k e d o u t.

E c c le s B u ild in g c o u r ty a r d o n 2 0 th S tr e e t

12 CFR Chapter il

a p p r o a c h , w h i c h h a s b e e n te r m e d th e

D o c k e t N o . R - 0 8 8 6 , a n d m a y b e m a ile d

ADDRESSES: C o m m e n t s s h o u l d r e f e r t o

FEDERAL RESERVE SYSTEM

c a p ita l a d e q u a c y , t u e B o a r d is
r e q u e s tin g c o m m e n t o n a n o v e l

r u le m a k in g t h a t w o u l d a m e n d i t s r is k b a s e d c a p it a l r e q u ir e m e n ts to
in c o r p o r a te m e a s u r e s o f m a r k e t r is k th a t
h a v e b e e n d e v e lo p e d b y t h e B a s le
C o m m itte e o n B a n k in g S u p e r v is io n .
T h is p r o p o s e d r u le i s p u b lis h e d
e l s e w h e r e i n t o d a y ’s F e d e r a l R e g i s t e r ,
u n d e r D o c k e t N o . R - 0 8 8 4 . T h e B o a r d ’s
p u b lic a tio n o f t h is p r o p o s e d r u le m a k in g
r e fle c ts it s j u d g m e n t th a t t h e B a s le
p r o p o s a l, e s p e c ia lly th e in te r n a l m o d e ls

T h e p r e -c o m m itm e n t a p p r o a c h d r a w s
it s in s p ir a tio n fr o m th e e c o n o m ic
lite r a tu r e o n " in c e n t iv e - c o m p a t ib le ”
r e g u la to r y s c h e m e s .1 A s in t h e in te r n a l
m o d e ls a p p r o a c h to m a r k e t r is k c a p ita l
r e q u ir e m e n ts th a t th e B o a r d h a s
p r o p o s e d , t h e r e g u la to r y o b je c tiv e i s t o
r e q u ir e a b a n k t o m a in t a in s u f f ic ie n t
c a p ita l to c o v e r p o te n tia l lo s s e s in its
tr a d in g a c t iv it ie s fr o m a ll b u t t h e m o s t
e x tr e m e p r ic e m o v e m e n t s .2 T h e in te r n a l
m o d e ls a p p r o a c h se e k s to e n su r e
c o m p lia n c e w it h t h is o b je c tiv e b y
sta n d a r d iz in g t h e p a r a m e te r s u n d e r
w h ic h a b a n k w o u ld c a lc u la te t h e v a lu e
a t r is k (V a R ) o f i t s t r a d in g p o r t f o lio a n d
th e n a p p ly in g a m u ltip lic a tio n fa c to r to
e a c h b a n k ’s c a l c u l a t e d V a R , i n p a r t t o
c o v e r p o te n tia l lo s s e s o v e r lo n g e r
h o r iz o n s . B y c o n tr a st, th e p rec o m m itm e n t a p p r o a c h w o u ld se e k to
i n d u c e b a n k s to m e e t t h e r e g u la to r y
o b je c tiv e b y p r o v id in g th e m w it h a
c o m m o n s e t o f e c o n o m ic in c e n t iv e s .
S p e c if ic a lly , in th e p r e -c o m m itm e n t
a p p r o a c h a b a n k w o u ld sp e c ify its
d e s ir e d a m o u n t o f c a p ita l fo r s u p p o r t in g
m a r k e t r is k s a n d w o u ld c o m m it to
m a n a g e i t s tr a d in g p o r tfo lio s o a s to

AGENCY: B o a r d o f G o v e r n o r s o f t h e

o p tio n , c o n s t it u t e s a v e r y s ig n ific a n t

lim it a n y c u m u la t iv e tr a d in g lo s s e s o v e r

F ed era l R eserv e S y stem .

im p r o v e m e n t in s u p e r v is o r y m e th o d s

s o m e s u b s e q u e n t in te r v a l to a n a m o u n t

ACTION: R e q u e s t f o r c o m m e n t s .

fo r a s s e s s in g c a p it a l a d e q u a c y .
N o n e th e le s s , th e B o a r a b e lie v e s th a t

l e s s th a n th a t c a p it a l a llo c a t io n . T h e

SUMMARY: T h e B o a r d i s r e q u e s t i n g

fu r th e r e v o lu t io n o f s u p e r v is o r y

c o m m e n t o n a p o s s ib le a p p r o a c h to

a p p r o a c h e s to a s s e s s in g c a p ita l

s e ttin g c a p ita l r e q u ir e m e n ts fo r m a r k e t

a d e q u a c y w ill b e n e c e s s a r y o v e r tim e .

r is k , w h ic h , i f f e a s ib le , m ig h t fo r m t h e

T e c h n iq u e s fo r m e a s u r in g a n d m a n a g in g

b a s is fo r fu tu r e e n h a n c e m e n t s to

m a r k e t r is k h a v e b e e n p r o g r e s s in g

su p e r v is o r y p r o c e d u r e s . T h e a p p r o a c h

r a p id ly in r e c e n t y e a r s , a n d fu r th e r

w o u ld r e q u ir e a b a n k to s p e c if y t h e

a d v a n c e s c a n b e e x p e c te d in th e fu tu re.

a m o u n t o f c a p ita l it c h o s e to a llo c a te to

It i s i m p o r t a n t t h a t c a p i t a l r e q u i r e m e n t s

su p p o r t m a r k e t r is k s . If c u m u la t iv e

p r o v id e in c e n t iv e s fo r s u c h a d v a n c e s

lo s s e s o v e r s o m e s u b s e q u e n t tr a d in g

a n d th a t t h e s e r e q u ir e m e n ts r e m a in

in te r v a l e x c e e d e d t h e c o m m it m e n t , t h e

c o m p a tib le w it h b e s t p r a c tic e s a s th e y

b a n k w o u ld b e s u b je c t to r e g u la to r y
p e n a ltie s , s u c h a s fin e s , h ig h e r c a p ita l

e v o lv e .
R e c o g n iz in g t h e n e e d fo r fu r th e r

r e q u ir e m e n ts , o r r e s tr ic tio n s o n tr a d in g

e v o lu tio n in s u p e r v is o r y a p p r o a c h e s to




le n g th o f th e in te r v a l w o u ld b e
e s t a b l i s h e d b y t h e b a n k ’s r e g u l a t o r ,
b a s e d o n t h e r e g u l a t o r ’s a b i l i t y t o

1The theory underlying the pre-commitment
approach is presented in Paul H. Kupiec and James
M. O’Brien, “A Pre-Commitment Approach to
Capital Requirements for Market Risk.” Board of
Governors of the Federal Reserve System, Division
of Research and Statistics, staff memorandum, June
1995. This paper can be obtained from the Board’s
Freedom of Information Office.
2The scope of activities and banks that would be
covered under a pre-commitment approach
presumably would be the same as the scope of the
proposed rulemaking on market risk that was
referenced above.

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules
m o n i t o r l o s s e s f r o m t h e b a n k ’s t r a d i n g
a c t iv it ie s a n d , i f n e c e s s a r y , to fo r c e
r e d u c t i o n s i n t h e s i z e o f t h e b a n k ’s o p e n ,
p o s it io n s . T h e in te r v a l m ig h t b e th r e e o r
s ix m o n t h s , b u t a sh o r te r in te r v a l w o u ld
b e p o s s ib le i f t h e r e g u la to r c a n
e f f e c t iv e ly m o n it o r tr a d in g a c t iv it y a t
th a t fr e q u e n c y a n d i f th e r e le v a n t
m a r k e ts a re s u f f ic ie n tly liq u id th a t th e
tr a d in g p o s it io n s c o u ld , i f n e c e s s a r y , b e
c lo s e d o u t p r o m p tly w it h o u t s u b s ta n tia l
m a r k e t im p a c t. A t th e e n d o f th e
in te r v a l, t h e b a n k c o u ld e it h e r in c r e a s e
o r d e c r e a s e it s c a p ita l c o m m itm e n t.
T o e n s u r e th a t th e b a n k c o m m itte d a n
a m o u n t o f c a p ita l c o m m e n s u r a te w it h
t h e r is k s in i t s tr a d in g p o r t fo lio a n d it s
c a p a c it y t o m a n a g e t h o s e r is k s , th e
r e g u la to r w o u l d n e e d t o p r o v id e
a p p r o p r ia te in c e n t iv e s in t h e fo r m o f
e c o n o m ic c o s t s o r “ p e n a lt ie s ” fo r f a ilin g
to lim it lo s s e s to le s s th a n th e c a p ita l
c o m m itm e n t. T h e m a g n itu d e o f t h e
p e n a ltie s w o u ld d e p e n d o n th e
r e g u la to r y o b je c tiv e . A b a n k th a t is
m a n a g e d a s a g o in g c o n c e r n w o u ld b e
e x p e c t e d to c h o o s e a c a p ita l
c o m m it m e n t th a t e n t a ile d a m a r g in a l
c o s t o f r e g u la to r y c a p ita l e q u a l to th e
e x p e c t e d c o s t o f th e p e n a lty fo r a
v io la tio n . T h e m o r e c o n s e r v a tiv e th e
c a p it a liz a t io n t h a t t h e r e g u la to r d e s ir e d ,
t h e la r g e r w o u l d b e t h e s p e c i f i e d
p e n a lty .
G i v e n t h e s e c o s t s , t h e b a n k ’s c h o i c e o f
a c a p ita l c o m m it m e n t w o u ld b e b a s e d
o n a s e lf-a s s e s s m e n t o f its c a p a b ilitie s to
m e a s u r e a n d c o n tr o l t h e r is k s o f its
t r a d in g a c t iv it ie s . T h e a d e q u a c y a n d
r e lia b ility o f it s in te r n a l m o d e ls fo r
m e a s u r in g r is k w o u l d p la y a n im p o r ta n t
r o l e i n t h e b a n k ’s d e t e r m i n a t i o n . B u t , a s
r e c o g n iz e d in t h e q u a lita tiv e sta n d a r d s
fo r r is k m a n a g e m e n t th a t are p a rt o f th e

t e s t s ” o f a n u l l h y p o t h e s i s t h a t a b a n k ’s
in te r n a l m o d e l i s a c c u r a te ly e s tim a tin g
a 9 9 p e r c e n t c o n f id e n c e lim it h a v e little
s t a t is t ic a l p o w e r a g a in s t a lte r n a tiv e s
th a t w o u ld in v o lv e s u b s ta n tia l
u n d e r e s tim a tio n o f p o te n tia l lo s s e s .
A fu r th e r im p lic a t io n is th a t d e c lin e s
in t h e m a r k e t v a lu e s o f p o r tfo lio s
b e y o n d t h o s e a n tic ip a t e d b y t h e m o d e ls
are in e v ita b le . In s u c h c ir c u m s ta n c e s ,
w h a t is c r itic a l— a n d w h a t c a n n o t b e
c a p tu r e d in sta n d a r d r is k m e a s u r e s — is
th e p o t e n t ia l fo r lo s s e s to b e c o n t a in e d
th r o u g h a c tiv e p o r tfo lio m a n a g e m e n t,
a n d , c o n v e r s e l y , t h e p o t e n t ia l fo r
c a ta s tr o p h ic lo s s e s i f s u c h a c tiv e
m a n a g e m e n t i s n o t fo r th c o m in g . In
c h o o s in g it s c a p ita l c o m m itm e n t, a
b a n k ’s m a n a g e m e n t w o u l d i n c o r p o r a t e
its ju d g m e n ts a b o u t th e c o m b in e d
e f fe c tiv e n e s s o f a ll c r itic a l e le m e n t s o f
t h e b a n k ’s r i s k m a n a g e m e n t s y s t e m —
n o t o n ly it s in te r n a l m o d e ls , b u t a ls o its
str u c tu r e o f r is k lim it s a n d th e
m a n a g e m e n t in fo r m a tio n s y s t e m s a n d
a u d it p r o g r a m s it h a s in p la c e to e n s u r e
c o m p lia n c e w it h t h o s e lim its .

in te r n a l m o d e ls a p p r o a c h , th e r e is m o r e
t o r is k m a n a g e m e n t th a n r is k
m e a s u r e m e n t . In a d d itio n to in te r n a l
m o d e ls fo r r is k m e a s u r e m e n t, s o u n d
r is k m a n a g e m e n t r e q u ir e s a d e t a ile d
s tr u c tu r e o f l i m it s o n r is k a n d a s tr o n g
m a n a g e m e n t in fo r m a t io n s y s t e m fo r
c o n t r o llin g , m o n ito r in g , a n d r e p o r tin g
r is k s .
T h e m e a s u r e m e n t o f m a r k e t r is k is
fr a u g h t w it h u n c e r ta in ty .
T h e m a g n it u d e o f t h e l o w p r o b a b ilit y

F u r th e r m o r e , m a n a g e m e n t w o u ld h a v e a
stro n g in c e n t iv e to str e n g th e n o v e r tim e
a ll e le m e n t s o f it s r is k m a n a g e m e n t
s y s te m to e c o n o m iz e o n c a p ita l w h ile
a v o id in g th e p e n a ltie s .
T h e b a n k ’s c h o i c e o f a c a p i t a l
c o m m it m e n t fo r m a r k e t r is k c o u l d b e
su b je c t to r e v ie w b y s u p e r v is o r y
a u th o r itie s . B a n k m a n a g e m e n t c o u ld b e
e x p e c te d to e x p la in h o w c u m u la tiv e
lo s s e s w o u ld b e c o n ta in e d w it h in th e
a m o u n t o f th e c o m m itm e n t. T h is
n e c e s s a r ily w o u l d r e q u ir e
d o c u m e n t a t io n o f h o w in te r n a l m o d e ls
a re u s e d to m e a s u r e r is k s , h o w lim it s
a re a p p lie d to t h e m e a s u r e d r is k s , h o w
c o m p lia n c e w it h lim it s is e n s u r e d , a n d
h o w m a n a g e m e n t w o u ld r e s p o n d to
u n a n tic ip a t e d lo s s e s . F u r th e r m o r e ,
s u p e r v is o r s c o u ld c o n d itio n u s e o f th e
p r e - c o m m it m e n t a lte r n a tiv e o n t h e
b a n k ’s m e e t i n g t h e s a m e q u a l i t a t i v e
s ta n d a r d s fo r m a r k e t r is k m a n a g e m e n t
s y s t e m s th a t w o u ld b e r e q u ir e d fo r u s e
o f th e in te r n a l m o d e ls a p p r o a c h , o r
p e r h a p s o n e v e n m o r e s tr in g e n t
sta n d a r d s.
It w o u l d b e im p o r ta n t t o e m p h a s iz e ,
h o w e v e r , th a t a n y su p e r v is o r y r e v ie w o f

38143

a p p r o a c h is th e sp e c ific a tio n o f th e
p e n a lt ie s th a t w o u l d r e s u lt fr o m a
f a ilu r e t o lim it t r a d in g l o s s e s t o a n
a m o u n t le s s th a n th e c o m m itm e n t.
A n a ly s is s u g g e s ts th a t th e c o s t o f th e
p e n a lt ie s s h o u ld in c r e a s e w it h t h e s iz e
o f t h e g a p b e t w e e n t h e lo s s e s in c u r r e d
a n d t h e p r e -c o m m itm e n t. T h e s e
p e n a lt ie s c o u ld ta k e v a r io u s fo r m s .
F in e s (m o n e ta r y p e n a ltie s ) w o u ld b e
e s p e c i a l ly e f f e c t iv e in c r e a tin g
a p p r o p r ia te in c e n t iv e s b e c a u s e o f t h e ir
t r a n s p a r e n c y . ( U .S . in s u r e d b a n k s m ig h t
b e r e q u ir e d to p a y a n y f in e s in to t h e
B a n k I n s u r a n c e F u n d .) A s a n a lt e r n a t iv e
to fin e s , s u p e r v is o r s c o u ld im p o s e
p u n itiv e c a p ita l c h a r g e s. T h e s e v e r ity o f
f in e s o r c a p ita l p e n a ltie s c o u ld b e
r e d u c e d i f th e y w e r e a c c o m p a n ie d b y
su p e r v is o r y s a n c tio n s , s u c h a s
r e s tr ic tio n s o n fu tu r e tr a d in g a c t iv ity .
T h e c o s t s o f t h e s e r e s tr ic tio n s w o u ld b e
m e a s u r e d b y t h e lo s s o f p r o fita b le
tr a d in g a c t iv it ie s in fu tu r e p e r io d s . S u c h
c o s ts c o u ld b e c o n s id e r a b le ; a b a n k th a t
i s u n a b le to p u r s u e p r o fita b le tr a d in g
o p p o r tu n it ie s fo r a n e x t e n d e d p e r io d
w o u ld h a v e d iffic u lty c o v e r in g o v e r h e a d
c o s ts in it s tr a d in g b u s in e s s e s a n d , o v e r
tim e , lik e ly w o u ld su ffe r d e f e c t io n s b y
it s b e s t tr a d e r s t o o t h e r fir m s .
F o r t h e p r e -c o m m itm e n t a p p r o a c h to
b e c r e d ib le , b a n k s w o u ld n e e d to b e
r e a s o n a b ly c e r ta in th a t s u p e r v is o r y
a u th o r itie s w o u ld im p o s e t h e s p e c if ie d
p e n a ltie s w h e n lo s s e s e x c e e d th e
c o m m itm e n t. T h e c e r ta in ty o f th e
p e n a lty w o u ld s tr e n g th e n t h e in c e n t iv e
fo r t h e b a n k to m a k e t h e in it ia l c a p it a l
c o m m itm e n t c o m m e n s u r a te w ith th e
s u p e r v i s o r ’s d e s i r e d c o v e r a g e o f
p o te n tia l lo s s e s . N o n e th e le s s ,
s u p e r v is o r s w o u ld n e e d to r e s e r v e th e
r ig h t t o s u s p e n d t h e p e n a lt ie s in t h e
e v e n t o f e x t r e m e p r ic e m o v e m e n t s th a t
r e f le c t m a c r o e c o n o m ic in s t a b ilit y . T h is
w o u ld h e lp e n s u r e th a t b a n k s c o u ld
c o n t in u e to p r o v id e liq u id it y to m a r k e ts
fo llo w in g s u c h s tr e s s fu l e p is o d e s . B u t
s u s p e n s io n s s h o u ld n o t in c lu d e
s itu a tio n s in w h ic h a p e n a lty w o u ld
s im p ly b e v e r y c o s tly to a n in d iv id u a l
b a n k b u t w it h o u t s y s te m ic
co n seq u en ces.
M a rk et fo r c e s m ig h t a ls o b e u t iliz e d to
p r o v id e b a n k s w it h in c e n t iv e s to

e v e n t s a b o u t w h i c h r e g u la to r s a re

th e c o m m itm e n t w o u ld in n o w a y

a llo c a t e a d e q u a te c a p it a l. I f t h e c a p it a l

c o n c e r n e d (fo r e x a m p le , t h e lo w e r lim it

d i m i n i s h t h e b a n k m a n a g e m e n t ’s

c o m m itm e n t w e r e p u b lic ly d is c lo s e d ,

o f a 9 9 p e r c e n t c o n f i d e n c e in te r v a l fo r
tr a d in g g a in s a n d lo s s e s ) s im p ly c a n n o t

r e s p o n s ib ilit y fo r s e ttin g a s id e a d e q u a te

th e r e p o r tin g o f lo s s e s in e x c e s s o f th e
c o m m it m e n t n o t o n ly w o u ld im p ly th a t

c a p it a l to c o v e r it s m a r k e t r is k s . A n

b e e s tim a te d w it h m u c h p r e c is io n .3 A

a ttr a c tiv e fe a tu r e o f th e p r e -c o m m itm e n t

c o r o lla r y o f t h is r e s u lt is th a t “ b a c k ­

a p p r o a c h is th a t it w o u ld u n d e r s c o r e th e
r e s p o n s ib ilit y o f b a n k m a n a g e m e n t fo r

o n t h e e f f e c t i v e n e s s o f t h e b a n k ’s r i s k

3 This point is developed further in Paul H.
Kupiec, “ Techniques for Verifying the Accuracy of
Risk Measurement Models.” Board of Governors of
the Federal Reserve System, Division of Research
and Statistics, staff memorandum. April 1995. This
paper can be obtained from the Board’s Freedom of
Information Office.

m a in t a in in g a d e q u a te c a p it a l, e v e n i f
th e a m o u n t n e e d e d e x c e e d s w h a t

m a n a g e m e n t c a p a b ilitie s . T o g e th e r ,




o t h e r w is e m ig h t b e r e g u la to r y m in im u m
r e q u ir e m e n ts .
T h e k e y to th e fe a s ib ility a n d
e f fe c tiv e n e s s o f t h e p r e -c o m m itm e n t

su p e r v is o r y s a n c tio n s h a d b e e n im p o s e d
o n th e b a n k , b u t c o u ld a ls o c a s t d o u b ts

t h e s e fa c to r s c o u ld a d v e r s e ly a ffe c t its
sh a r e p r ic e a n d it s fu n d in g c o s ts . F o r
t h is r e a s o n , s o m e b a n k s m ig h t a c t u a lly
b e t e m p t e d to c o m m it m o r e c a p ita l th a n
i s n e c e s s a r y t o m e e t r e g u la to r y

38144

Federal Register / Vol. 60, No. 142 / Tuesday, July 25, 1995 / Proposed Rules

o b je c tiv e s . H o w e v e r , t h is te n d e n c y
to w a r d c o n s e r v a tis m w o u ld b e
te m p e r e d b y fe a r s th a t a n e x c e s s iv e
c a p ita l c o m m it m e n t w o u ld c a u s e th e
p u b lic ( in c lu d in g s t o c k a n a ly s t s a n d
r a tin g a g e n c ie s ) to o v e r e s t im a t e t h e
r i s k i n e s s o f t h e b a n k ’s t r a d i n g a c t i v i t i e s .
T h u s, m a rk et fo r c e s c o u ld b e h a r n e ss e d
to in d u c e b a n k s to m a k e a p p r o p r ia te
c a p ita l c o m m itm e n ts .

c e r ta in c ir c u m s ta n c e s ? I f s o , u n d e r w h a t
c ir c u m s ta n c e s ? T o a v o id a d v e r s e e ffe c ts
o n m a r k e t liq u id it y ? T o a v o id im p a ir in g

T h e b a s ic is s u e is w h e th e r th e p rec o m m itm e n t a p p r o a c h is fe a s ib le a n d , if
s o , w h e t h e r it m ig h t fo r m t h e b a s is fo r
fu tu r e e n h a n c e m e n ts to s u p e r v is o r y
a p p r o a c h e s to a s s e s s in g c a p ita l
adequacy.
Q l . S h o u ld th e B o a r d e x p lo r e u s e o f
t h e p r e - c o m m it m e n t a p p r o a c h d u r in g
th e tim e th a t w ill e la p s e b e fo r e th e
s c h e d u le d im p le m e n ta tio n o f th e
p r o p o s e d m a r k e t r is k c a p it a l
r e q u ir e m e n ts ?
Q 2. W h a t are th e a d v a n ta g e s o f th e
p r e -c o m m it m e n t a p p r o a c h c o m p a r e d to
o th e r a p p r o a c h e s u n d e r c o n s id e r a tio n
b y s u p e r v is o r s ? W o u ld it, in fa c t,
p r o d u c e c a p ita l a llo c a t io n s th a t m o r e
a c c u r a te ly r e fle c t b a n k s ’ a s s e s s m e n t s o f
tr a d in g r is k s ? W o u ld it b e m o r e
c o m p a t ib le w it h b a n k s ’ r is k
m e a s u r e m e n t sy s te m s ? W o u ld it p r o v id e
str o n g e r in c e n t iv e s fo r th e im p r o v e m e n t
o f r is k m a n a g e m e n t s y s t e m s ?
Q 3 . W h a t are th e p o te n tia l d r a w b a c k s
to t h e p r e -c o m m it m e n t a p p r o a c h ? C o u ld
p e n a ltie s b e d e sta b iliz in g to b a n k s? T o
th e fin a n c ia l sy s te m ? W h a t o th e r
u n in t e n d e d c o n s e q u e n c e s m ig h t r e s u lt
fr o m im p le m e n t a tio n o f t h e a p p r o a c h ?
B e fo r e th e p r e -c o m m itm e n t a p p r o a c h
c o u ld b e im p le m e n t e d ,th e p e n a lt ie s
a s s o c i a t e d w i t h f a i lu r e t o l i m i t t r a d i n g
lo s s e s to a n a m o u n t le s s th a n t h e c a p ita l
c o m m itm e n t w o u ld n e e d to b e s p e c if ie d
m o r e p r e c is e ly .
Q 4 . W h a t fo r m s h o u ld t h e p e n a lt ie s
ta k e ? F in e s ? H ig h e r fu tu r e c a p it a l
r e q u ir e m e n ts ? O th e r r e s tr ic tio n s o n
fu tu r e tr a d in g o p p o r tu n it ie s ?
Q 5 . S h o u ld r e g u la to r s r e s e r v e t h e

a b a n k ’s c a p i t a l s o s i g n i f i c a n t l y t h a t i t s
v ia b ilit y is th r e a te n e d ? Is th e r e a d a n g e r
th a t th e p r o s p e c t o f a w a iv e r c o u ld
u n d e r m in e t h e in c e n t iv e e f fe c ts o f th e
p e n a ltie s ? H o w c o u ld s u c h a d v e r s e
in c e n t iv e e ffe c ts o f w a iv e r s b e
m in im iz e d ?
Q 6 . S h o u ld c a p ita l c o m m it m e n ts ,
tr a d in g r e s u lts , a n d p e n a lt ie s b e
p u b lic ly d is c lo s e d ? W h a t e f fe c ts w o u ld
p u b lic d is c lo s u r e h a v e o n c a p it a l
a llo c a t io n s ? O n tr a d in g b e h a v io r ? H o w
w o u ld s to c k h o ld e r s a n d c r e d ito r s re a c t
to n e w s th a t a c a p ita l c o m m it m e n t h a d
b e e n v io la te d ? C o u ld th e r e a c t io n s b e
d e s ta b iliz in g ? O n th e o th e r h a n d , i f
c o m m itm e n ts a n d r e s u lts a re n o t
p u b lic ly d is c lo s e d , w o u ld t h e a p p r o a c h
la c k c r e d ib ility ?
A n o th e r se t o f is s u e s th a t w o u ld n e e d
to b e a d d r e s s e d i s t h e r e s tr ic tio n s a n d
lim it a t io n s th a t w o u ld b e p la c e d o n u s e
o f a p r e -c o m m itm e n t a p p r o a c h .
Q 7 . A r e q u a lita t iv e s t a n d a r d s fo r
m a r k e t r is k m a n a g e m e n t n e c e s s a r y t o
im p le m e n t t h e p r e -c o m m itm e n t
a p p r o a c h ? W h a t q u a lita tiv e sta n d a r d s
fo r m a r k e t r is k m a n a g e m e n t s h o u l d b e
m e t b y b a n k s se e k in g to u s e th e p rec o m m itm e n t a p p r o a c h ? A r e th e
q u a lita tiv e s ta n d a r d s s e t o u t b y th e
B a s le S u p e r v is o r s fo r u s e o f t h e in t e r n a l
m o d e ls a p p r o a c h s u f f ic ie n t? O r s h o u ld
m o r e s tr in g e n t s ta n d a r d s b e im p o s e d ? If
so , in w h a t w a y s s h o u ld th e sta n d a r d s
b e m o r e s tr in g e n t?
Q 8 . S h o u l d a b a n k ’s c h o i c e o f a
c a p ita l c o m m itm e n t b e s u b je c t to r e v ie w
b y s u p e r v is o r y a u th o r itie s ? O r w o u ld
s u c h a r e v ie w b e u n n e c e s s a r y or
u n d e s ir a b le ?
Q 9 . T h e in c e n t iv e e ffe c ts o f th e p rec o m m itm e n t a p p r o a c h c a n b e r e lie d
u p o n to in d u c e b a n k s to m a k e r e a lis tic
c a p ita l c o m m it m e n ts o n ly i f t h e b a n k i s
b e in g m a n a g e d a s a g o in g c o n c e r n . (A
b a n k w o u ld n o t n e c e s s a r ily b e
c o n c e r n e d a b o u t p e n a ltie s th a t w o u ld b e
im p o s e d o n ly in d ie e v e n t o f its
in s o lv e n c y .) C o u ld t h is p o te n t ia l

r ig h t t o w a i v e t h e p e n a l t i e s u n d e r

p r o b le m b e a d d r e s s e d a d e q u a te ly b y

II. Issues and Questions for Public
Comment




lim itin g u s e o f th e p r e -c o m m itm e n t
a p p r o a c h to a d e q u a te ly c a p it a liz e d
b a n k s (o r e v e n t o w e l l - c a p i t a l i z e d
b a n k s)?
Q lO . E v e n f o r w e l l - c a p i t a l i z e d b a n k s ,
is t h e a p p r o a c h v ia b le i f m a r k e t r is k is
t h e p r e d o m in a n t e le m e n t in th e
i n s t i t u t i o n ’s o v e r a l l r i s k p r o f i l e ? O r
m u s t it s u s e b e r e s tr ic te d t o b a n k s fo r
w h ic h m a r k e t r is k a s s o c ia t e d w it h th e
t r a d in g a c c o u n t i s a r e la t iv e ly s m a ll
e le m e n t in t h e ir o v e r a ll r is k p r o f ile ? A s
p r a c tic a l m a tte r , d o b a n k s t y p ic a lly
a llo c a t e m o r e t h a n a s m a ll f r a c t io n o f
t h e i r t o t a l c a p i t a l t o c o v e r m a r k e t r is k ?
A f in a l is s u e th a t w o u ld b e n e f it fr o m
p u b lic c o m m e n t r e la te s to h o w tr a d in g
g a in s a n d lo s s e s s h o u ld b e m e a s u r e d fo r
p u r p o s e s o f d e t e r m in in g w h e t h e r t h e
c a p ita l c o m m it m e n t h a s b e e n v io la te d .
Q l l . S h o u ld sp r e a d s o n c u s t o m e r o r
m a r k e t-m a k in g b u s in e s s e s b e in c lu d e d
in tr a d in g g a in s a n d lo s s e s o r s h o u ld
th e y b e e x c lu d e d ? W h y o r w h y n o t? C a n
r e v e n u e s fr o m c u s t o m e r a c c o m m o d a t io n
a n d m a r k e t m a k in g b e s e p a r a te d r e lia b ly
fr o m r e v e n u e s fr o m p o s it io n ta k in g ?
Q 1 2 . S h o u ld g a in s o r lo s s e s fr o m
c h a n g e s in th e c r e d it q u a lity o f a s s e t s
h e ld in tr a d in g a c c o u n t s b e in c lu d e d o r
e x c lu d e d ? If in c lu d e d , w o u ld th e r e b e
a n y n e e d fo r se p a r a te c a p ita l
r e q u ir e m e n ts fo r s p e c i f i c r is k (a s
o p p o s e d t o g e n e r a l m a r k e t r is k ) ?
Q 1 3 . In g e n e r a l, a re p r o fits a n d lo s s e s
o n t r a d in g a c c o u n t s s u f f ic ie n t ly
tr a n sp a r e n t th a t su p e r v is o r s c o u ld
r e lia b ly d e t e r m in e w h e t h e r a c a p it a l
c o m m it m e n t h a s b e e n v io la te d ? C o u ld
c o n c e r n s o n th is sc o r e b e a d d r e ss e d
th r o u g h q u a lita tiv e sta n d a r d s fo r
v a l u a t i o n ( e .g ., s t a n d a r d s f o r
d o c u m e n t a t io n o f p o l i c i e s r e g a r d in g
v a lu a tio n a d ju s tm e n ts a n d a d h e r e n c e to
th o s e p o lic ie s )?

By order of the Board of Governors of the
Federal Reserve System, July 12,1995.
William W. Wiles,
Secretary of the Board.
(FR Doc. 95-17541 Filed 7-24-95; 8:45 am]
BILLING CODE 6210-01-P