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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 3
[Docket No. 00-06]
RIN 1557-AB14
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[Regulations H and Y; Docket No. R-1055]
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 325
RIN 3064-AB31
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
12 CFR Part 567
[Docket No. 2000-15]
RIN 1550-AB11
Risk-Based Capital Standards;
Recourse and Direct Credit Substitutes
AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of Governors of
the Federal Reserve System; Federal Deposit Insurance Corporation; and Office of Thrift
Supervision, Treasury.
ACTION: 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), the Federal Deposit Insurance Corporation
(FDIC), and the Office of Thrift Supervision (OTS) (collectively, the agencies) are proposing
changes to their risk-based capital standards to address the regulatory capital treatment of
recourse obligations and direct credit substitutes that expose banks, bank holding companies,
and thrifts (collectively, banking organizations) to credit risk. The proposal treats recourse
obligations and direct credit substitutes more consistently than under the agencies’current
-2risk-based capital standards. In addition, the agencies would use credit ratings and certain
alternative approaches to match the risk-based capital requirement more closely to a banking
organization’s relative risk of loss in asset securitizations. The proposal also requires the
sponsor of a revolving credit securitization that involves an early amortization feature to hold
capital against the amount of assets under management, i.e. the off-balance sheet securitized
receivables.
This proposal is intended to result in more consistent treatment of recourse obligations
and similar transactions among the agencies, more consistent risk-based capital treatment for
certain types of transactions involving similar risk, and capital requirements that more closely
reflect a banking organization’s relative exposure to credit risk.
DATES: Your comments must be received by [INSERT DATE 90 DAYS AFTER DATE
OF PUBLICATION IN THE FEDERAL REGISTER].
ADDRESSES: Comments should be directed to:
OCC: You may send comments electronically to regs.comments@occ.treas.gov or by
mail to Docket No. 00-06, Communications Division, Third Floor, Office of the Comptroller
of the Currency, 250 E Street, SW, Washington, DC 20219. In addition, you may send
comments by facsimile transmission to (202) 874-5274. You can inspect and photocopy
comments at that address.
Board: Comments, which should refer to Docket No. R-1055, may be mailed to
Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve System, 20th Street
and Constitution Avenue, NW, Washington, DC 20551. Comments may also be delivered to
Room B-2222 of the Eccles Building between 8:45 a.m. and 5:15 p.m. weekdays, or to the
guard station in the Eccles Building courtyard on 20th Street between Constitution Avenue
-3and C Street, NW, 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 addressed to Robert E. Feldman, Executive
Secretary, Attention: Comments/OES, Federal Deposit Insurance Corporation, 550
17th Street, NW, Washington, DC 20429. Comments may be hand delivered to the guard
station at the rear of the 550 17th Street Building (located on F Street), on business days
between 7:00 a.m. and 5:00 p.m. (Fax number: (202) 898-3838; Internet address:
comments@fdic.gov). Comments may be inspected and photocopied in the FDIC Public
Information Center, Room 100, 801 17th Street, NW, Washington, DC, between 9:00 a.m.
and 4:30 p.m. on business days.
OTS: Send comments to Manager, Dissemination Branch, Records Management and
Information Policy, Office of Thrift Supervision, 1700 G Street, NW, Washington, DC
20552, Attention Docket No. 2000-15. These submissions may be hand-delivered to 1700
G Street, NW, from 9:00 a.m. to 5:00 p.m. on business days or may be sent by facsimile
transmission to FAX number (202) 906-7755; or by e-mail: public.info@ots.treas.gov.
Those commenting by e-mail should include their name and telephone number. Comments
will be available for inspection at 1700 G Street, NW, from 9:00 to 4:00 p.m. on business
days.
FOR FURTHER INFORMATION CONTACT:
OCC: Roger Tufts, Senior Economic Advisor or Amrit Sekhon, Risk Specialist,
Capital Policy Division, (202) 874-5070; Laura Goldman, Senior Attorney, Legislative and
-4Regulatory Activities Division, (202) 874-5090, Office of the Comptroller of the Currency,
250 E Street, SW, Washington, DC 20219.
Board: Thomas R. Boemio, Senior Supervisory Financial Analyst, (202) 452-2982, or
Norah Barger, Assistant Director (202) 452-2402, Division of Banking Supervision and
Regulation. For the hearing impaired only, Telecommunication Device for the Deaf (TDD),
Diane Jenkins, (202) 452-3544, Board of Governors of the Federal Reserve System, 20th
Street and Constitution Avenue, NW, Washington, DC 20551.
FDIC: Robert F. Storch, Chief, Accounting Section, Division of Supervision, (202)
898-8906; or Jamey Basham, Counsel, Legal Division, (202) 898-7265, Federal Deposit
Insurance Corporation, 550 17th Street, NW, Washington, DC 20429.
OTS: Michael D. Solomon, Senior Program Manager for Capital Policy, Supervision
Policy, (202) 906-5654; or Karen Osterloh, Assistant Chief Counsel (202) 906-6639, Office
of Thrift Supervision, 1700 G Street, NW, Washington, DC 20552.
SUPPLEMENTARY INFORMATION:
I.
Introduction
The agencies are proposing to amend their risk-based capital standards to change the
treatment of certain recourse obligations, direct credit substitutes, and securitized transactions
that expose banking organizations to credit risk. This proposal amends the agencies' riskbased capital standards to align more closely the risk-based capital treatment of recourse
obligations and direct credit substitutes and to vary the capital requirements for positions in
securitized transactions (and certain other credit exposures) according to their relative risk.
The proposal also requires the sponsor of a revolving credit securitization that involves an
-5early amortization feature to hold capital against the amount of assets under management in
that securitization.
This proposal builds on the agencies’earlier work with respect to the appropriate riskbased capital treatment for recourse obligations and direct credit substitutes. On May 25,
1994, the agencies published in the Federal Register a proposal to reduce the capital
requirement for banks for low-level recourse transactions, to treat first-loss (but not secondloss) direct credit substitutes like recourse, and to implement definitions of "recourse," "direct
credit substitute," and related terms. 59 FR 27116 (May 25, 1994) (the 1994 Notice). The
1994 Notice also contained, in an advance notice of proposed rulemaking, a proposal to use
credit ratings to determine the capital treatment of certain recourse obligations and direct
credit substitutes. The OCC, the Board, and the FDIC subsequently implemented the capital
reduction for low-level recourse transactions, thereby satisfying the requirements of section
350 of the Riegle Community Development and Regulatory Improvement Act, Public Law
103-325, sec. 350, 108 Stat. 2160, 2242 (1994) (CDRI Act).1 The OTS risk-based capital
regulation already included the low-level recourse treatment required by the statute.2 The
agencies did not issue a final regulation on the remaining elements of the 1994 Notice.
On November 5, 1997, the agencies published another notice of proposed rulemaking.
62 FR 59943 (1997 Proposal). In the 1997 Proposal, the agencies proposed to use credit
ratings from nationally recognized statistical rating organizations to determine the capital
requirement for recourse obligations, direct credit substitutes, and senior asset-backed
1
See 60 FR 17986 (April 10, 1995) (OCC); 60 FR 8177 (February 13, 1995) (Board);
60 FR 15858 (March 28, 1995) (FDIC).
2
See 60 FR 45618 (August 31, 1995.)
-6securities. Additionally, the 1997 Proposal requested comment on a series of options and
alternatives to supplement or replace the ratings-based approach.
In June 1999, the Basel Committee on Banking Supervision issued a consultative
paper, "A New Capital Adequacy Framework, that sets forth possible revisions to the 1988
Basel Accord.3 The Basel consultative paper discusses potential modifications to the current
capital standards, including the capital treatment of securitizations. The suggested changes in
the Basel consultative paper move in the same direction as this proposal by looking to external
credit ratings issued by qualifying external credit assessment institutions as a basis for
determining the credit quality and the resulting capital treatment of securitizations.
II.
Background
A.
Asset Securitization
Asset securitization is the process by which loans or other credit exposures are pooled
and reconstituted into securities, with one or more classes or positions, that may then be sold.
Securitization4 provides an efficient mechanism for banking organizations to buy and sell loan
assets or credit exposures and thereby to make them more liquid.
Securitizations typically carve up the risk of credit losses from the underlying assets
and distribute it to different parties. The "first dollar," or subordinate, loss position is first to
absorb credit losses; the most "senior" investor position is last; and there may be one or more
3
International Convergence of Capital Measurement and Capital Standards (July
1988).
4
For purposes of this discussion, references to "securitization" also include structured
finance transactions or programs that generally create stratified credit risk positions, which
may or may not be in the form of a security, whose performance is dependent upon a pool of
loans or other credit exposures.
-7loss positions in between ("second dollar" loss positions). Each loss position functions as a
credit enhancement for the more senior loss positions in the structure.
For residential mortgages sold through certain Federally-sponsored mortgage
programs, a Federal government agency or Federal government sponsored enterprise (GSE)
guarantees the securities sold to investors. However, many of today's asset securitization
programs involve nonmortgage assets or are not Federally supported in any way. Sellers of
these privately securitized assets therefore often provide other forms of credit
enhancement--first and second dollar loss positions--to reduce investors' risk of credit loss.
A seller may provide this credit enhancement itself through recourse arrangements. As
defined in this proposal, "recourse" refers to the risk of credit loss that a banking organization
retains in connection with the transfer of its assets. Banking organizations have long provided
recourse in connection with sales of whole loans or loan participations; today, recourse
arrangements frequently are associated with asset securitization programs.
A seller may also arrange for a third party to provide credit enhancement5 in an asset
securitization. If the third-party enhancement is provided by another banking organization,
that organization assumes some portion of the assets' credit risk. In this proposal, all forms of
third-party enhancements, i.e., all arrangements in which a banking organization assumes risk
of credit loss from third-party assets or other claims that it has not transferred, are referred to
as "direct credit substitutes." The economic substance of a banking organization's risk of
credit loss from providing a direct credit substitute can be identical to its risk of credit loss
from transferring an asset with recourse.
5
As used in this proposal, the terms "credit enhancement" and "enhancement" refer to
both recourse arrangements and direct credit substitutes.
-8Depending on the type of securitization transaction, the sponsor of a securitization
may provide a portion of the total credit enhancement internally, as part of the securitization
structure, through the use of spread accounts, overcollateralization, retained subordinated
interests, or other similar forms of on-balance sheet assets. When these or other types of
internal enhancements are provided, the enhancements are considered a form of recourse for
risk-based capital purposes. Many asset securitizations use a combination of internal
enhancement, recourse, and third-party enhancement to protect investors from risk of credit
loss.
B.
Risk Management of Exposures Arising from Securitization Activities
While asset securitization can enhance both credit availability and a banking
organization’s profitability, managing the risks associated with this activity can pose
significant challenges. This is because the risks involved, while not new to banking
organizations, may be less obvious and more complex than the risks of traditional lending.
Specifically, securitization can involve credit, liquidity, operational, legal, and reputational
risks in concentrations and forms that may not be fully recognized by management or
adequately incorporated into a banking organization's risk management systems.
The risk-based capital treatment described in this proposal provides one important way
of addressing the credit risk presented by securitization activities, but a banking organization’s
compliance with capital standards should be complemented by effective risk management
strategies. The agencies expect that banking organizations will identify, measure, monitor and
control the risks of their securitization activities (including synthetic securitizations6 using
6
"Synthetic securitization" refers to the bundling of credit risk associated with onbalance sheet assets and off-balance sheet items for subsequent sale into the market.
-9credit derivatives) and explicitly incorporate the full range of risks into their risk management
systems. Management is responsible for having adequate policies and procedures in place to
ensure that the economic substance of their risks is fully recognized and appropriately
managed. Banking organizations should be able to measure and manage their risk exposure
from risk positions in the securitizations, either retained or acquired, and should be able to
assess the credit quality of the retained residual portfolio after the transfer of assets in a
securitization transaction. The formality and sophistication with which the risks of these
activities are incorporated into a banking organization's risk management system should be
commensurate with the nature and volume of its securitization activities. Banking
organizations with significant securitization activities, no matter what the size of their onbalance sheet assets, are expected to have more elaborate and formal approaches to manage
the risks. Failure to understand the risks inherent in securitization activities and to incorporate
them into risk management systems and internal capital allocations may constitute an unsafe or
unsound banking practice.
Banking organizations must have adequate systems that evaluate the effect of
securitization transactions on the banking organization’s risk profile and capital adequacy.
Based on the complexity of transactions, these systems should be capable of differentiating
between the nature and quality of the risk exposures transferred versus those that the banking
organization retains. Adequate management systems usually:
• Have an internal system for grading credit risk exposures, including: (1) adequate
differentiation of risk among risk grades; (2) adequate controls to ensure the objectivity and
- 10 consistency of the rating process; and (3) analysis or evidence supporting the accuracy or
appropriateness of the risk-grading system.7
• Evaluate the effect of the transaction on the nature and distribution of the banking
book exposures that have not been transferred in connection with securitization. This analysis
should include a comparison of the banking book’s risk profile before and after the
transaction, including the mix of exposures by risk grade and by business or economic sector.
The analysis should also include identification of any concentrations of credit risk.
• Perform rigorous, forward-looking stress testing8 on exposures that have not been
transferred (that is, loans and commitments remaining in the banking book), transferred
exposures, and exposures retained to facilitate transfers (that is, credit enhancements).
• Have an internal economic capital allocation methodology that provides the banking
organization will have adequate capitalization to meet a specific probability that it will not
become insolvent if unexpected credit losses occur and that readjusts, as necessary, the
7
In this regard, the agencies note that one increasingly important component of the
systems for controlling credit risk at larger banking organizations is the identification of the
gradations in credit risk among their business loans and the assignment of internal credit risk
ratings to loans that correspond to these gradations. The agencies believe that the use of such
an internal rating process is appropriate--indeed, necessary--for sound risk management at
large banking organizations. In particular, those banking organizations with significant
involvement in securitization activities should have relatively elaborate and formal approaches
for assessing and managing the associated credit risk.
8
Stress testing usually involves identifying possible events or changes in market
behavior that could have unfavorable effects on an banking organization and assessing the
organization’s ability to withstand them. Stress testing should not only consider the
probability of adverse events, but also potential "worst case" scenarios. Such an analysis
should be done on a consolidated basis and consider, for example, the effect of higher than
expected levels of delinquencies and defaults. The analysis should also consider the
consequences of early amortization events that could raise concerns regarding a banking
organization’s capital adequacy and its liquidity and funding capabilities. Stress test analyses
should also include contingency plans regarding the actions management might take given
certain situations.
- 11 sponsoring bank’s internal economic capital requirements to take into account the effect of the
securitization transactions.
Banking organizations should ensure that their capital positions are sufficiently strong
to support all of the risks associated with these activities on a fully consolidated basis and
should maintain adequate capital in all affiliated entities engaged in these activities.
C.
Current Risk-Based Capital Treatment of Recourse and Direct Credit
Substitutes
Currently, the agencies' risk-based capital standards apply different treatments to
recourse arrangements and direct credit substitutes. As a result, capital requirements
applicable to credit enhancements do not consistently reflect credit risk. The current rules of
the OCC, Board, and FDIC (the banking agencies) are also not entirely consistent with those
of the OTS.
1.
Recourse
The agencies' risk-based capital guidelines prescribe a single treatment for assets
transferred with recourse, regardless of whether the transaction is reported as a financing or a
sale of assets in a bank's Consolidated Reports of Condition and Income (Call Report), a bank
holding company’s FR Y-9 reports, or a thrift’s Thrift Financial Report.9 For a transaction
reported as a financing, the transferred assets remain on the balance sheet and are riskweighted. For a transaction reported as a sale, the entire outstanding amount of the assets
sold (not just the contractual amount of the recourse obligation) is converted into an on-
9
Assets transferred with any amount of recourse in a transaction reported as a
financing in accordance with generally accepted accounting principles (GAAP) remain on the
balance sheet and are risk-weighted in the same manner as any other on-balance sheet asset.
Assets transferred with recourse in a transaction that is reported as a sale under GAAP are
removed from the balance sheet and are treated as off-balance sheet exposures for risk-based
capital purposes.
- 12 balance sheet credit equivalent amount using a 100% credit conversion factor. This credit
equivalent amount (less any applicable recourse liability account recorded on the balance
sheet) is then risk-weighted.10 If the seller’s balance sheet includes as an asset any retained
interest in the assets sold, the retained interest is not risk-weighted separately. Thus,
regardless of the method used to account for the transfer, risk-based capital is held against the
full, risk-weighted amount of the transferred assets, although the transaction is subject to the
low-level recourse rule, which limits the maximum risk-based capital requirement to the
banking organization’s maximum contractual exposure.11
For leverage capital ratio purposes, if a transfer with recourse is reported as a
financing, the transferred assets remain on the transferring banking organization’s balance
sheet and the banking organization must hold leverage capital against these assets. If a
transfer with recourse is reported as a sale, the assets sold do not remain on the selling
banking organization’s balance sheet and the banking organization need not hold leverage
capital against these assets. However, if the seller’s balance sheet includes as an asset any
retained interest in the assets sold, leverage capital must be held against the retained interest.
2.
Direct Credit Substitutes
Direct credit substitutes are treated differently from recourse under the current riskbased capital standards. Under the banking agencies' current standards, off-balance sheet
10
Consistent with statutory requirements, the agencies’current rules also provide for
special treatment of sales of small business loan obligations with recourse. See 12 CFR
Part 3, appendix A, Section 3(c) (OCC); 12 CFR parts 208 and 225, appendix A, II.B.5
(FRB); 12 CFR part 325, appendix A, II.B.6 (FDIC); 12 CFR 567.6(E)(3) (OTS).
11
Section 350 of the CDRI Act required the agencies to prescribe regulations
providing that the risk-based capital requirement for assets transferred with recourse could not
exceed a banking organization’s maximum contractual exposure. The agencies may require a
higher amount if necessary for safety and soundness reasons. See 12 U.S.C. 4808.
- 13 direct credit substitutes, such as financial standby letters of credit provided for third-party
assets, carry a 100% credit conversion factor. However, only the dollar amount of the direct
credit substitute is converted into an on-balance sheet credit equivalent amount, so that capital
is held only against the face amount of the direct credit substitute. The capital requirement for
a recourse arrangement, in contrast, generally is based on the full amount of the assets
enhanced.
If a direct credit substitute covers less than 100% of the potential losses on the assets
enhanced, the current capital treatment results in a lower capital charge for a direct credit
substitute than for a comparable recourse arrangement. For example, if a direct credit
substitute covers losses up to the first 20% of the assets enhanced, then the on-balance sheet
credit equivalent amount equals that 20% amount, and risk-based capital is held against only
the 20% amount. In contrast, required capital for a first-loss 20% recourse arrangement is
higher because capital is held against the full outstanding amount of the assets enhanced,
subject to the low-level recourse rule.
Currently, under the banking agencies' guidelines, purchased subordinated interests
receive the same capital treatment as off-balance sheet direct credit substitutes. That is, the
amount of the purchased subordinated interest is placed in the appropriate risk-weight
category. In contrast, a banking organization that retains a subordinated interest in
connection with the transfer of its own assets is considered to have transferred the assets with
recourse. As a result, the banking organization must hold capital against the carrying amount
of the retained subordinated interest as well as the outstanding amount of all senior interests
that it supports, subject to the low-level recourse rule.
- 14 The OTS risk-based capital regulation treats some forms of direct credit substitutes
(e.g., financial standby letters of credit) in the same manner as the banking agencies'
guidelines. However, unlike the banking agencies, the OTS treats purchased subordinated
interests (except for certain high quality subordinated mortgage-related securities) under its
general recourse provisions. The risk-based capital requirement is based on the carrying
amount of the subordinated interest plus all senior interests, as though the thrift owned the full
outstanding amount of the assets enhanced.
3.
Concerns Raised by Current Risk-based Capital Treatment
The agencies’current risk-based capital standards raise significant concerns with
respect to the treatment of recourse and direct credit substitutes. First, banking organizations
are often required to hold different amounts of capital for recourse arrangements and direct
credit substitutes that expose the banking organization to equivalent risk of credit loss.
Banking organizations are taking advantage of this anomaly, for example, by providing firstloss letters of credit to asset-backed commercial paper conduits that lend directly to corporate
customers. This results in a significantly lower capital requirement than if the loans had
originally been carried on the banking organizations' balance sheets and then were sold.
Moreover, the current capital standards do not recognize differences in risk associated with
different loss positions in asset securitizations, nor do they provide uniform definitions of
recourse, direct credit substitute, and associated terms.
III.
Description of the Proposal
This proposal would amend the agencies' risk-based capital standards as follows:
- 15 • The proposal defines "recourse" and revises the definition of "direct credit
substitute";12
• It provides more consistent risk-based capital treatment for recourse obligations and
direct credit substitutes;
• It varies the capital requirements for positions in securitized transactions according
to their relative risk exposure, using credit ratings from nationally recognized statistical rating
organizations13 (rating agencies) to measure the level of risk;
• It permits the limited use of a banking organization’s qualifying internal risk rating
system, a rating agency’s or other appropriate third party’s review of the credit risk of
positions in structured programs, and qualifying software to determine the capital requirement
for certain unrated direct credit substitutes; and
• It requires the sponsor of a revolving credit securitization that involves an early
amortization feature to hold capital against the amount of assets under management in that
securitization.
The use of credit ratings in this proposal is similar to the 1997 Proposal. Although
many commenters expressed concerns about specific details in the 1997 Proposal, commenters
generally supported the goal of making the capital requirements associated with asset
12
The OTS, which already defines the term "recourse" in its rules, would revise its
definition so that it is consistent with the definition adopted by the other agencies. The OTS
is also adding a definition of "financial guarantee-type letter of credit" to be consistent with
the OCC and the Board.
13
"Nationally recognized statistical rating organization" means an entity recognized by
the Division of Market Regulation of the Securities and Exchange Commission as a nationally
recognized statistical rating organization for various purposes, including the capital rules for
broker-dealers. See SEC Rule 15c3-1(c)(2)(vi)(E), (F) and (H), 17 CFR 240.15c31(c)(2)(vi)(E), (F), and (H).
- 16 securitizations more rational and efficient, and viewed the 1997 Proposal as a positive step
toward achieving a more consistent, rational, and efficient regulatory capital framework. The
agencies have made several changes to the 1997 Proposal in response to commenters’
concerns and based on further agency consideration of the issues presented.
Several options and alternatives in the 1997 Proposal have been eliminated: the
modified gross-up approach, the ratings benchmark approach, and the historical losses
approach.14 Commenters expressed numerous concerns about these approaches and the
agencies agree that better alternatives exist.
Commenters responding to the 1997 Proposal expressed a number of concerns about
the use of ratings from rating agencies to determine capital requirements, especially in the case
of unrated direct credit substitutes. Commenters noted that banking organizations actively
involved in the securitization business have their own internal risk rating systems, that banking
organizations know their assets better than third parties, and that a requirement that a banking
organization obtain a rating from a rating agency solely for regulatory capital purposes is
burdensome. Some commenters also expressed skepticism about the suitability of rating
agency credit ratings for regulatory capital purposes.
In the opinion of the agencies, ratings have the advantages of being relatively
objective, widely used, and relied upon by investors and other participants in the financial
markets. Ratings provide a flexible, efficient, market-oriented way to measure credit risk.
The agencies recognize, however, that there are drawbacks to using credit ratings from rating
agencies to set capital requirements. Moreover, the agencies agree with some commenters’
14
1997).
For a description of these approaches, see 62 FR 59944, 59952-59961(November 5,
- 17 observation that credit ratings are most useful with respect to publicly-traded positions that
would be rated regardless of the agencies’risk-based capital requirements.
To minimize the need for banking organizations to obtain ratings on otherwise unrated
enhancements that are provided in asset-backed commercial paper securitizations, the
proposal permits banking organizations to use their own qualifying internal risk rating systems
in place of ratings from rating agencies for risk weighting certain direct credit substitutes. The
use of internal risk ratings to assign direct credit substitutes in asset-backed commercial paper
programs to rating categories under the ratings-based approach is dependent upon the
existence of adequate internal risk rating systems. The adequacy of any internal risk rating
system will be depend upon a banking organization’s incorporation of the prudential standards
outlined in this proposal, as well as other factors recommended through supervisory guidance
or on a case-by-case basis.
Finally, the agencies are proposing an additional measure to address the risk associated
with early amortization features in certain asset securitizations. The managed assets
approach, described in Section III.D., would apply a 20% risk weight to the amount of offbalance sheet securitized assets under management in such transactions.
A.
Definitions and Scope of the Proposal
1.
Recourse
The proposal defines the term "recourse" to mean an arrangement in which a banking
organization retains risk of credit loss in connection with an asset transfer, if the risk of credit
loss exceeds a pro rata share of the banking organization's claim on the assets. The proposed
definition of recourse is consistent with the banking agencies' longstanding use of this term,
- 18 and incorporates existing agency practices regarding retention of risk in asset transfers into the
risk-based capital standards.15
Currently, the term "recourse" is not defined explicitly in the banking agencies' riskbased capital guidelines. Instead, the guidelines use the term "sale of assets with recourse,"
which is defined by reference to the Call Report Instructions. See Call Report Instructions,
Glossary (entry for "Sales of Assets for Risk-Based Capital Purposes"). Once a definition of
recourse is adopted in the risk-based capital guidelines, the banking agencies would remove
the cross-reference to the Call Report instructions from the guidelines. The OTS capital
regulation currently provides a definition of the term "recourse," which would also be replaced
once a final definition of recourse is adopted.
2.
Direct Credit Substitute
The proposed definition of "direct credit substitute" complements the definition of
recourse. The term "direct credit substitute" would refer to any arrangement in which a
banking organization assumes risk of credit-related losses from assets or other claims it has
not transferred, if the risk of credit loss exceeds the banking organization's pro rata share of
the assets or other claims. Currently, under the banking agencies' guidelines, this term covers
guarantee-type arrangements. As revised, it would also include explicitly items such as
purchased subordinated interests, agreements to cover credit losses that arise from purchased
loan servicing rights, credit derivatives and lines of credit that provide credit enhancement.
15
The OTS currently defines the term "recourse" more broadly than the proposal to
include arrangements involving credit risk that a thrift assumes or accepts from third-party
assets as well as risk that it retains in an asset transfer. Under the proposal, credit risk that a
banking organization assumes from third-party assets falls under the definition of "direct credit
substitute" rather than "recourse."
- 19 Some commenters responding to the 1997 Proposal suggested that the definition of
"direct credit substitute" should exclude risk positions that are not part of an asset
securitization. Although direct credit substitutes commonly are used in asset securitizations,
enhancements involving similar credit risk exposure can arise in other contexts and should
receive the same capital treatment as enhancements associated with securitizations.
Several commenters objected to the 1997 Proposal’s treatment of direct credit
substitutes as recourse. Commenters asserted that the business of providing third-party credit
enhancements has historically been safe and profitable for banks and objected that the
proposed capital treatment would impair the competitive position of U.S. banks and thrifts.
As has been previously described, however, the current treatment of direct credit substitutes is
not consistent with the treatment of recourse obligations. The agencies have concluded that
the difference in treatment between the two forms of credit enhancement invites banking
organizations to obtain direct credit substitutes in place of recourse obligations in order to
avoid the capital requirement applicable to recourse obligations and on-balance-sheet assets.
For this reason, the agencies are again proposing, as a general rule, to extend the current riskbased capital treatment of asset transfers with recourse, including the low-level recourse rule,
to direct credit substitutes.
In an effort to address competitive inequities at the international level, however, the
agencies have raised this issue with the bank supervisory authorities from the other countries
represented on the Basel Committee on Banking Supervision. The Basel Committee’s
consultative paper, "A New Capital Adequacy Framework," acknowledges that the current
Basel Capital Accord, upon which the agencies’risk-based capital standards are based, lacks
consistency in its treatment of credit enhancements.
- 20 3.
Lines of Credit
One commenter requested clarification that a line of credit that provides credit
enhancement for the financial obligations of an account party could be a direct credit
substitute only if it represented an irrevocable obligation to the beneficiary. A revocable line
of credit would not be a direct credit substitute because the issuer could protect itself against
credit losses at any time prior to a draw on the line of credit. However, an irrevocable line of
credit could expose the issuer to credit losses and would constitute a direct credit substitute, if
it met the criteria in the definitions. Also, any conditions attached to the issuer’s ability to
revoke the undrawn portion of a line of credit, or that interfere with the issuer’s ability to
protect itself against credit loss prior to a draw, will cause the line of credit to constitute a
direct credit substitute.
4.
Credit Derivatives
The proposed definitions of "recourse" and "direct credit substitute" cover credit
derivatives to the extent that a banking organization’s credit risk exposure exceeds its pro rata
interest in the underlying obligation. The ratings-based approach therefore applies to rated
instruments such as credit-linked notes issued as part of a synthetic securitization.16 The
agencies request comment on the inclusion of credit derivatives in the definitions of "recourse"
and "direct credit substitute," as well as on the definition of "credit derivative" contained in
the proposal.
16
"Synthetic securitization" refers to the bundling of credit risk associated with onbalance sheet assets and off-balance sheet items for subsequent sale into the market. Credit
derivatives, and in particular credit-linked notes, are used to structure a synthetic
securitization. For more information on synthetic securitizations see, Joint OCC and Federal
Reserve Board Issuance on Credit Derivatives, "Capital Interpretations--Synthetic
Collateralized Loan Obligations," dated November 15, 1999.
- 21 5.
Risks Other than Credit Risks
A capital charge would be assessed only against arrangements that create exposure to
credit or credit-related risks. This continues the agencies' current practice and is consistent
with the risk-based capital standards' traditional focus on credit risk. The agencies have
undertaken other initiatives to ensure that the risk-based capital standards take interest rate
risk and other non-credit related market risks into account.
6.
Implicit Recourse
The definitions cover all arrangements that are recourse or direct credit substitutes in
form or in substance. Recourse may also exist when a banking organization assumes risk of
loss without an explicit contractual agreement or, if there is a contractual limit, when the
banking organization assumes risk of loss in an amount exceeding the limit. The existence of
implicit recourse is often a complex and fact-specific issue, usually demonstrated by a banking
organization’s actions to support a securitization beyond any contractual obligation. Actions
that may constitute implicit recourse include: providing voluntary support for a securitization
by selling assets to a trust at a discount from book value; exchanging performing for nonperforming assets; or other actions that result in a significant transfer of value in response to
deterioration in the credit quality of a securitized asset pool.
To date, the agencies have taken the position that when a banking organization
provides implicit recourse, it generally should hold capital in the same amount as for assets
sold with recourse. However, the complexity of many implicit recourse arrangements and the
variety of circumstances under which implicit recourse may be provided raise issues about
whether recourse treatment is always the most appropriate way to address the level of risk
that a banking organization has effectively retained or whether a different capital requirement
- 22 would be warranted in some circumstances. Accordingly, the 1997 Proposal requested
comment on the types of actions that should be considered implicit recourse and how the
agencies should treat those actions for regulatory capital purposes.
Commenters responding to the 1997 Proposal generally supported the view that
implicit recourse is best handled on a case-by-case basis, guided by the general rule that
actions that demonstrate retention of risk will trigger recourse treatment of affected
transactions. The agencies intend to continue to address implicit recourse case-by-case, but
may issue additional guidance if needed to clarify further the circumstances in which a banking
organization will be considered to have provided implicit recourse.
7.
Subordinated Interests in Loans or Pools of Loans
The definitions of recourse and direct credit substitute explicitly cover a banking
organization's ownership of subordinated interests in loans or pools of loans. This continues
the banking agencies' longstanding treatment of retained subordinated interests as recourse
and recognizes that purchased subordinated interests can also function as credit
enhancements. (The OTS currently treats both retained and purchased subordinated securities
as recourse obligations.) Subordinated interests generally absorb more than their pro rata
share of losses (principal and interest) from the underlying assets in the event of default. For
example, a multi-class asset securitization may have several classes of subordinated securities,
each of which provides credit enhancement for the more senior classes. Generally, the holder
of any class that absorbs more than its pro rata share of losses from the total underlying assets
is providing credit protection for all of the more senior classes.17
17
Current OTS risk-based capital guidelines exclude certain high-quality subordinated
mortgage-related securities from treatment as recourse arrangements due to their credit
quality.
- 23 Some commenters questioned the treatment of purchased subordinated interests as
recourse. Subordinated interests expose holders to comparable risk regardless of whether the
interests are retained or purchased. If purchased subordinated interests were not treated as
recourse, banking organizations could avoid recourse treatment by swapping retained
subordinated interests with other banking organizations or by purchasing subordinated
interests in assets originated by a conduit. The proposal would mitigate the effect of treating
purchased subordinated interests as recourse by reducing the capital requirement on interests
that qualify under the multi-level approach described in section III.B.
8.
Representations and Warranties
When a banking organization transfers assets, including servicing rights, it customarily
makes representations and warranties concerning those assets. When a banking organization
purchases loan servicing rights, it may also assume representations and warranties made by the
seller or a prior servicer. These representations and warranties give certain rights to other
parties and impose obligations upon the seller or servicer of the assets. The proposal
addresses those particular representations and warranties that function as credit
enhancements, i.e. those where, typically, a banking organization agrees to protect purchasers
or some other party from losses due to the default or non-performance of the obligor or
insufficiency in the value of collateral. Therefore, to the extent a banking organization's
representations and warranties function as credit enhancements to protect asset purchasers or
investors from credit risk by obligating the banking organization to protect another party from
losses due to credit risk in the transferred assets, the proposal treats them as recourse or direct
credit substitutes.
- 24 The 1997 Proposal treated as recourse or a direct credit substitute any representation
or warranty other than a standard representation or warranty. Standard representations and
warranties were those referring to facts verified by the seller or servicer with reasonable due
diligence or conditions within the control of the seller or servicer and those providing for the
return of assets in the event of fraud or documentation deficiencies. Some commenters
objected that the 1997 Proposal would treat as recourse many industry-standard warranties
that impose only minor operational risk instead of true credit risk. Other commenters
objected that the due diligence requirement was burdensome, and that it would impose
compliance costs on banking organizations disproportionate to the risk assumed.
The current proposal focuses on whether a warranty allocates credit risk to the
banking organization, rather than whether the warranty is somehow standard or customary
within the industry. Several commenters suggested that the agencies expressly take accepted
mortgage banking industry practice into account in determining whether a warranty should
receive recourse treatment. However, the agencies are aware of warranties sometimes
characterized as "standard" that effectively function as credit enhancements. These include
warranties that transferred loans will remain of investment quality, or that no circumstances
exist involving the loan collateral or borrower's credit standing that could cause the loan to
become delinquent. They may also include warranties that, for seasoned mortgages, the value
of the loan collateral still equals the original appraised value and the borrower's ability to pay
has not changed adversely.
The proposal is consistent with the agencies' longstanding recourse treatment of
representations and warranties that effectively guaranty performance or credit quality of
transferred loans. However, the proposal and the agencies' longstanding practice also
- 25 recognize that banking organizations typically make a number of factual warranties unrelated
to ongoing performance or credit quality. These warranties entail operational risk, as opposed
to the open-ended credit risk inherent in a financial guaranty. Warranties that create
operational risk include: warranties that assets have been underwritten or collateral appraised
in conformity with identified standards, and warranties that provide for the return of assets in
instances of incomplete documentation or fraud.
Warranties can impose varying degrees of operational risk. For example, a warranty
that asset collateral has not suffered damage from hazard entails risk that is offset to some
extent by prudent underwriting practices requiring the borrower to provide hazard insurance
to the banking organization. A warranty that asset collateral is free of environmental hazards
may present acceptable operational risk for certain types of properties that have been subject
to environmental assessment, depending on the circumstances. The agencies address
appropriate limits for these operational risks through supervision of a banking organization's
loan underwriting, sale, and servicing practices. Also, a banking organization that provides
warranties to loan purchasers and investors must include associated operational risks in its risk
management of exposures arising from loan sale or securitization-related activities. Banking
organizations should be prepared to demonstrate to examiners that the operational risks are
effectively managed.
The proposal continues the agencies' current practice of imposing recourse treatment
on "early-default" clauses. Early-default clauses typically warrant that transferred loans will
not become more than 30 days delinquent within a stated period, such as four months. Once
the stated period has run, the early-default clause will no longer trigger recourse treatment,
provided that there is no other provision that constitutes recourse. One commenter to the
- 26 1997 Proposal stated that early-default clauses carry minimal risk, and are intended to deal
with inadvertent transfers of loans that are already 30-day delinquencies, or to guard against
unsound originations by the loan seller. Another commenter found recourse treatment of
early-default clauses to be an appropriate response to the transfer of credit risk that takes
place under these clauses.
The agencies find that early-default clauses are often drafted so broadly that they are
indistinguishable from a guaranty of financial assets. The agencies have even found recent
examples in which early-default clauses have been expanded to cover the first year after loan
transfer. Industry concerns about assets delinquent at the time of transfer or unsound
originations could be dealt with by warranties directly addressing the condition of the asset at
the time of transfer and compliance with stated underwriting standards or, failing that,
exposure caps permitting the banking organization to take advantage of the low-level recourse
rule. The proposal also requires recourse treatment for warranties providing assurances about
the actual value of asset collateral, including that the market value corresponds to its
appraised value or that the appraised value will be realized in the event of foreclosure and sale.
The agencies invite further comment on these issues. The agencies also invite
comment on whether "premium refund" clauses should receive recourse treatment under any
final rule. These clauses require the seller to refund the premium paid by the investor for any
loan that prepays within a stated period after the loan is transferred. The agencies are aware
of premium refund clauses with terms ranging from 90 days to 36 months.
9.
Loan Servicing Arrangements
- 27 The proposed definitions of "recourse" and "direct credit substitute" cover loan
servicing arrangements if the servicer is responsible for credit losses associated with the loans
being serviced. However, cash advances made by residential mortgage servicers to ensure an
uninterrupted flow of payments to investors or the timely collection of the mortgage loans are
specifically excluded from the definitions of recourse and direct credit substitute, provided
that the residential mortgage servicer is entitled to reimbursement for any significant
advances.18 This type of advance is assessed risk-based capital only against the amount of the
cash advance, and is assigned to the risk-weight category appropriate to the party obligated to
reimburse the servicer.
If a residential mortgage servicer is not entitled to full reimbursement, then the
maximum possible amount of any nonreimbursed advances on any one loan must be
contractually limited to an insignificant amount of the outstanding principal on that loan in
order for the servicer’s obligation to make cash advances to be excluded from the definitions
of recourse and direct credit substitute. This treatment reflects the agencies' traditional view
that servicer cash advances meeting these criteria are part of the normal mortgage servicing
function and do not constitute credit enhancements.
Commenters responding to the 1997 Proposal generally supported the proposed
definition of servicer cash advances. Some commenters asked for clarification of the term
"insignificant" and whether "reimbursement" includes reimbursement payable out of
subsequent collections or reimbursement in the form of a general claim on the party obligated
to reimburse the servicer. Nonreimbursed advances on any one loan that are generally
18
Servicer cash advances include disbursements made to cover foreclosure costs or
other expenses arising from a loan in order to facilitate its timely collection (but not to protect
investors from incurring these expenses).
- 28 contractually limited to no more than one percent of the amount of the outstanding principal
on that loan would be considered insignificant. Reimbursement includes reimbursement
payable from subsequent collections and reimbursement in the form of a general claim on the
party obligated to reimburse the servicer, provided that the claim is not subordinated to other
claims on the cash flows from the underlying asset pool.
Some commenters responding to the 1997 Proposal suggested that the agencies treat
servicer cash advances as any advances that the servicer reasonably expects will be repaid.
The agencies believe that a clear, specific standard is needed to prevent the use of servicer
cash advances to circumvent the proposed risk-based capital treatment of recourse obligations
and direct credit substitutes.
10.
Spread Accounts and Overcollateralization
Several commenters requested that the agencies state in their rules that spread
accounts and overcollateralization do not impose a risk of loss on a banking organization and
are, therefore, not recourse. By its terms, the definition of recourse covers only the retention
of risk in a sale of assets. Overcollateralization does not ordinarily impose a risk of loss on a
banking organization, so it normally would not fall within the proposed definition of recourse.
However, a retained interest in a spread account that is reflected as an asset on a selling
banking organization’s balance sheet (directly as an asset or indirectly as a receivable) is a
form of recourse and is treated accordingly for risk-based capital purposes.
11.
Interaction with Market Risk Rule
Some commenters responding to the 1997 Proposal asked for clarification of the
treatment of a transaction covered by both the market risk rule and the recourse rule. Under
- 29 the market risk rule,19 a position properly located in the trading account is excluded from riskweighted assets. The banking agencies are not proposing to modify this treatment, so a
position that is properly held in the trading account would not be included in risk-weighted
assets, even if the position otherwise met the criteria for a recourse obligation or a direct
credit substitute.
12.
Participations in Direct Credit Substitutes
If a direct credit substitute is originated by a banking organization which then sells a
participation in that direct credit substitute to another entity, the originating banking
organization must apply a 100% conversion factor to the full amount of the assets supported
by the direct credit substitute. The originating banking organization would then risk weight
the credit equivalent amount of the participant’s pro rata share of the direct credit substitute at
the lower of the risk category appropriate to the obligor in the underlying transaction, after
considering any relevant guaranties or collateral, or the risk category appropriate to the
participant entity. The remaining pro rata share of the credit equivalent amount is assigned to
the risk-weight category appropriate to the obligor in the underlying transaction, guarantor or
collateral.
A banking organization that acquires a risk participation in a direct credit substitute
must apply a 100% conversion factor to its percentage share of the direct credit substitute
multiplied by the full amount of the assets supported by the credit enhancement. The credit
equivalent amount is then assigned to the risk category appropriate to the obligor or, if
relevant, the nature of the collateral or guaranty.
19
The OTS does not have a market risk rule.
- 30 Finally, in the case of the syndication of a direct credit substitute where each banking
organization is obligated only for its pro rata share of the risk and there is no recourse to the
originating banking organization, each banking organization must hold risk-based capital
against its pro rata share of the assets supported by the direct credit substitute.
13.
Reservation of Authority
The agencies are proposing to add language to the risk-based capital standards that
will provide greater flexibility in administering the standards. Banking organizations are
developing novel transactions that do not fit well into the risk-weight categories and credit
conversion factors set forth in the standards. Banking organizations also are devising novel
instruments that nominally fit into a particular risk-weight category or credit conversion
factor, but that impose risks on the banking organization at levels that are not commensurate
with the nominal risk-weight or credit conversion factor for the asset, exposure or instrument.
Accordingly, the agencies are proposing to add language to the standards to clarify their
authority, on a case-by-case basis, to determine the appropriate risk-weight for assets and
credit equivalent amounts and the appropriate credit conversion factor for off-balance sheet
items in these circumstances. Exercise of this authority by the agencies may result in a higher
or lower risk weight for an asset or credit equivalent amount or a higher or lower credit
conversion factor for an off-balance sheet item. This reservation of authority explicitly
recognizes the agencies retention of sufficient discretion to ensure that banking organizations,
as they develop novel financial assets, will be treated appropriately under the risk-based
- 31 capital standards.20 In addition, the agencies reserve the right to assign risk positions in
securitizations to appropriate risk categories if the credit rating of the risk position is deemed
to be inappropriate.
14.
Privately-issued mortgage-backed securities
Currently, the agencies assign privately-issued mortgage-backed securities to the 20%
risk-weight category if the underlying pool is composed entirely of mortgage-related securities
issued by the Federal National Mortgage Association (Fannie Mae), Federal Loan Mortgage
Corporation (Freddie Mac), or Government National Mortgage Association (Ginnie Mae).
Privately-issued mortgage-backed securities backed by whole residential mortgages are now
assigned to the 50% risk-weight category. The agencies propose to eliminate this "passthrough" treatment in favor of a ratings based approach. Because most mortgage-backed
securities usually also receive the highest or second highest credit rating, the agencies believe
that "pass-through" treatment will be redundant once the ratings-based approach is
implemented and, therefore, propose to eliminate it.
B.
Proposed Treatment for Rated Positions
As described in section II.A., each loss position in an asset securitization structure
functions as a credit enhancement for the more senior loss positions in the structure.
Currently, the risk-based capital standards do not vary the rate of capital requirement for
different credit enhancements or loss positions to reflect differences in the relative risk of
credit loss represented by the positions.
20
The Board is also proposing to add language to its risk-based capital standards that
would permit the Board to adjust the treatment of a capital instrument that does not fit into
the existing capital categories or that provides capital to a banking organization at levels that
are not commensurate with the nominal capital treatment of the instrument. The other
agencies already have this flexibility under their existing rules.
- 32 To address this issue, the agencies are proposing a multi-level, ratings-based approach
to assess capital requirements on recourse obligations, direct credit substitutes, and senior and
subordinated securities in asset securitizations based on their relative exposure to credit risk.
The approach uses credit ratings from the rating agencies and, to a limited extent, banking
organization’s internal risk ratings and other alternatives, to measure relative exposure to
credit risk and to determine the associated risk-based capital requirement. The use of credit
ratings provides a way for the agencies to use determinations of credit quality relied upon by
investors and other market participants to differentiate the regulatory capital treatment for loss
positions representing different gradations of risk. This use permits the agencies to give more
equitable treatment to a wide variety of transactions and structures in administering the riskbased capital system.
The fact that investors rely on these ratings to make investment decisions exerts
market discipline on the rating agencies and gives their ratings market credibility. The
market’s reliance on ratings, in turn, gives the agencies confidence that it is appropriate to
consider ratings as a major factor in the risk weighting of assets for regulatory capital
purposes. The agencies, however, would retain their authority to override the use of certain
ratings or the ratings on certain instruments, either on a case-by-case basis or through broader
supervisory policy, if necessary or appropriate to address the risk to banking organizations.
Under the ratings-based approach, the capital requirement for a recourse obligation,
direct credit substitute, or traded asset-backed security would be determined as follows:21
21
The example rating designations ("AAA," "BBB," etc.) are illustrative and do not
indicate any preference for, or endorsement of, any particular rating agency designation
system.
- 33 Rating Category
Examples
Risk Weight
Highest or second highest investment grade . . . . . . . .
AAA or AA
20%
Third highest investment grade . . . . . . . . . . . . . . . . .
A
50%
Lowest investment grade . . . . . . . . . . . . . . . . . . . . . .
BBB
100%
One category below investment grade . . . . . . . . . . . .
BB
200%
B or unrated
"Gross-up"
treatment
More than one category below investment grade, or
unrated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Many commenters expressed concerns about the so-called "cliff effect" that would
arise because of the small number of rating categories--three--contained in the 1997 Proposal.
To reduce the cliff effect, which causes relatively small differences in risk to result in
disproportionately large differences in the capital requirement for a risk position, the agencies
are proposing to add two additional rating categories, for a total of five.
Under the proposal, the ratings-based approach is available for traded asset-backed
securities22 and for traded and non-traded recourse obligations and direct credit substitutes. A
position is considered "traded" if, at the time it is rated by an external rating agency, there is a
reasonable expectation that in the near future: (1) the position may be sold to investors
relying on the rating; or (2) a third party may enter into a transaction (e.g., a loan or
repurchase agreement) involving the position in which the third party relies on the rating of
the position. If external rating agencies rate a traded position differently, the single highest
rating applies.
22
Similar to the current approach under which "stripped" mortgage-backed securities
are not eligible for risk weighting at 50% on a "pass-through" basis, stripped mortgagebacked securities are ineligible for the 20% or 50% risk categories under the ratings based
approach.
- 34 An unrated position that is senior (in all respects, including access to collateral) to a
rated position that is traded is treated as if it had the rating given the rated position, subject to
the banking organization satisfying its supervisory agency that such treatment is appropriate.
Recourse obligations and direct credit substitutes not qualifying for a reduced capital
charge and positions rated more than one category below investment grade receive "gross-up"
treatment, that is, the banking organization holding the position would hold capital against the
amount of the position plus all more senior positions, subject to the low-level recourse rule.23
This grossed-up amount is placed into risk-weight categories according to the obligor and
collateral.
The ratings-based approach is based on current ratings, so that a rating downgrade or
withdrawal of a rating could change the treatment of a position under the proposal. However,
a downgrade of a position by a single rating agency would not affect the capital treatment of a
position if the position still qualified for the previous capital treatment under one or more
ratings from a different rating agency.
23
"Gross-up" treatment means that a position is combined with all more senior
positions in the transaction. The result is then risk-weighted based on the nature of the
underlying assets. For example, if a banking organization retains a first-loss position in a pool
of mortgage loans that qualify for a 50% risk weight, the banking organization would include
the full amount of the assets in the pool, risk-weighted at 50% in its risk-weighted assets for
purposes of determining its risk-based capital ratio. The low level recourse rule provides that
the dollar amount of risk-based capital required for assets transferred with recourse should not
exceed the maximum dollar amount for which a banking organization is contractually liable.
See, 12 CFR part 3, appendix A, Section 3(d) (OCC); 12 CFR 208 and 225, appendix A,
III.D.1(g) (FRB); 12 CFR part 325, appendix A, II.D.1 (FDIC); 12 CFR 567.6(a)(2)(i)(C)
(OTS).
- 35 C.
Proposed Treatment for Non-traded and Unrated Positions
1.
Ratings on non-traded positions
In the 1994 Notice, the agencies proposed to permit a banking organization to obtain a
rating for a non-traded recourse obligation or direct credit substitute in order to permit that
position to qualify for a favorable risk-weight. In response to the 1994 Notice, one rating
agency expressed concern that use of ratings by the agencies for regulatory purposes could
undermine the integrity of the rating process. Ordinarily, according to the commenter, there is
a tension between the interests of the investors who rely on ratings and the interests of the
issuers who pay rating agencies to generate ratings. Under the ratings-based approach in the
1994 Notice, however, the holder of a recourse obligation or direct credit substitute that was
not traded or sold could, in some cases, seek a rating for the sole purposes of permitting the
credit enhancement to qualify for a favorable risk weight. The rating agency expressed a
strong concern that, without the counterbalancing interest of investors to rely on ratings,
rating agencies may have an incentive to issue inflated ratings.
In response to this concern, the 1997 Proposal included criteria to reduce the
possibility of inflated ratings and inappropriate risk weights if ratings are used for a position
that is not traded. A non-traded position could qualify for the ratings-based approach only if:
(1) it qualified under ratings obtained from two different rating agencies; (2) the ratings were
publicly available; (3) the ratings were based on the same criteria used to rate securities sold
to the public; and (4) at least one position in the securitization was traded. In comments
responding to the 1997 Proposal, banking organizations expressed concern about the cost and
delay associated with obtaining ratings, particularly for direct credit substitutes, that they
- 36 would not need absent the agencies’adoption of a ratings-based approach for risk-based
capital purposes.
In this proposal, the agencies continue to permit a non-traded recourse obligation or
direct credit substitute to qualify for the ratings-based approach if the banking organization
obtains ratings for the position. The agencies have retained the first three of the 1997
Proposal’s four criteria for non-traded positions, but have eliminated the fourth criterion, i.e.,
the requirement that one position in the securitization be traded.
To address concerns expressed by commenters on the 1997 Proposal, however, the
agencies have developed, and are also proposing, alternative approaches for determining the
capital requirements for unrated direct credit substitutes, which are discussed in the following
sections. Under each of these approaches, the banking organization must satisfy its
supervisory agency that use of the approach is appropriate for the particular banking
organization.
2.
Use of banking organizations’internal risk ratings
The proposal would permit a banking organization with a qualifying internal risk rating
system to use that system to apply the ratings-based approach to the banking organization’s
unrated direct credit substitutes in asset-backed commercial paper programs. Internal risk
ratings could be used to qualify a credit enhancement (other than a retained recourse position)
for a risk weight of 100% or 200% under the ratings-based approach, but not for a risk weight
of less than 100%. This relatively limited use of internal risk ratings for risk-based capital
purposes is a step towards potential adoption of broader use of internal risk ratings as
discussed in the Basel Committee’s June, 1999 Consultative Paper. Limiting the approach to
these types of credit enhancements reflects the agencies’view, based on industry research and
- 37 empirical evidence, that these positions are more likely than recourse positions to be of
investment-grade credit quality, and that the banking organizations providing them are more
likely to have internal risk rating systems for these credit enhancements that are sufficiently
accurate to be relied on for risk-based capital calculations.
Most sophisticated banking organizations that participate extensively in the asset
securitization business assign internal risk ratings to their credit exposures, regardless of the
form of the exposure. Usually, internal risk ratings more finely differentiate the credit quality
of a banking organization’s exposures than the categories that the agencies use to evaluate
credit risk during examinations of banking organizations (pass, substandard, doubtful, loss).
Individual banking organizations’internal risk ratings may be associated with a certain
probability of default, loss in the event of default, and loss volatility.
The credit enhancements that sponsors obtain for their commercial paper conduits are
rarely rated. If an internal risk ratings approach were not available for these unrated credit
enhancements, the provider of the enhancement would have to obtain two ratings solely to
avoid the gross-up treatment that would otherwise apply to unrated positions in asset
securitizations for risk-based capital purposes. However, before a provider of an
enhancement decides whether to provide a credit enhancement for a particular transaction
(and at what price), the provider will generally perform its own analysis of the transaction to
evaluate the amount of risk associated with the enhancement.
Allowing banking organizations to use internal credit ratings harnesses information and
analyses that they already generate rather than requiring them to obtain independent but
redundant ratings from outside rating agencies. An internal risk ratings approach therefore
- 38 has the potential to be less costly than a ratings-based approach that relies exclusively on
ratings by the rating agencies for the risk-weighting of these positions.
Internal risk ratings that correspond to the rating categories of the rating agencies
could be mapped to risk weights under the agencies’capital standards in a way that would
make it possible to differentiate the riskiness of various unrated direct credit substitutes based
on credit risk. However, the use of internal risk ratings raises concerns about the accuracy
and consistency of the ratings, especially because the mapping of ratings to risk-weight
categories will give banking organizations an incentive to rate their risk exposures in a way
that minimizes the effective capital requirement. Banking organizations engaged in
securitization activities that wish to use the internal risk ratings approach must ensure that
their internal risk rating systems are adequate. Adequate internal risk rating systems usually:
(1) Are an integral part of an effective risk management system that explicitly
incorporates the full range of risks arising from an organization’s participation in securitization
activities. The system must also fully take into account the effect of such activities on the
organization’s risk profile and capital adequacy as discussed in Section II.B.
(2) Link their ratings to measurable outcomes, such as the probability that a position
will experience any losses, the expected losses on that position in the event of default, and the
degree of variance in losses given default on that position.
(3) Separately consider the risk associated with the underlying loans and borrowers
and the risk associated with the specific positions in a securitization transaction.
(4) Identify gradations of risk among "pass" assets, not just among assets that have
deteriorated to the point that they fall into "watch" grades. Although it is not necessary for a
banking organization to use the same categories as the rating agencies, its internal ratings
- 39 must correspond to the ratings of the rating agencies so that agencies can determine which
internal risk rating corresponds to each rating category of the rating agencies. A banking
organization would have the responsibility to demonstrate to the satisfaction of its primary
regulator how these ratings correspond with the rating agency standards used as the
framework for this proposal. This is necessary so that the mapping of credit ratings to risk
weight categories in the ratings-based approach can be applied to internal ratings.
(5) Classify assets into each risk grade, using clear, explicit criteria, even for subjective
factors.
(6) Have independent credit risk management or loan review personnel assign or
review credit risk ratings. These personnel should have adequate training and experience to
ensure that they are fully qualified to perform this function.
(7) Periodically verify, through an internal audit procedure, that internal risk ratings
are assigned in accordance with the banking organization’s established criteria.
(8) Track the performance of its internal ratings over time to evaluate how well risk
grades are being assigned, make adjustments to its rating system when the performance of its
rated positions diverges from assigned ratings, and adjust individual ratings accordingly.
(9) Make credit risk rating assumptions that are consistent with, or more conservative
than, the credit risk rating assumptions and methodologies of the rating agencies.
The agencies also are considering whether to develop review and approval procedures
governing their respective determinations of whether a particular banking organization may
use the internal risk rating process. The agencies request comment on the appropriate scope
and nature of that process.
- 40 If a banking organization’s rating system is found to no longer be adequate, the
banking organization’s primary regulator may preclude it from applying the internal risk
ratings approach to new transactions for risk-based capital purposes until it has remedied the
deficiencies. Additionally, depending on the severity of the problems identified, the primary
regulator may also decline to rely on the internal risk ratings that the banking organization has
applied to previous transactions that remain outstanding for purposes of determining the
banking organization’s regulatory capital requirements.
3.
Ratings of specific positions in structured financing programs
The agencies also propose to authorize a banking organization to use a rating obtained
from a rating agency or other appropriate third party of unrated direct credit substitutes in
securitizations that satisfy specifications set by the rating agency. The banking organization
would need to demonstrate that the rating meets the same rating standards generally used by
the rating agency for rating publicly-issued securities. In addition, the banking organization
must also demonstrate to its primary regulator’s satisfaction that the criteria underlying the
rating agency’s assignment of ratings for the program are satisfied for the particular direct
credit substitute issued by the banking organization.
The proposal would also allow banking organizations to demonstrate to the agencies
that it is reasonable and consistent with the standards of this proposal to rely on the rating of
positions in a securitization structure under a program in which the banking organization
participates if the sponsor of that program has obtained a rating. This aspect of the proposal
is most likely to be useful to banking organizations with limited involvement in securitization
activities. In addition, some banking organizations extensively involved in securitization
activities already rely on ratings of the credit risk positions under their securitization programs
- 41 as part of their risk management practices. Such banking organizations also could rely on
such ratings under this proposal if the ratings are part of a sound overall risk management
process and the ratings reflect the risk of non-traded positions to the banking organizations.
This approach could be used to qualify a direct credit substitute (but not a retained
recourse position) for a risk weight of 100% or 200% of the face value of the position under
the ratings-based approach, but not for a risk weight of less than 100%.
4.
Use of qualifying rating software mapped to public rating standards
The agencies are also proposing to allow banking organizations, particularly those
with limited involvement in securitization activities, to rely on qualifying credit assessment
computer programs that the rating agencies or other appropriate third parties have developed
for rating otherwise unrated direct credit substitutes in asset securitizations. To qualify for
use by banking organizations for risk-based capital purposes, the computer programs must be
tracked to the rating standards of the rating agencies. Banking organizations must
demonstrate the credibility of these programs in the financial markets, which would generally
be shown by the significant use of the computer program by investors and market participants
for risk assessment purposes. Banking organizations also would need to demonstrate the
reliability of the programs in assessing credit risk. Banking organizations may use these
programs for purposes of applying the ratings-based approach under this proposal only if the
banking organization satisfies its primary regulator that the programs result in credit
assessments that credibly and reliably correspond with the rating of publicly issued securities
by the rating agencies. Sophisticated banking organizations with extensive securitization
activities generally should use this approach only if it is an integral part of their risk
- 42 management systems and their systems fully capture the risks from the banking organizations’
securitization activities.
This approach could be used to qualify a direct credit substitute (but not a retained
recourse position) for a risk weight of 100% or 200% of the face value of the position under
the ratings-based approach, but not for a risk weight of less than 100%.
D.
Managed Assets Approach
When assets are securitized, the extent to which the selling or sponsoring entity
transfers the risks associated with the assets depends on the structure of the securitization and
the revolving nature of the assets involved. To the extent the sponsoring institution is
dependent on future securitizations as a funding source, as a practical matter, the amount of
risk transferred often will be limited. Revolving credits include credit card and home equity
line securitizations as well as commercial loans drawn down under long-term commitments
that are securitized as collateralized loan obligations (CLOs).
The early amortization feature present in some revolving credit securitizations ensures
that investors will be repaid before being subject to any risk of significant credit losses. For
example, if a securitized asset pool begins to experience credit deterioration to the point
where the early amortization feature is triggered, then the asset-backed securities held by
investors begin to rapidly pay down. This occurs because, after an early amortization feature
is triggered, new receivables that are generated from the accounts designated to the
securitization trust are no longer sold to investors, but are instead retained on the sponsoring
banking organization's balance sheet.
Early amortization features raise several distinct concerns about risks to the seller.
First, the seller’s interest in the securitized assets is effectively subordinated to the interests of
- 43 the investors by the payment allocation formula applied during early amortization. Investors
effectively get paid first, and the seller’s residual interest will therefore absorb a
disproportionate share of credit losses.
Second, early amortization can create liquidity problems for the seller. For example, a
credit card issuer must fund a steady stream of new credit card receivables. When a
securitization trust is no longer able to purchase new receivables due to early amortization, the
seller must either find an alternative buyer for the receivables or else the receivables will
accumulate on the seller’s balance sheet, creating the need for another source of funding.
Third, the first two risks to the seller can create an incentive for the seller to provide
implicit recourse--credit enhancement beyond any pre-existing contractual obligation--to
prevent early amortization. Incentives to provide implicit recourse are to some extent present
in other securitizations, because of concerns about damage to the seller’s reputation and its
ability to securitize assets going forward if one of its securitizations performs poorly.
However, the early amortization feature creates additional and more direct financial incentives
to prevent early amortization through implicit recourse.
Because of their concerns about these risks, the agencies are proposing to apply a
managed assets approach to securitization transactions that incorporate early amortization
provisions. The approach would require a sponsoring banking organization's securitized (offbalance sheet) receivables to be included in risk-weighted assets when determining its
risk-based capital requirements. The securitized, off-balance sheet assets would be assigned
to the 20 percent risk category, thereby effectively applying a 1.6% risk-based capital charge
to those assets.
- 44 The 1.6% capital charge against securitized assets could be limited in certain cases. If
the sponsoring banking organization in a revolving credit securitization provides credit
protection to investors, either in the form of retained recourse or a direct credit substitute, the
sum of the regulatory capital requirements for the credit protection and the 1.6% charge on
the off-balance sheet securitized assets may not exceed 8% of securitized assets for that
particular securitization transaction.
A managed assets approach would require a banking organization to hold additional
capital against the potential credit and liquidity risks stemming from the early amortization
provisions of revolving credit securitization structures. This proposed capital charge would
ensure that a banking organization maintain at least a minimum level of capital against the
risks that arise when early amortization provisions are present in securitizations of revolving
credits.
The agencies request comment on the purpose of early amortization provisions, the
proposed managed assets approach, and on any potential effects that the approach will have
on current industry practices involving revolving credit securitizations. The agencies also
recognize that there may be concerns that the managed assets approach may not produce
safety and soundness benefits commensurate with the additional regulatory burden that would
result from a 20% risk weight on managed assets, and they request comment on possible
alternative measures that would address more effectively the risks arising from early
amortization provisions in revolving securitizations. For example, one alternative to the
managed assets approach described here would be to require greater public disclosure of
securitization performance. This additional information could allow market participants and
regulators to better assess the risks inherent in revolving securitizations with early
- 45 amortization provisions and the capital level appropriate for those risks. The agencies also
request comment on whether the benefits of greater public disclosure outweigh the costs
associated with increased reporting.
IV.
Effective Date of A Final Rule Resulting from This Proposal
The agencies intend that any final rules adopted as a result of this proposal that result
in increased risk-based capital requirements for banking organizations will apply only to
securitization activities (as defined in the proposal) entered into or acquired after the effective
date of those final rules. Conversely, any final rules that result in reduced risk-based capital
requirements for banking organizations may be applied to all transactions outstanding as of
the effective date of those final rules and to all subsequent transactions. Because some
ongoing securitization conduits may need additional time to adapt to any new capital
treatments, the agencies intend to permit banking organizations to apply the existing capital
rules to asset securitizations with no fixed term, e.g., asset-backed commercial paper conduits,
for up to two years after the effective date of any final rule.
V.
Request for Comment
The agencies request comment on all aspects of this proposal, as well as on the
specific issues described in the preamble.
VI.
Regulatory Flexibility Act
OCC: Pursuant to section 605(b) of the Regulatory Flexibility Act, the OCC certifies
that this proposal will not have a significant impact on a substantial number of small entities.
5 U.S.C. 601 et seq. The provisions of this proposal that increase capital requirements are
likely to affect large national banks almost exclusively. Small national banks rarely sponsor or
- 46 provide direct credit substitutes in asset securitizations. Accordingly, a regulatory flexibility
analysis is not required.
Board: Pursuant to section 605(b) of the Regulatory Flexibility Act, the Board has
determined that this proposal will not have a significant impact on a substantial number of
small business entities within the meaning of the Regulatory Flexibility Act (5 U.S.C. 601 et
seq.). The Board’s comparison of the applicability section of this proposal with Call Report
Data on all existing banks shows that application of the proposal to small entities will be the
rare exception. Accordingly, a regulatory flexibility analysis is not required. In addition,
because the risk-based capital standards generally do not apply to bank holding companies
with consolidated assets of less than $150 million, this proposal will not affect such
companies.
FDIC: Pursuant to section 605(b) of the Regulatory Flexibility Act (Public Law 96354, 5 U.S.C. 601 et seq.), the FDIC certifies that the proposed rule will not have a significant
impact on a substantial number of small entities. Comparison of Call Report data on FDICsupervised banks to the items covered by the proposal that result in increased capital
requirements shows that application of the proposal to small entities will be the infrequent
exception.
OTS: Pursuant to section 605(b) of the Regulatory Flexibility Act, the OTS certifies
that this proposal will not have a significant impact on a substantial number of small entities. A
comparison of TFR data on OTS-supervised thrifts shows that the proposed rule would have
little impact on the overall level of capital required at small thrifts, since capital requirements
(other than the risk-based capital standards) are typically more binding on smaller thrifts.
Moreover, the provisions of this proposal that may increase capital requirements are unlikely
- 47 to affect small savings associations. Small thrifts rarely provide direct credit substitutes in
asset securitizations and do not serve as sponsors of revolving securitizations. Accordingly, a
regulatory flexibility analysis is not required.
VII.
Paperwork Reduction Act
The Agencies have determined that this proposal does not involve a collection of
information pursuant to the provisions of the Paperwork Reduction Act of 1995 (44 U.S.C.
3501, et seq.).
VIII. Executive Order 12866
OCC: The OCC has determined that this proposal is not a significant regulatory action
for purposes of Executive Order 12866. The OCC expects that any increase in national
banks’risk-based capital requirement, resulting from the proposed treatment of direct credit
substitutes largely will be offset by the ability of those banks to reduce their capital
requirement in accordance with the ratings-based approach. The managed assets position of
the proposal may require a limited number of national banks to raise additional capital in order
to remain in the category to which they are assigned currently under the OCC’s prompt
corrective action framework. The OCC believes that the costs associated with raising this new
capital are below the thresholds prescribed in the Executive Order. Nonetheless, the impact of
any final rule resulting from this proposal will depend on factors for which the agencies do not
currently collect industry-wide information, such as the proportion of bank-provided direct
credit substitutes that would be rated below investment grade. The OCC, therefore,
welcomes any quantitative information national banks wish to provide about the impact they
expect the various portions of this proposal to have if issued in final form.
- 48 OTS: The Director of the OTS has determined that this proposal does not constitute
a "significant regulatory action" under Executive Order 12866. Since OTS already applies a
"gross up" treatment for recourse obligations and for most direct credit substitutes, the
proposal generally is likely to reduce the risk-based capital requirements for thrifts. The
proposed rule would increase capital requirements only for certain direct credit substitutes
issued in connection with asset securitizations or for thrifts that may serve as sponsors of
revolving securitization programs. Currently, thrifts rarely participate in such activities. As a
result, OTS has concluded that the proposal will have only minor effects on the thrift industry.
IX.
OCC and OTS--Unfunded Mandates Reform Act of 1995
Section 202 of the Unfunded Mandates Reform Act of 1995, Public Law 104-4,
(Unfunded Mandates Act), requires that an agency prepare a budgetary impact statement
before promulgating a rule that includes a Federal mandate that may result in the expenditure
by state, local, and tribal governments, in the aggregate, or by the private sector, of $100
million or more in any one year. If a budgetary impact statement is required, section 205 of
the Unfunded Mandates Act also requires an agency to identify and consider a reasonable
number of regulatory alternatives before promulgating a rule. The OCC and OTS have
determined that this proposed rule will not result in expenditures by state, local, and tribal
governments, or by the private sector, of more than $100 million or more in any one year.
Therefore, the OCC and OTS have not prepared a budgetary impact statement or specifically
addressed the regulatory alternatives considered. As discussed in the preamble, this proposal
will reduce inconsistencies in the agencies’risk-based capital standards and, in certain
circumstances, will allow banking organizations to maintain lower amounts of capital against
certain rated recourse obligations and direct credit substitutes.
- 49 X.
Plain Language Requirement
Section 722 of the Gramm-Leach-Bliley Act of 1999 requires the federal banking
agencies to use "plain language" in all proposed and final rules published after January 1,
2000. We invite your comments on how to make this proposal easier to understand. For
example:
(1) Have we organized the material to suit your needs?
(2) Are the requirements in the rule clearly stated?
(3) Does the rule contain technical language or jargon that isn't clear?
(4) Would a different format (grouping and order of sections, use of headings,
paragraphing) make the rule easier to understand?
(5) Would more (but shorter) sections be better?
(6) What else could we do to make the rule easier to understand?
XI.
FDIC Assessment of Impact of Federal Regulation On Families
The FDIC has determined that this proposed rule will not affect family well-being
within the meaning of section 654 of the Treasury and General Government Appropriations
Act of 1999 (Pub. Law 105-277).
List of Subjects
12 CFR Part 3
Administrative practice and procedure, Capital, National banks, Reporting and
recordkeeping requirements, Risk.
- 50 12 CFR Part 208
Accounting, Agriculture, Banks, banking, Confidential business information, Crime,
Currency, Federal Reserve System, Mortgages, Reporting and recordkeeping requirements,
Securities.
12 CFR Part 225
Administrative practice and procedure, Banks, banking, Federal Reserve System,
Holding companies, Reporting and recordkeeping requirements, Securities.
12 CFR Part 325
Administrative practice and procedure, Bank deposit insurance, Banks, Banking,
Capital adequacy, Reporting and recordkeeping requirements, Savings associations, State
non-member banks.
12 CFR Part 567
Capital, Reporting and recordkeeping requirements, Savings associations.