Rule: Risk-Based Capital: Advnced Capital Adequacy Framework Basel II

Friday,
December 7, 2007
Part II
Department of the Treasury

Office of the Comptroller of the
Currency
12 CFR Part 3
Federal Reserve System

12 CFR Parts 208 and 225
Federal Deposit Insurance

Corporation
12 CFR Part 325
Department of the Treasury

Office of Thrift Supervision
12 CFR Parts 559, 560, 563, and 567
Risk-Based Capital Standards: Advanced

Capital Adequacy Framework—Basel II;
Final Rule
mstockstill on PROD1PC66 with RULES2
VerDate Aug<31>2005 21:05 Dec 06, 2007 Jkt 214001 PO 00000 Frm 00001 Fmt 4737 Sfmt 4737 E:\FR\FM\07DER2.SGM 07DER2
69288 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations
DEPARTMENT OF THE TREASURY capital requirements for banks that B. Qualification Requirements
operate under the framework. 1. Process and Systems Requirements
Office of the Comptroller of the 2. Risk rating and Segmentation Systems
DATES: This final rule is effective April
Currency for Wholesale and Retail Exposures
1, 2008. Wholesale Exposures
FOR FURTHER INFORMATION CONTACT: Retail Exposures
12 CFR Part 3 OCC: Mark Ginsberg, Risk Expert, Rating Philosophy
Capital Policy (202–927–4580) or Ron Rating and Segmentation Reviews and
[Docket No. OCC–2007–0018] Updates
Shimabukuro, Senior Counsel,
3. Quantification of Risk Parameters for
RIN 1557–AC91 Legislative and Regulatory Activities
Wholesale and Retail Exposures
Division (202–874–5090). Office of the Probability of Default (PD)
FEDERAL RESERVE SYSTEM Comptroller of the Currency, 250 E Loss Given Default (LGD)
Street, SW., Washington, DC 20219. Expected Loss Given Default (ELGD)
12 CFR Parts 208 and 225 Board: Barbara Bouchard, Deputy Economic Loss and Post-Default
Associate Director (202–452–3072 or Extensions of Credit
[Regulations H and Y; Docket No. R–1261] barbara.bouchard@frb.gov) or Anna Lee Economic Downturn Conditions
Hewko, Senior Supervisory Financial Supervisory Mapping Function
FEDERAL DEPOSIT INSURANCE Analyst (202–530–6260 or Pre-default Reductions in Exposure
CORPORATION anna.hewko@frb.gov), Division of
Exposure at Default (EAD)
General Quantification Principles
Banking Supervision and Regulation; or Portfolios With Limited Data or Limited
12 CFR Part 325 Mark E. Van Der Weide, Senior Counsel Defaults
RIN 3064–AC73 (202–452–2263 or 4. Optional Approaches That Require Prior
mark.vanderweide@frb.gov), Legal Supervisory Approval
DEPARTMENT OF THE TREASURY Division. For users of 5. Operational Risk
Telecommunications Device for the Deaf Operational Risk Data and Assessment
Office of Thrift Supervision (‘‘TDD’’) only, contact 202–263–4869. System
FDIC: Jason C. Cave, Associate Operational risk Quantification System
6. Data management and maintenance
12 CFR Parts 559, 560, 563, and 567 Director, Capital Markets Branch, (202)
7. Control and oversight mechanisms
898–3548, Bobby R. Bean, Chief, Policy Validation
RIN 1550–AB56; Docket No. OTS 2007–0021 Section, Capital Markets Branch, (202) Internal Audit
898–3575, Kenton Fox, Senior Policy Stress Testing
Risk-Based Capital Standards: Analyst, Capital Markets Branch, (202) 8. Documentation
Advanced Capital Adequacy 898–7119, Division of Supervision and C. Ongoing Qualification
Framework — Basel II Consumer Protection; or Michael B. D. Merger and Acquisition Transition
Phillips, Counsel, (202) 898–3581, Provisions
AGENCIES: Office of the Comptroller of IV. Calculation of Tier 1 Capital and Total
the Currency, Treasury; Board of Supervision and Legislation Branch,
Qualifying Capital
Governors of the Federal Reserve Legal Division, Federal Deposit
V. Calculation of Risk-Weighted Assets
System; Federal Deposit Insurance Insurance Corporation, 550 17th Street, A. Categorization of Exposures
Corporation; and Office of Thrift NW., Washington, DC 20429. 1. Wholesale Exposures
Supervision, Treasury. OTS: Michael D. Solomon, Director, 2. Retail Exposures
Capital Policy, Supervision Policy (202) 3. Securitization Exposures
ACTION: Final rule.
906–5654; David W. Riley, Senior 4. Equity Exposures
Analyst, Capital Policy (202) 906–6669; 5. Boundary Between Operational Risk and
SUMMARY: The Office of the Comptroller
Austin Hong, Senior Analyst, Capital Other Risks
of the Currency (OCC), the Board of 6. Boundary Between the Final Rule and
Governors of the Federal Reserve Policy (202) 906–6389; or Karen
the Market Risk Rule
System (Board), the Federal Deposit Osterloh, Special Counsel, Regulations
B. Risk-Weighted Assets for General Credit
Insurance Corporation (FDIC), and the and Legislation Division (202) 906– Risk (Wholesale Exposures, Retail
Office of Thrift Supervision (OTS) 6639, Office of Thrift Supervision, 1700 Exposures, On-Balance Sheet Assets that
(collectively, the agencies) are adopting G Street, NW., Washington, DC 20552. Are Not Defined by Exposure Category,
a new risk-based capital adequacy SUPPLEMENTARY INFORMATION: and Immaterial Credit Exposures)
framework that requires some and 1. Phase 1 — Categorization of Exposures
Table of Contents 2. Phase 2 — Assignment of Wholesale
permits other qualifying banks 1 to use
I. Introduction Obligors and Exposures to Rating Grades
an internal ratings-based approach to A. Executive Summary of the Final Rule and retail exposures to segments
calculate regulatory credit risk capital B. Conceptual Overview Purchased Wholesale Exposures
requirements and advanced 1. The IRB Approach for Credit Risk Wholesale Lease Residuals
measurement approaches to calculate 2. The AMA for Operational Risk 3. Phase 3 — Assignment of risk
regulatory operational risk capital C. Overview of Final Rule Parameters to Wholesale Obligors and
requirements. The final rule describes D. Structure of Final Rule Exposures and Retail Segments
the qualifying criteria for banks required E. Overall Capital Objectives 4. Phase 4 — Calculation of Risk-Weighted
or seeking to operate under the new F. Competitive Considerations Assets
framework and the applicable risk-based II. Scope 5. Statutory Provisions on the Regulatory
A. Core and Opt-In Banks Capital Treatment of Certain Mortgage
B. U.S. Subsidiaries of Foreign Banks Loans
1 For simplicity, and unless otherwise indicated,
C. Reservation of Authority C. Credit Risk Mitigation (CRM)
this final rule uses the term ‘‘bank’’ to include D. Principle of Conservatism Techniques
banks, savings associations, and bank holding
companies (BHCs). The terms ‘‘bank holding
III. Qualification 1. Collateral
company’’ and ‘‘BHC’’ refer only to bank holding A. The Qualification Process 2. Counterparty Credit Risk of Repo-Style
companies regulated by the Board and do not 1. In General Transactions, Eligible Margin Loans, and
include savings and loan holding companies 2. Parallel Run and Transitional Floor OTC Derivative Contracts
regulated by the OTS. Periods Qualifying master netting agreement
Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69289
EAD for Repo-Style Transactions and Simple Modified Look-Through Approach approach uses risk parameters
Eligible Margin Loans Alternative modified look-through determined by a bank’s internal systems
Collateral Haircut Approach approach in the calculation of the bank’s credit
Simple VaR Methodology VI. Operational Risk
risk capital requirements. The AMA
3. EAD for OTC derivative Contracts VII. Disclosure
Current Exposure Methodology 1. Overview relies on a bank’s internal estimates of
4. Internal Models Methodology Comments on the Proposed Rule its operational risks to generate an
Maturity Under the Internal Models 2. General Requirements operational risk capital requirement for
Methodology Frequency/Timeliness the bank.4
Collateral Agreements Under the Internal Location of Disclosures and Audit/ The agencies now are adopting this
Models Methodology Attestation Requirements final rule implementing a new risk-
Alternative Methods Proprietary and Confidential Information based regulatory capital framework,
5. Guarantees and Credit Derivatives That 3. Summary of Specific Public Disclosure
based on the New Accord, that is
Cover Wholesale Exposures Requirements
4. Regulatory Reporting mandatory for some U.S. banks and
Eligible Guarantees and Eligible Credit
Derivatives optional for others. While the New
PD Substitution Approach
I. Introduction Accord includes several methodologies
LGD Adjustment Approach A. Executive Summary of the Final Rule for determining risk-based capital
Maturity Mismatch Haircut requirements, the agencies are adopting
Restructuring Haircut On September 25, 2006, the agencies only the advanced approaches at this
Currency Mismatch Haircut issued a joint notice of proposed time.
Example rulemaking (proposed rule or proposal) The agencies received approximately
Multiple Credit Risk Mitigants (71 FR 55830) seeking public comment 90 public comments on the proposed
Double Default Treatment on a new risk-based regulatory capital rule from banking organizations, trade
6. Guarantees and Credit Derivatives That framework for banks.2 The agencies
Cover Retail Exposures associations representing the banking or
previously issued an advance notice of financial services industry, supervisory
D. Unsettled Securities, Foreign Exchange, proposed rulemaking (ANPR) related to
and Commodity Transactions authorities, and other interested parties.
the new risk-based regulatory capital This section of the preamble highlights
E. Securitization Exposures
1. Hierarchy of Approaches framework (68 FR 45900, August 4, several fundamental issues that
Gains-on-Sale and CEIOs 2003). The proposed rule was based on commenters raised about the agencies’
The Ratings-Based Approach (RBA) a series of releases from the Basel proposal and briefly describes how the
The Internal Assessment Approach (IAA) Committee on Banking Supervision agencies have responded to those issues
The Supervisory Formula Approach (SFA) (BCBS), culminating in the BCBS’s in the final rule. More detail is provided
Deduction comprehensive June 2006 release in the preamble sections below. Overall,
Exceptions to the General Hierarchy of entitled ‘‘International Convergence of
Approaches commenters supported the development
Capital Measurement and Capital
Servicer Cash Advances of the framework and the move to more
Standards: A Revised Framework’’ (New
Amount of a Securitization Exposure risk-sensitive capital requirements. One
Accord).3 The New Accord sets forth a
Implicit Support overarching issue, however, was the
Operational Requirements for Traditional ‘‘three pillar’’ framework encompassing
areas where the proposal differed from
Securitizations risk-based capital requirements for
the New Accord. Commenters said the
Clean-Up Calls credit risk, market risk, and operational
divergences generally created
Additional Supervisory Guidance risk (Pillar 1); supervisory review of
competitive problems, raised home-host
2. Ratings-Based Approach (RBA) capital adequacy (Pillar 2); and market
issues, entailed extra cost and regulatory
3. Internal Assessment Approach (IAA) discipline through enhanced public
4. Supervisory Formula Approach (SFA) disclosures (Pillar 3). The New Accord burden, and did not necessarily improve
General Requirements includes several methodologies for the overall safety and soundness of
Inputs to the SFA Formula determining a bank’s risk-based capital banks subject to the rule.
5. Eligible Disruption Liquidity Facilities Commenters also generally disagreed
requirements for credit, market, and
6. CRM for Securitization Exposures with the agencies’ proposal to adopt
7. Synthetic Securitizations operational risk.
The proposed rule included the only the advanced approaches from the
Background New Accord. Further, commenters
Operational Requirements for Synthetic advanced capital methodologies from
the New Accord, including the objected to the agencies’ retention of the
Securitizations
advanced internal ratings-based (IRB) leverage ratio, the transitional
First-Loss Tranches
Mezzanine Tranches approach for credit risk and the arrangements in the proposal, and the
Super-Senior Tranches advanced measurement approaches 10 percent numerical benchmark for
8. Nth-to-Default Credit Derivatives (AMA) for operational risk (together, the identifying material aggregate
9. Early Amortization Provisions advanced approaches). The IRB reductions in risk-based capital
Background requirements to be used for evaluating
Controlled Early Amortization 2 The agencies also issued proposed changes to and responding to capital outcomes
Non-Controlled Early Amortization the risk-based capital rule for market risk in a during the parallel run and transitional
Securitization of Revolving Residential separate notice of proposed rulemaking (71 FR floor periods (discussed below).
Mortgage Exposures 55958, September 25, 2006). A final rule on that Commenters also noted numerous
F. Equity Exposures proposal is under development and will be issued
1. Introduction and Exposure Measurement in the near future.
technical issues with the proposed rule.
Hedge Transactions 3 The BCBS is a committee of banking supervisory As noted in an interagency press
Measures of Hedge Effectiveness authorities established by the central bank release issued July 20, 2007 (Banking
2. Simple Risk-Weight Approach (SRWA) governors of the G–10 countries in 1975. The BCBS Agencies Reach Agreement on Basel II
Non-Significant Equity Exposures issued the New Accord to modernize its first capital Implementation), the agencies have
Accord, which was endorsed by the BCBS members
3. Internal Models Approach (IMA) in 1988 and implemented by the agencies in 1989. agreed to eliminate the language from
IMA Qualification The New Accord, the 1988 Accord, and other
Risk-Weighted Assets Under the IMA documents issued by the BCBS are available 4 The agencies issued draft guidance on the
4. Equity Exposures to Investment Funds through the Bank for International Settlements’ Web advanced approaches. See 72 FR 9084 (February 28,
Full Look-Through Approach site at http://www.bis.org. 2007).
the preamble concerning a 10 percent satisfaction of its primary Federal distinct risk weight function for
limitation on aggregate reductions in supervisor that not applying the exposures to small- and medium-size
risk-based capital requirements. The provision would, in all circumstances, enterprises (SMEs) as provided in the
press release also stated that the unambiguously generate a risk-based New Accord. In the proposal, the
agencies are retaining intact the capital requirement for each such agencies noted they were not aware of
transitional floor periods (see preamble exposure that is greater than that which compelling evidence that smaller firms
sections I.E. and III.A.2.). In addition, would otherwise be required under the with the same probability of default
while not specifically mentioned in the regulation, and the bank meets other (PD) and LGD as larger firms are subject
press release, the agencies are retaining specified requirements (see preamble to less systemic risk than is already
the leverage ratio and the prompt section II.D.). reflected in the wholesale risk-based
corrective action (PCA) regulations In the proposal, the agencies modified capital functions. The agencies continue
without modification. the definition of default for wholesale to believe an SME-specific risk weight
The final rule adopts without change exposures from that in the New Accord function is not supported by sufficient
the proposed criteria for identifying core to address issues commenters had raised evidence and might give rise to
banks (banks required to apply the on the ANPR. Commenters objected to competitive inequities across U.S.
advanced approaches) and continues to the agencies’ modified definition of banks, and have not adopted such a
permit other banks (opt-in banks) to default for wholesale exposures, function in the final rule (see preamble
adopt the advanced approaches if they however, asserting that a definition section V.A.1.)
meet the applicable qualification different from the New Accord would With regard to the proposed treatment
requirements. Core banks are those with result in competitive inequities and for securitization exposures,
consolidated total assets (excluding significant implementation burden commenters raised a number of
assets held by an insurance without associated supervisory benefit. technical issues. Many objected to the
underwriting subsidiary of a bank In response to these concerns, the proposed definition of a securitization
holding company) of $250 billion or agencies have adopted a definition of exposure, which included exposures to
more or with consolidated total on- default for wholesale exposures that is investment funds with material
balance-sheet foreign exposure of $10 consistent with the New Accord (see liabilities (including exposures to hedge
billion or more. A depository institution preamble section III.B.2.). For retail funds). The agencies agree with
(DI) also is a core bank if it is a exposures, the final rule retains the commenters that the proposed
subsidiary of another DI or bank holding proposed definition of default and definition for securitization exposures
company that uses the advanced clarifies that, subject to certain was quite broad and captured some
approaches. The final rule also provides considerations, a foreign subsidiary of a exposures that would more
that a bank’s primary Federal supervisor U.S. bank may, in its consolidated risk- appropriately be treated under the
may determine that application of the based capital calculations, use the wholesale or equity frameworks. To
final rule is not appropriate in light of applicable host jurisdiction definition of limit the scope of the IRB securitization
the bank’s asset size, level of default for retail exposures of the framework, the agencies have modified
complexity, risk profile, or scope of foreign subsidiary in that jurisdiction the definition of traditional
operations (see preamble sections II.A. (see preamble section III.B.2.). securitization in the final rule as
and B.). Another concept introduced in the described in preamble section V.A.3.
As noted above, the final rule proposal that was not in the New Technical issues related to
includes only the advanced approaches. Accord was the expected loss given securitization exposures are discussed
The July 2007 interagency press release default (ELGD) risk parameter. ELGD in preamble sections V.A.3. and V.E.
stated that the agencies have agreed to had four functions in the proposed For equity exposures, commenters
issue a proposed rule that would rule—as a component of the calculation focused on the proposal’s lack of a
provide non-core banks with the option of expected credit loss (ECL) in the grandfathering period. The New Accord
to adopt an approach consistent with numerator of the risk-based capital provides national discretion for each
the standardized approach included in ratios; in the expected loss (EL) implementing jurisdiction to adopt a
the New Accord. This new proposal (the component of the IRB risk-based capital grandfather period for equity exposures.
standardized proposal) will replace the formulas; as a floor on the value of the Commenters asserted that this omission
earlier proposal to adopt the so-called loss given default (LGD) risk parameter; would result in competitive inequity for
Basel IA option (Basel 1A proposal).5 and as an input into a supervisory U.S. banks as compared to other
The press release also noted the mapping function. Many commenters internationally active institutions. The
agencies’ intention to finalize the objected to the inclusion of ELGD as a agencies believe that, overall, the
standardized proposal before core banks departure from the New Accord that proposal’s approach to equity exposures
begin the first transitional floor period would create regulatory burden and results in a competitive risk-based
under this final rule. competitive inequity. Many commenters capital requirement. The final rule does
In response to commenters’ concerns also objected to the supervisory not include a grandfathering provision,
that some aspects of the proposed rule mapping function, which the agencies and the agencies have adopted the
would result in excessive regulatory intended as an alternative for banks that proposed treatment for equity exposures
burden without commensurate safety were not able to estimate reliably the without significant change (see
and soundness enhancements, the LGD risk parameter. The agencies have preamble section V.F.).
agencies included a principle of eliminated ELGD from the final rule. A number of commenters raised
conservatism in the final rule. In Banks are required to estimate only the issues related to operational risk. Most
general, under this principle, in limited LGD risk parameter, which reflects significantly, commenters noted that
situations, a bank may choose not to economic downturn conditions (see activities besides securities processing
apply a provision of the rule to one or preamble section III.B.3.). The and credit card fraud have highly
more exposures if the bank can supervisory mapping function also has predictable and reasonably stable losses
demonstrate on an ongoing basis to the been eliminated from the rule. and should be considered for
Commenters also objected to the operational risk offsets. The agencies
5 71 FR 77445 (Dec. 26, 2006). agencies’ decision not to include a believe that the proposed definition of
eligible operational risk offsets allows consistent with the New Accord. These practices are both continually evolving
for the consideration of other activities disclosures will enable market and subject to uncertainty, the
in a flexible and prudent manner and, participants to gain key insights framework should be viewed as an effort
thus, are retaining the proposed regarding a bank’s capital structure, risk to improve the risk sensitivity of the
definition in the final rule. Commenters exposures, risk assessment processes, risk-based capital requirements for
also noted that the proposal appeared to and, ultimately, capital adequacy. The banks, rather than as an effort to
place limits on the use of operational agencies have modified the final rule to produce a statistically precise
risk mitigants. The agencies have provide flexibility regarding proprietary measurement of risk.
provided flexibility in this regard and information.
The framework’s conceptual
under the final rule will take into
consideration whether a particular B. Conceptual Overview foundation is based on the view that
operational risk mitigant covers This final rule is intended to produce risk can be quantified through the
potential operational losses in a manner risk-based capital requirements that are estimation of specific characteristics of
equivalent to holding regulatory capital more risk-sensitive than those produced the probability distribution of potential
(see preamble sections III.B.5. and V.I.). under the agencies’ existing risk-based losses over a given time horizon. This
Many commenters expressed concern capital rules (general risk-based capital approach assumes that a suitable
that the proposed public disclosures rules). In particular, the IRB approach estimate of that probability distribution,
were excessive and would hinder, rather requires banks to assign risk parameters or at least of the specific characteristics
than facilitate, market discipline by to wholesale exposures and retail to be measured, can be produced. Figure
requiring banks to disclose information segments and provides specific risk- 1 illustrates some of the key concepts
that would not be well understood by or based capital formulas that must be associated with the framework. The
useful to the market. Commenters also used to transform these risk parameters figure shows a probability distribution
expressed concern about possible into risk-based capital requirements. of potential losses associated with some
disclosure of proprietary information. The framework is based on ‘‘value-at- time horizon (for example, one year). It
The agencies believe that it is important risk’’ (VaR) modeling techniques that could reflect, for example, credit losses,
to retain the vast majority of the measure credit risk and operational risk. operational losses, or other types of
proposed disclosures, which are Because bank risk measurement losses.
The area under the curve to the right the figure UL is measured at the 99.9th standard reflects a very high percentile
of a particular loss amount is the percentile level and thus is equal to the level, so that there is a very low
probability of experiencing losses value of the loss distribution estimated probability that actual losses
exceeding this amount within a given corresponding to the 99.9th percentile, would exceed the UL amount associated
time horizon. The figure also shows the less the amount of EL. This is shown with that confidence level or soundness
statistical mean of the loss distribution, graphically at the bottom of the figure. standard.
which is equivalent to the amount of The particular percentile level chosen Assessing risk and assigning
loss that is ‘‘expected’’ over the time for the measurement of UL is referred to regulatory capital requirements by
horizon. The concept of ‘‘expected loss’’ as the ‘‘confidence level’’ or the reference to a specific percentile of a
(EL) is distinguished from that of ‘‘soundness standard’’ associated with probability distribution of potential
‘‘unexpected loss’’ (UL), which the measurement. If capital is available losses is commonly referred to as a VaR
represents potential losses over and to cover losses up to and including this approach. Such an approach was
above the EL amount. A given level of percentile level, then the bank should adopted by the FDIC, Board, and OCC
UL can be defined by reference to a remain solvent in the face of actual for assessing a bank’s risk-based capital
particular percentile threshold of the losses of that magnitude. Typically, the requirements for market risk in 1996
ER07DE07.000</GPH>
probability distribution. For example, in choice of confidence level or soundness (market risk rule). Under the market risk
rule, a bank’s own internal models are small percentage of the time. The A number of important explicit
used to estimate the 99th percentile of agencies believe that a one-year horizon general assumptions and specific
the bank’s market risk loss distribution is appropriate because it balances the parameters are built into the IRB
over a ten-business-day horizon. The difficulty of easily or rapidly exiting approach to make the framework
bank’s market risk capital requirement non-trading positions against the applicable to a range of banks and to
is based on this VaR estimate, generally possibility that in many cases a bank obtain tractable information for
multiplied by a factor of three. The can cover credit losses by raising calculating risk-based capital
agencies implemented this additional capital should the underlying requirements. Chief among the
multiplication factor to provide a credit problems manifest themselves assumptions embodied in the IRB
prudential buffer for market volatility gradually. The nominal confidence level approach are: (i) Assumptions that a
and modeling uncertainty. of the IRB risk-based capital formulas bank’s credit portfolio is infinitely
(99.9 percent) means that if all the granular; (ii) assumptions that loan
1. The IRB Approach for Credit Risk defaults at a bank are driven by a single,
assumptions in the IRB supervisory
The conceptual foundation of this model for credit risk were correct for a systematic risk factor; (iii) assumptions
final rule’s approach to credit risk bank, there would be less than a 0.1 that systematic and non-systematic risk
capital requirements is similar to the percent probability that credit losses at factors are log-normal random variables;
market risk rule’s approach to market the bank in any year would exceed the and (iv) assumptions regarding
risk capital requirements, in the sense IRB risk-based capital requirement.7 correlations among credit losses on
that each is VaR-oriented. Nevertheless, As noted above, the supervisory various types of assets.
there are important differences between model of credit risk underlying the IRB The specific risk-based capital
the IRB approach and the market risk approach embodies specific formulas in this final rule require the
rule. The current market risk rule assumptions about the economic drivers bank to estimate certain risk parameters
specifies a nominal confidence level of of portfolio credit risk at banks. As with for its wholesale and retail exposures,
99.0 percent and a ten-business-day any modeling approach, these which the bank may do using a variety
horizon, but otherwise provides banks assumptions represent simplifications of of techniques. These risk parameters are
with substantial modeling flexibility in very complex real-world phenomena PD, LGD, exposure at default (EAD),
determining their market risk loss and, at best, are only an approximation and, for wholesale exposures, effective
distribution and capital requirements. In of the actual credit risks at any bank. If remaining maturity (M). The proposed
contrast, the IRB approach for assessing these assumptions (described in greater rule included an additional risk
credit risk capital requirements is based detail below) are incorrect or otherwise parameter, ELGD. As discussed in
on a 99.9 percent nominal confidence do not characterize a given bank section III.B.3. of the preamble, the
level, a one-year horizon, and a precisely, the actual confidence level agencies have eliminated the ELGD risk
supervisory model of credit losses implied by the IRB risk-based capital parameter from the final rule. The risk-
embodying particular assumptions formulas may exceed or fall short of a based capital formulas into which the
about the underlying drivers of portfolio true 99.9 percent confidence level. estimated risk parameters are inserted
credit risk, including loss correlations In combination with other are simpler than the economic capital
among different asset types.6 supervisory assumptions and methodologies typically employed by
The IRB approach is broadly similar parameters underlying the IRB banks, which often require complex
to the credit VaR approaches used by a computer simulations. In particular, an
approach, the approach’s 99.9 percent
number of banks as the basis for their important property of the IRB risk-based
nominal confidence level reflects a
internal assessment of the economic capital formulas is portfolio invariance.
judgmental pooling of available
capital necessary to cover credit risk. It That is, the risk-based capital
information, including supervisory
is common for a bank’s internal credit requirement for a particular exposure
experience. The framework underlying
risk models to consider a one-year loss generally does not depend on the other
this final rule reflects a desire on the
horizon and to focus on a high loss exposures held by the bank. Like the
part of the agencies to achieve (i) risk-
threshold confidence level. As with the general risk-based capital rules, the total
based capital requirements that are
internal credit VaR models used by credit risk capital requirement for a
reflective of relative risk across different
banks, the output of the risk-based bank’s wholesale and retail exposures is
assets and that are broadly consistent the sum of the credit risk capital
capital formulas in the IRB approach is with maintaining at least an investment- requirements on individual wholesale
an estimate of the amount of credit grade rating (for example, at least BBB) exposures and segments of retail
losses above ECL over a one-year on the liabilities funding those assets, exposures.
horizon that would only be exceeded a even in periods of economic adversity; The IRB risk-based capital formulas
and (ii) for the U.S. banking system as contain supervisory asset value
6 The theoretical underpinnings for the
a whole, aggregate minimum regulatory correlation (AVC) factors, which have a
supervisory model of credit risk underlying the IRB
approach are provided in a paper by Michael
capital requirements that are not a significant impact on the capital
Gordy, ‘‘A Risk-Factor Model Foundation for material reduction from the aggregate requirements generated by the formulas.
Ratings-Based Bank Capital Rules,’’ Journal of minimum regulatory capital The AVC assigned to a given portfolio
Financial Intermediation, July 2003. The IRB requirements under the general risk-
formulas are derived as an application of these of exposures is an estimate of the degree
results to a single-factor CreditMetricsTM-style
based capital rules. to which any unanticipated changes in
model. For mathematical details on this model, see the financial conditions of the
Michael Gordy, ‘‘A Comparative Anatomy of Credit 7 Banks’ internal economic capital models
underlying obligors of the exposures are
Risk Models,’’ Journal of Banking and Finance, typically focus on measures of equity capital,
January 2000, or H.U. Koyluogu and A. Hickman, whereas the total regulatory capital measure
correlated (that is, would likely move
‘‘Reconcilable Differences,’’ Risk, October 1998. For underlying this rule includes not only equity up and down together). High correlation
a less technical overview of the IRB formulas, see capital, but also certain debt and hybrid of exposures in a period of economic
the BCBS’s ‘‘An Explanatory Note on the Basel II instruments, such as subordinated debt. Thus, the downturn conditions is an area of
Risk Weight Functions,’’ July 2005 (BCBS 99.9 percent nominal confidence level embodied in
Explanatory Note). The document can be found on the IRB approach is not directly compatable to the
supervisory concern. For a portfolio of
the Bank for International Settlements Web site at nominal solvency standards underpinning banks’ exposures having the same risk
http://www.bis.org. economic capital models. parameters, a larger AVC implies less
diversification within the portfolio, shorter maturity relative to traditional inclusion of excess reserves in tier 2
greater overall systematic risk, and, mortgage exposures. capital to be approximately as restrictive
hence, a higher risk-based capital However, most commenters as the existing cap on the inclusion of
requirement.8 For example, a 15 percent recognized that the proposed AVCs allowance for loan and lease losses
AVC for a portfolio of residential were consistent with those in the New (ALLL) under the 1988 Accord, based
mortgage exposures would result in a Accord and recommended that the on data obtained in the BCBS’s Third
lower risk-based capital requirement agencies use the AVCs contained in the Quantitative Impact Study (QIS–3).11
than a 20 percent AVC and a higher New Accord to avoid international In developing the New Accord, the
risk-based capital requirement than a 10 competitive inequity and unnecessary BCBS sought broadly to maintain the
percent AVC. burden. Several commenters suggested current overall level of minimum risk-
The AVCs that appear in the IRB risk- that the agencies should reconsider the based capital requirements within the
based capital formulas for wholesale AVCs going forward, working with the banking system. Using data from QIS–3,
exposures decline with increasing PD; BCBS. the BCBS conducted an analysis of the
that is, the IRB risk-based capital The agencies agree with the prevailing risk-based capital requirements that
formulas generally imply that a group of view of the commenters that using the would be generated under the New
low-PD wholesale exposures are more AVCs in the New Accord alleviates a Accord. Based on this analysis, the
correlated than a group of high-PD potential source of international BCBS concluded that a ‘‘scaling factor’’
wholesale exposures. Thus, under the inconsistency and implementation (multiplier) should apply to credit risk-
rule, a low-PD wholesale exposure burden. The final rule therefore weighted assets. The BCBS, in the New
would have a higher relative risk-based maintains the proposed AVCs. As the Accord, indicated that the best estimate
capital requirement than that implied by agencies gain more experience with the of the scaling factor was 1.06. In May
its PD were the AVC in the IRB risk- advanced approaches, they may revisit 2006, the BCBS decided to maintain the
based capital formulas for wholesale the AVCs for wholesale exposures and 1.06 scaling factor based on the results
exposures fixed rather than a decreasing retail exposures, along with other of a fourth quantitative impact study
function of PD. The AVCs included in calibration issues identified during the (QIS–4) conducted in some
the IRB risk-based capital formulas for parallel run and transitional floor jurisdictions, including the United
both wholesale and retail exposures periods (as described below) and make States, and a fifth quantitative impact
reflect a combination of supervisory changes to the rule as necessary. The study (QIS–5), not conducted in the
judgment and empirical evidence.9 agencies would address this issue United States.12 The BCBS noted that
working with the BCBS and other national supervisory authorities will
However, the historical data available
supervisory and regulatory authorities, continue to monitor capital
for estimating correlations among retail
as appropriate. requirements during implementation of
exposures, particularly for non-mortgage
Another important conceptual the New Accord, and that the BCBS, in
retail exposures, was more limited than
element of the IRB approach concerns turn, will monitor national experiences
was the case with wholesale exposures.
the treatment of ECL. The IRB approach with the framework.
As a result, supervisory judgment The agencies generally agree with the
played a greater role. Moreover, the flat assumes that reserves should cover ECL
while capital should cover credit losses BCBS regarding calibration of the New
15 percent AVC for residential mortgage Accord. Therefore, consistent with the
exposures is based largely on exceeding ECL (that is, unexpected
credit losses). Accordingly, the final New Accord and the proposed rule, the
supervisory experience with and final rule contains a scaling factor of
analysis of traditional long-term, fixed- rule, consistent with the proposal and
the New Accord, removes ECL from the 1.06 for credit-risk-weighted assets. As
rate mortgages. the agencies gain more experience with
Several commenters stated that the risk-weighted assets calculation but
requires a bank to compare its ECL to its the advanced approaches, the agencies
proposed AVCs for wholesale exposures will revisit the scaling factor along with
were too high in general, and a few eligible credit reserves (as defined
below). If a bank’s ECL exceeds its other calibration issues identified
claimed that, in particular, the AVCs for during the parallel run and transitional
multi-family residential real estate eligible credit reserves, the bank must
deduct the excess ECL amount 50 floor periods (described below) and will
exposures should be lower. Other make changes to the rule as necessary,
commenters suggested that the AVCs of percent from tier 1 capital and 50
working with the BCBS and other
wholesale exposures should be a percent from tier 2 capital. If a bank’s
supervisory and regulatory authorities,
function of obligor size rather than PD. eligible credit reserves exceed its ECL,
as appropriate.
Similarly, several commenters the bank may include the excess eligible
maintained that the proposed AVCs for credit reserves amount in tier 2 capital, 2. The AMA for Operational Risk
retail exposures were too high. Some of up to 0.6 percent of the bank’s credit The final rule also includes the AMA
these commenters suggested that the risk-weighted assets.10 This treatment is for determining risk-based capital
AVCs for qualifying revolving exposures intended to maintain a capital incentive requirements for operational risk. Under
(QREs), such as credit cards, should be to reserve prudently and ensure that the final rule (consistent with the
in the range of 1 to 2 percent, not 4 ECL over a one-year horizon is covered proposed rule), operational risk is
percent as proposed. Similarly, some of either by reserves or capital. This defined as the risk of loss resulting from
those commenters opposed the treatment also recognizes that prudent inadequate or failed internal processes,
proposed flat 15 percent AVC for reserving that considers probable losses people, and systems or from external
residential mortgage exposures; one over the life of a loan may result in a events. This definition of operational
commenter suggested that the agencies bank holding reserves in excess of ECL risk includes legal risk—which is the
measured with a one-year horizon. The risk of loss (including litigation costs,
should consider employing lower AVCs

for home equity loans and lines of credit BCBS calibrated the 0.6 percent limit on
11 BCBS, ‘‘QIS 3: Third Quantitative Impact
(HELOCs) to take into account their 10 In contrast, under the general risk-based capital Study,’’ May 2003.
rules, the allowance for loan and lease losses 12 BCBS press release, ‘‘Basel Committee
8 See BCBS Explanatory Note. (ALLL) may be included in tier 2 capital up to 1.25 maintains calibration of Base II Framework,’’ May
9 See BCBS Explanatory Note, section 5.3. percent of total risk-weighted assets. 24, 2006.
settlements, and regulatory fines) determine risk-weighted asset amounts. determine the risk-based capital
resulting from the failure of the bank to Each of these areas is discussed below. requirement for the exposure.
comply with laws, regulations, prudent Banks using the final rule also are Retail exposures under the final rule
ethical standards, and contractual subject to supervisory review of their include most credit exposures to
obligations in any aspect of the bank’s capital adequacy (Pillar 2) and certain individuals and small credit exposures
business—but excludes strategic and public disclosure requirements to foster to businesses that are managed as part
reputational risks. transparency and market discipline of a segment of exposures with similar
Under the AMA, a bank must use its (Pillar 3). In addition, each bank using risk characteristics and not managed on
internal operational risk management the advanced approaches remains an individual-exposure basis. A bank
systems and processes to assess its subject to the tier 1 leverage ratio must classify each of its retail exposures
exposure to operational risk. Given the requirement,13 and each DI (as defined into one of three retail subcategories—
complexities involved in measuring in section 3 of the Federal Deposit residential mortgage exposures; QREs,
operational risk, the AMA provides Insurance Act (12 U.S.C. 1813)) using such as credit cards and overdraft lines;
banks with substantial flexibility and, the advanced approaches remains and other retail exposures. Within these
therefore, does not require a bank to use subject to the prompt corrective action three subcategories, the bank must
specific methodologies or distributional (PCA) thresholds.14 Banks using the group exposures into segments with
assumptions. Nevertheless, a bank using advanced approaches also remain similar risk characteristics. The bank
the AMA must demonstrate to the subject to the market risk rule, where must then assign the risk parameters PD,
satisfaction of its primary Federal applicable. LGD, and EAD to each retail segment.
supervisor that its systems for managing Under the final rule, a bank must The bank may take into account the risk
and measuring operational risk meet identify whether each of its on- and off- mitigating impact of collateral and
established standards, including balance sheet exposures is a wholesale, guarantees in the segmentation process
producing an estimate of operational retail, securitization, or equity exposure. and in the assignment of risk parameters
risk exposure that meets a one-year, Assets that are not defined by any to retail segments. Like wholesale
99.9th percentile soundness standard. A exposure category (and certain exposures, the risk parameters for each
bank’s estimate of operational risk immaterial portfolios of exposures) retail segment are used as inputs into an
exposure includes both expected generally are assigned risk-weighted IRB risk-based capital formula to
operational loss (EOL) and unexpected asset amounts equal to their carrying determine the risk-based capital
operational loss (UOL) and forms the value (for on-balance sheet exposures) requirement for the segment.
basis of the bank’s risk-based capital or notional amount (for off-balance For securitization exposures, the bank
requirement for operational risk. sheet exposures). must apply one of three general
The AMA allows a bank to base its Wholesale exposures under the final
approaches, subject to various
risk-based capital requirement for conditions and qualifying criteria: the
rule include most credit exposures to
operational risk on UOL alone if the Ratings-Based Approach (RBA), which
companies, sovereigns, and other
bank can demonstrate to the satisfaction uses external ratings to risk-weight
governmental entities. For each
of its primary Federal supervisor that exposures; the Internal Assessment
wholesale exposure, a bank must assign
the bank has eligible operational risk Approach (IAA), which uses internal
four quantitative risk parameters: PD
offsets, such as certain operational risk ratings to risk-weight exposures to asset-
(which is expressed as a decimal (that
reserves, that equal or exceed the bank’s backed commercial paper programs
is, 0.01 corresponds to 1 percent) and is
EOL. To the extent that eligible (ABCP programs); or the Supervisory
an estimate of the probability that an
operational risk offsets are less than Formula Approach (SFA), which uses
obligor will default over a one-year
EOL, the bank’s risk-based capital bank inputs that are entered into a
requirement for operational risk must horizon); LGD (which is expressed as a supervisory formula to risk-weight
incorporate the shortfall. decimal and reflects an estimate of the exposures. Securitization exposures in
economic loss rate if a default occurs the form of gain-on-sale or credit-
C. Overview of Final Rule during economic downturn conditions); enhancing interest-only strips (CEIOs)15
The final rule maintains the general EAD (which is measured in dollars and and securitization exposures that do not
risk-based capital rules’ minimum tier 1 is an estimate of the amount that would qualify for the RBA, the IAA, or the SFA
risk-based capital ratio of 4.0 percent be owed to the bank at the time of must be deducted from regulatory
and total risk-based capital ratio of 8.0 default); and M (which is measured in capital.
percent. The components of tier 1 and years and reflects the effective Banks may use an internal models
total capital in the final rule are also the remaining maturity of the exposure). approach (IMA) for determining risk-
same as in the general risk-based capital Banks may factor into their risk based capital requirements for equity
rules, with a few adjustments described parameter estimates the risk mitigating exposures, subject to certain qualifying
in more detail below. The primary impact of collateral, credit derivatives, criteria and floors. If a bank does not
difference between the general risk- and guarantees that meet certain have a qualifying internal model for
based capital rules and the final rule is criteria. Banks must input the risk equity exposures, or chooses not to use
the methodologies used for calculating parameters for each wholesale exposure such a model, the bank must apply a
risk-weighted assets. Banks applying the into an IRB risk-based capital formula to simple risk weight approach (SRWA) in
final rule generally must use their which publicly traded equity exposures
internal risk measurement systems to 13 See 12 CFR part 3.6(b) and (c) (national banks);
calculate the inputs for determining the 12 CFR part 208, appendix B (state member banks); 15 A CEIO is an on-balance sheet asset that, in
12 CFR part 225, appendix D (bank holding form or in substance, (i) represents the contractual
risk-weighted asset amounts for (i) companies); 12 CFR 325.3 (state nonmember banks); right to receive some or all of the interest and no
general credit risk (including wholesale 12 CFR 567.2(a)(2) and 567.8 (savings associations). more than a minimal amount of principal due on
and retail exposures); (ii) securitization 14 See 12 CFR part 6 (national banks); 12 CFR part
the underlying exposures of a securitization and (ii)
exposures; (iii) equity exposures; and 208, subpart D (state member banks); 12 CFR exposes the holder to credit risk directly or
325.103 (state nonmember banks); 12 CFR part 565 indirectly associated with the underlying exposures
(iv) operational risk. In certain cases, (savings associations). In addition, savings that exceeds its pro rata claim on the underlying
however, banks must use external associations remain subject to the tangible capital exposures, whether through subordination
ratings or supervisory risk weights to requirement at 12 CFR 567.2(a)(3) and 567.9. provisions or other credit-enhancement techniques.
generally are assigned a 300 percent risk The agencies are aware that the fair definition of a wholesale, retail,
weight and non-publicly traded equity value option in generally accepted securitization, or equity exposure; and
exposures generally are assigned a 400 accounting principles as used in the certain immaterial portfolios of credit
percent risk weight. Under both the IMA United States (GAAP) raises potential exposures. This part also describes the
and the SRWA, equity exposures to risk-based capital issues not risk-based capital treatment for over-the-
certain entities or made pursuant to contemplated in the development of the counter (OTC) derivative contracts,
certain statutory authorities (such as New Accord. The agencies will continue repo-style transactions, and eligible
community development laws) are to analyze these issues and may make margin loans. In addition, this part
subject to a 0 to 100 percent risk weight. changes to this rule at a future date as describes the methodologies for
Banks must develop qualifying AMA necessary. The agencies would address reflecting credit risk mitigation in risk-
systems to determine risk-based capital these issues working with the BCBS and weighted assets for wholesale and retail
requirements for operational risk. Under other supervisory and regulatory exposures. Furthermore, this part sets
the AMA, a bank must use its own authorities, as appropriate. forth the risk-based capital requirements
methodology to identify operational loss for failed and unsettled securities,
D. Structure of Final Rule
events, measure its exposure to commodities, and foreign exchange
operational risk, and assess a risk-based The agencies are implementing a transactions.
capital requirement for operational risk. regulatory framework for the advanced Part V identifies operating criteria for
Under the final rule, a bank must approaches in which each agency has an recognizing risk transference in the
calculate its tier 1 and total risk-based advanced approaches appendix that securitization context and outlines the
capital ratios by dividing tier 1 capital incorporates (i) definitions of tier 1 and approaches for calculating risk-weighted
by total risk-weighted assets and by tier 2 capital and associated adjustments assets for securitization exposures. Part
dividing total qualifying capital by total to the risk-based capital ratio VI describes the approaches for
numerators, (ii) the qualification calculating risk-weighted assets for
risk-weighted assets, respectively. To
requirements for using the advanced equity exposures. Part VII describes the
calculate total risk-weighted assets, a
approaches, and (iii) the details of the calculation of risk-weighted assets for
bank must first convert the dollar risk-
advanced approaches.17 The agencies operational risk. Finally, Part VIII
based capital requirements for
also are incorporating their respective provides public disclosure requirements
exposures produced by the IRB risk-
market risk rules, by cross-reference.18 for banks employing the advanced
based capital approaches and the AMA In this final rule, as in the proposed
into risk-weighted asset amounts by approaches (Pillar 3).
rule, the agencies are not restating the The structure of the preamble
multiplying the capital requirements by elements of tier 1 and tier 2 capital, generally follows the structure of the
12.5 (the inverse of the overall 8.0 which largely remain the same as under regulatory text. Definitions, however,
percent risk-based capital requirement). the general risk-based capital rules. are discussed in the portions of the
After determining the risk-weighted Adjustments to the risk-based capital preamble where they are most relevant.
asset amounts for credit risk and ratio numerators specific to banks
operational risk, a bank must sum these applying the final rule are in part II of E. Overall Capital Objectives
amounts and then subtract any excess the rule and explained in greater detail The preamble to the proposed rule
eligible credit reserves not included in in section IV of this preamble. described the agencies’ intention to
tier 2 capital to determine total risk- The final rule has eight parts. Part I avoid a material reduction in overall
weighted assets. identifies criteria for determining which risk-based capital requirements under
The final rule contains specific public banks are subject to the rule, provides the advanced approaches. The agencies
disclosure requirements to provide key definitions, and sets forth the also identified other objectives, such as
important information to market minimum risk-based capital ratios. Part ensuring that differences in capital
participants on the capital structure, II describes the adjustments to the requirements appropriately reflect
risk exposures, risk assessment numerator of the regulatory capital differences in risk and ensuring that the
processes, and, hence, the capital ratios for banks using the advanced U.S. implementation of the New Accord
adequacy of a bank. The public approaches. Part III describes the will not be a significant source of
disclosure requirements apply only to qualification process and provides competitive inequity among
the DI or bank holding company qualification requirements for obtaining internationally active banks or among
representing the top consolidated level supervisory approval for use of the domestic banks operating under
of the banking group that is subject to advanced approaches. This part different risk-based capital rules. The
the advanced approaches, unless the incorporates critical elements of final rule modifies and clarifies the
entity is a subsidiary of a non-U.S. supervisory oversight of capital approach the agencies will use to
banking organization that is subject to adequacy (Pillar 2). achieve these objectives.
comparable disclosure requirements in Parts IV through VII address the The agencies proposed a series of
its home jurisdiction. All banks subject calculation of risk-weighted assets. Part transitional floors to provide a smooth
to the rule, however, must disclose total IV provides the risk-weighted assets transition to the advanced approaches
and tier 1 risk-based capital ratios and calculation methodologies for wholesale and to temporarily limit the amount by
the components of these ratios. The and retail exposures; on-balance sheet which a bank’s risk-based capital
agencies also proposed a package of assets that do not meet the regulatory requirements could decline over a
regulatory reporting templates for the period of at least three years. The
agencies’ use in assessing and 17 As applicable, certain agencies are also making
transitional floors are described in more
monitoring the levels and components conforming changes to existing regulations as
necessary to incorporate the new appendices.
detail in section III.A.2. of this
of bank risk-based capital requirements
18 12 CFR part 3, Appendix B (for national banks), preamble. The floors generally prohibit
under the advanced approaches.16 12 CFR part 208, Appendix E (for state member a bank’s risk-based capital requirement
These templates will be finalized banks), 12 CFR part 225, Appendix E (for bank under the advanced approaches from
shortly. holding companies), and 12 CFR part 325,
Appendix C (for state nonmember banks). OTS
falling below 95 percent, 90 percent,
intends to codify a market risk rule for savings and 85 percent of what it would be
16 71 FR 55981 (September 25, 2006). associations at 12 CFR part 567, Appendix D. under the general risk-based capital
rules during the bank’s first, second, New Accord and the rules implemented sentence, a primary Federal supervisor
and third transitional floor periods, by foreign supervisory authorities. In that disagrees with the finding of
respectively. The proposal stated that particular, commenters expressed material deficiency may not authorize a
banks would be required to receive the concerns that the aggregate 10 percent bank under its jurisdiction to exit the
approval of their primary Federal limit added a degree of uncertainty to third transitional floor period unless the
supervisor before entering each their capital planning process, since the supervisor first provides a public report
transitional floor period. limit was beyond the control of any explaining its reasoning.
The preamble to the proposal noted individual bank. They maintained that The agencies intend to establish a
that if there was a material reduction in it might take only a few banks that transparent and collaborative process
aggregate minimum regulatory capital decided to reallocate funds toward for conducting the interagency study,
upon implementation of the advanced lower-risk activities during the consistent with the recommendations
approaches, the agencies would propose transition period to impose a penalty on made by the U.S. Government
regulatory changes or adjustments all U.S. banks using the advanced Accountability Office (GAO) in its
during the transitional floor periods. approaches. Other commenters stated report on implementation of the New
The preamble further noted that in this that the benchmark lacked transparency Accord in the United States.20 In
context, materiality would depend on a and would be operationally difficult to conducting the interagency study the
number of factors, including the size, apply. agencies would consider, for example,
source, and nature of any reduction; the Commenters also criticized the the following:
risk profiles of banks authorized to use duration, level, and construct of the • The level of minimum required
the advanced approaches; and other transitional floors in the proposed rule. regulatory capital under U.S. advanced
considerations relevant to the Commenters believed it was approaches compared to the capital
maintenance of a safe and sound inappropriate to extend the transitional required by other international and
banking system. The agencies also floors by an additional year (to three domestic regulatory capital standards.
stated that they would view a 10 percent years), and raised concerns that the • Peer comparisons of minimum
or greater decline in aggregate minimum floors were more binding than those regulatory capital requirements,
required risk-based capital (without proposed in the New Accord. including but not limited to banks’
reference to the effects of the Commenters strongly urged the agencies estimates of risk parameters for
transitional floors), compared to to adopt the transition periods and portfolios of similar risk.
minimum required risk-based capital as floors in the New Accord to limit any • The processes banks use to develop
determined under the general risk-based competitive inequities that could arise and assess risk parameters and
capital rules, as a material reduction among internationally active banks. advanced systems, and supervisory
warranting modification to the To better balance commenters’ assessments of their accuracy and
supervisory risk functions or other concerns and the agencies’ capital reliability.
aspects of the framework. adequacy objectives, the agencies have • Potential cyclical implications.
Further, the agencies stated that they decided not to include the 10 percent • Changes in portfolio composition or
were ‘‘identifying a numerical benchmark language in this preamble. business mix, including those that
benchmark for evaluating and This will alleviate uncertainty and might result in changes in capital
responding to capital outcomes during enable each bank to develop capital requirements per dollar of credit
the parallel run and transitional floor plans in accordance with its individual exposure.
periods that do not comport with the risk profile and business model. The • Comparison of regulatory capital
overall capital objectives.’’ The agencies agencies have taken a number of steps requirements to market-based measures
also stated that ‘‘[a]t the end of the to address their capital adequacy of capital adequacy to assess relative
transitional floor periods, the agencies objectives. Specifically, the agencies are minimum capital requirements across
would reevaluate the consistency of the retaining the existing leverage ratio and banks and broad asset categories.
framework, as (possibly) revised during PCA requirements and are adopting the Market-based measures might include
the transitional floor periods, with the three transitional floor periods at the credit default swap spreads,
capital goals outlined in the ANPR and proposed numerical levels. subordinated debt spreads, external
with the maintenance of broad Under the final rule, the agencies will rating agency ratings, and other market
competitive parity between banks jointly evaluate the effectiveness of the measures of risk.
adopting the framework and other new capital framework. The agencies • Examination of the quality and
banks, and would be prepared to make will issue a series of annual reports robustness of advanced risk
further changes to the framework if during the transition period that will management processes related to
warranted.’’ The agencies viewed the provide timely and relevant information assessment of capital adequacy, as in
parallel run and transitional floor on the implementation of the advanced the comprehensive supervisory
periods as ‘‘a trial of the new framework approaches. In addition, after the end of assessments performed under Pillar 2.
under controlled conditions.’’ 19 the second transition year, the agencies • Additional reviews, including
The agencies sought comment on the will publish a study (interagency study) analysis of interest rate and
appropriateness of using a 10 percent or that will evaluate the advanced concentration risks that might suggest
greater decline in aggregate minimum approaches to determine if there are any the need for higher regulatory capital
required risk-based capital as a material deficiencies. For any primary requirements.
numerical benchmark for material Federal supervisor to authorize any
F. Competitive Considerations
reductions when determining whether bank to exit the third transitional floor
capital objectives were achieved. Many period, the study must determine that A fundamental objective of the New
Accord is to strengthen the soundness
commenters objected to the proposed there are no such material deficiencies

transitional floors and the 10 percent that cannot be addressed by then-
20 United States Government Accountability
benchmark on the grounds that both existing tools, or, if such deficiencies
Office, ‘‘Risk-Based Capital: Bank Regulators Need
safeguards deviated materially from the are found, they must be first remedied to Improve Transparency and Overcome
by changes to regulation. Impediments to Finalizing the Proposed Basel II
19 71 FR 55839–40 (September 25, 2006). Notwithstanding the preceding Framework’’ (GAO–07–253), February 15, 2007.
and stability of the international The agencies extended the comment implementation issues, maintain a
banking system while maintaining period for the advanced approaches constructive dialogue about
sufficient consistency in capital proposal to coincide with the comment implementation processes, and
adequacy regulation to ensure that the period on the Basel IA proposal so that harmonize approaches as much as
New Accord will not be a significant commenters would have an opportunity possible within the range of national
source of competitive inequity among to analyze the effects of the two discretion embedded in the New
internationally active banks. The proposals concurrently.22 Accord. The BCBS also has established
agencies support this objective and Seeking to minimize potential a Capital Interpretation Group to foster
believe that it is important to promote competitive inequities and regulatory consistency in applying the New Accord
continual advancement of the risk burden, a number of commenters on on an ongoing basis. The agencies
measurement and management practices both the advanced approaches proposal intend to participate fully in these
of large and internationally active and the Basel IA proposal urged the groups to ensure that issues relating to
banks. agencies to adopt all of the approaches international implementation and
While all banks should work to included in the New Accord—including competitive effects are addressed. While
enhance their risk management the foundation IRB and standardized supervisory judgment will play a critical
practices, the advanced approaches and approaches for credit risk and the role in the evaluation of risk
the systems required to support their standardized and basic indicator measurement and management practices
use may not be appropriate for many approaches for operational risk. In at individual banks, supervisors remain
banks from a cost-benefit point of view. response to these comments, the committed to and have made significant
For a number of banks, the agencies agencies have decided to issue a new progress toward developing protocols
believe that the general risk-based standardized proposal, which would and information-sharing arrangements
capital rules continue to provide a replace the Basel IA proposal for banks that should minimize burdens on banks
reasonable alternative for regulatory that do not apply the advanced operating in multiple countries and
risk-based capital measurement approaches. The standardized proposal ensure that supervisory authorities are
purposes. However, the agencies would allow banks that are not core implementing the New Accord as
recognize that a bifurcated risk-based banks to implement a standardized consistently as possible.
capital framework inevitably raises approach for credit risk and an With regard to implementation timing
competitive considerations. The approach to operational risk consistent concerns, the agencies believe that the
agencies have received comments on with the New Accord. Like the Basel IA transitional arrangements described in
risk-based capital proposals issued in proposal, the standardized proposal will preamble section III.A.2. below provide
the past several years 21 stating that for retain the existing general risk-based a prudent and reasonable framework for
some portfolios, competitive inequities capital rules for those banks that do not moving to the advanced approaches.
would be worse under a bifurcated wish to move to the new rules. The Where international implementation
framework. These commenters agencies expect to issue the differences affect an individual bank,
expressed concern that banks operating standardized proposal in the first the agencies are working with the bank
under the general risk-based capital quarter of 2008. and appropriate national supervisory
rules would be at a competitive A number of commenters expressed authorities to ensure that
disadvantage relative to banks applying concern about competitive inequities implementation proceeds as efficiently
the advanced approaches because the among internationally active banks as possible.
IRB approach would likely result in arising from differences in
implementation and application of the II. Scope
lower risk-based capital requirements
for certain types of exposures. New Accord by supervisory authorities The agencies have identified three
The agencies recognize the potential in different countries. In particular, groups of banks: (i) Large or
competitive inequities associated with a some commenters asserted that the internationally active banks that are
bifurcated risk-based capital framework. proposed U.S. implementation would be required to adopt the advanced
As part of their effort to develop a risk- different from other countries in a approaches (core banks); (ii) banks that
based capital framework that minimizes number of key areas, such as the voluntarily decide to adopt the
competitive inequities and is not definition of default, and that these advanced approaches (opt-in banks);
disruptive to the banking sector, the differences would give rise to and (iii) banks that do not adopt the
agencies issued the Basel IA proposal in substantial implementation cost and advanced approaches (general banks).
December 2006. The Basel IA proposal burden. Other commenters continued to Each core and opt-in bank is required to
included modifications to the general raise concern about the delayed meet certain qualification requirements
risk-based capital rules to improve risk implementation schedule in the United to the satisfaction of its primary Federal
sensitivity and to reduce potential States. supervisor, which in turn will consult
competitive disparities between As discussed in more detail with other relevant supervisors, before
domestic banks subject to the advanced throughout this preamble, the agencies the bank may use the advanced
approaches and domestic banks not have made a number of changes from approaches for risk-based capital
subject to the advanced approaches. the proposal to conform the final rule purposes.
more closely to the New Accord. These Pillar 1 of the New Accord requires all
Recognizing that some banks might
changes should help minimize banks subject to the New Accord to
prefer not to incur the additional
regulatory burden and mitigate potential calculate capital requirements for
regulatory burden of moving to
competitive inequities across national exposure to credit risk and operational
modified capital rules, the Basel IA
jurisdictions. In addition, the BCBS has risk. The New Accord sets forth three
proposal retained the existing general
established an Accord Implementation approaches to calculating the credit risk

risk-based capital rules and permitted
Group, comprised of supervisors from capital requirement and three
banks to opt in to the modified rules.
member countries, whose primary approaches to calculating the
21 See 68 FR 45900 (Aug. 4, 2003), 70 FR 61068 objectives are to work through operational risk capital requirement.
(Oct. 20, 2005), 71 FR 55830 (Sept. 25, 2006), and Outside the United States, countries that
71 FR 77446 (Dec. 26, 2006). 22 See 71 FR 77518 (Dec. 26, 2006). are replacing Basel I with the New
Accord generally have required all a subsidiary of another DI or BHC that In the preamble to the proposed rule,
banks to comply with the New Accord, uses the advanced approaches. the agencies also included a question on
but have provided banks the option of Under the proposed rule, a U.S.- potential regulatory burden associated
choosing among the New Accord’s chartered BHC 23 would be a core bank with requiring a bank that applies the
various approaches for calculating if the BHC had: (i) Consolidated total advanced approaches to implement the
credit risk and operational risk capital assets (excluding assets held by an advanced approaches at each subsidiary
requirements. insurance underwriting subsidiary) of DI—even if those subsidiary DIs do not
For banks in the United States, the $250 billion or more, as reported on the individually meet a threshold criterion.
agencies have taken a different most recent year-end regulatory reports; A number of commenters addressed this
approach. This final rule focuses on the (ii) consolidated total on-balance sheet issue. While they expressed a range of
largest and most internationally active foreign exposure of $10 billion or more views, most commenters maintained
banks and requires those banks to at the most recent year-end; or (iii) a that small DI subsidiaries of core banks
comply with the most advanced subsidiary DI that is a core bank or opt- should not be required to implement the
approaches for calculating credit and in bank. advanced approaches. Rather,
operational risk capital requirements The agencies included a question in commenters asserted that these DIs
(the IRB and the AMA). The final rule the proposal seeking commenters’ views should be permitted to use simpler
allows other U.S. banks to ‘‘opt in’’ to on using consolidated total assets methodologies, such as the New
the advanced approaches. The agencies (excluding assets held by an insurance Accord’s standardized approach.
have decided at this time to require underwriting subsidiary) as one Commenters asserted there would be
large, internationally active U.S. banks criterion to determine whether a BHC regulatory burden and costs associated
to use the most advanced approaches of would be viewed as a core BHC. Some with the proposed push-down
the New Accord. The less advanced of the commenters addressing this issue approach, particularly if a stand-alone
approaches of the New Accord lack the supported the proposed approach, AMA is required at each DI.
noting it was a reasonable proxy for The agencies have considered
degree of risk sensitivity of the
mandatory applicability of a framework comments on this issue and have
advanced approaches. The agencies
designed to measure capital decided to retain the proposed
have the view that risk-sensitive
requirements for consolidated risk approach. Thus, under the final rule,
regulatory capital requirements are
exposures of a BHC. Other commenters, each DI subsidiary of a core or opt-in
integral to ensuring that large,
particularly foreign banking bank is itself a core bank required to
sophisticated banks and the financial
organizations and their trade apply the advanced approaches. The
system have an adequate capital
associations, contended that the BHC agencies believe that this approach
cushion to absorb financial losses. Also,
asset size threshold criterion instead serves as an important safeguard against
the advanced approaches provide more
should be $250 billion of assets in U.S. regulatory capital arbitrage among
substantial incentives for banks to affiliated banks that would otherwise be
improve their risk measurement and subsidiary DIs. These commenters
further suggested that if the Board kept subject to substantially different capital
management practices than do the other rules. Moreover, to calculate its
approaches. The agencies do not believe the proposed $250 billion consolidated
total BHC assets criterion, it should consolidated IRB risk-based capital
that competitive equity concerns are requirements, a bank must estimate risk
sufficiently compelling to warrant limit the scope of this criterion to BHCs
with a majority of their assets in U.S. DI parameters for all credit exposures
permitting large, internationally active within the bank except for exposures in
U.S. banks to adopt the standardized subsidiaries. The Board has decided to
retain the proposed approach using portfolios that, in the aggregate, are
approaches in the New Accord. immaterial to the bank. Because the
consolidated total assets (excluding
A. Core and Opt-In Banks assets held by an insurance consolidated bank must already
underwriting subsidiary) as one estimate risk parameters for all material
Under section 1(b) of the proposed portfolios of wholesale and retail
rule, a DI would be a core bank if it met threshold criterion for BHCs in this final
rule. This approach recognizes that exposures in all of its consolidated
either of two independent threshold subsidiaries, the agencies believe that
criteria: (i) Consolidated total assets of BHCs can hold similar assets within and
outside of DIs and reduces potential there is limited additional regulatory
$250 billion or more, as reported on the burden associated with application of
most recent year-end regulatory reports; incentives to structure BHC assets and
the IRB approach at each subsidiary DI.
or (ii) consolidated total on-balance activities to arbitrage capital regulations.
Likewise, to calculate its consolidated
sheet foreign exposure of $10 billion or The final rule continues to exclude
AMA risk-based capital requirements, a
more at the most recent year end. To assets held in an insurance
bank must estimate its operational risk
determine total on-balance sheet foreign underwriting subsidiary of a BHC from
exposure using a unit of measure
exposure, a bank would sum its the asset threshold because the
(defined below) that does not combine
adjusted cross-border claims, local advanced approaches were not designed
business activities or operational loss
country claims, and cross-border to address insurance underwriting
events with demonstrably different risk
revaluation gains calculated in exposures.
profiles within the same loss
accordance with the Federal Financial The final rule also retains the
distribution. Each subsidiary DI could
Institutions Examination Council threshold criterion for core bank/BHC
have a demonstrably different risk
(FFIEC) Country Exposure Report status of consolidated total on-balance
profile that would require the
(FFIEC 009). Adjusted cross-border sheet foreign exposure of $10 billion or
generation of separate loss distributions.
claims would equal total cross-border more at the most recent year-end. The However, the agencies recognize there
calculation of this exposure amount is
claims less claims with the head office may be situations where application of
or guarantor located in another country, unchanged in the final rule. the advanced approaches at an
plus redistributed guaranteed amounts 23 OTS does not currently impose any explicit
individual DI subsidiary of an advanced
to the country of head office or capital requirements on savings and loan holding
approaches bank may not be
guarantor. The agencies also proposed companies and is not implementing the advanced appropriate. Therefore, the final rule
that a DI would be a core bank if it is approaches for these holding companies. includes the proposed provision that
permits a core or opt-in bank’s primary unless otherwise required to do so by of the other agencies of its
Federal supervisor to determine in the Board. In response to the potential determination.
writing that application of the advanced burden issues identified by commenters Several commenters raised concerns
approaches is not appropriate for the DI and outlined above, the Board notes that with the scope of the reservation of
in light of the bank’s asset size, level of the final rule allows the Board to authority, particularly as it would apply
complexity, risk profile, or scope of exempt any BHC from mandatory to operational risk. These commenters
operations. application of the advanced approaches. asserted, for example, that the agencies
The Board will make such a should address identified operational
B. U.S. Subsidiaries of Foreign Banks risk-related capital deficiencies through
determination in light of the BHC’s asset
Under the proposed rule, any U.S.- size (including subsidiary DI asset size Pillar 2, rather than through requiring a
chartered DI that is a subsidiary of a relative to total BHC asset size), level of bank to adjust input variables or
foreign banking organization would be complexity, risk profile, or scope of techniques used for the calculation of
subject to the U.S. regulatory capital operation. Similarly, the final rule Pillar 1 operational risk capital
requirements for domestically-owned allows a primary Federal supervisor to requirements. Commenters were
U.S. DIs. Thus, if the U.S. DI subsidiary exempt any DI under its jurisdiction concerned that excessive agency Pillar 1
of a foreign banking organization met from mandatory application of the intervention on operational risk might
any of the threshold criteria, it would be advanced approaches. A primary inhibit innovation.
a core bank and would be subject to the Federal supervisor will consider the While the agencies agree that
advanced approaches. If it did not meet same factors in making its innovation is important and that general
any of the criteria, the U.S. DI could determination. supervisory oversight likely would be
remain a general bank or could opt in sufficient in many cases to address risk-
to the advanced approaches, subject to C. Reservation of Authority related capital deficiencies, the agencies
the same qualification process and also believe that it is important to retain
The proposed rule restated the as much supervisory flexibility as
requirements as a domestically-owned authority of a bank’s primary Federal
U.S. DI. possible as they move forward with
supervisor to require a bank to hold an implementation of the final rule. In
The proposed rule also provided that overall amount of capital greater than
a top-tier U.S. BHC, and its subsidiary general, the proposed reservation of
would otherwise be required under the authority represented a reaffirmation of
DIs, that was owned by a foreign rule if the agency determined that the
banking organization would be subject the current authority of a bank’s primary
bank’s risk-based capital requirements Federal supervisor to require the bank to
to the same threshold levels for core were not commensurate with the bank’s
bank determination as a top-tier BHC hold an overall amount of regulatory
credit, market, operational, or other capital or maintain capital ratios greater
that is not owned by a foreign banking risks. In addition, the preamble of the
organization.24 The preamble noted that than would be required under the
proposed rule noted the agencies’ general risk-based capital rules. There
a U.S. BHC that met the conditions in expectation that there may be instances
Federal Reserve SR letter 01–01 25 and may be cases where requiring a bank to
when the rule would generate a risk- assign a different risk-weighted asset
that was a core bank would not be weighted asset amount for specific
required to meet the minimum capital amount for operational risk may not
exposures that is not commensurate sufficiently address problems associated
ratios in the Board’s capital adequacy with the risks posed by such exposures.
guidelines, although it would be with underlying quantification practices
Accordingly, under the proposed rule, and may cause an ongoing misalignment
required to adopt the advanced the bank’s primary Federal supervisor
approaches, compute and report its between the operational risk of a bank
would retain the authority to require the and the risk-weighted asset amount for
capital ratios in accordance with the bank to use a different risk-weighted
advanced approaches, and make the operational risk generated by the bank’s
asset amount for the exposures or to use operational risk quantification system.
required public and regulatory different risk parameters (for wholesale
disclosures. A DI subsidiary of such a In view of this and the inherent
or retail exposures) or model flexibility provided for operational risk
U.S. BHC also would be a core bank and assumptions (for modeled equity or
would be required to adopt the measurement under the AMA, the
securitization exposures) than those agencies believe it is appropriate to
advanced approaches and meet the required when calculating the risk-
minimum capital ratio requirements. articulate the specific measures a
weighted asset amount for those primary Federal supervisor may take if
Under the final rule, consistent with exposures. Similarly, the proposed rule
SR 01–01, a foreign-owned U.S. BHC it determines that a bank’s risk-weighted
provided explicit authority for a bank’s asset amount for operational risk is not
that is a core bank and that also is primary Federal supervisor to require
subject to SR 01–01 will, as a technical commensurate with the operational
the bank to assign a different risk- risks of the bank. Therefore, the final
matter, be required to adopt the weighted asset amount for operational
advanced approaches, and compute and rule retains the reservation of authority
risk, to change elements of its as proposed. The agencies emphasize
report its capital ratios and make other operational risk analytical framework
required disclosures. It will not, that any decision to exercise this
(including distributional and authority would be made judiciously
however, be required to maintain the dependence assumptions), or to make
minimum capital ratios at the U.S. and that a bank bears the primary
other changes to the bank’s operational responsibility for maintaining the
consolidated holding company level risk management processes, data and integrity, reliability, and accuracy of its
24 The Board notes that it generally does not
assessment systems, or quantification risk management and measurement
apply regulatory capital requirements to subsidiary systems if the supervisor found that the systems.
BHCs of top-tier U.S. BHCs, regardless of whether risk-weighted asset amount for
the top-tier U.S. BHC is itself a subsidiary of a operational risk produced by the bank D. Principle of Conservatism
foreign banking organization. under the rule was not commensurate Several commenters asked whether it
25 SR 01–01, ‘‘Application of the Board’s Capital
Adequacy Guidelines to Bank Holding Companies

with the operational risks of the bank. would be permissible not to apply an
Owned by Foreign Banking Organizations,’’ January Any agency that exercised a reservation aspect of the rule for cost or regulatory
5, 2001. of authority was expected to notify each burden reasons, if the result would be
a more conservative capital planning and governance process to and each of its consolidated
requirement. For example, for purposes oversee the implementation efforts subsidiaries. The implementation plan
of the RBA for securitization exposures, described in the plan, demonstrate to its must justify and support any proposed
some commenters asked whether a bank primary Federal supervisor that it meets temporary or permanent exclusion of a
could choose not to track the seniority the qualification requirements in section business line, portfolio, or exposure
of a securitization exposure and, 22 of the final rule, and complete a from the advanced approaches. The
instead, assume that the exposure is not satisfactory ‘‘parallel run’’ (discussed business lines, portfolios, and exposures
a senior securitization exposure. below) before it may use the advanced that the bank proposes to exclude from
Similarly, some commenters asked if approaches for risk-based capital the advanced approaches must be, in
risk-based capital requirements for purposes. A bank’s primary Federal the aggregate, immaterial to the bank.
certain exposures could be calculated supervisor is responsible, after The implementation plan must include
ignoring the benefits of risk mitigants consultation with other relevant objective, measurable milestones
such as collateral or guarantees. supervisors, for evaluating the bank’s (including delivery dates and a date
The agencies believe that in some initial and ongoing compliance with the when the bank’s implementation of the
cases it may be reasonable to allow a qualification requirements for the advanced approaches will be fully
bank to implement a simplified capital advanced approaches. operational). For core banks, the
calculation if the result is more Under the final rule, as under the implementation plan must include an
conservative than would result from a proposed rule, a bank preparing to explicit first transitional floor period
comprehensive application of the rule. implement the advanced approaches start date that is no later than 36 months
Under a new section 1(d) of the final must adopt a written implementation after the later of the effective date of the
rule, a bank may choose not to apply a plan, approved by its board of directors, rule or the date the bank meets at least
provision of the rule to one or more describing in detail how the bank one of the threshold criteria.26 Further,
exposures provided that (i) the bank can complies, or intends to comply, with the the implementation plan must describe
demonstrate on an ongoing basis to the qualification requirements. A core bank the resources that the bank has budgeted
satisfaction of its primary Federal must adopt a plan no later than six and that are available to implement the
supervisor that not applying the months after it meets a threshold plan.
provision would, in all circumstances, criterion in section 1(b)(1) of the final The proposed rule allowed a bank to
unambiguously generate a risk-based rule. If a bank meets a threshold exclude a portfolio of exposures from
capital requirement for each exposure criterion on the effective date of the the advanced approaches if the bank
greater than that which would otherwise final rule, the bank would have to adopt could demonstrate to the satisfaction of
be required under this final rule, (ii) the a plan within six months of the effective its primary Federal supervisor that the
bank appropriately manages the risk of date. Banks that do not meet a threshold portfolio, when combined with all other
those exposures, (iii) the bank provides criterion, but are nearing any criterion portfolios of exposures that the bank
written notification to its primary by internal growth or merger, are sought to exclude from the advanced
Federal supervisor prior to applying this expected to engage in ongoing dialogue approaches, was not material to the
principle to each exposure, and (iv) the with their primary Federal supervisor bank. Some commenters asserted that a
exposures to which the bank applies regarding implementation strategies to bank should be permitted to exclude
this principle are not, in the aggregate, ensure their readiness to adopt the from the advanced approaches any
material to the bank. advanced approaches when a threshold business line, portfolio, or exposure that
The agencies emphasize that a criterion is reached. An opt-in bank may is immaterial on a stand-alone basis
conservative capital requirement for a adopt an implementation plan at any (regardless of whether the excluded
group of exposures does not reduce the time. Under the final rule, each core and exposures in the aggregate are material
need for appropriate risk management of opt-in bank must submit its to the bank). The agencies believe that
those exposures. Moreover, the implementation plan, together with a it is not appropriate for a bank to
principle of conservatism applies to the copy of the minutes of the board of permanently exclude a material portion
determination of capital requirements directors’ approval of the plan, to its of its exposures from the enhanced risk
for specific exposures; it does not apply primary Federal supervisor at least 60 sensitivity and risk measurement and
to the qualification or disclosure days before the bank proposes to begin management requirements of the
requirements in sections 22 and 71 of its parallel run, unless the bank’s advanced approaches. Accordingly, the
the final rule. Sections V.A.1., V.A.3., primary Federal supervisor waives this final rule retains the requirement that
and V.E.2. of this preamble contain prior notice provision. The submission the business lines, portfolios, and
examples of the appropriate use of this to the primary Federal supervisor exposures that the bank proposes to
principle of conservatism. should indicate the date that the bank exclude from the advanced approaches
proposes to begin its parallel run. must be, in the aggregate, immaterial to
III. Qualification In developing an implementation the bank.
A. The Qualification Process plan, a bank must assess its current state During implementation of the
of readiness relative to the qualification advanced approaches, a bank should
1. In General requirements in this final rule. This work closely with its primary Federal
Supervisory qualification to use the assessment must include a gap analysis supervisor to ensure that its risk
advanced approaches is an iterative and that identifies where additional work is measurement and management systems
ongoing process that begins when a needed and a remediation or action plan are functional and reliable and are able
bank’s board of directors adopts an that clearly sets forth how the bank to generate risk parameter estimates that
implementation plan and continues as intends to fill the gaps it has identified. can be used to calculate the risk-based
the bank operates under the advanced The implementation plan must capital ratios correctly under the
approaches. Under the final rule, as comprehensively address the advanced approaches. The
under the proposal, a bank must qualification requirements for the bank
develop and adopt a written and each of its consolidated subsidiaries 26 The bank’s primary Federal supervisor may
implementation plan, establish and (U.S. and foreign-based) with respect to extend the bank’s first transitional floor period start
maintain a comprehensive and sound all portfolios and exposures of the bank date.
implementation plan, including the gap requirements during the parallel run under the general risk-based capital
analysis and action plan, will provide a period. rules and the advanced approaches to
basis for ongoing supervisory dialogue Commenters also requested the its primary Federal supervisor through
and review during the qualification flexibility, permitted under the New the supervisory process on a quarterly
process. The primary Federal supervisor Accord, to apply the advanced basis. The agencies will share this
will assess a bank’s progress relative to approaches to some portfolios and other information with each other.
its implementation plan. To the extent approaches (such as the standardized As described above, a bank must
that adjustments to target dates are approach in the New Accord) to other provide its board-approved
needed, these adjustments should be portfolios during the transitional floor implementation plan to its primary
made subject to the ongoing supervisory periods. The agencies believe, however, Federal supervisor at least 60 days
discussion between the bank and its that banks applying the advanced before the bank proposes to begin its
primary Federal supervisor. approaches should move expeditiously parallel run period. A bank also must
to extend the robust risk measurement receive approval from its primary
2. Parallel Run and Transitional Floor and management practices required by
Periods Federal supervisor before beginning its
the advanced approaches to all material first transitional floor period. In
Under the proposed and final rules, exposures. To preserve these positive evaluating whether to grant approval to
once a bank has adopted its risk measurement and management a bank to begin using the advanced
implementation plan, it must complete incentives for banks and to prevent approaches for risk-based capital
a satisfactory parallel run before it may ‘‘cherry picking’’ of portfolios, the final purposes, the bank’s primary Federal
use the advanced approaches to rule retains the provision in the supervisor must determine that the bank
calculate its risk-based capital proposed rule that states that a bank fully complies with all the qualification
requirements. The proposed rule may enter the first transitional floor requirements, the bank has conducted a
defined a satisfactory parallel run as a period only if it fully complies with the satisfactory parallel run, and the bank
period of at least four consecutive qualification requirements in section 22 has an adequate process to ensure
calendar quarters during which a bank of the rule. As described above, the final ongoing compliance with the
complied with all of the qualification rule allows a simplified approach for qualification requirements.
requirements to the satisfaction of its portfolios that are, in the aggregate, To provide for a smooth transition to
primary Federal supervisor. immaterial to the bank. the advanced approaches, the proposed
Many commenters objected to the Another concern identified by rule imposed temporary limits on the
proposed requirement that the bank had commenters regarding the parallel run amount by which a bank’s risk-based
to meet all of the qualification was the asymmetric treatment of capital requirements could decline over
requirements before it could begin the mergers and acquisitions consummated a period of at least three years (that is,
parallel run period. The agencies before and after the date a bank at least four consecutive calendar
recognize that certain qualification qualified to use the advanced
requirements, such as outcomes quarters in each of the three transitional
approaches. Under the proposed rule, a
analysis, become more meaningful as a floor periods). Based on its assessment
bank qualified to use the advanced
bank gains experience employing the of the bank’s ongoing compliance with
approaches that merged with or
advanced approaches. The agencies the qualification requirements, a bank’s
acquired a company would have up to
therefore are modifying the definition of primary Federal supervisor would
24 months following the calendar
a satisfactory parallel run in the final determine when the bank is ready to
quarter during which the merger or
rule. Under the final rule, a satisfactory move from one transitional floor period
acquisition was consummated to
parallel run is a period of at least four to the next period and, after the full
integrate the merged or acquired
consecutive calendar quarters during transition has been completed, to exit
company into the bank’s advanced
which the bank complies with the the last transitional floor period and
approaches capital calculations. In
qualification requirements to the contrast, the proposed rule could be move to stand-alone use of the advanced
satisfaction of its primary Federal read to provide that a bank that merged approaches. Table A sets forth the
supervisor. This revised definition, with or acquired a company before the proposed transitional floor periods for
which does not contain the word ‘‘all,’’ bank qualified to use the advanced banks moving to the advanced
recognizes that the qualification of approaches had to fully implement the approaches:
banks for the advanced approaches advanced approaches for the merged or
during the parallel run period will be an acquired company before the bank TABLE A.—TRANSITIONAL FLOORS
iterative and ongoing process. The could qualify to use the advanced
agencies intend to assess individual Transitional
approaches. The agencies agree that this Transitional floor period floor percentage
advanced approaches methodologies asymmetric treatment is not
through numerous discussions, reviews, appropriate. Accordingly, the final rule First floor period ................. 95
data collection and analysis, and applies the merger and acquisition Second floor period ............ 90
examination activities. The agencies transition provisions both before and Third floor period ................ 85
also emphasize the critical importance after a bank qualifies to use the
of ongoing validation of advanced advanced approaches. The merger and During the proposed transitional floor
approaches methodologies both before acquisition transition provisions are periods, a bank would calculate its risk-
and after initial qualification decisions. described in section III.D. of this weighted assets under the general risk-
A bank’s primary Federal supervisor preamble. based capital rules. Next, the bank
will review a bank’s validation process During the parallel run period, a bank would multiply this risk-weighted
and documentation for the advanced continues to be subject to the general assets amount by the appropriate floor
approaches on an ongoing basis through risk-based capital rules but percentage in the table above. This
the supervisory process. The bank simultaneously calculates its risk-based product would be the bank’s ‘‘floor-
should include in its implementation capital ratios under the advanced adjusted’’ risk-weighted assets. Third,
plan the steps it will take to enhance approaches. During this period, a bank the bank would calculate its tier 1 and
compliance with the qualification will report its risk-based capital ratios total risk-based capital ratios using the
definitions of tier 1 and tier 2 capital Under the proposed rule, after a bank agencies’ overall capital objectives.
(and associated deductions and completed its transitional floor periods Therefore, the agencies are adopting in
adjustments) in the general risk-based and its primary Federal supervisor this final rule the proposed level,
capital rules for the numerator values determined the bank could begin using duration, and calculation methodology
and floor-adjusted risk-weighted assets the advanced approaches with no of the transitional floors, with the
for the denominator values. These ratios further transitional floor, the bank revised process for determining when
would be referred to as the ‘‘floor- would use its tier 1 and total risk-based banks may exit the third transitional
adjusted risk-based capital ratios.’’ capital ratios as calculated under the floor period discussed in section I.E.,
The bank also would calculate its tier advanced approaches and its tier 1 above.
1 and total risk-based capital ratios leverage ratio calculated using the Under the final rule, as under the
using the advanced approaches advanced approaches definition of tier 1 proposed rule, banks that meet the
definitions and rules. These ratios capital for PCA and all other threshold criteria in section 1(b)(1) (core
would be referred to as the ‘‘advanced supervisory and regulatory purposes. banks) as of the effective date of this
approaches risk-based capital ratios.’’ In Although one commenter supported final rule, and banks that opt in
addition, the bank would calculate a tier the proposed transitional provisions, pursuant to section 1(b)(2) at the earliest
1 leverage ratio using tier 1 capital as many commenters objected to these possible date, must use the general risk-
defined in the proposed rule for the transitional provisions. Commenters based capital rules both during the
numerator of the ratio. urged the agencies to conform the parallel run and as a basis for the
During a bank’s transitional floor transitional provisions to those in the transitional floor calculations. Should
periods, the bank would report all five New Accord. Specifically, they the agencies finalize a standardized risk-
regulatory capital ratios described requested that the three transitional based capital rule, the agencies expect
above—two floor-adjusted risk-based floor periods be reduced to two periods that a bank that opts in after the earliest
capital ratios, two advanced approaches and that the transitional floor possible date or becomes a core bank
risk-based capital ratios, and one percentages be reduced from 95 percent, after the effective date of the final rule
leverage ratio. To determine its 90 percent, and 85 percent to 90 percent would use the risk-based capital regime
applicable capital category for PCA and 80 percent. Commenters also (the general risk-based capital rules or
purposes and for all other regulatory requested that the transitional floor the standardized risk-based capital
and supervisory purposes, a bank’s risk- calculation methodology be conformed rules) used by the bank immediately
based capital ratios during the to the generally less restrictive before the bank begins its parallel run
transitional floor periods would be set methodology of the New Accord. both during the parallel run and as a
equal to the lower of the respective Moreover, they expressed concern about basis for the transitional floor
floor-adjusted risk-based capital ratio the requirement that a bank obtain calculations. Under the final rule, 2008
and the advanced approaches risk-based supervisory approval to move from one is the first possible year for a bank to
capital ratio. transitional floor period to the next, begin its parallel run and 2009 is the
During the proposed transitional floor which could potentially extend each first possible year for a bank to begin its
periods, a bank’s tier 1 capital and tier floor period beyond four calendar first of three transitional floor periods.
2 capital for all non-risk-based-capital quarters.
The agencies believe that the B. Qualification Requirements
supervisory and regulatory purposes (for
prudential transitional safeguards are Because the advanced approaches use
example, lending limits and Regulation
necessary to address concerns identified banks’ estimates of certain key risk
W quantitative limits) would be the parameters to determine risk-based
in the analysis of the results of QIS–4.28
bank’s tier 1 capital and tier 2 capital as capital requirements, they introduce
Specifically, the transitional safeguards
calculated under the advanced greater complexity to the regulatory
will ensure that implementation of the
approaches. capital framework and require banks to
advanced approaches will not result in
Thus, for example, to be well possess a high level of sophistication in
a precipitous drop in risk-based capital
capitalized under PCA, a bank would risk measurement and risk management
requirements, and will provide a
have to have a floor-adjusted tier 1 risk- systems. As a result, the final rule
smooth transition process as banks
based capital ratio and an advanced requires each core or opt-in bank to
refine their advanced systems. Banks’
approaches tier 1 risk-based capital ratio meet the qualification requirements
computation of risk-based capital
of 6 percent or greater, a floor-adjusted described in section 22 of the final rule
requirements under both the general
total risk-based capital ratio and an to the satisfaction of its primary Federal
risk-based capital rules and the
advanced approaches total risk-based supervisor for a period of at least four
advanced approaches during the
capital ratio of 10 percent or greater, and parallel run and transitional floor consecutive calendar quarters before
a tier 1 leverage ratio of 5 percent or periods will help the agencies assess the using the advanced approaches to
greater (with tier 1 capital calculated impact of the advanced approaches on calculate its minimum risk-based capital
under the advanced approaches). overall capital requirements, including requirements (subject to the transitional
Although the PCA rules do not apply to whether the change in capital floor provisions for at least an
BHCs, a BHC would be required to requirements relative to the general risk- additional three years). The
report all five of these regulatory capital based capital rules is consistent with the qualification requirements are written
ratios and would have to meet broadly to accommodate the many ways
applicable supervisory and regulatory For other BHCs, the minimum leverge ratio a bank may design and implement
requirements using the lower of the requirement is 4 percent. robust internal credit and operational
respective floor-adjusted risk-based 28 Preliminary analysis of the QIS–4 submissions
risk measurement and management
capital ratio and the advanced evidenced material reductions in the aggregate
minimum required capital for the QIS–4 participant systems, and to permit industry practice
approaches risk-based capital ratio.27 population and significant dispersion of results to evolve.
across institutions and portfolio types. See Many of the qualification
27 The Board notes that, under the applicable Interagency Press Release, Banking ‘‘Agencies To
leverage ratio rule, a BHC that is rated composite Perform Additional Analysis Before Issuing Notice
requirements relate to a bank’s
‘‘1’’ or that has adopted the market risk rule has a of Proposed Rulemaking Related To Basel II,’’ April advanced IRB systems. A bank’s
minimum leverage ratio requirement of 3 percent. 29, 2005. advanced IRB systems must incorporate
five interdependent components in a supervisor determines that current must ensure that the risk parameters
framework for evaluating credit risk and levels or ratios are deficient or some (PD, LGD, EAD, and, for wholesale
measuring regulatory capital: element of the bank’s business practices exposures, M) and reference data used
(i) A risk rating and segmentation suggests the need for higher capital to determine its risk-based capital
system that assigns ratings to individual levels or ratios. In addition, the primary requirements are representative of its
wholesale obligors and exposures and Federal supervisor may, under its own credit and operational risk
assigns individual retail exposures to enforcement authority, require a bank to exposures.
segments; modify or enhance risk management The final rule also requires that the
(ii) A quantification process that and internal control authority, or reduce systems and processes that an advanced
translates the risk characteristics of risk exposures, or take any other action approaches bank uses for risk-based
wholesale obligors and exposures and as deemed necessary to address capital purposes must be consistent
segments of retail exposures into identified supervisory concerns. with the bank’s internal risk
numerical risk parameters that are used As outlined in the proposed guidance, management processes and management
as inputs to the IRB risk-based capital the agencies expect banks to implement information reporting systems. This
formulas; and continually update the fundamental means, for example, that data from the
(iii) An ongoing process that validates elements of a sound ICAAP—identifying latter processes and systems can be used
the accuracy of the rating assignments, and measuring material risks, setting to verify the reasonableness of the
segmentations, and risk parameters; capital adequacy goals that relate to risk, inputs the bank uses for calculating risk-
(iv) A data management and and ensuring the integrity of internal based capital ratios.
maintenance system that supports the capital adequacy assessments. A bank is
advanced IRB systems; and 2. Risk Rating and Segmentation
expected to ensure adequate capital is
(v) Oversight and control mechanisms Systems for Wholesale and Retail
held against all material risks.
that ensure the advanced IRB systems In developing its ICAAP, a bank Exposures
are functioning effectively and should be particularly mindful of the To implement the IRB approach, a
producing accurate results. limitations of regulatory risk-based bank must have internal risk rating and
capital requirements as a measure of its segmentation systems that accurately
1. Process and Systems Requirements
full risk profile—including risks not and reliably differentiate between
One of the objectives of the advanced covered or not adequately quantified in degrees of credit risk for wholesale and
approaches framework is to provide the risk-based capital requirements—as retail exposures. As described below,
appropriate incentives for banks to well as specific assumptions embedded wholesale exposures include most
develop and use better techniques for in risk-based regulatory capital credit exposures to companies,
measuring and managing their risks and requirements (such as diversification in sovereigns, and other governmental
to ensure that capital is adequate to credit portfolios). A bank should also be entities, as well as some exposures to
support those risks. Section 3 of the mindful of the capital adequacy effects individuals. Retail exposures include
final rule requires a bank to hold capital of concentrations that may arise within most credit exposures to individuals
commensurate with the level and nature each risk type or across risk types. In and small credit exposures to businesses
of all risks to which the bank is general, a bank’s ICAAP should reflect that are managed as part of a segment of
exposed. Section 22 of the final rule an appropriate level of conservatism to exposures with homogeneous risk
specifically requires a bank to have a account for uncertainty in risk characteristics. Together, wholesale and
rigorous process for assessing its overall identification, risk mitigation or control, retail exposures cover most credit
capital adequacy in relation to its risk quantitative processes, and any use of exposures of banks.
profile and a comprehensive strategy for modeling. In most cases, this To differentiate among degrees of
maintaining appropriate capital levels conservatism will result in higher levels credit risk, a bank must be able to make
(known as the internal capital adequacy of capital or higher capital ratios being meaningful and consistent distinctions
assessment process or ICAAP). Another regarded as adequate. among credit exposures along two
objective of the advanced approaches As noted above, each core and opt-in dimensions—default risk and loss
framework is to ensure comprehensive bank must apply the advanced severity in the event of a default. In
supervisory review of capital adequacy. approaches for risk-based capital addition, a bank must be able to assign
On February 28, 2007, the agencies purposes at the consolidated top-tier wholesale obligors to rating grades that
issued proposed guidance setting forth U.S. legal entity level (either the top-tier approximately reflect likelihood of
supervisory expectations for a bank’s U.S. BHC or top-tier DI that is a core or default and must be able to assign
ICAAP and addressing the process for a opt-in bank) and at each DI that is a wholesale exposures to loss severity
comprehensive supervisory assessment subsidiary of such a top-tier legal entity rating grades (or LGD estimates) that
of capital adequacy.29 As set forth in (unless a primary Federal supervisor approximately reflect the loss severity
that guidance, and consistent with provides an exemption under section expected in the event of default during
existing supervisory practice, a bank’s 1(b)(3) of the final rule). Each bank that economic downturn conditions. As
primary Federal supervisor will applies the advanced approaches must discussed below, the final rule requires
evaluate how well the bank is assessing have an appropriate infrastructure with banks to treat wholesale exposures
its capital needs relative to its risks. The risk measurement and management differently from retail exposures when
supervisor will assess the bank’s overall processes that meet the final rule’s differentiating among degrees of credit
capital adequacy and will take into qualification requirements and that are risk; specifically, risk parameters for
account a bank’s ICAAP, its compliance appropriate given the bank’s size and retail exposures are assigned at the
with the minimum capital requirements level of complexity. Regardless of segment level.
set forth in this rule, and all other whether the systems and models that
relevant information. The primary generate the risk parameters necessary Wholesale Exposures
Federal supervisor will require a bank to for calculating a bank’s risk-based Under the proposed rule, a bank
increase its capital levels or ratios if the capital requirements are located at an would be required to have an internal
affiliate of the bank, each legal entity risk rating system that indicates the
29 72 FR 9189. that applies the advanced approaches likelihood of default of each individual
obligor and would either use an internal management based on an evaluation of may have different default probabilities.
risk rating system that indicates the management’s ability to make realistic For example, a sovereign government
economic loss rate upon default of each projections, management’s track record may impose prohibitive exchange
individual exposure or directly assign in meeting projections, and restrictions that make it impossible for
an LGD estimate to each individual management’s ability to effectively a borrower to transfer payments in one
exposure. A bank would assign an adapt to changes in the economy and particular currency.
internal risk rating to each wholesale the competitive environment. In addition, the agencies agree that
obligor that reflected the obligor’s Under the proposed rule, a bank certain income-producing real estate
likelihood of default. would assign each legal entity exposures for which the bank, in
Several commenters objected to the wholesale obligor to a single rating economic substance, does not have
proposed requirement to assign an grade. Accordingly, if a single wholesale recourse to the borrower beyond the real
internal risk rating to each wholesale exposure of the bank to an obligor estate serving as collateral for the
obligor that reflected the obligor’s triggered the proposed rule’s definition exposure, have default probabilities
likelihood of default. Commenters of default, all of the bank’s wholesale distinct from that of the borrower. Such
asserted that this requirement was exposures to that obligor would be in situations would arise, for example,
burdensome and unnecessary where a default for risk-based capital purposes. where real estate collateral is located in
bank underwrote an exposure based In addition, under the proposed rule, a a state where a bank, under applicable
solely on the financial strength of a bank would not be allowed to consider state law, effectively does not have
guarantor and used the PD substitution the value of collateral pledged to recourse to the borrower if the bank
approach (discussed below) to recognize support a particular wholesale exposure pursues the real estate collateral in the
the risk mitigating effects of an eligible (or any other exposure-specific event of default (for example, in a ‘‘one-
guarantee on the exposure. In such characteristics) when assigning a rating action’’ state or a state with a similar
cases, commenters maintained that to the obligor of the exposure. A bank law). In one-action states such as
banks should be allowed to assign a PD would, however, consider all available Arizona, California, Idaho, Montana,
only to the guarantor and not the financial information about the Nevada, and Utah, or in a state with a
underlying obligor. obligor—including, where applicable, similar law, such as New York, the
While the agencies believe that the total operating income or cash flows applicable foreclosure laws materially
maintaining internal risk ratings of both from all of the obligor’s projects or limit a bank’s ability to collect against
a protection provider and underlying businesses—when assigning an obligor both the collateral and the borrower.
obligor provides helpful information for rating. A third instance in which exposures
risk management purposes and While a few commenters expressly to the same borrower may have
facilitates a greater understanding of so- supported the proposal’s requirement significantly different default
called double default effects, the for banks to assign each legal entity probabilities is when a borrower enters
agencies appreciate the commenters’ wholesale obligor to a single rating bankruptcy and the bank extends
concerns about burden in this context. grade, a substantial number of additional credit to the borrower under
Accordingly, the final rule does not commenters expressed reservations the auspices of the bankruptcy
require a bank to assign an internal risk about this requirement. These proceedings. This so-called debtor in
rating to an underlying obligor to whom commenters observed that in certain possession (DIP) financing is unique
the bank extends credit based solely on circumstances an exposure’s from other exposure types because it
the financial strength of a guarantor, transaction-specific characteristics affect typically has priority over existing debt,
provided that all of the bank’s exposures its likelihood of default. Commenters equity, and other claims on the
to that obligor are fully covered by asserted that the agencies should borrower. The agencies believe that
eligible guarantees and the bank applies provide greater flexibility and allow because of this unique priority status, if
the PD substitution approach to all of banks to depart from the one-rating-per- a bank has an exposure to a borrower
those exposures. A bank in this obligor requirement based on the that declares bankruptcy and defaults
situation is only required to assign an economic substance of an exposure. In on that exposure, and the bank
internal risk rating to the guarantor. particular, commenters maintained that subsequently provides DIP financing to
However, a bank must immediately income-producing real estate lending that obligor, it may not be appropriate
assign an internal risk rating to the should be exempt from the one-rating- to require the bank to treat the DIP
obligor if a guarantee can no longer be per-obligor requirement. The financing exposure at inception as an
recognized under this final rule. commenters noted that the probability exposure to a defaulted borrower.
In determining an obligor rating, a that an obligor will default on any one To address these circumstances and
bank should consider key obligor such facility depends primarily on the clarify the application of the one-rating-
attributes, including both quantitative cash flows from the individual property per-obligor requirement, the agencies
and qualitative factors that could affect securing the facility, not the overall added a definition of obligor in the final
the obligor’s default risk. From a condition of the obligor. Similarly, rule. The final rule defines an obligor as
quantitative perspective, this could several commenters asserted that the legal entity or natural person
include an assessment of the obligor’s exposures involving transfer risk and contractually obligated on a wholesale
historic and projected financial non-recourse exposures should be exposure except that a bank may treat
performance, trends in key financial exempted from the one-rating-per- three types of exposures to the same
performance ratios, financial obligor requirement. legal entity or natural person as having
contingencies, industry risk, and the In general, the agencies believe that a separate obligors. First, exposures to the
obligor’s position in the industry. On two-dimensional rating system that same legal entity or natural person
the qualitative side, this could include strictly separates borrower and denominated in different currencies.
an assessment of the quality of the exposure-level characteristics is a Second, (i) income-producing real estate
obligor’s financial reporting, non- critical underpinning of the IRB exposures for which all or substantially
financial contingencies (for example, approach. However, the agencies agree all of the repayment of the exposure is
labor problems and environmental that exposures to the same borrower reliant on cash flows of the real estate
issues), and the quality of the obligor’s denominated in different currencies serving as collateral for the exposure;
the bank, in economic substance, does the risk parameters for wholesale likelihood of default and loss severity
not have recourse to the borrower exposures are assigned at the individual given default. Regardless of the risk
beyond the real estate serving as exposure level, whereas risk parameters drivers used, a bank must be able to
collateral for the exposure; and no cross- for retail exposures are assigned at the demonstrate to its primary Federal
default or cross-acceleration clauses are segment level. Banks typically manage supervisor that its system assigns
in place other than clauses obtained retail exposures on a segment basis, accurate and reliable PD and LGD
solely in an abundance of caution; and where each segment contains exposures estimates for each retail segment on a
(ii) other credit exposures to the same with similar risk characteristics. consistent basis.
legal entity or natural person. Third, (i) Therefore, a key characteristic of the
Definition of Default
wholesale exposures authorized under final rule’s retail framework is that the
section 364 of the U.S. Bankruptcy Code risk parameters for retail exposures are Wholesale default. In the ANPR, the
(11 U.S.C. 364) to a legal entity or assigned to segments of exposures rather agencies proposed to define default for
natural person who is a debtor-in- than to individual exposures. Under the a wholesale exposure as either or both
possession for purposes of Chapter 11 of retail framework, a bank groups its retail of the following events: (i) The bank
the Bankruptcy Code; and (ii) other exposures into segments with determines that the borrower is unlikely
credit exposures to the same legal entity homogeneous risk characteristics and to pay its obligations to the bank in full,
or natural person. All exposures to a estimates PD and LGD for each segment. without recourse to actions by the bank
single legal entity or natural person Some commenters stated that for such as the realization of collateral; or
must be treated as exposures to a single internal risk management purposes they (ii) the borrower is more than 90 days
obligor unless they qualify for one of assign risk parameters at the individual past due on principal or interest on any
these three exceptions in the final rule’s retail exposure level rather than at the material obligation to the bank. The
definition of obligor. segment level. These commenters ANPR’s definition of default was
A bank’s obligor rating system must requested confirmation that this practice generally consistent with the New
have at least seven discrete (non- would be permissible for risk-based Accord.
overlapping) obligor grades for non- capital purposes under the final rule. A number of commenters on the
defaulted obligors and at least one The agencies believe that a bank may ANPR encouraged the agencies to use a
obligor grade for defaulted obligors. The use its advanced systems, including wholesale definition of default that
agencies believe that because the risk- exposure-level risk parameter estimates, varied from the New Accord but
based capital requirement of a to group exposures into segments with conformed more closely to that used by
wholesale exposure is directly linked to homogeneous risk characteristics. Such bank risk managers. Many of these
its obligor rating grade, a bank must exposure-level estimates must be commenters recommended that the
have at least seven non-overlapping aggregated in order to assign segment- agencies define default for wholesale
obligor grades to differentiate level risk parameters to each segment of exposures as the entry into non-accrual
sufficiently the creditworthiness of nonretail exposures. or charge-off status. In the proposed
defaulted wholesale obligors. A bank must group its retail rule, the agencies amended the ANPR
A bank must capture the estimated exposures into three separate definition of default to respond to these
loss severity upon default for a subcategories: (i) Residential mortgage concerns. Under the proposed definition
wholesale exposure either by directly exposures; (ii) QREs; and (iii) other of default, a bank’s wholesale obligor
assigning an LGD estimate to the retail exposures. The bank must classify would be in default if, for any wholesale
exposure or by grouping the exposure the retail exposures in each subcategory exposure of the bank to the obligor, the
with other wholesale exposures into into segments to produce a meaningful bank had (i) placed the exposure on
loss severity rating grades (reflecting the differentiation of risk. The final rule non-accrual status consistent with the
bank’s estimate of the LGD of the requires banks to segment separately (i) Consolidated Report of Condition and
exposure). LGD is described in more defaulted retail exposures from non- Income (Call Report) Instructions or the
detail below. Whether a bank chooses to defaulted retail exposures and (ii) retail Thrift Financial Report (TFR) and the
assign LGD values directly or, eligible margin loans for which the bank TFR Instruction Manual; (ii) taken a full
alternatively, to assign exposures to adjusts EAD rather than LGD to reflect or partial charge-off or write-down on
rating grades and then quantify the LGD the risk mitigating effects of financial the exposure due to the distressed
for the rating grades, the key collateral from other retail eligible financial condition of the obligor; or (iii)
requirement is that the bank must margin loans. Otherwise, the agencies incurred a credit-related loss of 5
identify exposure characteristics that do not require that banks consider any percent or more of the exposure’s initial
influence LGD. Each of the loss severity particular risk drivers or employ any carrying value in connection with the
rating grades must be associated with an minimum number of segments in any of sale of the exposure or the transfer of
empirically supported LGD estimate. the three retail subcategories. the exposure to the held-for-sale,
Banks employing loss severity grades In determining how to segment retail available-for-sale, trading account, or
must have a sufficiently granular loss exposures within each subcategory for other reporting category.
severity grading system to avoid the purpose of assigning risk The agencies received extensive
grouping together exposures with parameters, a bank should use a comment on the proposed definition of
widely ranging LGDs. segmentation approach that is default for wholesale exposures.
consistent with its approach for internal Commenters observed that the proposed
Retail Exposures risk assessment purposes and that definition of default was different from
To implement the advanced approach classifies exposures according to and more prescriptive than the
for retail exposures, a bank must have predominant risk characteristics or definition in the New Accord and
an internal system that segments its drivers. Examples of risk drivers could employed in other major jurisdictions.
retail exposures to differentiate include loan-to-value ratios, credit They asserted that the proposed
accurately and reliably among degrees scores, loan terms and structure, definition would impose unjustifiable
of credit risk. The most significant origination channel, geographical systems burden and expense on banks
difference between the treatment of location of the borrower, collateral type, operating across multiple jurisdictions.
wholesale and retail exposures is that and bank internal estimates of Commenters also asserted that many
banks’ data collection systems are based (i) The bank places the exposure on Policy. 30 Specifically, revolving retail
on the New Accord’s definition of non-accrual status consistent with the exposures and residential mortgage
default, and therefore historical data Call Report Instructions or the TFR and exposures would be in default at 180
relevant to the proposed definition of the TFR Instruction Manual; days past due; other retail exposures
default are limited. Moreover, (ii) The bank takes a full or partial would be in default at 120 days past
commenters expressed concern that risk charge-off or write-down on the due. In addition, a retail exposure
parameters estimated using the exposure due to the distressed financial would be in default if the bank had
proposed definition of default would condition of the obligor; taken a full or partial charge-off or
differ materially from those estimated write-down of principal on the exposure
(iii) The bank incurs a material credit- for credit-related reasons. Such an
using the New Accord’s definition of
related loss in connection with the sale exposure would remain in default until
default, resulting in different capital
of the exposure or the transfer of the the bank had reasonable assurance of
requirements for U.S. banks relative to
exposure to the held-for-sale, available- repayment and performance for all
their foreign peers.
for-sale, trading account, or other contractual principal and interest
The 5 percent credit-related loss reporting category;
trigger in the proposed definition of payments on the exposure.
default for wholesale obligors was the (iv) The bank consents to a distressed Although some commenters
focus of significant commenter concern. restructuring of the exposure that is supported the proposed rule’s retail
Commenters asserted that the trigger likely to result in a diminished financial definition of default, others urged the
inappropriately imported LGD and obligation caused by the material agencies to adopt a 90-days-past-due
maturity-related considerations into the forgiveness or postponement of default trigger consistent with the New
definition of default, could hamper the principal, interest or (where relevant) Accord’s definition of default for retail
use of loan sales as a risk management fees; exposures. Other commenters requested
practice, and could cause obligors that (v) The bank has filed as a creditor of that a non-accrual trigger be added to
are performing on their obligations to be the obligor for purposes of the obligor’s the retail definition of default similar to
considered defaulted. These bankruptcy under the U.S. Bankruptcy that in the proposed wholesale
commenters also claimed that the 5 Code (or a similar proceeding in a definition of default. The commenters
percent trigger would add significant foreign jurisdiction regarding the viewed this as a practical way to allow
implementation burden by, for example, obligor’s credit obligation to the bank); a foreign banking organization to
requiring banks to distinguish between or harmonize the U.S. retail definition of
credit-related and non-credit-related default to a home country definition of
(vi) The obligor has sought or has
losses on sale. default that has a 90-days-past-due
been placed in bankruptcy or similar
Many commenters requested that the trigger.
protection that would avoid or delay The agencies believe that adding a
agencies conform the U.S. wholesale repayment of the exposure to the bank.
definition of default to the New Accord. non-accrual trigger to the retail
If a bank carries a wholesale exposure definition of default is not appropriate.
Other commenters requested that banks at fair value for accounting purposes,
be allowed the option to apply either Retail non-accrual practices vary
the bank’s practices for determining considerably among banks, and adding
the U.S. or the New Accord definition unlikeliness to pay for purposes of the
of default. a non-accrual trigger to the retail
definition of default should be definition of default would result in
The agencies agree that the proposed consistent with the bank’s practices for greater inconsistency among banks in
definition of default for wholesale determining credit-related declines in the treatment of retail exposures.
obligors could have unintended the fair value of the exposure. Moreover, a bank that considers retail
consequences for implementation
Like the proposed definition of exposures to be defaulted at 90 days
burden and international consistency.
default for wholesale obligors, the final past due could have significantly
Therefore, the final rule contains a
rule states that a wholesale exposure to different risk parameter estimates than
definition of default for wholesale
an obligor remains in default until the one that uses 120- and 180-days-past-
obligors that is similar to the definition
bank has reasonable assurance of due thresholds. Such a bank would
proposed in the ANPR and consistent
repayment and performance for all likely have higher PD estimates and
with the New Accord. Specifically,
contractual principal and interest lower LGD estimates due to the
under the final rule, a bank’s wholesale
payments on all exposures of the bank established tendency of a nontrivial
obligor is in default if, for any wholesale
to the obligor (other than exposures that proportion of U.S. retail exposures to
exposure of the bank to the obligor: (i)
have been fully written-down or ‘‘cure’’ or return to performing status
The bank considers that the obligor is
charged-off). The agencies expect a bank after becoming 90 days past due and
unlikely to pay its credit obligations to
to employ standards for determining before becoming 120 or 180 days past
the bank in full, without recourse by the
whether it has a reasonable assurance of due. The agencies believe that the 120-
bank to actions such as realizing
repayment and performance that are and 180-days-past-due thresholds,
collateral (if held); or (ii) the obligor is
similar to those for determining whether which are consistent with national
past due more than 90 days on any
to restore a loan from non-accrual to discretion provided by the New Accord,
material credit obligation to the bank.
accrual status. reflect a point at which retail exposures
The final rule also clarifies, consistent
Retail default. In response to in the United States are unlikely to
with the New Accord, that an overdraft
comments on the ANPR, the agencies return to performing status. Therefore,
is past due once the obligor has
proposed to define default for retail the agencies are incorporating the
breached an advised limit or has been
exposures according to the timeframes proposed retail definition of default
advised of a limit smaller than the

for loss classification that banks without substantive change in the final
current outstanding balance.
generally use for internal purposes. rule. (Parallel to the full or partial
Consistent with the New Accord, the
following elements may be indications These timeframes are embodied in the 30 FFIEC, ‘‘Uniform Retail Credit Classification
of unlikeliness to pay under this FFIEC’s Uniform Retail Credit and Account Management Policy,’’ 65 FR 36903,
definition: Classification and Account Management June 12, 2000.
charge-off or write-down trigger for distort the estimated risk parameters One commenter noted that quarterly
retail exposures not held at fair value, assigned by a bank to its wholesale reviews may not be appropriate for
the agencies added a material negative exposures and retail segments. high-quality retail portfolios, such as
fair value adjustment of principal for retail exposures associated with a bank’s
Rating Philosophy
credit-related reasons trigger for retail wealth management or private banking
exposures held at fair value.) A bank’s internal risk rating policy for businesses. The commenter suggested
The New Accord provides discretion wholesale exposures must describe the that banks should have the flexibility to
for national supervisors to set the retail bank’s rating philosophy, which is how review and update segmentation
default trigger at up to 180 days past the bank’s wholesale obligor rating assignments for such portfolios on a less
due for different products, as assignments are affected by the bank’s frequent basis appropriate to the credit
appropriate to local conditions. choice of the range of economic, quality of the portfolios.
Accordingly, banks implementing the business, and industry conditions that The agencies agree that it may be
IRB approach in multiple jurisdictions are considered in the obligor rating appropriate for a bank to review and
may be subject to different retail process. The philosophical basis of a update segmentation assignments for
definitions of default in their home and bank’s rating system is important certain high-quality retail exposures on
host jurisdictions. The agencies because, when combined with the credit a less frequent basis than quarterly,
recognize that it could be costly and quality of individual obligors, it will provided a bank is following sound risk
burdensome for a U.S. bank to track determine the frequency of obligor management practices. Therefore, the
default data and estimate risk rating changes in a changing economic final rule generally requires a quarterly
parameters based on both the U.S. environment. Rating systems that rate review and update, as appropriate, of
definition of default and the definitions obligors based on their ability to retail exposure segmentation
of default in non-U.S. jurisdictions perform over a wide range of economic, assignments, allowing some flexibility
where subsidiaries of the U.S. bank business, and industry conditions, to accommodate sound internal risk
implement the IRB approach. The sometimes described as ‘‘through-the- management practices.
agencies are therefore incorporating cycle’’ systems, tend to have ratings that
migrate more slowly as conditions 3. Quantification of Risk Parameters for
flexibility into the retail definition of
change. Banks that rate obligors based Wholesale and Retail Exposures
default. Specifically, for a retail
exposure held by a U.S. bank’s non-U.S. on a more narrow range of likely A bank must have a comprehensive
subsidiary subject to an internal ratings- expected conditions (primarily on risk parameter quantification process
based approach to capital adequacy recent conditions), sometimes called that produces accurate, timely, and
consistent with the New Accord in a ‘‘point-in-time’’ systems, tend to have reliable estimates of the risk
non-U.S. jurisdiction, the final rule ratings that migrate more frequently. parameters—PD, LGD, EAD, and (for
allows the bank to elect to use the Many banks will rate obligors using an wholesale exposures) M—for its
definition of default of that jurisdiction, approach that considers a combination wholesale obligors and exposures and
subject to prior approval by the bank’s of the current conditions and a wider retail exposures. Statistical methods and
primary Federal supervisor. The range of other likely conditions. In any models used to develop risk parameter
primary Federal supervisor will revoke case, the bank must specify the rating estimates, as well as any adjustments to
approval for a bank to use this provision philosophy used and establish a policy the estimates or empirical data, should
if the supervisor finds that the bank uses for the migration of obligors from one be transparent, well supported, and
the provision to arbitrage differences in rating grade to another in response to documented. The following sections of
national definitions of default. economic cycles. A bank should the preamble discuss the rule’s
The definition of default for retail understand the effects of ratings definitions of the risk parameters for
exposures differs from the definition for migration on its risk-based capital wholesale exposures and retail
the wholesale portfolio in that the retail requirements and ensure that sufficient segments.
default definition applies on an capital is maintained during all phases
of the economic cycle. Probability of Default (PD)
exposure-by-exposure basis rather than
on an obligor-by-obligor basis. In other As noted above, under the final rule,
Rating and Segmentation Reviews and a bank must assign each of its wholesale
words, default on one retail exposure
Updates obligors to an internal rating grade and
does not require a bank to treat all other
retail obligations of the same borrower Each wholesale obligor rating and (if then must associate a PD with each
to the bank as defaulted. This difference applicable) wholesale exposure loss rating grade. PD for a wholesale
reflects the fact that banks generally severity rating must reflect current exposure to a non-defaulted obligor is
manage retail credit risk based on information. A bank’s internal risk the bank’s empirically based best
segments of similar exposures rather rating system for wholesale exposures estimate of the long-run average one-
than through the assignment of ratings must provide for the review and update year default rate for the rating grade
to particular borrowers. In addition, it is (as appropriate) of each obligor rating assigned by the bank to the obligor,
quite common for retail borrowers that and (if applicable) loss severity rating capturing the average default experience
default on some of their obligations to whenever the bank receives new for obligors in the rating grade over a
continue payment on others. material information, but no less mix of economic conditions (including
Although the retail definition of frequently than annually. Under the economic downturn conditions)
default does not explicitly include proposed rule, a bank’s retail exposure sufficient to provide a reasonable
credit-related losses in connection with segmentation system would provide for estimate of the average one-year default
loan sales and the agencies have the review and update (as appropriate) rate over the economic cycle for the
replaced the 5 percent credit-related of assignments of retail exposures to rating grade.

loss threshold for wholesale exposures segments whenever the bank received In addition, under the final rule, a
with a less prescriptive treatment that is new material information. The proposed bank must assign a PD to each segment
consistent with the New Accord, the rule specified that the review would be of retail exposures. Some types of retail
agencies expect banks to ensure that required no less frequently than exposures typically display a seasoning
exposure sales do not bias or otherwise quarterly. pattern—that is, the exposures have
relatively low default rates in their first amounts of risk-based capital to address year horizon.31 The proposed rule
year, rising default rates in the next few credit risks over a one-year horizon, the defined ELGD for a segment of retail
years, and declining default rates for the final rule’s incorporation of seasoning exposures as the bank’s empirically
remainder of their terms. Because of the effects is explicitly one-directional. based best estimate of the default-
one-year IRB horizon, the proposed rule Specifically, a bank must increase PDs weighted average economic loss per
provided two different definitions of PD above the best estimate of the long-run dollar of EAD the bank expected to
for a segment of non-defaulted retail average one-year default rate for incur on exposures in the segment that
exposures based on the materiality of segments of unseasoned retail default within a one-year horizon. ELGD
seasoning effects for the segment or for exposures, but may not decrease PD estimates would incorporate a mix of
the segment’s retail exposure below the best estimate of the long-run economic conditions (including
subcategory. Under the proposed rule, average one-year default rate for a economic downturn conditions). ELGD
PD for a segment of non-defaulted retail segment of retail exposures that the had four functions in the proposed
exposures for which seasoning effects bank estimates will have lower PDs in rule—as a component of the calculation
were not material, or for a segment of future years due to seasoning. of ECL in the numerator of the risk-
non-defaulted retail exposures in a retail The final rule defines PD for a based capital ratios; in the EL
exposure subcategory for which segment of non-defaulted retail component of the IRB risk-based capital
seasoning effects were not material, formulas; as a floor on the value of the
exposures as the bank’s empirically
would be the bank’s empirically based LGD risk parameter; and as an input
based best estimate of the long-run
best estimate of the long-run average of into the supervisory mapping function.
average one-year default rate for the Many commenters objected to the
one-year default rates for the exposures
exposures in the segment, capturing the proposed rule’s requirement for banks to
in the segment, capturing the average
average default experience for exposures estimate ELGD for each wholesale
default experience for exposures in the
in the segment over a mix of economic exposure and retail segment, noting that
segment over a mix of economic
conditions (including economic ELGD estimation is not required under
conditions (including economic
downturn conditions) sufficient to the New Accord. Commenters asserted
downturn conditions) sufficient to
provide a reasonable estimate of the that requiring ELGD estimation would
provide a reasonable estimate of the
average one-year default rate over the average one-year default rate over the create a competitive disadvantage by
economic cycle for the segment. PD for economic cycle for the segment and creating additional systems,
a segment of non-defaulted retail adjusted upward as appropriate for compliance, calculation, and reporting
exposures for which seasoning effects segments for which seasoning effects are burden for those banks subject to the
were material would be the bank’s material. If a bank does not adjust PD to U.S. rule, many of which have already
empirically based best estimate of the reflect seasoning effects for a segment of substantially developed their systems
annualized cumulative default rate over exposures, it should be able to based on the New Accord. They also
the expected remaining life of exposures demonstrate to its primary Federal maintained that it would decrease the
in the segment, capturing the average supervisor, using empirical analysis, comparability of U.S. banks’ capital
default experience for exposures in the why seasoning effects are not material requirements and public disclosures
segment over a mix of economic or why adjustment is not relevant for relative to those of foreign banking
conditions (including economic the segment. organizations applying the advanced
downturn conditions) to provide a For wholesale exposures to defaulted approaches. Several commenters also
reasonable estimate of the average obligors and for segments of defaulted contended that defining ECL in terms of
performance over the economic cycle retail exposures, PD is 100 percent. ELGD instead of LGD raised tier 1 risk-
for the segment. based capital requirements for U.S.
Commenters objected to this Loss Given Default (LGD)
banks compared to foreign banks using
treatment of retail exposures with Under the proposed rule, a bank the New Accord’s LGD-based ECL
material seasoning effects. They asserted would directly estimate an ELGD and definition.
that requiring banks to use an LGD risk parameter for each wholesale The agencies have concluded that the
annualized cumulative default rate to exposure or would assign each regulatory burden and potential
recognize seasoning effects was too wholesale exposure to an expected loss competitive inequities identified by
prescriptive and would preclude other severity grade and a downturn loss commenters outweigh the supervisory
reasonable approaches. The agencies severity grade, estimate an ELGD risk benefits of the proposed ELGD risk
believe that commenters have presented parameter for each expected loss parameter, and are, therefore, not
reasonable alternative approaches to severity grade, and estimate an LGD risk including it in the final rule. Instead,
recognizing the effects of seasoning in parameter for each downturn loss consistent with the New Accord, a bank
PD and are, therefore, providing severity grade. In addition, a bank must use LGD for the calculation of ECL
additional flexibility for recognizing would estimate an ELGD and LGD risk and the EL component of the IRB risk-
those effects in the final rule. parameter for each segment of retail based capital formulas. Because the
Based on comments and additional proposed ELGD risk parameter was
exposures.
consideration, the agencies also are equal to or less than LGD, this change
clarifying that a segment of retail Expected Loss Given Default (ELGD) generally will have the effect of
exposures has material seasoning effects decreasing both the numerator and
if there is a material relationship The proposed rule defined the ELGD
denominator of the risk-based capital
between the time since origination of of a wholesale exposure as the bank’s
ratios.
exposures within the segment and the empirically based best estimate of the
Consistent with the New Accord,
default-weighted average economic loss
bank’s best estimate of the long-run under the final rule, the LGD of a
average one-year default rate for the per dollar of EAD the bank expected to
wholesale exposure or retail segment
exposures in the segment. Moreover, incur in the event that the obligor of the
must not be less than the bank’s
because the agencies believe that the exposure (or a typical obligor in the loss
IRB approach must, at a minimum, severity grade assigned by the bank to 31 Under the proposal, ELGD was not the
require banks to hold appropriate the exposure) defaulted within a one- statistical expected value of LGD.
empirically based best estimate of the Economic Downturn Conditions conditions in which the aggregate
long-run default-weighted average The expected loss severities of some default rates for the exposure’s entire
economic loss, per dollar of EAD, the exposures may be substantially higher wholesale or retail subcategory held by
bank would expect to incur if the during economic downturn conditions the bank (or subdivision of such
obligor (or a typical obligor in the loss than during other periods, while for subcategory selected by the bank) in the
severity grade assigned by the bank to other types of exposures they may not. exposure’s national jurisdiction (or
the exposure or segment) were to default Accordingly, the proposed rule required subdivision of such jurisdiction selected
within a one-year horizon over a mix of banks to use an LGD estimate that by the bank) were significantly higher
economic conditions, including reflected economic downturn than average.
economic downturn conditions. The The agencies specifically sought
conditions for purposes of calculating
final rule also specifies that LGD may comment on whether to require banks to
the risk-based capital requirements for
not be less than zero. The implications determine economic downturn
wholesale exposures and retail
of eliminating the ELGD risk parameter conditions at a more granular level than
segments. an entire wholesale or retail exposure
for the supervisory mapping function Several commenters objected to the
are discussed below. subcategory in a national jurisdiction.
requirement that LGD estimates must
Some commenters stated that the
Economic Loss and Post-Default reflect economic downturn conditions.
proposed requirement is at a sufficiently
Extensions of Credit Some of these commenters stated that
granular level. Others asserted that the
empirical evidence of correlation requirement should be eliminated or
Commenters requested additional between economic downturn and LGD made less granular. Those commenters
clarity regarding the treatment of post- is inconclusive, except in certain cases. favoring less granularity stated that
default extensions of credit. LGD is an A few noted that estimates of expected aggregate default rates for different
estimate of the economic loss that LGD include conservative inputs, such product subcategories in different
would be incurred on an exposure, as a conservative estimate of potential countries are unlikely to peak at the
relative to the exposure’s EAD, if the loss in the event of default or a same time and that requiring economic
obligor were to default within a one- conservative discount rate or collateral downturn analysis at the product
year horizon during economic downturn assumptions. One commenter suggested subcategory and national jurisdiction
conditions. The estimated economic that if a bank can demonstrate it has level does not recognize potential
loss amount must capture all material been prudent in its LGD estimation and diversification effects across products
credit-related losses on the exposure it has no evidence of the cyclicality of and national jurisdictions and is thus
(including accrued but unpaid interest LGDs, it should not be required to overly conservative. Commenters also
or fees, losses on the sale of repossessed calculate downturn LGDs. Other maintained that the proposed
collateral, direct workout costs, and an commenters remarked that the granularity requirement adds
appropriate allocation of indirect requirement to incorporate downturn complexity and implementation burden
workout costs). Where positive or conditions into LGD estimates should relative to the New Accord.
negative cash flows on a wholesale not be used as a surrogate for proper The agencies believe that the
exposure to a defaulted obligor or on a modeling of PD/LGD correlations. proposed definition of economic
defaulted retail exposure (including Finally, a number of commenters downturn conditions incorporates an
proceeds from the sale of collateral, supported a pillar 2 approach for appropriate level of granularity and are
workout costs, and draw-downs of addressing LGD estimation. incorporating it unchanged in the final
unused credit lines) are expected to Consistent with the New Accord, the rule. The agencies understand that
occur after the date of default, the final rule maintains the requirement for downturns in particular geographical
estimated economic loss amount must a bank to use an LGD estimate that subdivisions of national jurisdictions or
reflect the net present value of cash reflects economic downturn conditions in particular industrial sectors may
for purposes of calculating the risk- result in significantly increased loss
flows as of the default date using a
based capital requirements for rates in material subdivisions of a
discount rate appropriate to the risk of
wholesale exposures and retail bank’s exposures. The agencies also
the exposure. The possibility of post-
segments. More specifically, banks must recognize that diversification across
default extensions of credit made to
produce for each wholesale exposure (or those subdivisions may mitigate risk for
facilitate collection of an exposure
loss severity rating grade) and retail the overall organization. However, the
would be treated as negative cash flows
segment an estimate of the economic agencies believe that the required
and reflected in LGD.
loss per dollar of EAD that the bank minimum level of granularity at the
For example, assume a loan to a would expect to incur if default were to subcategory and national jurisdiction
retailer goes into default. The bank occur within a one-year horizon during level provides a suitable balance
determines that the recovery would be economic downturn conditions. between allowing for the benefits of
enhanced by some additional For the purpose of defining economic diversification and appropriate
expenditure to ensure an orderly downturn conditions, the proposed rule conservatism for risk-based capital
workout process. One option would be identified two wholesale exposure requirements.
for the bank to hire a third-party to subcategories—high-volatility Under the final rule, a bank must
facilitate the collection of the loan. commercial real estate (HVCRE) consider economic downturn conditions
Another option would be for the bank wholesale exposures and non-HVCRE that appropriately reflect its actual
to extend additional credit directly to wholesale exposures (that is, all exposure profile. For example, a bank
the defaulted obligor to allow the wholesale exposures that are not with a geographical or industry sector
obligor to make an orderly liquidation of HVCRE exposures)—and three retail concentration in a subcategory of
inventory. Both options represent exposure subcategories—residential exposures may find that information
negative cash flows on the original mortgage exposures, QREs, and other relating to a downturn in that
exposure, which must be discounted at retail exposures. The proposed rule geographical region or industry sector
a rate that is appropriate to the risk of defined economic downturn conditions may be more relevant for the bank than
the exposure. with respect to an exposure as those a general downturn affecting many
regions or industries. The final rule (like methodology for banks to use while a one-year horizon) is one way a bank
the proposed rule) allows banks to refining their LGD estimation could address difficulties in estimating
subdivide exposure subcategories or techniques. LGD. However it chooses to estimate
national jurisdictions as they deem In general, commenters viewed the LGD, a bank’s estimates of LGD must be
appropriate given the exposures held by supervisory mapping function as a reliable and sufficiently reflective of
the bank. Moreover, the agencies note significant deviation from the New economic downturn conditions, and the
that the exposure subcategory/national Accord that would add unwarranted bank should have rigorous and well-
jurisdiction granularity requirement is prescriptiveness and regulatory burden documented policies and procedures for
only a minimum granularity to the U.S. rule. Commenters requested identifying economic downturn
requirement. more flexibility to address problems conditions for each exposure
with LGD estimation, including the subcategory, identifying changes in
Supervisory Mapping Function ability to apply appropriate margins of material adverse relationships between
The proposed rule provided banks conservatism as contemplated in the the relevant drivers of default rates and
two methods of generating LGD New Accord. Commenters expressed loss rates given default, and
estimates for wholesale exposures and concern that U.S. supervisors would incorporating identified relationships
retail segments. First, a bank could use employ an unreasonably high standard into LGD estimates.
its own estimates of LGD for a for allowing own estimates of LGD,
subcategory of exposures if the bank had forcing banks to use the supervisory Pre-Default Reductions in Exposure
prior written approval from its primary mapping function for an extended The proposed rule incorporated
Federal supervisor to use internal period of time. Commenters also comments on the ANPR suggesting a
estimates for that subcategory of expressed concern that supervisors need to better accommodate certain
exposures. In approving a bank’s use of would view the output of the credit products, most prominently asset-
internal estimates of LGD, a bank’s supervisory mapping function as a floor based lending programs, whose
primary Federal supervisor would on internal estimates of LGD. structures typically result in a bank
consider whether the bank’s internal Commenters asserted that in both cases recovering substantial amounts of the
estimates of LGD were reliable and risk-based capital requirements would exposure prior to the default date—for
sufficiently reflective of economic be increased at U.S. banks relative to example, through paydowns of
downturn conditions. The supervisor their foreign competitors, particularly outstanding principal. The agencies
would also consider whether the bank for high-quality assets, putting U.S. believe that actions taken prior to
has rigorous and well-documented banks at a competitive disadvantage to default to mitigate losses are an
policies and procedures for identifying foreign banks. important component of a bank’s overall
economic downturn conditions for the In particular, many commenters credit risk management, and that such
exposure subcategory, identifying viewed the supervisory mapping actions should be reflected in LGD
material adverse correlations between function as overly punitive for exposure when banks can quantify their
the relevant drivers of default rates and categories with relatively low loss effectiveness in a reliable manner. In the
loss rates given default, and severities, effectively imposing an 8 proposed rule, this was achieved by
incorporating identified correlations percent floor on LGD. Commenters also measuring LGD relative to the
into internal LGD estimates. If a bank objected to the proposed requirement exposure’s EAD (defined in the next
had supervisory approval to use its own that a bank use the supervisory mapping section) as opposed to the amount
estimates of LGD for an exposure function for an entire subcategory of actually owed at default.32
subcategory, it would use its own exposures even if it had difficulty Commenters agreed that the IRB
estimates of LGD for all exposures estimating LGD only for a small subset
approach should allow banks to
within that subcategory. of those exposures.
As an alternative to internal estimates recognize in their risk parameters the
The agencies continue to believe that
of LGD, the proposed rule provided a the supervisory mapping function is a benefits of expected pre-default
supervisory mapping function for reasonable aid for dealing with recoveries and other expected
converting ELGD into LGD for risk- problems in LGD estimation. The reductions in exposure prior to default.
based capital purposes. A bank that did agencies recognize, however, that there Some commenters suggested, however,
not qualify to use its own estimates of may be several valid methodologies for that it is more appropriate to reflect pre-
LGD for a subcategory of exposures addressing such problems. For example, default recoveries in EAD rather than
would instead compute LGD using the a relative scarcity of historical loss data LGD. Other commenters supported the
linear supervisory mapping function: for a particular obligor or exposure type proposed rule’s approach or asserted
LGD = 0.08 + 0.92 × ELGD. A bank may be addressed by increased reliance that banks should have the option of
would not have to apply the supervisory on alternative data sources and data- incorporating pre-default recoveries in
mapping function to repo-style enhancing tools for quantification and either LGD or EAD. Commenters
transactions, eligible margin loans, and alternative techniques for validation. In discouraged the agencies from
OTC derivative contracts (defined below addition, a bank should reflect in its restricting the types of pre-default
in section V.C. of this preamble). The estimates of risk parameters a margin of 32 To illustrate, suppose that for a particular asset-
agencies proposed the supervisory conservatism that is related to the likely based lending exposure the EAD equaled $100 and
mapping function because of concerns range of uncertainty. These concepts are that for every $1 owed by the obligor at the time
that banks may find it difficult to discussed below in the quantification of default the bank’s recovery would be $0.40.
produce internal estimates of LGD that principles section of the preamble. Furthermore, suppose that in the event of default
within a one-year horizon, pre-default paydowns of
are sufficient for risk-based capital Therefore, the agencies are not $20 would reduce the exposure amount to $80 at
purposes because LGD data for including the supervisory mapping the time of default. In this case, the bank’s
important portfolios may be sparse, and function in the final rule. However, the economic loss rate measured relative to the amount
there is limited industry experience agencies continue to believe that the owed at default (60 percent) would exceed the
economic loss rate measured relative to EAD (48
with incorporating downturn conditions function (and associated estimation of percent = .60 × ($100 ¥$20)/$100), because the
into LGD estimates. The supervisory the long-run default-weighted average former does not reflect fully the impact of the pre-
mapping function provided a pragmatic economic loss rate given default within default paydowns.
reductions in exposure that could be on the asset-based loans being exposure (including net accrued but
recognized, and generally contended significantly reduced between the time unpaid interest and fees) less any
that the reductions should be the loan is identified internally as a allocated transfer risk reserve for the
recognized for all exposures for which problem exposure and the time when exposure and any unrealized gains on
a pattern of pre-default reductions can the obligor is in default for risk-based the exposure plus any unrealized losses
be estimated reliably and accurately by capital purposes. The bank studies the on the exposure, if the exposure was
the bank. pre-default paydown behavior of classified as available-for-sale.
Consistent with the New Accord, the obligors that default within the next One commenter asserted that banks
agencies have decided to maintain the one-year horizon and during economic should not be required to include net
proposed treatment of pre-default downturn conditions. In particular, the accrued but unpaid interest and fees in
reductions in exposure in the final rule. bank uses its internal historical data to EAD. Rather, this commenter requested
The final rule does not limit the map exposure amounts for asset-based the flexibility to incorporate such
exposure types to which a bank may loans at the time of default to exposure interest and fees in either EAD or LGD.
apply this treatment. However, the amounts for the same loans at various The agencies believe that net accrued
agencies have clarified their points in time prior to default and but unpaid interest and fees represent
requirement for quantification of LGD in confirms that the pattern of pre-default credit exposure to an obligor, similar to
section 22(c)(4) of the final rule. This paydowns corresponds to reductions in the unpaid principal of a loan extended
section states that where the bank’s the bank’s overall exposures to the to the obligor, and thus are most
quantification of LGD directly or obligors, as opposed to refinancings. appropriately included in EAD.
indirectly incorporates estimates of the Robust empirical analysis further Moreover, requiring all banks to include
effectiveness of its credit risk indicates that pre-default paydowns for such interest and fees in EAD rather
management practices in reducing its asset-based loans to obligors that default than LGD promotes consistency and
exposure to troubled obligors prior to within the next one-year horizon during comparability across banks for
default, the bank must support such economic downturn conditions depend regulatory reporting and public
estimates with empirical analysis on the length of time the loan has been disclosure purposes.
showing that the estimates are subject to workout. Specifically, the The agencies are therefore
consistent with its historical experience bank finds that the prospects for further maintaining the substance of the
in dealing with such exposures during pre-default paydowns diminish proposed rule’s definition of EAD for
economic downturn conditions. markedly the longer the bank has on-balance sheet exposures in the final
A bank’s methods for reflecting managed the loan as a problem credit rule. The final rule clarifies that, for
changes in exposure during the period exposure. For loans that are not in purposes of EAD, all exposures other
prior to default must be consistent with workout or that the bank has placed in than securities classified as available-for
other aspects of the final rule. For workout for fewer than 90 days, the sale receive the treatment specified for
example, a bank must use a default bank’s analysis indicates that pre- exposures classified as held-to-maturity
horizon no longer than one year, default paydowns on loans to obligors or for trading under the proposal. Some
consistent with the one-year default defaulting within the next year during exposures held at fair value, such as
horizon incorporated in other aspects of economic downturn conditions were, on partially funded loan commitments,
the final rule, such as the quantification average, 50 percent of the current may have both on-balance sheet and off-
of PD. In addition, a pre-default amount owed by the obligor. In contrast, balance sheet components. In such
reduction in the outstanding amount on for asset-based loans that have been in cases, a bank must compute EAD for
one exposure that does not reflect a workout for at least 90 days, the bank’s both the positive on- and off-balance
reduction in the bank’s total exposure to analysis indicates that any further pre- sheet components of the exposure.
the obligor, such as a refinancing, For the off-balance sheet component
default recoveries tend to be immaterial.
should not be reflected as a pre-default of a wholesale or retail exposure (other
Thus, provided this analysis is suitable
recovery for LGD quantification than an OTC derivative contract, repo-
for estimating LGDs according to section
purposes. style transaction, or eligible margin
22(c) of the final rule, the bank may
The following simplified example loan) in the form of a loan commitment
appropriately assign an LGD estimate of
illustrates how a bank could approach or line of credit, EAD under the
40 percent to asset-based loans that are
incorporating pre-default reductions in proposed rule was the bank’s best
not in workout or that have been in
exposure in LGD. Assume a bank has a estimate of net additions to the
portfolio of asset-based loans fully workout for fewer than 90 days. For outstanding amount owed the bank,
collateralized by receivables. The bank asset-based loans that have been in including estimated future additional
maintains a database of such loans that workout for at least 90 days, the bank draws of principal and accrued but
have defaulted, which records the should assign an LGD of 80 percent. unpaid interest and fees, that were
exposure at the time of default and the Exposure at Default (EAD) likely to occur over the remaining life of
losses incurred at and after the date of Under the proposed rule, EAD for the the exposure assuming the exposure
default. After careful analysis of its on-balance sheet component of a were to go into default. This estimate of
historical data, the bank finds that for wholesale or retail exposure generally net additions would reflect what would
every $100 of exposure on a typical was (i) the bank’s carrying value for the be expected during a period of
asset-based loan at the time of default, exposure (including net accrued but economic downturn conditions. This
properly discounted average losses are unpaid interest and fees) 33 less any treatment is retained in the final rule.
$80 under economic downturn Also, consistent with the New Accord,
allocated transfer risk reserve for the
conditions. Thus, the bank may assign the final rule extends this ‘‘own
exposure, if the exposure was classified
an LGD estimate of 80 percent that is estimates’’ treatment to trade-related

as held-to-maturity or for trading; or (ii)
based on such evidence. letters of credit and for transaction-
the bank’s carrying value for the
However, assume that the bank related contingencies. Trade-related
division responsible for collections 33 ‘‘Net accrued but unpaid interest and fees’’ are letters of credit are short-term self-
reports that the bank’s loan workout accrued but unpaid interest and fees net of any liquidating instruments used to finance
practices generally result in exposures amount expensed by the bank as uncollectable. the movement of goods and are
collateralized by the underlying goods. unused portion of the line is $30). General Quantification Principles
A transaction-related contingency Current accrued but unpaid interest and
includes such items as a performance fees are zero. The bank can document The final rule, like the proposed rule,
bond or performance-based standby that, on average, during economic requires data used by a bank to estimate
letter of credit. downturn conditions, 20 percent of the risk parameters to be relevant to the
For the off-balance sheet component remaining undrawn amounts are drawn bank’s actual wholesale and retail
of a wholesale or retail exposure other in the year preceding a firm’s default. exposures and of sufficient quality to
than an OTC derivative contract, repo- Therefore, the bank’s estimate of future support the determination of risk-based
style transaction, eligible margin loan, draws is $6 (20% × $30). Additionally, capital requirements for the exposures.
loan commitment, or line of credit the bank’s analysis indicates that, on For wholesale exposures, estimation of
issued by a bank, EAD was the notional average, during economic downturn the risk parameters must be based on a
amount of the exposure. This treatment conditions, such a facility can be minimum of five years of default data to
is retained in the final rule. estimate PD, seven years of loss severity
expected to have accrued at the time of
One commenter asked the agencies to data to estimate LGD, and seven years
default unpaid interest and commitment
permit banks to employ the New of exposure amount data to estimate
fees equal to three months of interest
Accord’s flexibility to reflect additional EAD. For segments of retail exposures,
against the drawn amount and 0.5
draws on lines of credit in either LGD estimation of risk parameters must be
percent against the undrawn amount,
or EAD. For the same reasons that the based on a minimum of five years of
which in this example is assumed to
agencies are requiring banks to include default data to estimate PD, five years of
equal $0.25. Thus, the EAD for
net accrued but unpaid interest and fees loss severity data to estimate LGD, and
estimated future accrued but unpaid
in EAD, the agencies have decided to five years of exposure amount data to
interest and fees equals $0.25. In sum,
continue the requirement in the final estimate EAD. Default, loss severity, and
rule for banks to reflect estimates of the EAD should be the drawn amount
exposure amount data must include
additional draws in EAD, consistent plus estimated future accrued but periods of economic downturn
with the proposed rule. unpaid fees plus the estimated amount conditions or the bank must adjust its
Another commenter noted that the of future draws = $76.25 ($70 + $0.25 + estimates of risk parameters to
‘‘remaining life of the exposure’’ $6). compensate for the lack of data from
concept in the proposed definition of Under the proposed rule, EAD for a such periods. Banks must base their
EAD for off-balance sheet exposures is segment of retail exposures was the sum estimates of PD, LGD, and EAD on the
ambiguous and inconsistent with of the EADs for each individual final rule’s definition of default, and
defining PD over a one-year horizon. To exposure in the segment. The agencies must review at least annually and
address this commenter’s concern, the have changed this provision in the final update (as appropriate) their risk
agencies have modified the definition of rule, recognizing that banks typically parameters and risk parameter
EAD. The final rule requires a bank to estimate EAD for a segment of retail quantification process.
estimate net additions to the exposures rather than on an individual In all cases, banks are expected to use
outstanding amount owed the bank in exposure basis. the best available data for quantifying
the event of default over a one-year Under the final and proposed rules, the risk parameters. A bank could meet
horizon. for wholesale or retail exposures in
Other commenters noted that banks the minimum data requirement by using
which only the drawn balance has been internal data, external data, or pooled
may reduce their exposure to certain
securitized, the bank must reflect its data combining internal data with
sectors in periods of economic
share of the exposures’ undrawn external data. Internal data refers to any
downturn, and inquired as to the extent
balances in EAD. The undrawn balances data on exposures held in a bank’s
to which such practices may be
of revolving exposures for which the existing or historical portfolios,
reflected in EAD estimates. The agencies
drawn balances have been securitized including data elements or information
believe that such practices may be
must be allocated between the seller’s provided by third parties regarding such
reflected in EAD estimates for loan
and investors’ interests on a pro rata exposures. External data refers to
commitments, lines of credit, trade-
basis, based on the proportions of the information on exposures held outside
related letters of credit, and transaction-
seller’s and investors’ shares of the of the bank’s portfolio or aggregate
related contingencies to the extent that
securitized drawn balances. For information across an industry. For new
those practices are reflected in the
example, if the EAD of a group of lines of business, where a bank lacks
bank’s data on defaulted exposures.
securitized exposures’ undrawn sufficient internal data, a bank likely
They may be reflected in EAD estimates
balances is $100, and the bank’s share will need to use external data to
for on-balance sheet exposures only at
(seller’s interest) in the securitized supplement its internal data.
the time the on-balance sheet exposure
exposures is 25 percent, the bank must The agencies recognize that the
is actually reduced.
To illustrate the EAD concept, assume reflect $25 in EAD for the undrawn minimum sample period for reference
a bank has a $100 unsecured, fully balances. data provided in the final rule may not
drawn, two-year term loan with $10 of The final rule (like the proposed rule) provide the best available results. A
interest payable at the end of the first contains a separate treatment of EAD for longer sample period usually captures
year and a balloon payment of $110 at OTC derivative contracts, which is in varying economic conditions better than
the end of the term. Suppose it has been section 32 of the rule and discussed in a shorter sample period. In addition, a
six months since the loan’s origination, more detail in section V.C. of the longer sample period will include more
and accrued interest equals $5. The EAD preamble. The final rule also clarifies default observations for LGD and EAD
of this loan would be equal to the that a bank may use the treatment of estimation. Banks should consider using
outstanding principal amount plus EAD in section 32 of the rule for repo- a longer-than-minimum sample period
accrued interest, or $105. style transactions and eligible margin when possible. However, the potential
Next, consider the case of an open- loans, or the bank may use the general increase in precision afforded by a
end revolving credit line of $100, on definition of EAD described in this larger sample size should be weighed
which the borrower had drawn $70 (the section for such exposures. against the potential for diminished
comparability of older data to the requirements of the rule. Alternatively, that are then mapped to the low default
existing portfolio. a bank may be able to identify a set of portfolio or obligor. For example, banks
data-rich internal exposures that could could consider instances of near default
Portfolios With Limited Data or Limited
be used to inform the estimation of risk or credit deterioration short of default in
Defaults
parameters for the portfolio for which it these low default portfolios to inform
Many commenters requested further has insufficient data. The key estimates of what might happen if a
clarity about the procedures that banks considerations for a bank in determining default were to occur. Similarly,
should use to estimate risk parameters whether to use alternative data sources scenario analysis that evaluates the
for portfolios characterized by a lack of will be whether such data are hypothetical impact of severe market
internal data or with very little default sufficiently accurate, complete, disruptions may help inform the bank’s
experience. In particular, the GAO representative and informative of the parameter estimates for margin loans.
report recommended that the agencies bank’s existing exposures and whether For very low-risk wholesale obligors
provide additional clarity on this issue. the bank’s quantification of risk that have publicly traded financial
Several commenters indicated that the parameters is rigorously conducted and instruments, banks may be able to glean
agencies should establish criteria for well documented. information about the relative values of
identifying homogeneous portfolios of For instance, consider a bank that has PD and LGD from different changes in
low-risk exposures and allow banks to recently extended its credit card credit spreads on instruments of
apportion expected loss between LGD operations to include a new market different maturity or from different
and PD for those portfolios rather than segment for credit card loans and, moves in credit spreads and equity
estimating each risk parameter therefore, has limited internal data on prices. In all cases, risk parameter
separately. Other commenters suggested the performance of the exposures in this estimates should incorporate a degree of
that the agencies consider whether new market segment. The bank could conservatism that is appropriate for the
banks should be permitted to use the acquire external data from various overall rigor of the quantification
New Accord’s standardized approach vendors that would provide a broad, process.
for credit risk for such portfolios. market-wide picture of default and loss Other quantification process
The final rule requires banks to meet experience in the new market segment. considerations. Both internal and
the qualification requirements in section This external data could then be external reference data should not differ
22 for all portfolios of exposures. The supplemented by the bank’s internal systematically from a bank’s existing
agencies expect that banks data and experience with its existing portfolio in ways that seem likely to be
demonstrating appropriately rigorous credit card operations. By comparing related to default risk, loss severity, or
processes and sufficient degrees of the bank’s experience with its existing exposure at default. Otherwise, the
conservatism for portfolios with limited customers to the market data, the bank derived PD, LGD, or EAD estimates may
data or limited defaults will be able to can refine the risk parameters estimated not be applicable to the bank’s existing
meet the qualification requirements. from the external data on the new portfolio. Accordingly, the bank must
Section 22(c)(3) of the final rule market segment and make those conduct a comprehensive review and
specifically states that a bank’s risk parameters more accurate for the bank’s analysis of reference data at least
parameter quantification process ‘‘must new market segment of exposures. annually to determine the relevance of
produce appropriately conservative risk Using the combination of these data reference data to the bank’s exposures,
parameter estimates where the bank has sources, the bank may be able to the quality of reference data to support
limited relevant data.’’ The agencies estimate appropriately conservative PD, LGD, and EAD estimates, and the
believe that this section provides estimates of risk parameters for its new consistency of reference data to the
sufficient flexibility and incentives for market segment of exposures. If the definition of default in the final rule.
banks to develop and document sound bank is not able to do so, it must include Furthermore, a bank must have
practices for applying the IRB approach the new market segment of exposures in adequate internal or external data to
to portfolios lacking sufficient data. its set of aggregate immaterial exposures estimate the risk parameters PD, LGD,
The section of the preamble below and apply a 100 percent risk weight. and EAD (each of which incorporates a
expands upon potential approaches to Portfolios with limited defaults. one-year time horizon) for all wholesale
portfolios with limited data. The BCBS Commenters indicated that they had exposure and retail segments, including
publication ‘‘Validation of low-default experienced very few defaults for some those originated for sale or that are in
portfolios in the Basel II Framework’’ 34 portfolios, most notably margin loans the securitization pipeline.
also provides a resource for banks facing and exposures to some sovereign As noted above, periods of economic
this issue. The agencies will work with issuers, which made it difficult to downturn conditions must be included
banks through the supervisory and separately estimate PD and LGD. The in the data sample (or adjustments to
examination processes to address agencies recognize that some portfolios risk parameters must be made). If the
particular situations. have experienced very few defaults and reference data include data from beyond
Portfolios with limited data. The final have very low loss experiences. The the minimum number of years (to
rule, like the proposal, permits the use absence of defaults or losses in capture a period of economic downturn
of external data in quantification of risk historical data does not, however, conditions or for other valid reasons),
parameters. External data should be preclude the potential for defaults or the reference data need not cover all of
informative of, and appropriate to, a large losses to arise in future the intervening years. However, a bank
bank’s existing exposures. In some circumstances. Moreover, as discussed should justify the exclusion of available
cases, a bank may be able to acquire and previously, the ability to separate EL data and, in particular, any temporal
use external data from a third party to into PD and LGD is a key component of discontinuities in data used. Including
estimate risk parameters until the bank’s the IRB approach. periods of economic downturn
As with the cases described above in conditions increases the size and
internal database meets the
which internal data are limited in all potentially the breadth of the reference
34 BCBS, Basel Committee Newsletter No. 6, dimensions, external data from some data set. According to some empirical
‘‘Validation of low-default portfolios in the Base II related portfolios or for similar obligors studies, the average loss rate is higher
Framework,’’ September 2005. may be used to estimate risk parameters during periods of economic downturn
conditions, such that exclusion of such that materially lower risk parameter relevant operational risk information to
periods would bias LGD or EAD estimates may be evidence of systematic business unit management, senior
estimates downward and unjustifiably bias, which is not permitted. management, and to the board of
lower risk-based capital requirements. In estimating relevant risk parameters, directors (or a designated committee of
Risk parameter estimates should take banks should not rely on the possibility the board).
into account the robustness of the of U.S. government financial assistance, The final rule defines an operational
quantification process. The assumptions except for the financial assistance that loss event as an event that results in loss
and adjustments embedded in the the U.S. government has a legally and is associated with any of the seven
quantification process should reflect the binding commitment to provide. operational loss event type categories.
degree of uncertainty or potential error Under the final rule, the agencies have
4. Optional Approaches That Require
inherent in the process. In practice, a included definitions of the seven
Prior Supervisory Approval
reasonable estimation approach likely operational loss event type categories,
would result in a range of defensible A bank that intends to apply the consistent with the descriptions
risk parameter estimates. The choices of internal models methodology to outlined in the New Accord. The seven
the particular assumptions and counterparty credit risk, the double operational loss event type categories
adjustments that determine the final default treatment for credit risk are: (i) Internal fraud, which is the
estimate, within the defensible range, mitigation, the IAA for securitization operational loss event type category that
should reflect the uncertainty in the exposures to ABCP programs, or the comprises operational losses resulting
quantification process. More uncertainty IMA to equity exposures must receive from an act involving at least one
in the process should be reflected in the prior written approval from its primary internal party of a type intended to
assignment of final risk parameter Federal supervisor. The criteria on defraud, misappropriate property or
estimates that result in higher risk-based which approval will be based are circumvent regulations, the law or
capital requirements relative to a described in the respective sections
company policy, excluding diversity
quantification process with less below.
and discrimination-type events; (ii)
uncertainty. The degree of conservatism 5. Operational Risk external fraud, which is the operational
applied to adjust for uncertainty should loss event type category that comprises
be related to factors such as the A bank must have operational risk
management processes, data and operational losses resulting from an act
relevance of the reference data to a by a third party of a type intended to
bank’s existing exposures, the assessment systems, and quantification
systems that meet the qualification defraud, misappropriate property or
robustness of the models, the precision circumvent the law; 35 (iii) employment
of the statistical estimates, and the requirements in section 22(h) of the
final rule. A bank must have an practices and workplace safety, which is
amount of judgment used throughout the operational loss event type category
the process. A bank is not required to operational risk management function
that is independent of business line that comprises operational losses
add a margin of conservatism at each resulting from an act inconsistent with
step if doing so would produce an management. The operational risk
management function is responsible for employment, health, or safety laws or
excessively conservative result. Instead, agreements, payment of personal injury
the overall margin of conservatism the design, implementation, and
oversight of the bank’s operational risk claims, or payment arising from
should adequately account for all diversity or discrimination events; (iv)
uncertainties and weaknesses in the data and assessment systems,
operational risk quantification systems, clients, products, and business
quantification process. Improvements in
and related processes. The roles and practices, which is the operational loss
the quantification process (including
responsibilities of the operational risk event type category that comprises
use of more complete data and better
management function may vary between operational losses resulting from the
estimation techniques) may reduce the
banks, but should be clearly nature or design of a product or from an
appropriate degree of conservatism over
documented. The operational risk unintentional or negligent failure to
time.
Judgment will inevitably play a role management function should have an meet a professional obligation to
in the quantification process and may organizational stature commensurate specific clients (including fiduciary and
materially affect the estimates of risk with the bank’s operational risk profile. suitability requirements); (v) damage to
parameters. Judgmental adjustments to At a minimum, the bank’s operational physical assets, which is the operational
estimates are often necessary because of risk management function should loss event type category that comprises
limitations on available reference data ensure the development of policies and operational losses resulting from the
or because of inherent differences procedures for the explicit management loss of or damage to physical assets from
between the reference data and the of operational risk as a distinct risk to natural disaster or other events; (vi)
bank’s existing exposures. The bank’s the bank’s safety and soundness. business disruption and system failures,
risk parameter quantification process A bank also must establish and which is the operational loss event type
must produce appropriately document a process to identify, category that comprises operational
conservative risk parameter estimates measure, monitor, and control losses resulting from disruption of
when the bank has limited relevant operational risk in bank products, business or system failures; and (vii)
data, and any adjustments that are part activities, processes, and systems. This execution, delivery, and process
of the quantification process must not process should provide for the management, which is the operational
result in a pattern of bias toward lower consistent and comprehensive loss event type category that comprises
risk parameter estimates. This does not collection of the data needed to estimate operational losses resulting from failed
prohibit individual adjustments that the bank’s exposure to operational risk. transaction processing or process
management or losses arising from
result in lower estimates of risk This process must capture business

parameters, as both upward and environment and internal control factors
35 Retail credit card losses arising from non-
downward adjustments are expected. affecting the bank’s operational risk
contractual, third-party initiated fraud (for example,
Individual adjustments are less profile. The process must also ensure identity theft) are external fraud operational losses.
important than broad patterns; reporting of operational risk exposures, All other third-party initiated credit losses are to be
consistent signs of judgmental decisions operational loss events, and other treated as credit risk losses.
relations with trade counterparties and operational risk—is an estimate of The agencies are maintaining the
vendors. aggregate operational losses generated proposed rule’s treatment of fixed assets
The final rule does not require a bank by the bank’s AMA process. in the final rule. The New Accord
to capture internal operational loss Many commenters supported the generally provides a risk weight of 100
event data according to these categories. agencies’ proposed definition of percent for assets for which an IRB
However, unlike the proposed rule, the operational loss and viewed it as treatment is not specified.37 Consistent
final rule requires that a bank must be appropriate and consistent with general with the New Accord, the final rule
able to map such data into the seven use within the banking industry. Some provides that the risk-weighted asset
operational loss event type categories. commenters, however, opposed the amount for any on-balance sheet asset
The agencies believe such mapping will inclusion of a specific definition of that does not meet the definition of a
promote reporting consistency and operational loss and asserted that the wholesale, retail, securitization, or
comparability across banks and is proposed treatment of operational loss equity exposure is equal to the carrying
consistent with expectations in the New is too prescriptive. In addition, some value of the asset. Also consistent with
Accord.36 commenters maintained that including a the New Accord, the final rule
A bank’s operational risk management definition of operational loss is continues to include damage to physical
processes should reflect the scope and inconsistent with the New Accord, assets among the operational loss event
complexity of its business lines, as well which does not explicitly define types incorporated into a bank’s
as its corporate organizational structure. operational loss. In response to a operational risk exposure estimate.38
Each bank’s operational risk profile is specific question in the proposal, many The agencies believe that requiring a
unique and should have a tailored risk commenters asserted that the definition bank to calculate both a credit risk and
management approach appropriate for of operational loss should relate to its operational risk capital requirement for
the scale and materiality of the impact on regulatory capital rather than premises and fixed assets is justified in
operational risks present in the bank. economic capital concepts. One light of the fact that the credit risk
Operational Risk Data and Assessment commenter, however, recommended capital requirement covers a broader set
System using the replacement cost of any fixed of risks, whereas the operational risk
A bank must have an operational risk asset affected by an operational loss capital requirement covers potential
data and assessment system that event to reflect the actual financial physical damage to the asset. The
incorporates on an ongoing basis the impact of the event. agencies view this treatment of premises
following four elements: internal Because operational losses are the and other fixed assets as consistent with
operational loss event data, external building blocks in a bank’s calculation the New Accord and have confirmed
operational loss event data, results of of its operational risk capital that the approach is consistent with the
scenario analysis, and assessments of requirement under the AMA, the approaches used by other jurisdictions
the bank’s business environment and agencies continue to believe that it is implementing the New Accord.
internal controls. These four operational necessary to define what is meant by A bank must have a systematic
risk elements should aid the bank in operational loss to achieve process for capturing and using internal
identifying the level and trend of comparability and foster consistency operational loss event data in its
operational risk, determining the both across banks and across business operational risk data and assessment
effectiveness of operational risk lines within a bank. Additionally, the systems. The final rule defines a bank’s
management and control efforts, agencies agree with those commenters internal operational loss event data as
highlighting opportunities to better who asserted that the definition of its gross operational loss amounts,
mitigate operational risk, and assessing operational loss should relate to its dates, recoveries, and relevant causal
operational risk on a forward-looking impact on regulatory capital. Therefore, information for operational loss events
basis. A bank’s operational risk data and the agencies have adopted the proposed occurring at the bank. Under the
assessment system must be structured in definition of operational loss proposed rule, a bank’s operational risk
a manner consistent with the bank’s unchanged. data and assessment system would
current business activities, risk profile, In the preamble to the proposed rule, include a minimum historical
technological processes, and risk the agencies recognized that there was observation period of five years of
management processes. a potential to double-count all or a internal operational losses. With
The proposed rule defined portion of the risk-based capital approval of its primary Federal
operational loss as a loss (excluding requirement associated with fixed supervisor, however, a bank could use
insurance or tax effects) resulting from assets. Under the proposed rule, the a shorter historical observation period to
an operational loss event. Operational credit-risk-weighted asset amount for a address transitional situations such as
losses included all expenses associated bank’s premises would equal the integrating a new business line. A bank
with an operational loss event except for carrying value of the premises on the also could refrain from collecting
opportunity costs, forgone revenue, and financial statements of the bank, internal operational loss event data for
costs related to risk management and determined in accordance with GAAP. individual operational losses below
control enhancements implemented to A bank’s operational risk exposure established dollar threshold amounts if
prevent future operational losses. The estimate addressing bank premises the bank could demonstrate to the
definition of operational loss is an generally would be different than, and satisfaction of its primary Federal
important issue, as it is a critical in addition to, the risk-based capital supervisor that the thresholds were
building block in a bank’s calculation of requirement generated under the reasonable, did not exclude important
its operational risk capital requirement proposed rule and could, at least in part, internal operational loss event data, and
under the AMA. More specifically, the address the same risk exposure. The permitted the bank to capture
bank’s estimate of operational risk majority of commenters on this issue substantially all the dollar value of the
exposure—the basis for determining a recommended removing the credit risk bank’s operational losses.
bank’s risk-weighted asset amount for capital requirement for premises and
other fixed assets and preserving only 37 New Accord, ¶ 214.
36 New Accord, ¶ 673. the operational risk capital requirement. 38 New Accord, Annex 9.
Several commenters expressed quantification system as well as its results of its prior business environment
concern over the proposal’s five-year control, oversight, and validation and internal control factor assessments
minimum historical observation period mechanisms. Such modeling against the bank’s actual operational
requirement for internal operational loss considerations, however, would not losses incurred in the intervening
event data. These commenters eliminate the requirement for a bank to period.
recommended that the agencies align demonstrate the appropriateness of any A few commenters sought
this provision with the New Accord, established internal operational loss clarification on the agencies’
which allows for a three-year historical event data collection thresholds. expectations regarding a bank’s periodic
observation period upon initial AMA A bank also must establish a comparisons of its prior business
implementation. systematic process to determine its environment and internal control factor
While the proposed rule required a methodologies for incorporating assessments against its actual
bank to include in its operational risk external operational loss event data into operational losses. One commenter
data and assessment systems a historical its operational risk data and assessment expressed concern over the difficulty of
observation period of at least five years systems. The proposed and final rules conducting an empirically robust
for internal operational loss event data, define external operational loss event analysis to fulfill the requirement.
it also provided for a shorter observation data for a bank as gross operational loss Under the final rule, a bank has
period subject to agency approval to amounts, dates, recoveries, and relevant flexibility in the approach it uses to
address transitional situations, such as causal information for operational loss conduct its business environment and
integrating a new business line. The events occurring at organizations other internal control factor assessments. As
agencies believe that these proposed than the bank. External operational loss such, the methods for conducting
provisions provide sufficient flexibility event data may serve a number of comparisons of these assessments
to consider other situations, on a case- different purposes in a bank’s against actual operational loss
by-case basis, in which a shorter operational risk data and assessment experience may also vary and precise
observation period may be appropriate, systems. For example, external modeling calibration may not be
such as a bank’s initial implementation operational loss event data may be a practical. The agencies maintain,
of an AMA. Therefore, the final rule particularly useful input in determining however, that it is important for a bank
retains the five-year historical a bank’s level of exposure to operational to perform such comparisons to ensure
observation period requirements and the risk when internal operational loss that its assessments are current,
transitional flexibility for internal event data are limited. In addition, reasonable, and appropriately factored
operational loss event data, as proposed. external operational loss event data into the bank’s AMA framework. In
In relation to the provision that provide a means for the bank to addition, the comparisons could
permits a bank to refrain from collecting understand industry experience and, in highlight the need for potential
internal operational loss event data turn, provide a means for the bank to adjustments to the bank’s operational
below established thresholds, a few assess the adequacy of its internal risk management processes.
commenters sought clarification of the operational loss event data. A bank also must have a systematic
proposed requirement that the While internal and external process for determining its
thresholds must permit the bank to operational loss event data provide a methodologies for incorporating
capture ‘‘substantially all’’ of the dollar historical perspective on operational scenario analysis into its operational
value of a bank’s operational losses. In risk, it is also important that a bank risk data and assessment systems. As an
particular, they questioned whether a incorporate forward-looking elements input to a bank’s operational risk data
bank must collect all or a very high into its operational risk data and and assessment systems, scenario
percentage of operational losses or assessment systems. Accordingly, under analysis is especially relevant for
whether smaller losses could be the final rule, as under the proposed business lines or operational loss event
modeled. rule, a bank must incorporate business types where internal data, external data,
To demonstrate the appropriateness of environment and internal control factors and assessments of the business
its threshold for internal operational into its operational risk data and environment and internal control factors
loss event data collection, a bank might assessment systems to assess fully its do not provide a sufficiently robust
choose to collect all internal operational exposure to operational risk. In estimate of the bank’s exposure to
loss event data, at least for a time, to principle, a bank with strong internal operational risk.
support a meaningful analysis around controls in a stable business Similar to business environment and
the appropriateness of its chosen data environment would have less exposure internal control factor assessments, the
collection threshold. Alternatively, a to operational risk than a bank with results of scenario analysis provide a
bank might be able to obtain data from internal control weaknesses that is means for a bank to incorporate a
systems outside of its operational risk growing rapidly or introducing new forward-looking element into its
data and assessment system (for products. In this regard, a bank should operational risk data and assessment
example, the bank’s general ledger identify and assess the level and trends systems. Under the proposed rule,
system) to demonstrate the impact of in operational risk and related control scenario analysis was defined as a
choosing different thresholds on its structures at the bank. These systematic process of obtaining expert
operational risk exposure estimates. assessments should be current and opinions from business managers and
With respect to the commenters’ comprehensive across the bank, and risk management experts to derive
question regarding modeling smaller they should identify the operational reasoned assessments of the likelihood
losses, the agencies would consider risks facing the bank. The framework and loss impact of plausible high-
permitting such an approach based on established by a bank to maintain these severity operational losses. The agencies
whether the approach meets the overall risk assessments should be sufficiently have clarified this definition in the final
qualification requirements outlined in flexible to accommodate increasing rule to recognize that there are various
the final rule. In particular, the agencies complexity, new activities, changes in methods and inputs a bank may use to
would consider whether the bank internal control systems, and an conduct its scenario analysis. For this
satisfies those requirements pertaining increasing volume of information. A reason, the modified definition
to a bank’s operational risk bank must also periodically compare the indicates that scenario analysis may
include the well-reasoned evaluation combining the four required elements of The agencies have retained the
and use of external operational loss a bank’s operational risk data and proposed definition of unit of measure
event data, adjusted as appropriate to assessment system (internal operational in the final rule. The agencies recognize,
ensure relevance to a bank’s operational loss event data, external operational loss however, that there is a need for
risk profile and control structure. event data, scenario analysis, and flexibility in assessing whether a bank’s
A bank’s operational risk data and assessments of the bank’s business chosen unit of measure is appropriate
assessment systems must include environment and internal control for the bank’s range of business
credible, transparent, systematic, and factors) will also vary across banks. activities and the variety of operational
verifiable processes that incorporate all Factors affecting the weighting include loss events to which it is exposed. In
four operational risk elements (that is, a bank’s operational risk profile, some instances, data limitations may
internal operational loss event data, operational loss experience, internal indeed prevent a bank’s operational risk
external operational loss event data, control environment, and relative quantification systems from generating a
scenario analysis, and business quality and content of the four elements. separate distribution of potential
environment and internal control These factors will influence the operational losses for certain business
factors). The bank should have clear emphasis placed on certain elements lines or operational loss event types.
standards for the collection and relative to others. As such, the agencies Therefore, the agencies have modified
modification of all elements. The bank are not prescribing specific the final rule to provide a bank more
should combine these four elements in requirements around the weighting of flexibility in devising an appropriate
a manner that most effectively enables each element, nor are they placing any unit of measure. Specifically, a bank
it to quantify its exposure to operational specific limitations on the use of the must employ a unit of measure that is
risk. elements. In view of this flexibility, appropriate for its range of business
Operational Risk Quantification System however, under the final rule a bank’s activities and the variety of operational
operational risk quantification systems loss events to which it is exposed, and
A bank must have an operational risk must include a credible, transparent, that does not combine business
quantification system that generates systematic, and verifiable approach for activities or operational loss events with
estimates of its operational risk weighting the use of the four elements. demonstrably different risk profiles
exposure using its operational risk data As part of its operational risk within the same loss distribution.
and assessment systems. The final rule exposure estimate, a bank must use a The agencies recognize that
defines operational risk exposure as the unit of measure that is appropriate for operational losses across operational
99.9th percentile of the distribution of the bank’s range of business activities loss event types and business lines may
potential aggregate operational losses, as and the variety of operational loss be related. Under the final rule, as under
generated by the bank’s operational risk events to which it is exposed. The the proposed rule, a bank may use its
quantification system over a one-year proposed rule defined a unit of measure internal estimates of dependence among
horizon (and not incorporating eligible as the level (for example, organizational operational losses within and across
operational risk offsets or qualifying unit or operational loss event type) at business lines and operational loss
operational risk mitigants). The mean of which the bank’s operational risk event types if the bank can demonstrate
such a total loss distribution is the quantification system generated a to the satisfaction of its primary Federal
bank’s EOL. The final rule defines EOL separate distribution of potential supervisor that its process for estimating
as the expected value of the distribution operational losses. Under the proposed dependence is sound, robust to a variety
of potential aggregate operational losses, rule, a bank could not combine business of scenarios, implemented with
as generated by the bank’s operational activities or operational loss events with integrity, and allows for the uncertainty
risk quantification system using a one- different risk profiles within the same surrounding the estimates. The agencies
year horizon. The bank’s UOL is the loss distribution. expect that a bank’s assumptions
difference between the bank’s Many commenters expressed concern regarding dependence will be
operational risk exposure and the bank’s that the prohibition against combining conservative given the uncertainties
EOL. business activities or operational loss surrounding dependence modeling for
A few commenters sought events with different risk profiles within operational risk. If a bank does not
clarification on whether the agencies the same loss distribution was an satisfy the requirements surrounding
would impose specific requirements impractical standard because some level dependence, the bank must sum
around the use and weighting of the of combination was unavoidable. operational risk exposure estimates
four elements of a bank’s operational Additionally, commenters noted that across units of measure to calculate its
risk data and assessment system, and data limitations made it difficult to total operational risk exposure.
whether there were any limitations on quantify risk profiles at a granular level. Under the proposed rule, dependence
how external data or scenario analysis Commenters also expressed concern was defined as ‘‘a measure of the
could be used as modeling inputs. that the proposed rule appeared to association among operational losses
Another commenter expressed concern preclude the use of ‘‘top-down’’ across and within business lines and
that for some U.S.-chartered DIs that approaches, given that under a firm- operational loss event types.’’ One
were subsidiaries of foreign banking wide approach business activities or commenter recommended that the
organizations, it might be difficult to operational loss events with different agencies revise the definition of
ever have enough internal operational risk profiles would necessarily be dependence to ‘‘a measure of the
loss event data to generate statistically combined within the same loss association among operational losses
significant operational risk exposure distribution. One commenter suggested across and within units of measure.’’
estimates. that, because of data limitations and the The agencies recognize that examples of
The agencies recognize that banks potential for wide variations in risk units of measure include, but are not
will have different inputs and profiles within individual business lines limited to, business lines and
methodologies for estimating their and/or types of operational loss events, operational loss event types, and that a
operational risk exposure given the banks be afforded some latitude in bank’s operational risk quantification
inherent flexibility of the AMA. It moving from a ‘‘top-down’’ approach to system could generate distributions of
follows that the weights assigned in a ‘‘bottom-up’’ approach. potential operational losses that are
separate from its business lines and acceptable estimates of dependency are operational risk measurement
operational loss event types. Units of available. approaches, all banks, including BHCs,
measure can also encompass The agencies recognize that there may should be permitted to adopt an
correlations over time. Therefore, the be different ways to estimate the alternative operational risk
agencies have amended the final rule to relationship among operational losses quantification system, such as the New
define dependence as a measure of the across and within units of measure. Accord’s standardized approach or
association among operational losses Therefore, under the final rule, a bank allocation approach. The commenter
across and within units of measure. has flexibility to use different further noted that a bank’s use of an
As noted above, under the proposed methodologies to demonstrate allocation approach should not be
rule, a bank that did not satisfy the dependence across units of measure. subject to more stringent terms and
requirements surrounding dependence However, the bank must demonstrate to conditions than those set forth in the
would sum operational risk exposure the satisfaction of its primary Federal New Accord.
estimates across units of measure to supervisor that its process for estimating The agencies are maintaining the
calculate its total operational risk dependence is sound, robust to a variety alternative approach provision in the
exposure. Several commenters asserted of scenarios, implemented with final rule. The agencies are not
that the New Accord does not require a integrity, and allows for the uncertainty prescribing specific estimation
bank to sum its operational risk surrounding the estimates. methodologies under this approach and
exposure estimates across units of A bank’s chosen unit of measure expect use of an alternative approach to
measure if the bank cannot demonstrate affects how it should account for occur on a very limited basis. A bank
adequate support of its dependence dependence. Explicit assumptions proposing to use an alternative
assumptions. One commenter asked the regarding dependence across units of operational risk quantification system
agencies to remove this requirement measure are always necessary to must submit a proposal to its primary
from the final rule. Several commenters estimate operational risk exposure at the Federal supervisor. In evaluating a
suggested that if a bank cannot provide bank level. However, explicit bank’s proposal, the primary Federal
sufficient support for its dependence assumptions regarding dependence supervisor will review the bank’s
estimates, a conservative assumption of within units of measure are not justification for requesting use of an
positive dependence is warranted, but necessary, and under many alternative approach in light of the
circumstances models assume statistical
not an assumption of perfect positive bank’s size, complexity, and risk profile.
independence within each unit of
dependence as implied by the The bank’s primary Federal supervisor
measure. The use of only a few units of
summation requirement. Another will also consider whether the estimate
measure increases the need to ensure
commenter suggested that the of operational risk under the alternative
that dependence within units of
dependence assumption should be approach is appropriate (for example,
measure is suitably reflected in the
based upon a conservative statistical whether the estimate results in capital
operational risk exposure estimate.
analysis of industry data. In addition, the bank’s process for levels that are commensurate with the
The New Accord states that, absent a estimating dependence should provide bank’s operational risk profile and is
satisfactory demonstration of a bank’s for ongoing monitoring, recognizing that sensitive to changes in the bank’s risk
‘‘systems for determining correlations’’ dependence estimates can change. The profile) and can be supported
to its national supervisor, ‘‘risk agencies expect that a bank’s approach empirically. Furthermore, the agencies
measures for different operational risk for developing explicit and objective expect a bank using an alternative
estimates must be added for purposes of dependence determinations will operational risk quantification system to
calculating the regulatory minimum improve over time. As such, the bank adhere to the rule’s qualification
capital requirement.’’ 39 The agencies should develop a process for assessing requirements, including establishment
continue to believe that this treatment of incremental improvements to the and use of operational risk management
operational risk exposure estimates approach (for example, through out-of- processes and data and assessment
across units of measure is prudent until sample testing). systems. As under the proposed rule,
the relationships among operational Under the final rule, as under the the alternative approach is not available
losses are better understood. Therefore, proposed rule, a bank must review and at the BHC level.
the final rule retains the proposed rule’s update (as appropriate) its operational A bank proposing an alternative
requirement regarding the summation of risk quantification system whenever the approach to operational risk based on an
operational risk exposure estimates. bank becomes aware of information that allocation methodology should be aware
Several commenters believed that a may have a material effect on the bank’s of certain limitations associated with
bank should be permitted to estimate of operational risk exposure, the use of such an approach.
demonstrate the nature of the but no less frequently than annually. Specifically, the agencies will not
relationship between the causes of The agencies recognize that, in permit a DI to accept an allocation of
different operational losses based on limited circumstances, there may not be operational risk capital requirements
any available informative empirical sufficient data available for a bank to that includes non-DIs. Unlike the cross-
evidence. These commenters suggested generate a credible estimate of its own guarantee provision of the Federal
that such evidence could be statistical operational risk exposure at the 99.9 Deposit Insurance Act, which provides
or anecdotal, and could be based on percent confidence level. In these that a DI is liable for any losses incurred
information ranging from established limited circumstances, under the by the FDIC in connection with the
statistical techniques to more general proposed rule, a bank could use an failure of a commonly-controlled DI,
mathematical approaches to clear alternative operational risk there are no statutory provisions
logical arguments about the degree to requiring cross-guarantees between a DI
quantification system, subject to prior

which risks and losses are related, or the approval by the bank’s primary Federal and its non-DI affiliates. 40 Furthermore,
similarity of circumstance between the supervisor. The alternative approach depositors and creditors of a DI
bank and a peer group for which was not available at the BHC level. generally have no legal recourse to
One commenter asserted that, in line
39 New Accord, ¶669. with the New Accord’s continuum of 40 12 U.S.C. 1815(e).
capital funds that are not held by the DI directors should have more narrowly systems; (ii) ongoing monitoring that
or its affiliate DIs. defined responsibilities, and that includes process verification and
evaluation of a bank’s advanced systems comparison of the bank’s internal
6. Data Management and Maintenance
would be more effectively and estimates with relevant internal and
A bank must have data management appropriately accomplished by senior external data sources or results from
and maintenance systems that management. other estimation techniques
adequately support all aspects of the The agencies believe that a bank’s (benchmarking); and (iii) outcomes
bank’s advanced IRB systems, board of directors has ultimate analysis that includes back-testing.
operational risk management processes, accountability for the effectiveness of Each of these three components of
operational risk data and assessment the bank’s advanced systems. However, validation must be applied to the bank’s
systems, operational risk quantification the agencies agree that it is not risk rating and segmentation systems,
systems, and, to the extent the bank uses necessarily the responsibility of a bank’s risk parameter quantification processes,
the following systems, the internal board of directors to conduct an and internal models that are part of the
models methodology, the double default evaluation of the effectiveness of a bank’s advanced systems. A sound
excessive correlation detection process, bank’s advanced systems. Evaluation validation process should take business
the IMA for equity exposures, and the may include transaction testing, cycles into account, and any
IAA for securitization exposures to validation, and audit activities more adjustments for stages of the economic
ABCP programs (collectively, advanced appropriately the responsibility of cycle should be clearly specified in
systems). senior management. Accordingly, the advance and fully documented as part
The bank’s data management and final rule requires a bank’s board of of the validation policy. Senior
maintenance systems must adequately directors to review the effectiveness of, management of the bank should be
support the timely and accurate and approve, the bank’s advanced notified of the validation results and
reporting of risk-based capital systems at least annually. should take corrective action where
requirements. Specifically, a bank must To support senior management’s and appropriate.
retain sufficient data elements related to the board of directors’’ oversight
key risk drivers to permit monitoring, A bank’s validation process must be
responsibilities, a bank must have an
validation, and refinement of the bank’s independent of the advanced systems’
effective system of controls and
advanced systems. A bank’s data development, implementation, and
oversight that ensures ongoing
management and maintenance systems compliance with the qualification operation, or be subject to independent
should generally support the rule’s requirements; maintains the integrity, assessment of its adequacy and
qualification requirements relating to reliability, and accuracy of the bank’s effectiveness. A bank should ensure that
quantification, validation, and control advanced systems; and includes individuals who perform the review are
and oversight mechanisms, as well as adequate corporate governance and not biased in their assessment due to
the bank’s broader risk management and project management processes. Banks their involvement in the development,
reporting needs. The precise data have flexibility to determine how to implementation, or operation of the
elements to be collected are dictated by achieve integrity in their risk processes or products. For example,
the features and methodologies of the management systems. Banks are, reviews of the internal risk rating and
risk measurement and management however, expected to follow standard segmentation systems should be
systems employed by the bank. To meet control principles in their systems such performed by individuals who were not
the significant data management as checks and balances, separation of part of the development,
challenges presented by the duties, appropriateness of incentives, implementation, or maintenance of
quantification, validation, and control and data integrity assurance, including those systems. In addition, individuals
and oversight requirements of the that of information purchased from performing the reviews should possess
advanced approaches, a bank must third parties. Moreover, the oversight the requisite technical skills and
retain data in an electronic format that process should be sufficiently expertise to fulfill their mandate.
allows timely retrieval for analysis, independent of the advanced systems’’ The first component of validation is
reporting, and disclosure purposes. The development, implementation, and evaluating conceptual soundness, which
agencies did not receive any material operation to ensure the integrity of the involves assessing the quality of the
comments on these data management component systems. The objective of design and construction of a risk
requirements. risk management system oversight is to measurement or management system.
ensure that the various systems used in This evaluation of conceptual
7. Control and Oversight Mechanisms determining risk-based capital soundness should include
The consequences of an inaccurate or requirements are operating as intended. documentation and empirical evidence
unreliable advanced system can be The oversight process should draw supporting the methods used and the
significant, particularly regarding the conclusions on the soundness of the variables selected in the design and
calculation of risk-based capital components of the risk management quantification of the bank’s advanced
requirements. Accordingly, bank senior system, identify errors and flaws, and systems. The documentation should
management is responsible for ensuring recommend corrective action as also evidence an understanding of the
that all advanced systems function appropriate. systems’ limitations. The development
effectively and comply with the of internal risk rating and segmentation
qualification requirements. Validation systems and their quantification
Under the proposed rule, a bank’s A bank must validate its advanced processes requires banks to exercise
board of directors (or a designated systems on an ongoing basis. Validation judgment. Validation should ensure that
committee of the board) would at least is the set of activities designed to give these judgments are well informed and
annually evaluate the effectiveness of, the greatest possible assurances of considered, and generally include a
and approve, the bank’s advanced accuracy of the advanced systems. body of expert opinion. A bank should
systems. Multiple commenters objected Validation includes three broad review developmental evidence
to this requirement. Commenters components: (i) Evaluation of the whenever the bank makes material
suggested that a bank’s board of conceptual soundness of the advanced changes in its advanced systems.
The second component of the the comparison of the bank’s forecasts of that a bank should be able to assess how
validation process for a bank’s advanced risk parameters and other model outputs actual losses compare with estimates
systems is ongoing monitoring to with actual outcomes. A bank’s previously generated by its model.
confirm that the systems were outcomes analysis must include
Internal Audit
implemented appropriately and backtesting, which is the comparison of
continue to perform as intended. Such the bank’s forecasts generated by its A bank must have an internal audit
monitoring involves process verification internal models with actual outcomes function independent of business-line
and benchmarking. Process verification during a sample period not used in management that at least annually
includes verifying that internal and model development. In this context, assesses the effectiveness of the controls
external data are accurate and complete, backtesting is one form of out-of-sample supporting the bank’s advanced
as well as ensuring that: Internal risk testing. The agencies note that in other systems. Internal audit should review
rating and segmentation systems are contexts backtesting may refer to in- the validation process, including
being used, monitored, and updated as sample fit, but in-sample fit analysis is validation procedures, responsibilities,
designed; ratings are assigned to not what the rule requires a bank to do results, timeliness, and responsiveness
wholesale obligors and exposures as as part of the advanced approaches to findings. Further, internal audit
intended; and appropriate remediation validation process. should evaluate the depth, scope, and
is undertaken if deficiencies exist. Actual outcomes should be compared quality of the risk management system
Benchmarking means the comparison with expected ranges around the review process and conduct appropriate
of a bank’s internal estimates with estimated values of the risk parameters testing to ensure that the conclusions of
relevant internal and external data or and model results. Randomness and these reviews are well founded. Internal
with estimates based on other many other variables will make audit must report its findings at least
estimation techniques. Banks are discrepancies between realized annually to the bank’s board of directors
required to use alternative data sources outcomes and the estimated risk (or a committee thereof).
or risk assessment approaches to draw parameters inevitable. Therefore the Stress Testing
inferences about the validity of their expected ranges should take into
internal risk ratings, segmentations, risk account relevant elements of a bank’s A bank must periodically stress test
parameter estimates, and model outputs internal risk rating or segmentation its advanced systems. Stress testing
on an ongoing basis. For credit risk processes. For example, depending on analysis is a means of understanding
ratings, examples of alternative data the bank’s rating philosophy, year-by- how economic cycles, especially
sources include independent internal year realized default rates may be downturns as described by stress
raters (such as loan review), external expected to differ significantly from the scenarios, affect risk-based capital
rating agencies, wholesale and retail long-run one-year average. Also, requirements, including migration
credit risk models developed changes in economic conditions across rating grades or segments and the
independently, or retail credit bureau between the historical data and current credit risk mitigation benefits of double
models. Because it may take period can lead to differences between default treatment. Stress testing analysis
considerable time before outcomes with actual outcomes and estimates. consists of identifying stress scenarios
which to conduct sufficiently robust One commenter asserted that and then assessing the effects of the
backtesting are available, benchmarking requiring a bank to perform a scenarios on key performance measures,
will be a very important validation statistically robust form of backtesting including risk-based capital
device. Benchmarking applies to all would be an impractically high standard requirements. Under the rule, changes
quantification processes and internal for AMA qualification given the nature in borrower credit quality will lead to
risk rating and segmentation activities. of operational risk. The commenter changes in risk-based capital
Benchmarking allows a bank to further claimed that validating an requirements. Because credit quality
compare its estimates with those of operational risk model must rely on the changes typically reflect changing
other estimation techniques and data robustness of the logical structure of the economic conditions, risk-based capital
sources. Results of benchmarking model and the appropriateness of the requirements may also vary with the
exercises can be a valuable diagnostic resultant operational risk exposure economic cycle. During an economic
tool in identifying potential weaknesses when benchmarked against other downturn, risk-based capital
in a bank’s risk quantification system. established reference points. requirements will increase if wholesale
While benchmarking activities allow for The agencies recognize that it may obligors or retail exposures migrate
inferences about the appropriateness of take considerable time before actual toward lower credit quality rating
the quantification processes and outcomes outside of the sample period grades or segments.
internal risk rating and segmentation used in model development are Supervisors expect banks to manage
systems, they are not the same as available that would allow a bank to their regulatory capital position so that
backtesting. Differences observed backtest its operational risk models by they remain at least adequately
between the bank’s risk estimates and comparing its internal estimates with capitalized during all phases of the
the benchmark do not necessarily these outcomes. The agencies also economic cycle. A bank that credibly
indicate that the internal risk ratings, acknowledge that a bank may be unable estimates regulatory capital levels
segmentation decisions, or risk to backtest an operational risk model during a downturn can be more
parameter estimates are in error. The with the same degree of statistical confident of appropriately managing
benchmark itself is an alternative precision that it is able to backtest an regulatory capital.
prediction, and the difference may be internal market risk model. When a Banks should use a range of plausible
due to different data or methods. As part bank’s backtesting process is not but severe scenarios and methods when
of the benchmarking exercise, the bank sufficiently robust, a bank may need to stress testing to manage regulatory
should investigate the source of the rely more heavily on benchmarking and capital. Scenarios may be historical,
differences and whether the extent of other alternative validation devices. The hypothetical, or model-based. Key
the differences is appropriate. agencies maintain, however, that variables specified in a scenario may
The third component of the validation backtesting provides important feedback include, for example, interest rates,
process is outcomes analysis, which is on the accuracy of model outputs and transition matrices (ratings and score-
band segments), asset values, credit makes any significant change to its provisions applied only to banks that
spreads, market liquidity, economic modeling assumptions. had already qualified to use the
growth rates, inflation rates, exchange If an agency determines that a bank advanced approaches. The agencies
rates, or unemployment rates. A bank that uses the advanced approaches to recognize, however, that a bank in the
may choose to have scenarios apply to calculate its risk-based capital process of qualifying to use the
an entire portfolio, or it may identify requirements has fallen out of advanced approaches may merge with
scenarios specific to various sub- compliance with one or more of the or acquire a company and need time to
portfolios. The severity of the stress qualification requirements, the agency integrate the company into its advanced
scenarios should be consistent with the will notify the bank of its failure to approaches on an implementation
periodic economic downturns comply. After receiving such notice, a schedule distinct from its original
experienced in the bank’s market areas. bank must establish and submit a plan implementation plan. In the final rule,
Such scenarios may be less severe than satisfactory to its primary Federal the agencies are therefore allowing
those used for other purposes, such as supervisor to return to compliance. If banks to take advantage of the proposed
testing a bank’s solvency. the bank’s primary Federal supervisor rule’s transition provisions for mergers
The scope of stress testing analysis determines that the bank’s risk-based and acquisitions both before and after
should be broad and include all material capital requirements are not they qualify to use the advanced
portfolios. The time horizon of the commensurate with the bank’s credit, approaches.
analysis should be consistent with the market, operational, or other risks, it Under the proposed rule, a bank
specifics of the scenario and should be may require the bank to calculate its could use the transition provisions for
long enough to measure the material risk-based capital requirements using the merged or acquired company’s
effects of the scenario on key the general risk-based capital rules or a exposures for up to 24 months following
performance measures. For example, if modified form of the advanced the calendar quarter during which the
a scenario such as a historical recession approaches (for example, with fixed merger or acquisition consummates. A
has material income and segment or supervisory risk parameters). bank’s primary Federal supervisor could
ratings migration effects over two years, Under the proposed rule, a bank that extend the transition period for up to an
the appropriate time horizon is at least fell out of compliance with the additional 12 months. Commenters
two years. qualification requirements would also generally supported this timeframe and
be required to disclose publicly its associated supervisory flexibility.
8. Documentation noncompliance with the qualification Therefore, the final rule adopts the
A bank must adequately document all requirements promptly after receiving proposed rule’s merger and acquisition
material aspects of its advanced notice of noncompliance from its transition timeframe without change.
systems, including but not limited to the primary Federal supervisor. To take advantage of the merger and
internal risk rating and segmentation Commenters objected to this acquisition transition provisions, the
systems, risk parameter quantification requirement, noting that it is not one of acquiring bank must submit to its
processes, model design, assumptions, the public disclosure requirements of primary Federal supervisor an
and validation results. The guiding the New Accord. The agencies have implementation plan for using the
principle governing documentation is determined that the public disclosure of advanced approaches for the merged or
that it should support the requirements noncompliance is not always necessary, acquired company. The proposed rule
for the quantification, validation, and because the disclosure may not reflect required a bank to submit such a plan
control and oversight mechanisms as the degree of noncompliance. Therefore, within 30 days of consummating the
well as the bank’s broader risk the agencies are not including a general merger or acquisition. Many
management and reporting needs. noncompliance disclosure requirement commenters asserted that the 30-day
Documentation is also critical to the in the final rule. However, the agencies timeframe for submission of an
supervisory oversight process. acknowledge that a bank’s significant implementation plan may be too short,
The bank should document the noncompliance with the qualification particularly given the many integration
rationale for all material assumptions requirements is an important factor in activities that must take place
underpinning its chosen analytical market participants’ assessments of the immediately following the
frameworks, including the choice of bank’s risk profile and, thus, a primary consummation of a merger or
inputs, distributional assumptions, and Federal supervisor may require public acquisition. These commenters
weighting of quantitative and qualitative disclosure of noncompliance with the generally suggested that banks instead
elements. The bank also should qualification requirements if such be given 90 or 180 days to submit the
document and justify any subsequent noncompliance is significant. implementation plan. The agencies
changes to these assumptions. agree with these commenters that the
D. Merger and Acquisition Transition proposed timeframe for submitting an
C. Ongoing Qualification Provisions implementation plan may be too short.
A bank using the advanced Due to the advanced approaches’ Accordingly, the final rule requires a
approaches must meet the qualification rigorous systems requirements, a bank bank to submit an implementation plan
requirements on an ongoing basis. that merges with or acquires another within 90 days of the consummation of
Banks are expected to improve their company might not be able to quickly a merger or acquisition.
advanced systems as they improve data integrate the merged or acquired Under the final rule, if a bank that
gathering capabilities and as industry company’s exposures into its risk-based uses the advanced approaches to
practice evolves. To facilitate the capital calculations. The proposed rule calculate risk-based capital
supervisory oversight of systems provided transition provisions that requirements merges with or acquires a
changes, a bank must notify its primary would allow the acquiring bank time to company that does not calculate risk-
Federal supervisor when it makes a integrate the merged or acquired based capital requirements using the
change to its advanced systems that company into its advanced approaches, advanced approaches, the acquiring
results in a material change in the subject to an implementation plan bank may use the general risk-based
bank’s risk-weighted asset amount for submitted to the bank’s primary Federal capital rules to compute the risk-
an exposure type, or when the bank supervisor. As proposed, the transition weighted assets and associated capital
for the merged or acquired company’s exposures, including those of the based capital rules.42 Consistent with
exposures during the merger and acquired bank. the proposed rule, the final rule
acquisition transition timeframe. Any If the acquiring bank chooses or is includes regulatory text for certain
ALLL (net of allocated transfer risk required to move to the advanced adjustments to the capital elements for
reserves) associated with the acquired approaches, however, it could apply the purposes of the advanced approaches.
company’s exposures may be included advanced approaches to the acquired Under the final rule, consistent with
in the acquiring bank’s tier 2 capital up exposures (provided that it continues to the proposal, after identifying the
to 1.25 percent of the acquired meet all of the qualification elements of tier 1 and tier 2 capital, a
company’s risk-weighted assets.41 Such requirements for those exposures) for up bank must make certain adjustments to
ALLL is excluded from the acquiring to 24 months (with a potential 12-month determine its tier 1 capital and total
bank’s eligible credit reserves. The risk- extension) while it completes the qualifying capital (the numerator of the
weighted assets of the acquired process of qualifying to use the total risk-based capital ratio). Some of
company are not included in the advanced approaches for the entire these adjustments are made only to the
acquiring bank’s credit-risk-weighted bank. If the acquiring bank has not tier 1 portion of the capital base. Other
assets but are included in the acquiring begun implementing the advanced adjustments are made 50 percent from
bank’s total risk-weighted assets. If the approaches at the time of the merger or tier 1 capital and 50 percent from tier 2
acquiring bank uses the general risk- acquisition, it may instead use the capital.43 A bank must still have at least
based capital rules for acquired transition timeframes described in 50 percent of its total qualifying capital
exposures, it must disclose publicly the section III.A. of the preamble and in the form of tier 1 capital.44
amounts of risk-weighted assets and section 21 of the final rule. In the latter Under the final rule, as under the
qualifying capital calculated under the case, the bank must consult with its proposal, a bank must deduct from tier
general risk-based capital rules with primary Federal supervisor regarding 1 capital goodwill, other intangible
respect to the acquired company and the appropriate risk-based capital assets, and deferred tax assets to the
under this rule for the acquiring bank. treatment of the acquired exposures. In same extent that those assets are
The primary Federal supervisor of the no case may a bank permanently apply deducted from tier 1 capital under the
bank will monitor the merger or the advanced approaches only to an general risk-based capital rules. Thus,
acquisition to determine whether the acquired bank’s exposures and not to all goodwill is deducted from tier 1
acquiring bank’s application of the the consolidated bank. capital. Certain intangible assets—
general risk-based capital rules for the Because eligible credit reserves and including mortgage servicing assets,
acquired company produces appropriate the ALLL are treated differently under non-mortgage servicing assets, and
risk-based capital requirements for the the general risk-based capital rules and purchased credit card relationships—
assets of the acquired company in light the advanced approaches, the final rule that meet the conditions and limits in
of the overall risk profile of the specifies how the acquiring bank must the general risk-based capital rules do
acquiring bank. treat the general allowances associated not have to be deducted from tier 1
Similarly, a core or opt-in bank that with the merged or acquired company’s capital. Likewise, deferred tax assets
merges with or acquires another core or exposures during the period when the that are dependent upon future taxable
opt-in bank might not be able to apply general risk-based capital rules apply to income and that meet the valuation
its systems for the advanced approaches the acquiring bank. Specifically, ALLL requirements and limits in the general
immediately to the acquired bank’s associated with the exposures of the risk-based capital rules do not have to
exposures. Accordingly, the final rule merged or acquired company may not be deducted from tier 1 capital.45
permits a core or opt-in bank that be directly included in the acquiring Under the general risk-based capital
merges with or acquires another core or bank’s tier 2 capital. Rather, any excess rules, a bank also must deduct from its
opt-in bank to use the acquired bank’s eligible credit reserves (that is, eligible
42 See 12 CFR part 3, Appendix A, § 2 (national
advanced approaches to determine the credit reserves minus total expected
banks); 12 CFR part 208, Appendix A, § II (state
risk-weighted asset amounts for, and credit losses) associated with the member banks); 12 CFR part 225, Appendix A, § II
deductions from capital associated with, merged or acquired company’s (bank holding companies); 12 CFR part 325,
the acquired bank’s exposures during exposures may be included in the Appendix A, § I (state nonmember banks); and 12
acquiring bank’s tier 2 capital up to 0.6 CFR 567.5 (savings associations).
the merger and acquisition transition 43 If the amount deductible from tier 2 capital
timeframe. percent of the credit-risk-weighted
exceeds the bank’s actual tier 2 capital, however,
assets associated with those exposures. the bank must deduct the shortfall amount from tier
A third potential merger or
1 capital.
acquisition scenario is a bank subject to IV. Calculation of Tier 1 Capital and 44 Any assets deducted from capital in computing
the general risk-based capital rules that Total Qualifying Capital the numerator of the risk-based capital ratios are
merges with or acquires a bank that uses The final rule maintains the minimum also not included in risk-weighted assets in the
the advanced approaches. If, after the denominator of the ratio.
risk-based capital ratio requirements of 45 See 12 CFR part 3, Appendix A, § 2 (national
merger or acquisition, the acquiring 4.0 percent tier 1 capital to total risk- banks); 12 CFR part 208, Appendix A, § II (state
bank is not a core bank, it could choose weighted assets and 8.0 percent total member banks); 12 CFR part 225, Appendix A, § II
to opt in to the advanced approaches or qualifying capital to total risk-weighted (bank holding companies); 12 CFR part 325,
to apply the general risk-based capital assets. A bank’s total qualifying capital Appendix A, § I (state nonmember banks). OTS
rules to the consolidated bank. If the existing rules are formulated differently, but
is the sum of its tier 1 (core) capital include similar deductions. Under OTS rules, for
acquiring bank chooses to remain on the elements and tier 2 (supplemental) example, goodwill is included within the definition
general risk-based capital rules, the capital elements, subject to various of ‘‘intangible assets’’ and is deducted from tier 1
bank must immediately apply the limits and restrictions, minus certain (core) capital along with other intangible assets. See
general risk-based capital rules to all its 12 CFR 567.1 and 567.5(a)(2)(i). Similarly,
deductions (adjustments). The agencies purchased credit card relationships and mortgage
are not restating the elements of tier 1 and non-mortgage servicing assets are included in
41 Any amount of the acquired company’s ALLL capital to the same extent as the other agencies’
and tier 2 capital in the final rule. Those
that was eliminated in accounting for the rules. See 12 CFR 567.5(a)(2)(ii) and 567.12. The
acquisition is not included in the acquiring bank’s
capital elements generally remain as deduction of deferred tax assets is discussed in
regulatory capital. they are currently in the general risk- Thrift Bulletin 56.
tier 1 capital certain percentages of the a charge against earnings to absorb this treatment requires a bank to specify
adjusted carrying value of its credit losses associated with on-or off- how much of its ALLL is attributable to
nonfinancial equity investments. An balance sheet wholesale and retail defaulted exposures, and emphasize
advanced approaches bank is not exposures. As proposed, eligible credit that a bank must capture all material
required to make these deductions. reserves did not include allocated economic losses on defaulted exposures
Instead, the bank’s equity exposures transfer risk reserves established when building its databases for
generally are subject to the equity pursuant to 12 U.S.C. 390447 and other estimating LGDs for non-defaulted
treatment in part VI of the final rule and specific reserves created against exposures.
described in section V.F. of this recognized losses. The final rule The agencies also sought comment on
preamble.46 maintains the proposed definition of the appropriate measure of ECL for
A number of commenters urged the eligible credit reserves. assets held at fair value with gains and
agencies to revisit the existing The proposed rule defined a bank’s losses flowing through earnings.
definitions of tier 1 and tier 2 capital, total ECL as the sum of ECL for all Commenters expressed the view that
including some of the deductions. Some wholesale and retail exposures other there should be no ECL for such assets
offered specific suggestions, such as than exposures to which the bank because expected losses on such assets
removing the requirement to deduct applied the double default treatment already have been removed from
goodwill from tier 1 capital or revising (described below). The bank’s ECL for a regulatory capital. The agencies agree
the limitations on certain capital wholesale exposure to a non-defaulted with this position and, therefore, under
instruments that may be included in obligor or a non-defaulted retail segment the final rule, a bank may assign an ECL
regulatory capital. Other commenters was equal to the product of PD, ELGD, of zero to assets held at fair value with
noted that the definition of regulatory and EAD for the exposure or segment. gains and losses flowing through
capital and related deductions should The ECL for non-defaulted exposures earnings. The agencies are otherwise
be thoroughly debated internationally thus reflected expected economic losses, maintaining the proposed definition of
before changes are made in any one including the cost of carry and direct ECL in the final rule, with the
national jurisdiction. The agencies and indirect workout expenses. The substitution of LGD for ELGD noted
believe that the definition of regulatory bank’s ECL for a wholesale exposure to above.
capital should be as consistent as a defaulted obligor or a defaulted retail Under the final rule, consistent with
possible across national jurisdictions. segment was equal to the bank’s the proposal, a bank must compare the
The BCBS has formed a working group impairment estimate for allowance total dollar amount of its ECL to its
that is currently looking at issues related purposes for the exposure or segment. eligible credit reserves. If there is a
to the definition of regulatory capital. The ECL for defaulted exposures thus shortfall of eligible credit reserves
Accordingly, the agencies have not was based on accounting measures of compared to total ECL, the bank must
modified the existing definition of credit loss incorporated into a bank’s deduct 50 percent of the shortfall from
regulatory capital and related charge-off and reserving practices. tier 1 capital and 50 percent from tier 2
deductions at this time, other than with In the proposal, the agencies solicited capital. If eligible credit reserves exceed
respect to implementation of the comment on a possible alternative total ECL, the excess portion of eligible
advanced approaches. treatment for determining ECL for a credit reserves may be included in tier
Under the general risk-based capital defaulted exposure that would be more 2 capital up to 0.6 percent of credit-risk-
rules, a bank is allowed to include in consistent with the proposed treatment weighted assets.
tier 2 capital its ALLL up to 1.25 percent A number of commenters objected to
of ECL for non-defaulted exposures.
of risk-weighted assets (net of certain the 0.6 percent limit on inclusion of
That alternative approach calculated
deductions). Amounts of ALLL in excess reserves in tier 2 capital and
ECL as the bank’s current carrying value
excess of this limit are deducted from suggested that there should be a higher
of the exposure multiplied by the bank’s
the gross amount of risk-weighted or no limit on the amount of excess
best estimate of the expected economic reserves that may be included in
assets. loss rate associated with the exposure
Under the proposed rule, the ALLL regulatory capital. While the 0.6 percent
(measured relative to the current limit is part of the New Accord, some
was treated differently. The proposed carrying value). Commenters on this
rule included a methodology for commenters asserted that this limitation
issue generally supported the proposed would put U.S. banks at a competitive
adjusting risk-based capital treatment and expressed some concern
requirements based on a comparison of disadvantage because U.S. accounting
about the added complexity of the practices (as compared to accounting
the bank’s eligible credit reserves to its alternative treatment.
ECL. The proposed rule defined eligible practices in many other countries) lead
The agencies believe that, for to higher reserves that are more likely to
credit reserves as all general allowances, defaulted exposures, any difference
including the ALLL, established through exceed the limitation. Another
between a bank’s best estimate of commenter asserted that the proposed
46 By contrast, OTS rules require the deduction of
economic losses and its impairment limitation on excess reserves is more
equity investments from total capital. 12 CFR estimate for ALLL purposes is likely to restrictive than the current cap on ALLL
567.5(c)(2)(ii). ‘‘Equity investments’’ are defined to be small. The agencies also believe that in the general risk-based capital rules.
include (i) investments in equity securities (other the proposed ALLL impairment Finally, several commenters suggested
than investments in subsidiaries, equity approach is less burdensome for banks
investments that are permissible for national banks, that because ALLL is the first buffer
indirect ownership interests in certain pools of than the ‘‘best estimate of economic against credit losses, it should be
assets (for example, mutual funds), Federal Home loss’’ approach. As a result, the agencies included without limit in tier 1 capital.
Loan Bank stock and Federal Reserve Bank stock); are retaining this aspect of the proposed The agencies believe that the
and (ii) investments in certain real property. 12 CFR definition of ECL for defaulted
567.1. Savings associations applying the final rule proposed 0.6 percent limit on inclusion
are not required to deduct investments in equity exposures. The agencies recognize that of excess reserves in tier 2 capital is
securities. Instead, such investments are subject to roughly equivalent to the 1.25 percent
the equity treatment in part VI of the final rule. 47 12 U.S.C. 3904 does not apply to savings
Equity investments in real estate continue to be associations regulated by the OTS. As a result, the
cap in the general risk-based capital
deducted to the same extent as under the general OTS final rule does not refer to allocated transfer rules and serves to maintain general
risk-based capital rules. risk reserves. consistency in the treatment of reserves
domestically and internationally. The agencies received a number of BHC generally does not deconsolidate
Accordingly, the agencies have included comments on the proposed the assets and liabilities of the financial
the 0.6 percent cap in the final rule. securitization-linked deductions. In subsidiaries of the BHC’s subsidiary
Under the proposed rule, a bank particular, some commenters urged the banks and does not deduct from its
would deduct from tier 1 capital any agencies to retain the general risk-based regulatory capital the equity
after-tax gain-on-sale. Gain-on-sale was capital rule for deducting only CEIOs investments of its subsidiary banks in
defined as an increase in a bank’s equity that exceed 25 percent of tier 1 capital. financial subsidiaries. Rather, a BHC
capital that resulted from a Some of these commenters noted that generally fully consolidates the
securitization, other than an increase in the ‘‘harsher’’ securitization-linked financial subsidiaries of its subsidiary
equity capital that resulted from the deductions under the advanced banks. These treatments continue under
bank’s receipt of cash in connection approaches could have a significant tier the final rule.
with the securitization. The agencies 1 capital impact and, accordingly, could For BHCs with consolidated
designed this deduction to offset have an unwarranted effect on a bank’s insurance underwriting subsidiaries that
accounting treatments that produce an tier 1 leverage ratio calculation. A few are functionally regulated by a State
increase in a bank’s equity capital and commenters encouraged the agencies to insurance regulator (or subject to
tier 1 capital at the inception of a permit a bank to replace the deduction comparable supervision and regulatory
securitization—for example, a gain approach for certain securitization capital requirements in a non-U.S.
attributable to a CEIO that results from exposures with a 1,250 percent risk jurisdiction), the proposed rule set forth
Financial Accounting Standard (FAS) weight approach, in part to mitigate the following treatment. The assets and
140 accounting treatment for the sale of potential tier 1 leverage ratio effects. liabilities of the subsidiary would be
underlying exposures to a securitization The agencies are retaining the consolidated for purposes of
special purpose entity (SPE). Over time, securitization-related deductions as determining the BHC’s risk-weighted
as the bank, from an accounting proposed. The proposed deductions are assets. However, the BHC would deduct
perspective, realizes the increase in part of the New Accord’s securitization from tier 1 capital an amount equal to
equity capital and tier 1 capital booked framework. The agencies believe that the insurance underwriting subsidiary’s
at the inception of the securitization they should be retained to foster minimum regulatory capital
through actual receipt of cash flows, the consistency among participants in the requirement as determined by its
amount of the required deduction international securitization markets. functional (or equivalent) regulator. For
would shrink accordingly. The proposed rule also required a U.S. regulated insurance underwriting
Under the general risk-based capital bank to deduct the bank’s exposure on subsidiaries, this amount generally
rules,48 a bank must deduct CEIOs, certain unsettled and failed capital would be 200 percent of the subsidiary’s
whether purchased or retained, from tier markets transactions 50 percent from Authorized Control Level as established
1 capital to the extent that the CEIOs tier 1 capital and 50 percent from tier 2 by the appropriate state insurance
exceed 25 percent of the bank’s tier 1 capital. The agencies are retaining this regulator.
capital. Under the proposed rule, a bank deduction as proposed. The proposal noted that its approach
would deduct CEIOs from tier 1 capital The agencies are also retaining, as with respect to functionally regulated
to the extent they represent gain-on-sale, proposed, the deductions in the general consolidated insurance underwriting
and would deduct any remaining CEIOs risk-based capital rules for investments subsidiaries was different from the New
50 percent from tier 1 capital and 50 in unconsolidated banking and finance Accord, which broadly endorses a
percent from tier 2 capital. subsidiaries and reciprocal holdings of deconsolidation and deduction
Under the proposed rule, certain other bank capital instruments. Further, the approach for insurance subsidiaries.
securitization exposures also would be agencies are retaining the current The proposal acknowledged the Board’s
deducted from tier 1 and tier 2 capital. treatment for national and state banks concern that a full deconsolidation and
These exposures included, for example, that control or hold an interest in a deduction approach does not capture
securitization exposures with an financial subsidiary. As required by the the credit risk in insurance
applicable external rating (defined Gramm-Leach-Bliley Act, assets and underwriting subsidiaries at the
below) that is more than one category liabilities of the financial subsidiary are consolidated BHC level.
below investment grade (for example, not consolidated with those of the bank Several commenters objected to the
below BB-) and most subordinated for risk-based capital purposes and the proposed deduction from tier 1 capital
unrated securitization exposures. When bank must deduct its equity investment and instead supported a deduction 50
a bank deducted a securitization (including retained earnings) in the percent from tier 1 capital and 50
exposure (other than gain-on-sale) from financial subsidiary from regulatory percent from tier 2 capital. Others
regulatory capital, the bank would take capital—50 percent from tier 1 capital supported the full deduction and
the deduction 50 percent from tier 1 and 50 percent from tier 2 capital.49 A deconsolidation approach endorsed by
capital and 50 percent from tier 2 the New Accord and maintained that, by
capital. Moreover, under the proposal, a 49 See Public Law 106–102 (November 12, 1999),
contrast, the proposed approach was
bank could calculate any deductions codified, among other places, at 12 U.S.C. 24a. See
also 12 CFR 5.39(h)(1) (national banks); 12 CFR overly conservative and resulted in a
from tier 1 and tier 2 capital with 208.73(a) (state member banks); 12 CFR part 325, double-count of capital requirements for
respect to a securitization exposure Appendix A, § I.B.2. (state nonmember banks). insurance regulation and banking
(including after-tax gain-on-sale) net of Again, OTS rules are formulated differently. For regulation.
any deferred tax liabilities associated example, OTS rules do not use the terms
‘‘unconsolidated banking and finance subsidiary’’ The Board continues to believe that a
with the exposure. or ‘‘financial subsidiary.’’ Rather, as required by consolidated BHC risk-based capital
section 5(t)(5) of the Home Owners’ Loan Act measure should incorporate all credit,
48 See 12 CFR part 3, Appendix A, § 2(c)(4) (HOLA), equity and debt investments in non- market, and operational risks to which
(national banks); 12 CFR part 208, Appendix A, includable subsidiaries (generally subsidiaries that
§ I.B.1.c. (state member banks); 12 CFR part 225, are engaged in activities that are not permissible for the BHC is exposed, regardless of the
Appendix A, § I.B.1.c. (bank holding companies); 12 a national bank) are deducted from assets and tier
CFR part 325, Appendix A, § I.B.5. (state 1 (core) capital. 12 CFR 567.5(a)(2)(iv) and (v). As bank capital instruments are deducted from a
nonmember banks); 12 CFR 567.5(a)(2)(iii) and required by HOLA, OTS will continue to deduct savings association’s total capital under 12 CFR
567.12(d)(2) (savings associations). non-includable subsidiaries. Reciprocal holdings of 567.5(c)(2).
legal entity subsidiary where a risk seeks to exclude from the IRB approach) capital formula for non-HVCRE
exposure resides. The Board also is not material to the bank. As described wholesale exposures. Further, the
believes that a fully consolidated above, credit-risk-weighted assets is agencies proposed that once an
approach minimizes the potential for defined as 1.06 multiplied by the sum exposure was determined to be an
regulatory capital arbitrage; it eliminates of total wholesale and retail risk- HVCRE exposure, it would remain an
incentives to book individual exposures weighted assets, risk-weighted assets for HVCRE exposure until paid in full, sold,
at a subsidiary that is deducted from the securitization exposures, and risk- or converted to permanent financing.
consolidated entity for capital purposes weighted assets for equity exposures. The proposed rule defined an HVCRE
where a different, potentially more exposure as a credit facility that
favorable, capital requirement is applied 1. Wholesale Exposures finances or has financed the acquisition,
at the subsidiary. Moreover, the Board Consistent with the proposed rule, the development, or construction of real
does not agree that the proposed final rule defines a wholesale exposure property, excluding facilities that
approach results in a double-count of as a credit exposure to a company, finance (i) one-to four-family residential
capital requirements. Rather, the capital individual, sovereign entity, or other properties or (ii) commercial real estate
requirements imposed by a functional governmental entity (other than a projects that meet the following
regulator or other supervisory authority securitization exposure, retail exposure, conditions: (A) The exposure’s loan-to-
at the subsidiary level reflect the capital or equity exposure).50 The term value (LTV) ratio is less than or equal
needs at the particular subsidiary. The ‘‘company’’ is broadly defined to mean to the applicable maximum supervisory
consolidated measure of minimum a corporation, partnership, limited LTV ratio in the real estate lending
capital requirements should reflect the liability company, depository standards of the agencies; 52 (B) the
consolidated organization. institution, business trust, SPE, borrower has contributed capital to the
Thus, the Board is retaining the association, or similar organization. project in the form of cash or
proposed requirement that assets and Examples of a wholesale exposure unencumbered readily marketable assets
liabilities of insurance underwriting include: (i) A non-tranched guarantee (or has paid development expenses out-
subsidiaries are consolidated for issued by a bank on behalf of a of-pocket) of at least 15 percent of the
determining risk-weighted assets. The company; 51 (ii) a repo-style transaction real estate’s appraised ‘‘as completed’’
Board has modified the final rule for entered into by a bank with a company value; and (C) the borrower contributed
BHCs, however, to allow the associated and any other transaction in which a the amount of capital required before
capital deduction to be made 50 percent bank posts collateral to a company and the bank advances funds under the
from tier 1 capital and 50 percent from faces counterparty credit risk; (iii) an credit facility, and the capital
tier 2 capital. exposure that a bank treats as a covered contributed by the borrower or
V. Calculation of Risk-Weighted Assets position under the market risk rule for internally generated by the project is
which there is a counterparty credit risk contractually required to remain in the
Under the final rule, a bank’s total capital requirement; (iv) a sale of project throughout the life of the project.
risk-weighted assets is the sum of its corporate loans by a bank to a third Several commenters raised issues
credit risk-weighted assets and risk- party in which the bank retains full related to the requirement that banks
weighted assets for operational risk, recourse; (v) an OTC derivative contract must separate HVCRE exposures from
minus the sum of its excess eligible entered into by a bank with a company; other wholesale exposures. One
credit reserves (eligible credit reserves (vi) an exposure to an individual that is commenter asserted that a separate risk-
in excess of its total ECL) not included not managed by the bank as part of a weight function for HVCRE exposures is
in tier 2 capital. Unlike under the segment of exposures with unnecessary because the higher risk
proposal, allocated transfer risk reserves homogeneous risk characteristics; and associated with such exposures would
are not subtracted from total risk- (vii) a commercial lease. be reflected in higher PDs and LGDs.
weighted assets under the final rule. The agencies proposed two Other commenters stated that tracking
Because the EAD of wholesale subcategories of wholesale exposures— the exception requirements for
exposures and retail segments is HVCRE exposures and non-HVCRE acquisition, development, or
calculated net of any allocated transfer exposures. Under the proposed rule, construction loans would be
risk reserves, a second subtraction of the HVCRE exposures would be subject to a burdensome and expressed concern that
reserves from risk-weighted assets is not separate IRB risk-based capital formula all multifamily loans could be subject to
appropriate. that would produce a higher risk-based the HVCRE treatment. Yet other
A. Categorization of Exposures capital requirement for a given set of commenters requested that the agencies
risk parameters than the IRB risk-based exclude from the definition of HVCRE
To calculate credit risk-weighted
assets, a bank must determine risk- all multifamily acquisition,
50 The proposed rule excluded from the definition
weighted asset amounts for exposures development, or construction loans;
of a wholesale exposure certain pre-sold one-to-four
that have been grouped into four general family residential construction loans and certain
additional commercial real estate
categories: wholesale, retail, multifamily residential loans. The treatment of such exposures; and other exposures with
securitization, and equity. It must also loans under the final rule is discussed below in significant project equity and/or pre-sale
section V.B.5. of the preamble. commitments. A few commenters
identify and determine risk-weighted 51 As described below, tranched guarantees (like
asset amounts for assets not included in supported the proposed approach to
most transactions that involve a tranching of credit
an exposure category and any non- risk) generally are securitization exposures under HVCRE exposures.
material portfolios of exposures to the final rule. The final rule defines a guarantee The agencies have determined that
which the bank elects not to apply the broadly to include almost any transaction (other the proposed definition of HVCRE
than a credit derivative) that involves the transfer exposures strikes an appropriate balance
IRB approach. To exclude a portfolio of the credit risk of an exposure from one party to
from the IRB approach, a bank must another party. This definition of guarantee generally between risk-sensitivity and simplicity.
demonstrate to the satisfaction of its includes, for example, a credit spread option under
which a bank has agreed to make payments to its 52 12 CFR part 34, Subpart D (OCC); 12 CFR part
primary Federal supervisor that the counterparty in the event of an increase in the 208, Appendix C (Board); 12 CFR part 365,
portfolio (when combined with all other credit spread associated with a particular reference Appendix A (FDIC); and 12 CFR 560.100–560.101
portfolios of exposures that the bank obligation issued by a company. (OTS).
Thus, the final rule retains the SME lending between U.S. banks and than managed as part of a segment, are
definition as proposed. If a bank does foreign banks subject to rules that categorized as wholesale exposures.
not want to track compliance with the include the New Accord’s treatment of QREs are defined as exposures to
definition for burden-related reasons, SME exposures. Others asserted that individuals that are (i) revolving,
the bank may choose to apply the lower AVCs and risk-based capital unsecured, and unconditionally
HVCRE risk-weight function to all credit requirements were appropriate for SME cancelable by the bank to the fullest
facilities that finance the acquisition, exposures because the asset values of extent permitted by Federal law; (ii)
construction, or development of exposures to smaller firms are more have a maximum exposure amount
multifamily and commercial real idiosyncratic than those of exposures to (drawn plus undrawn) of up to
property. The agencies believe that this larger firms. $100,000; and (iii) are managed as part
treatment would be an appropriate While commenters raised important of a segment of exposures with
application of the principle of issues related to SME exposures, the homogeneous risk characteristics. In
conservatism discussed in section II.D. agencies have decided not to add a practice, QREs typically include
of the preamble and set forth in section distinct risk-weight function for such exposures where customers’ outstanding
1(d) of the final rule. exposures to the final rule. The agencies borrowings are permitted to fluctuate
The New Accord identifies five sub- continue to believe that a distinct risk- based on their decisions to borrow and
classes of specialized lending for which weight function with a lower AVC for repay, up to a limit established by the
the primary source of repayment of the SME exposures is not substantiated by bank. Most credit card exposures to
obligation is the income generated by sufficient empirical evidence and may individuals and overdraft lines on
the financed asset(s) rather than the give rise to a domestic competitive individual checking accounts are QREs.
independent capacity of a broader inequity between banks subject to the The category of other retail exposures
commercial enterprise. The sub-classes advanced approaches and banks subject includes two types of exposures. First,
are project finance, object finance, all exposures to individuals for non-
to the general risk-based capital rules.
commodities finance, income-producing business purposes (other than
real estate, and HVCRE. The New 2. Retail Exposures residential mortgage exposures and
Accord provides a methodology to QREs) that are managed as part of a
Under the final rule, as under the
accommodate banks that cannot meet segment of similar exposures are other
proposed rule, retail exposures
the requirements for the estimation of retail exposures. Such exposures may
generally include exposures (other than
PD for these exposure types. The include personal term loans, margin
securitization exposures or equity
proposed rule did not include a separate loans, auto loans and leases, credit card
exposures) to an individual and small
treatment for specialized lending accounts with credit lines above
exposures to businesses that are
beyond the separate IRB risk-based $100,000, and student loans. There is no
managed as part of a segment of similar upper limit on the size of these types of
capital formula for HVCRE exposures
exposures, not on an individual- retail exposures to individuals. Second,
specified in the New Accord. The
exposure basis. There are three exposures to individuals or companies
agencies noted in the proposal that
subcategories of retail exposure: (i) for business purposes (other than
sophisticated banks that would be
Residential mortgage exposures; (ii) residential mortgage exposures and
applying the advanced approaches in
QREs; and (iii) other retail exposures. QREs), up to a single-borrower exposure
the United States should be able to
The final rule retains the proposed threshold of $1 million, that are
estimate risk parameters for specialized
lending. The agencies continue to definitions of the retail exposure managed as part of a segment of similar
believe that banks using the advanced subcategories and, thus, defines exposures are other retail exposures. For
approaches in the United States should residential mortgage exposure as an the purpose of assessing exposure to a
be able to estimate risk parameters for exposure that is primarily secured by a single borrower, the bank must
specialized lending and, therefore, have first or subsequent lien on one- to four- aggregate all business exposures to a
not adopted a separate treatment for family residential property.53 This particular legal entity and its affiliates
specialized lending in the final rule. includes both term loans and HELOCs. that are consolidated under GAAP. If
In contrast to the New Accord, the An exposure primarily secured by a first that borrower is a natural person, any
agencies did not propose a separate risk- or subsequent lien on residential consumer loans (for example, personal
based capital function for exposures to property that is not one to four family credit card loans or mortgage loans) to
small- and medium-size enterprises also is included as a residential that borrower would not be part of the
(SMEs). The SME function in the New mortgage exposure as long as the aggregate. A bank could distinguish a
Accord generates a lower risk-based exposure has both an original and consumer loan from a business loan by
capital requirement for an exposure to current outstanding amount of no more the loan department through which the
an SME than for an exposure to a larger than $1 million. There is no upper limit loan is made. Exposures to a borrower
firm that has the same risk parameter on the size of an exposure that is for business purposes primarily secured
values. The agencies were not aware of secured by one-to four-family by residential property count toward the
compelling evidence that smaller firms residential properties. To be a $1 million single-borrower other retail
are subject to less systematic risk than residential mortgage exposure, the bank business exposure threshold.54
is already reflected in the wholesale must manage the exposure as part of a The residual value portion of a retail
exposure risk-based capital formula, segment of exposures with lease exposure is excluded from the
which specifies lower AVCs as PDs homogeneous risk characteristics. definition of an other retail exposure.
increase. Residential mortgage loans that are Consistent with the New Accord, a bank
A number of commenters objected to managed on an individual basis, rather must assign the residual value portion
this aspect of the proposal and urged the

agencies to include in the final rule the 53 The proposed rule excluded from the definition 54 The proposed rule excluded from the definition
SME risk-based capital function from of a residential mortgage exposure certain pre-sold of an other retail exposure certain pre-sold one-to-
one- to-four family residential construction loans four family residential construction loans and
the New Accord. Several commenters and certain multifamily residential loans. The certain multifamily residential loans. The treatment
expressed concern about potential treatment of such loans under the final rule is of such loans under the final rule is discussed
competitive disparities in the market for discussed below in section V.B.5. of the preamble. below in section V.B.5. of the preamble.
of a retail lease exposure a risk-weighted credit risk, securitization exposures finance the construction or acquisition
asset amount equal to its residual value could include, among other things, of large-scale projects (for example,
as described in section 31 of the final asset-backed and mortgage-backed airports and power plants), objects (for
rule. securities; loans, lines of credit, example, ships, aircraft, or satellites), or
liquidity facilities, and financial commodities (for example, reserves,
3. Securitization Exposures
standby letters of credit; credit inventories, precious metals, oil, or
The proposed rule defined a derivatives and guarantees; loan natural gas) generally is not a
securitization exposure as an on-balance servicing assets; servicer cash advance securitization exposure because the
sheet or off-balance sheet credit facilities; reserve accounts; credit- assets backing the loan typically are
exposure that arises from a traditional or enhancing representations and nonfinancial assets (the facility, object,
synthetic securitization (including warranties; and CEIOs. Securitization or commodity being financed). In
credit-enhancing representations and exposures also could include assets sold addition, although some structured
warranties). A traditional securitization with retained tranched recourse. transactions involving income-
was defined as a transaction in which (i) As explained in the proposal, if a producing real estate or HVCRE can
all or a portion of the credit risk of one bank purchases an asset-backed security resemble securitizations, these
or more underlying exposures is issued by a securitization SPE and transactions generally would not be
transferred to one or more third parties purchases a credit derivative to protect securitizations because the underlying
other than through the use of credit itself from credit losses associated with exposure would be real estate.
derivatives or guarantees; (ii) the credit the asset-backed security, the purchase Consequently, exposures resulting from
risk associated with the underlying of the credit derivative by the investing the tranching of the risks of
exposures has been separated into at bank does not turn the traditional nonfinancial assets are not subject to the
least two tranches reflecting different securitization into a synthetic final rule’s securitization framework,
levels of seniority; (iii) performance of securitization. Instead, the investing but generally are subject to the rules for
the securitization exposures depends on bank would be viewed as having wholesale exposures.
the performance of the underlying purchased a traditional securitization Based on their cash flow
exposures; and (iv) all or substantially exposure and would reflect the CRM characteristics, for purposes of the final
all of the underlying exposures are benefits of the credit derivative through rule, the agencies would consider many
financial exposures. Examples of the securitization CRM rules described of the asset classes identified by
financial exposures are loans, later in the preamble and in section 46 commenters including lease residuals
commitments, receivables, asset-backed of the rule. Moreover, if a bank provides and entertainment royalties—to be
securities, mortgage-backed securities, a guarantee or a credit derivative on a financial assets. Both the designation of
other debt securities, equity securities, securitization exposure, that guarantee exposures as securitization exposures
or credit derivatives. The proposed rule or credit derivative would also be a and the calculation of risk-based capital
also defined mortgage-backed pass- securitization exposure. requirements for securitization
through securities guaranteed by Fannie Commenters raised several objections exposures will be guided by the
Mae or Freddie Mac (whether or not to the proposed definitions of economic substance of a transaction
issued out of a structure that tranches traditional and synthetic securitizations. rather than its legal form.55
credit risk) as securitization exposures. First, several commenters objected to Some commenters asserted that the
A synthetic securitization was defined the requirement that all or substantially proposal generally to define as
as a transaction in which (i) all or a all of the underlying exposures must be securitization exposures all exposures
portion of the credit risk of one or more financial exposures. These commenters involving credit risk tranching of
underlying exposures is transferred to noted that the securitization market underlying financial assets was too
one or more third parties through the rapidly evolves and expands to cover broad. The proposed definition captured
use of one or more credit derivatives or new asset classes—such as intellectual many exposures these commenters did
guarantees (other than a guarantee that property rights, project finance not consider to be securitization
transfers only the credit risk of an revenues, and entertainment royalties— exposures, including tranched
individual retail exposure); (ii) the that may or may not be financial assets. exposures to a single underlying
credit risk associated with the Commenters expressed particular financial exposure and exposures to
underlying exposures has been concern that the proposed definitions many hedge funds and private equity
separated into at least two tranches may exclude from the securitization funds. Commenters requested flexibility
reflecting different levels of seniority; framework leases that include a material to apply the wholesale or equity
(iii) performance of the securitization lease residual component. framework (depending on the exposure)
exposures depends on the performance The agencies believe that requiring all rather than the securitization framework
of the underlying exposures; and (iv) all or substantially all of the underlying to these exposures.
or substantially all of the underlying exposures for a securitization to be The agencies believe that a single,
exposures are financial exposures. financial exposures creates an important unified approach to dealing with the
Accordingly, the proposed definition of boundary between the wholesale and tranching of credit risk is important to
a securitization exposure included retail frameworks, on the one hand, and create a level playing field across the
tranched cover or guarantee the securitization framework, on the securitization, credit derivative, and
arrangements—that is, arrangements in other hand. Accordingly, the agencies other financial markets, and therefore
which an entity transfers a portion of are maintaining this requirement in the have decided to maintain the proposed
the credit risk of an underlying final rule. The securitization framework treatment of tranched exposures to a
exposure to one or more guarantors or was designed to address the tranching of
credit derivative providers but also the credit risk of financial exposures 55 Several commenters asked the agencies to
retains a portion of the credit risk, and was not designed, for example, to confirm that the typical syndicated credit facility
where the risk transferred and the risk apply to tranched credit exposures to would not be a securitization exposure. The
agencies confirm that a syndicated credit facility is
retained are of different seniority levels. commercial or industrial companies or not a securitization exposure so long as less than
The preamble to the proposal noted nonfinancial assets. Accordingly, under substantially all of the borrower’s assets are
that, provided there is a tranching of the final rule, a specialized loan to financial exposures.
single underlying financial asset in the Federal supervisor of a bank with appropriate IRB classification is made.
final rule. The agencies believe that discretion to exclude from the definition The agencies will consider a number of
basing the applicability of the of traditional securitization investment factors when assessing the economic
securitization framework on the firms that exercise substantially substance of a transaction including, for
presence of some minimum number of unfettered control over the size and example, the amount of equity in the
underlying exposures would complicate composition of their assets, liabilities, structure, overall leverage (whether on-
the rule and would create a divergence and off-balance sheet transactions. The or off-balance sheet), whether
from the New Accord, without any agencies will consider a number of redemption rights attach to the equity
material improvement in risk factors in the exercise of this discretion, investor, and the ability of the junior
sensitivity. The securitization including an assessment of the tranches to absorb losses without
framework is designed specifically to investment firm’s leverage, risk profile, interrupting contractual payments to
deal with tranched exposures to credit and economic substance. This more senior tranches.
risk. Moreover, the principal risk-based supervisory exclusion is intended to One commenter asked whether a bank
capital approaches of the securitization provide discretion to a bank’s primary could ignore the credit protection
framework take into account the Federal supervisor to distinguish provided by a tranched guarantee for
effective number of underlying structured finance transactions, to risk-based capital purposes and instead
exposures. which the securitization framework was calculate the risk-based capital
The agencies agree with commenters designed to apply, from more flexible requirement for the guaranteed exposure
that the proposed definition for investment firms such as many hedge as if the guarantee did not exist. The
securitization exposures was quite funds and private equity funds. Only agencies believe that this treatment
broad and captured some exposures that investment firms that can easily change would be an appropriate application of
would more appropriately be treated the size and composition of their capital the principle of conservatism discussed
under the wholesale or equity structure, as well as the size and in section II.D. of this preamble and set
frameworks. To limit the scope of the composition of their assets and off- forth in section 1(d) of the final rule.
IRB securitization framework, the balance sheet exposures, would be As noted above, the proposed rule
agencies have modified the definition of eligible for this exclusion from the defined mortgage-backed pass-through
traditional securitization in the final definition of traditional securitization securities guaranteed by Fannie Mae or
rule to make clear that operating under this new provision. The agencies Freddie Mac (whether or not issued out
companies are not traditional do not consider managed collateralized of a structure that tranches credit risk)
securitizations (even if all or debt obligation vehicles, structured as securitization exposures. The
substantially all of their assets are investment vehicles, and similar agencies have reconsidered this
financial exposures). For purposes of structures, which allow considerable proposal and have concluded that a
the final rule’s definition of traditional management discretion regarding asset special treatment for these securities is
securitization, operating companies composition but are subject to inconsistent with the New Accord and
generally are companies that produce substantial restrictions regarding capital would violate the fundamental credit-
goods or provide services beyond the structure, to have substantially tranching-based nature of the definition
business of investing, reinvesting, unfettered control. Thus, such of securitization exposures. The final
holding, or trading in financial assets. transactions meet the final rule’s rule therefore does not define all
Examples of operating companies are definition of traditional securitization. mortgage-backed pass-through securities
depository institutions, bank holding The agencies also have added two guaranteed by Fannie Mae or Freddie
companies, securities brokers and additional exclusions to the definition Mac to be securitization exposures. As
dealers, insurance companies, and non- of traditional securitization for small a result, those mortgage-backed
bank mortgage lenders. Accordingly, an business investment companies (SBICs) securities that involve tranching of
equity investment in an operating and community development credit risk will be securitization
company, such as a bank, generally investment vehicles. As a result, a exposures; those mortgage-backed
would be an equity exposure under the bank’s equity investments in SBICs and securities that do not involve tranching
final rule; a debt investment in an community development equity of credit risk will not be securitization
operating company, such as a bank, investments generally are treated as exposures.56
generally would be a wholesale equity exposures under the final rule. A few commenters asserted that OTC
exposure under the final rule. The agencies remain concerned that derivatives with a securitization SPE as
Investment firms, which generally do the line between securitization the counterparty should be excluded
not produce goods or provide services exposures and non-securitization from the definition of securitization
beyond the business of investing, exposures may be difficult to draw in exposure and treated as wholesale
reinvesting, holding, or trading in some circumstances. In addition to the exposures. The agencies believe that the
financial assets, are not operating supervisory exclusion from the securitization framework is the most
companies for purposes of the final rule definition of traditional securitization appropriate way to assess the
and would not qualify for this general described above, the agencies have counterparty credit risk of such
exclusion from the definition of added a new component to the exposures because this risk is a tranched
traditional securitization. Examples of definition of traditional securitization to exposure to the credit risk of the
investment firms would include specifically permit a primary Federal underlying financial assets of the
companies that are exempted from the supervisor to scope certain transactions
definition of an investment company into the securitization framework if 56 Several commenters asked the agencies to
justified by the economics of the clarify whether a special purpose entity that issues
under section 3(a) of the Investment multiple classes of securities that have equal
Company Act of 1940 (15 U.S.C. 80a– transaction. Similar to the analysis for priority in the capital structure of the issuer but
3(a)) by either section 3(c)(1) (15 U.S.C. excluding an investment firm from different maturities would be considered a
80a–3(c)(1)) or section 3(c)(7) (15 U.S.C. treatment as a traditional securitization, securitization SPE. The agencies do not believe that
maturity differentials alone constitute credit risk
80a–3(c)(7)) of the Act. the agencies will consider the economic tranching for purposes of the definitions of
The final definition of a traditional substance, leverage, and risk profile of traditional securitization and synthetic
securitization also provides the primary transactions to ensure that the securitization.
securitization SPE. The agencies are The agencies are adopting the proposed operational risk is supported by current
addressing specific commenter concerns definition for equity exposures with one U.S. accounting standards for the
about the burden of applying the exception. They have eliminated in the treatment of credit risk.
securitization framework to these final rule the exclusion of a redeemable To be consistent with prevailing
exposures in preamble section V.E. ownership interest from the definition practice in the credit card industry, the
below and section 42(a)(5) of the final of equity exposure. The agencies believe proposed rule included an exception to
rule. that redeemable ownership interests, this standard for retail credit card fraud
such as those in mutual funds and losses. Specifically, retail credit card
4. Equity Exposures losses arising from non-contractual,
private equity funds, are most
The proposed rule defined an equity appropriately treated as equity third party-initiated fraud (for example,
exposure to mean: exposures. identity theft) would be treated as
(i) A security or instrument whether The agencies anticipate that, as a external fraud operational losses under
voting or non-voting that represents a general matter, each of a bank’s the proposed rule. All other third party-
direct or indirect ownership interest in, exposures will fit in one and only one initiated losses would be treated as
and a residual claim on, the assets and exposure category. One exception to this credit losses.
income of a company, unless: (A) The principle is that equity derivatives Generally, commenters urged the
issuing company is consolidated with generally will meet the definition of an agencies not to be prescriptive on risk
the bank under GAAP; (B) the bank is equity exposure (because of the bank’s boundary issues and to give banks
required to deduct the ownership exposure to the underlying equity discretion to categorize risk as they
interest from tier 1 or tier 2 capital; (C) security) and the definition of a deem appropriate, subject to
the ownership interest is redeemable; wholesale exposure (because of the supervisory review. Other commenters
(D) the ownership interest incorporates bank’s credit risk exposure to the noted that boundary issues are so
a payment or other similar obligation on counterparty). In such cases, as significant that the agencies should not
the part of the issuing company (such as discussed in more detail below, the contemplate any additional exceptions
an obligation to pay periodic interest); bank’s risk-based capital requirement to treating losses related to both credit
or (E) the ownership interest is a for the equity derivative generally is the and operational risk as credit losses
securitization exposure. sum of its risk-based capital unless the exceptions are agreed to by
(ii) A security or instrument that is requirement for the derivative the BCBS. Several commenters objected
mandatorily convertible into a security counterparty credit risk and for the to specific aspects of the agencies’
or instrument described in (i). underlying exposure. proposal and suggested that additional
(iii) An option or warrant that is types of losses related to credit risk and
exercisable for a security or instrument 5. Boundary Between Operational Risk operational risk, including losses related
described in (i). and Other Risks to check fraud, overdraft fraud, and
(iv) Any other security or instrument With the introduction of an explicit small business loan fraud, should be
(other than a securitization exposure) to risk-based capital requirement for treated as operational losses for
the extent the return on the security or operational risk, issues arise about the purposes of calculating risk-based
instrument is based on the performance proper treatment of operational losses capital requirements. One commenter
of a security or instrument described in that also could be attributed to either expressly noted its support for the
(i). For example, a short position in an credit risk or market risk. The agencies agencies’ proposal, which effectively
equity security or a total return equity recognize that these boundary issues are requires banks to treat losses on
swap would be characterized as an important and have significant HELOCs related to both credit risk and
equity exposure. implications for how banks must operational risk as credit losses for
The proposal noted that compile loss data sets and compute risk- purposes of calculating risk-based
nonconvertible term or perpetual based capital requirements under the capital requirements.
preferred stock generally would be final rule. Consistent with the treatment Because of the substantial potential
considered wholesale exposures rather in the New Accord and the proposed impact boundary issues have on risk-
than equity exposures. Financial rule, banks must treat operational losses based capital requirements under the
instruments that are convertible into an that are related to market risk as advanced approaches, there should be
equity exposure only at the option of the operational losses for purposes of consistency across U.S. banks in how
holder or issuer also generally would be calculating risk-based capital they categorize losses that relate to both
considered wholesale exposures rather requirements under this final rule. For credit risk and operational risk.
than equity exposures provided that the example, losses incurred from a failure Moreover, the agencies believe that
conversion terms do not expose the of bank personnel to properly execute a international consistency on this issue
bank to the risk of losses arising from stop loss order, from trading fraud, or is an important objective. Therefore, the
price movements in that equity from a bank selling a security when a final rule maintains the proposed
exposure. Upon conversion, the purchase was intended, must be treated boundaries for losses that relate to both
instrument would be treated as an as operational losses. credit risk and operational risk and does
equity exposure. In addition, the Under the proposed rule, banks not incorporate any additional
agencies note that unfunded equity would treat losses that are related to exemptions beyond that in the proposal.
commitments, which are commitments both operational risk and credit risk as
to make equity investments at a future credit losses for purposes of calculating 6. Boundary Between the Final Rule and
date, meet the definition of an equity risk-based capital requirements. For the Market Risk Rule
exposure. example, where a loan defaults (credit For banks subject to the market risk
Many commenters expressed support risk) and the bank discovers that the rule, the existing market risk rule
for the proposed definition of equity collateral for the loan was not properly applies to all positions classified as
exposure, except for the proposed secured (operational risk), the bank’s trading positions in regulatory reports.
exclusion of equity investments in resulting loss would be attributed to The New Accord establishes additional
hedge funds and other leveraged credit risk (not operational risk). This criteria for positions to be eligible for
investment vehicles, as discussed above. general separation between credit and application of the market risk rule. The
agencies are incorporating these exposures and exposures to or directly part of the process of assigning
additional criteria into the market risk and unconditionally guaranteed by the wholesale obligors to rating grades, a
rule through a separate rulemaking that Bank for International Settlements, the bank must identify which of its
is expected to be finalized soon and International Monetary Fund, the wholesale obligors are in default. In
published in the Federal Register. European Commission, the European addition, a bank must group its retail
Under this final rule, as under the Central Bank, and multilateral exposures within each retail
proposal, core and opt-in banks subject development banks are exempt from the subcategory into segments that have
to the market risk rule must use the 0.03 percent floor on PD discussed in homogeneous risk characteristics. 57
market risk rule for exposures that are the next section. Segmentation is the grouping of
covered positions under the market risk The proposed rule recognized as exposures within each subcategory
rule. Core and opt-in banks not subject multilateral development banks only according to the predominant risk
to the market risk rule must use this those multilateral lending institutions or characteristics of the borrower (for
final rule for all of their exposures. regional development banks in which example, credit score, debt-to-income
the U.S. government is a shareholder or ratio, and delinquency) and the
B. Risk-Weighted Assets for General contributing member. The final rule exposure (for example, product type and
Credit Risk (Wholesale Exposures, Retail adopts a slightly expanded definition of LTV ratio). In general, retail segments
Exposures, On-Balance Sheet Assets multilateral development bank. should not cross national jurisdictions.
That Are Not Defined by Exposure Specifically, under the final rule, A bank has substantial flexibility to use
Category, and Immaterial Credit multilateral development bank is the retail portfolio segmentation it
Portfolios) defined to include the International believes is most appropriate for its
Under the proposed rule, the Bank for Reconstruction and activities, subject to the following broad
wholesale and retail risk-weighted Development, the International Finance principles:
assets calculation consisted of four Corporation, the Inter-American • Differentiation of risk—
phases: (1) Categorization of exposures; Development Bank, the Asian Segmentation should provide
(2) assignment of wholesale exposures Development Bank, the African meaningful differentiation of risk.
to rating grades and segmentation of Development Bank, the European Bank Accordingly, in developing its risk
retail exposures; (3) assignment of risk for Reconstruction and Development, segmentation system, a bank should
parameters to wholesale obligors and the European Investment Bank, the consider the chosen risk drivers’ ability
exposures and segments of retail European Investment Fund, the Nordic to separate risk consistently over time
exposures; and (4) calculation of risk- Investment Bank, the Caribbean and the overall robustness of the bank’s
weighted asset amounts. The agencies Development Bank, the Islamic approach to segmentation.
did not receive any negative comments Development Bank, the Council of • Reliable risk characteristics—
on the four phases for calculating Europe Development Bank; any Segmentation should use borrower-
wholesale and retail risk-weighted multilateral lending institution or related risk characteristics and
assets and, thus, are adopting the four- regional development bank in which the exposure-related risk characteristics that
phase concept as proposed. Where U.S. government is a shareholder or reliably and consistently over time
applicable, the agencies have clarified contributing member; and any differentiate a segment’s risk from that
particular issues within the four-phase multilateral lending institution that a of other segments.
process. bank’s primary Federal supervisor • Consistency—Risk drivers for
determines poses comparable credit segmentation should be consistent with
1. Phase 1—Categorization of Exposures the predominant risk characteristics
risk.
In phase 1, a bank must determine In phase 1, a bank also must used by the bank for internal credit risk
which of its exposures fall into each of subcategorize its retail exposures as measurement and management.
the four principal IRB exposure residential mortgage exposures, QREs, • Accuracy—The segmentation
categories—wholesale exposures, retail or other retail exposures. In addition, a system should generate segments that
exposures, securitization exposures, and bank must identify any on-balance sheet separate exposures by realized
equity exposures. In addition, a bank asset that does not meet the definition performance and should be designed so
must identify within the wholesale of a wholesale, retail, securitization, or that actual long-run outcomes closely
exposure category certain exposures that equity exposure, as well as any non- approximate the retail risk parameters
receive a special treatment under the material portfolio of exposures to which estimated by the bank.
wholesale framework. These exposures it chooses, subject to supervisory A bank might choose to segment
include HVCRE exposures, sovereign review, not to apply the IRB risk-based exposures by common risk drivers that
exposures, eligible purchased wholesale capital formulas. are relevant and material in determining
exposures, eligible margin loans, repo- the loss characteristics of a particular
style transactions, OTC derivative 2. Phase 2—Assignment of Wholesale retail product. For example, a bank may
contracts, unsettled transactions, and Obligors and Exposures to Rating segment mortgage loans by LTV band,
eligible guarantees and eligible credit Grades and Retail Exposures to age from origination, geography,
derivatives that are used as credit risk Segments origination channel, and credit score.
mitigants. In phase 2, a bank must assign each Statistical modeling, expert judgment,
The treatment of HVCRE exposures wholesale obligor to a single rating or some combination of the two may
and eligible purchased wholesale grade (for purposes of assigning an determine the most relevant risk drivers.
receivables is discussed below in this estimated PD) and may assign each Alternatively, a bank might segment by
section. The treatment of eligible margin wholesale exposure to loss severity grouping exposures with similar loss
characteristics, such as loss rates or
loans, repo-style transactions, OTC rating grades (for purposes of assigning

derivative contracts, and eligible an estimated LGD). A bank that elects
57 If the bank determines the EAD for eligible
guarantees and eligible credit not to use a loss severity rating grade
margin loans using the approach in section 32(b) of
derivatives that are credit risk mitigants system for a wholesale exposure must the rule, it must segment retail eligible margin loans
is discussed in section V.C. of the directly assign an estimated LGD to the for which the bank uses this approach separately
preamble. In addition, sovereign wholesale exposure in phase 3. As a from other retail exposures.
default rates, as determined by margin loan portfolio using only Purchased Wholesale Exposures
historical performance of segments with product-specific risk drivers, such as A bank may also elect to use a top-
similar risk characteristics. product type and origination channel. A down approach, similar to the treatment
A bank must segment defaulted retail bank could then use the definition of of retail exposures, for eligible
exposures separately from non- default to associate a PD and LGD with purchased wholesale exposures. Under
defaulted retail exposures and should each segment. As described in section the final rule, as under the proposal,
base the segmentation of defaulted retail 32 of the rule, a bank may adjust the this approach may be used for
exposures on characteristics that are EAD of eligible margin loans to reflect exposures purchased directly by the
most predictive of current loss and the risk-mitigating effect of financial
bank. In addition, the final rule clarifies
recovery rates. This segmentation collateral. If a bank elects this option to
that this approach also may be used for
should provide meaningful adjust the EAD of eligible margin loans,
differentiation so that individual exposures purchased by a securitization
it must associate an LGD with the
exposures within each defaulted SPE in which the bank has invested and
segment that does not reflect the
segment do not have material for which the bank calculates the capital
presence of collateral.
differences in their expected loss Under the proposal, if a bank was not requirement on the underlying
severity. able to estimate PD and LGD for an exposures (KIRB) for purposes of the
Banks commonly obtain tranched eligible margin loan, the bank could SFA (as defined in section V.E.4. of the
credit protection, for example first-loss apply a 300 percent risk weight to the preamble). Under this approach, in
or second-loss guarantees, on certain EAD of the loan. Commenters generally phase 2, a bank would group its eligible
retail exposures such as residential objected to this approach. As discussed purchased wholesale exposures into
mortgages. The proposal recognized that in section III.B.3. of the preamble, segments that have homogeneous risk
the securitization framework, which several commenters asserted that the characteristics. To be an eligible
applies to tranched wholesale agencies should permit banks to treat purchased wholesale exposure, several
exposures, is not appropriate for margin loans and other portfolios that criteria must be met:
individual retail exposures. Therefore, exhibit low loss frequency or for which • The purchased wholesale exposure
the agencies proposed to exclude a bank has limited data on a portfolio must be purchased from an unaffiliated
tranched guarantees that apply only to basis, by apportioning EL between PD seller and must not have been directly
an individual retail exposure from the and LGD for portfolios rather than or indirectly originated by the
securitization framework. The preamble estimating each risk parameter purchasing bank or securitization SPE;
to the proposal noted that an important separately. Other commenters suggested • The purchased wholesale exposure
result of this exclusion is that, in that banks should be expected to must be generated on an arm’s-length
contrast to the treatment of wholesale develop sound practices for applying basis between the seller and the obligor
exposures, a bank may recognize the IRB approach to such exposures and (intercompany accounts receivable and
recoveries from both a borrower and a adopt an appropriate degree of receivables subject to contra-accounts
guarantor for purposes of estimating conservatism to address the level of between firms that buy and sell to each
LGD for certain retail exposures. uncertainty in the estimation process. other would not satisfy this criterion);
Most commenters who addressed the Several commenters added that if a bank • The purchasing bank must have a
agencies’ proposed treatment for simply is unable to estimate PD and claim on all proceeds from the exposure
tranched retail guarantees supported the LGD for eligible margin loans, they or a pro rata interest in the proceeds;
proposed approach. One commenter would support the agencies’ proposal to • The purchased wholesale exposure
urged the agencies to extend the apply a flat risk weight to the EAD of must have an effective remaining
treatment of tranched guarantees of eligible margin loans. However, they maturity of less than one year; and
retail exposures to wholesale exposures. asserted that the risk weight should not • The purchased wholesale exposure
Another commenter asserted that the exceed 100 percent given the low levels must, when consolidated by obligor, not
proposed treatment was inconsistent of loss associated with these types of represent a concentrated exposure
with the New Accord. exposures. relative to the portfolio of purchased
The agencies have determined that As discussed in section III.B.3. of the wholesale exposures.
while the securitization framework is preamble, the final rule provides Wholesale Lease Residuals
the most appropriate risk-based capital flexibility and incentives for banks to
treatment for most tranched guarantees, develop and document sound practices The agencies proposed a treatment for
the regulatory burden associated with for applying the IRB approach to wholesale lease residuals that differs
applying it to tranched guarantees of portfolios with limited data or default from the New Accord. A wholesale lease
individual retail exposures exceeds the history, which may include eligible residual typically exposes a bank to the
supervisory benefit. The agencies are margin loans. However, the agencies risk of a decline in value of the leased
therefore adopting the proposed believe that for banks facing particular asset and to the credit risk of the lessee.
treatment in the final rule and excluding challenges with respect to estimating PD Although the New Accord provides for
tranched guarantees of individual retail and LGD for eligible margin loans, the a flat 100 percent risk weight for
exposures from the securitization proposed application of a 300 percent wholesale lease residuals, the preamble
framework. risk weight to the EAD of an eligible to the proposal noted that the agencies
Some banks expressed concern about margin loan is a reasonable alternative. believed this treatment was excessively
the treatment of eligible margin loans The option balances pragmatism with punitive for leases to highly
under the New Accord. Due to the the provision of appropriate incentives creditworthy lessees. Accordingly, the
highly collateralized nature and low for banks to develop processes to apply proposed rule required a bank to treat
loss frequency of margin loans, banks the IRB approach to such exposures. its net investment in a wholesale lease
typically collect little customer-specific Accordingly, the final rule continues to as a single exposure to the lessee. As
information that they could use to provide banks with the option of proposed, there would not be a separate
differentiate margin loans into applying a 300 percent risk weight to capital calculation for the wholesale
segments. The agencies believe that a the EAD of an eligible margin loan for lease residual. Commenters on this issue
bank could appropriately segment its which it cannot estimate PD and LGD. broadly supported the agencies’
proposed approach. The agencies the reference data, borrower and loan data sets or estimation methods are
believe the proposed approach characteristics related to the risk used, the bank must adopt a means of
appropriately reflects current bank risk parameters (such as loan terms, LTV combining the various estimates at this
management practice and are adopting ratio, credit score, income, debt-to- stage.
the proposed approach in the final rule. income ratio, or performance history), or The final rule, as noted above, permits
Commenters also requested this other factors that are related in some a bank to elect to segment its eligible
treatment for retail lease residuals. way to the risk parameters. Banks may purchased wholesale exposures like
However, the agencies have determined use more than one reference data set to retail exposures. A bank that chooses to
that the proposal to apply a flat 100 improve the robustness or accuracy of apply this treatment must directly
percent risk weight for retail lease the parameter estimates. assign a PD, LGD, EAD, and M to each
residuals, consistent with the New A bank should then apply statistical such segment. If a bank can estimate
Accord, appropriately balances risk techniques to the reference data to ECL (but not PD or LGD) for a segment
sensitivity and complexity and are determine a relationship between risk of eligible purchased wholesale
maintaining this treatment in the final characteristics and the estimated risk exposures, the bank must assume that
rule. parameter. The result of this step is a the LGD of the segment equals 100
model that ties descriptive percent and that the PD of the segment
3. Phase 3—Assignment of Risk
characteristics to the risk parameter equals ECL divided by EAD. The bank
Parameters to Wholesale Obligors and
estimates. In this context, the term must estimate ECL for the eligible
Exposures and Retail Segments
‘‘model’’ is used in the most general purchased wholesale exposures without
In phase 3, a bank associates a PD sense; a model may use simple regard to any assumption of recourse or
with each wholesale obligor rating concepts, such as the calculation of guarantees from the seller or other
grade; associates an LGD with each averages, or more complex ones, such as parties. The bank must then use the
wholesale loss severity rating grade or an approach based on rigorous wholesale exposure formula in section
assigns an LGD to each wholesale regression techniques. This step may 31(e) of the final rule to determine the
exposure; assigns an EAD and M to each include adjustments for differences risk-based capital requirement for each
wholesale exposure; and assigns a PD, between this final rule’s definition of segment of eligible purchased wholesale
LGD, and EAD to each segment of retail default and the default definition in the exposures.
exposures. In some cases it may be reference data set, or adjustments for A bank may recognize the credit risk
reasonable to assign the same PD, LGD, data limitations. This step includes mitigation benefits of collateral that
or EAD to multiple segments of retail adjustments for seasoning effects related secures a wholesale exposure by
exposures. The quantification phase for to retail exposures, if material. adjusting its estimate of the LGD of the
PD, LGD, and EAD can generally be A bank may use more than one exposure and may recognize the credit
divided into four steps—obtaining estimation technique to generate risk mitigation benefits of collateral that
historical reference data, estimating the estimates of the risk parameters, secures retail exposures by adjusting its
risk parameters for the reference data, especially if there are multiple sets of estimate of the PD and LGD of the
mapping the historical reference data to reference data or multiple sample segment of retail exposures. In certain
the bank’s current exposures, and periods. If multiple estimates are cases, however, a bank may take
determining the risk parameters for the generated, the bank should have a clear financial collateral into account in
bank’s current exposures. As discussed and consistent policy on reconciling estimating the EAD of repo-style
in more detail below, quantification of and combining the different estimates. transactions, eligible margin loans, and
M is accomplished through direct Once a bank estimates PD, LGD, and OTC derivative contracts (as provided in
computation based on the contractual EAD for its reference data sets, it should section 32 of the final rule).
characteristics of the exposure. create a link between its portfolio data Consistent with the proposed rule, the
A bank should base its estimation of and the reference data based on final rule also provides that a bank may
the values assigned to PD, LGD, and corresponding characteristics. Variables use an EAD of zero for (i) derivative
EAD 58 on historical reference data that or characteristics that are available for contracts that are publicly traded on an
are a reasonable proxy for the bank’s the existing portfolio should be mapped exchange that requires the daily receipt
current exposures and that provide or linked to the variables used in the and payment of cash-variation margin;
meaningful predictions of the default, loss-severity, or exposure (ii) derivative contracts and repo-style
performance of such exposures. A amount model. In order to effectively transactions that are outstanding with a
‘‘reference data set’’ consists of a set of map the data, reference data qualifying central counterparty (defined
exposures to defaulted wholesale characteristics need to allow for the below), but not for those transactions
obligors and defaulted retail exposures construction of rating and segmentation that the qualifying central counterparty
(in the case of LGD and EAD estimation) criteria that are consistent with those has rejected; and (iii) credit risk
or to both defaulted and non-defaulted used on the bank’s portfolio. An exposures to a qualifying central
wholesale obligors and retail exposures important element of mapping is counterparty that arise from derivative
(in the case of PD estimation). making adjustments for differences contracts and repo-style transactions in
The reference data set should be between reference data sets and the the form of clearing deposits and posted
described using a set of observed bank’s exposures. collateral. The final rule, like the
characteristics. Relevant characteristics Finally, a bank must apply the risk proposed rule, defines a qualifying
might include debt ratings, financial parameters estimated for the reference central counterparty as a counterparty
measures, geographic regions, the data to the bank’s actual portfolio data. (for example, a clearing house) that: (i)
economic environment and industry/ As noted above, the bank must attribute Facilitates trades between
sector trends during the time period of
a PD to each wholesale obligor risk counterparties in one or more financial

grade, an LGD to each wholesale loss markets by either guaranteeing trades or
58 EAD for repo-style transactions and eligible
severity grade or wholesale exposure, an novating contracts; (ii) requires all
margin loans may be calculated as described in
section 32 of the final rule. EAD for OTC derivatives
EAD and M to each wholesale exposure, participants in its arrangements to be
must be calculated as described in section 32 of the and a PD, LGD, and EAD to each fully collateralized on a daily basis; and
final rule. segment of retail exposures. If multiple (iii) the bank demonstrates to the
satisfaction of its primary Federal directly and unconditionally guaranteed remaining maturity (measured in whole
supervisor is in sound financial by the full faith and credit of a sovereign or fractional years) of the exposure. The
condition and is subject to effective entity) could not be less than 10 M for repo-style transactions, eligible
oversight by a national supervisory percent. These supervisory floors on PD margin loans, and OTC derivative
authority. and LGD applied regardless of whether contracts subject to a qualifying master
Some repo-style transactions and OTC the bank recognized an eligible netting agreement was the weighted-
derivative contracts giving rise to guarantee or eligible credit derivative as average remaining maturity (measured
counterparty credit risk may result, from provided in sections 33 and 34 of the in whole or fractional years) of the
an accounting point of view, in both on- proposed rule. individual transactions subject to the
and off-balance sheet exposures. A bank Commenters did not object to the
qualifying master netting agreement,
that uses an EAD approach to measure floor on PD, and the agencies are
the exposure amount of such including it in the final rule. A number with the weight of each individual
transactions is not required to apply of commenters, however, objected to the transaction set equal to the notional
separately a risk-based capital 10 percent floor on LGD for segments of amount of the transaction. The M for
requirement to an on-balance sheet residential mortgage exposures. These netting sets for which the bank used the
receivable from the counterparty commenters asserted that the floor internal models methodology was
recorded in connection with that would penalize low-risk mortgage calculated as described in section 32(c)
transaction. Because any exposure lending and would provide a of the proposed rule.
arising from the on-balance sheet disincentive for obtaining high-quality Many commenters requested more
receivable is captured in the risk-based collateral. The agencies continue to flexibility in the definition of M,
capital requirement determined under believe that the LGD floor is appropriate including the ability to estimate
the EAD approach, a separate capital at least until banks and the agencies noncontractually required prepayments
requirement would double count the gain more experience with the advanced and the ability to use either discounted
exposure for regulatory capital approaches. Accordingly, the agencies
or undiscounted cash flows. However,
purposes. are maintaining the floor in the final
A bank may take into account the risk the agencies believe that the proposed
rule. As the agencies gain more
reducing effects of eligible guarantees experience with the advanced definition of M, which is consistent
and eligible credit derivatives in approaches they will reconsider the with the New Accord, is appropriately
support of a wholesale exposure by need for the floor together with other conservative and provides for a
applying the PD substitution approach calibration issues identified during the consistent definition of M across
or the LGD adjustment approach to the parallel run and transitional floor internationally active banks. The final
exposure as provided in section 33 of periods. The agencies also intend to rule therefore maintains the proposed
the final rule or, if applicable, applying address this issue and other calibration definition of M.
the double default treatment to the issues with the BCBS and other Under the final rule, as under the
exposure as provided in section 34 of supervisory and regulatory authorities, proposal, for most exposures M may be
the final rule. A bank may decide as appropriate. no greater than five years and no less
separately for each wholesale exposure The 10 percent LGD floor for than one year. For exposures that have
that qualifies for the double default residential mortgage exposures applies
an original maturity of less than one
treatment whether to apply the PD at the segment level. The agencies will
year and are not part of a bank’s ongoing
substitution approach, the LGD not allow a bank to artificially group
adjustment approach, or the double exposures into segments to avoid the financing of the obligor, however, a
default treatment. A bank may take into LGD floor for mortgage products. A bank bank may set M as low as one day,
account the risk-reducing effects of should use consistent risk drivers to consistent with the New Accord. An
guarantees and credit derivatives in determine its retail exposure exposure is not part of a bank’s ongoing
support of retail exposures in a segment segmentations and not artificially financing of the obligor if the bank (i)
when quantifying the PD and LGD of the segment low LGD loans with higher has a legal and practical ability not to
segment. LGD loans to avoid the floor. renew or roll over the exposure in the
The proposed rule imposed several A bank also must calculate M for each event of credit deterioration of the
supervisory limitations on risk wholesale exposure. Under the obligor; (ii) makes an independent
parameters assigned to wholesale proposed rule, for wholesale exposures credit decision at the inception of the
obligors and exposures and segments of other than repo-style transactions, exposure and at every renewal or
retail exposures. First, the PD for each eligible margin loans, and OTC rollover; and (iii) has no substantial
wholesale obligor or segment of retail derivative contracts subject to a commercial incentive to continue its
exposures could not be less than 0.03 qualifying master netting agreement credit relationship with the obligor in
percent, except for exposures to or (defined in section V.C.2. of this the event of credit deterioration of the
directly and unconditionally guaranteed preamble), M was defined as the obligor. Examples of transactions that
by a sovereign entity, the Bank for weighted-average remaining maturity
may qualify for the exemption from the
International Settlements, the (measured in whole or fractional years)
one-year maturity floor include amounts
International Monetary Fund, the of the expected contractual cash flows
from the exposure, using the due from other banks, including
European Commission, the European
undiscounted amounts of the cash flows deposits in other banks; bankers’’
Central Bank, or a multilateral
development bank, to which the bank as weights. A bank could use its best acceptances; sovereign exposures; short-
assigns a rating grade associated with a estimate of future interest rates to term self-liquidating trade finance
exposures; repo-style transactions;
PD of less than 0.03 percent. compute expected contractual interest

Second, the LGD of a segment of payments on a floating-rate exposure, eligible margin loans; unsettled trades
residential mortgage exposures (other but it could not consider expected but and other exposures resulting from
than segments of residential mortgage noncontractually required returns of payment and settlement processes; and
exposures for which all or substantially principal, when estimating M. A bank collateralized OTC derivative contracts
all of the principal of the exposures is could, at its option, use the nominal subject to daily remargining.
4. Phase 4—Calculation of Risk- treatment in section 34 of the final rule, capital requirement formula. Eligible
Weighted Assets a bank makes this calculation by guarantees and eligible credit
inserting the risk parameters for the derivatives that are hedges of a
After a bank assigns risk parameters to wholesale obligor and exposure or retail wholesale exposure are reflected in the
each of its wholesale obligors and segment into the appropriate IRB risk- risk-weighted assets amount of the
exposures and retail segments, the bank based capital formula specified in Table hedged exposure (i) through
must calculate the dollar risk-based B, and multiplying the output of the adjustments made to the risk parameters
capital requirement for each wholesale of the hedged exposure under the PD
formula (K) by the EAD of the exposure
exposure to a non-defaulted obligor and substitution or LGD adjustment
or segment.59 Section 34 contains a
each segment of non-defaulted retail approach in section 33 of the final rule
separate double default risk-based
exposures (except eligible guarantees or (ii) through a separate double default
and eligible credit derivatives that 59 Alternatively, as noted above, a bank may risk-based capital requirement formula
hedge another wholesale exposure). apply a 300 percent risk weight to the EAD of an in section 34 of the final rule.
Other than for exposures to which the eligible margin loan if the bank is not able to assign BILLING CODE 4810–33–P; 6210–01–P; 6714–01–P;
bank applies the double default a rating grade to the obligor of the loan. 6720–01–P
The sum of the dollar risk-based Under the proposed rule, to compute exposure became defaulted. If the
capital requirements for wholesale the risk-weighted asset amount for a amount calculated in (i) were equal to
exposures to non-defaulted obligors wholesale exposure to a defaulted or greater than the amount calculated in
(including exposures subject to the obligor, a bank would first have to (ii), the dollar risk-based capital
double default treatment described compare two amounts: (i) The sum of requirement for the exposure would be
below) and segments of non-defaulted 0.08 multiplied by the EAD of the 0.08 multiplied by the EAD of the
retail exposures equals the total dollar wholesale exposure plus the amount of exposure. If the amount calculated in (i)
risk-based capital requirement for those any charge-offs or write-downs on the were less than the amount calculated in
exposures and segments. The total exposure; and (ii) K for the wholesale (ii), the dollar risk-based capital
dollar risk-based capital requirement exposure (as determined in Table B requirement for the exposure would be
multiplied by 12.5 equals the risk- immediately before the obligor became K for the exposure (as determined in
weighted asset amount. defaulted), multiplied by the EAD of the Table B immediately before the obligor
ER07DE07.001</GPH>
exposure immediately before the became defaulted), multiplied by the
EAD of the exposure. The reason for this supervisor’s satisfaction is, when multifamily residential loans that meet
comparison was to ensure that a bank combined with all other portfolios of specific statutory criteria in the RTCRRI
did not receive a regulatory capital exposures that the bank seeks to treat as Act and any other underwriting criteria
benefit as a result of the exposure immaterial for risk-based capital imposed by the agencies; and (ii) a 100
moving from non-defaulted to defaulted purposes, not material to the bank percent risk weight for one-to four-
status. generally is its carrying value (for on- family residential pre-sold construction
The proposed rule provided a simpler balance sheet exposures) or notional loans for residences for which the
approach for segments of defaulted amount (for off-balance sheet purchase contract is cancelled.62
retail exposures. The dollar risk-based exposures). For this purpose, the When Congress enacted the RTCRRI
capital requirement for a segment of notional amount of an OTC derivative Act in 1991, the agencies’ risk-based
defaulted retail exposures was 0.08 contract that is not a credit derivative is capital rules reflected the Basel I
multiplied by the EAD of the segment. the EAD of the derivative as calculated framework. Consequently, the risk
Some commenters objected to the in section 32 of the final rule. If an OTC weight treatment for certain categories
proposed risk-based capital treatment of derivative contract is a credit derivative, of mortgage loans in the RTCRRI Act
defaulted wholesale exposures, which the notional amount is the notional assumes a risk weight bucketing
differs from the approach in the New amount of the credit derivative. approach, instead of the more risk-
Accord. These commenters contended Total wholesale and retail risk- sensitive IRB approach in the advanced
that it would be burdensome to track the weighted assets are defined as the sum approaches.
pre-default risk-based capital of risk-weighted assets for wholesale In the proposed rule, the agencies
requirements for purposes of the exposures to non-defaulted obligors and identified three types of residential
proposed comparison. These segments of non-defaulted retail mortgage loans addressed by the
commenters also claimed that the cost exposures, wholesale exposures to RTCRRI Act that would continue to
and burden of the proposed treatment of defaulted obligors and segments of receive the risk weights provided in the
defaulted wholesale exposures would defaulted retail exposures, assets not Act. Consistent with the general risk-
subject banks to a competitive included in an exposure category, non- based capital rules, the proposed rule
disadvantage relative to international material portfolios of exposures (as would apply the following risk weights
counterparts subject to an approach calculated under section 31 of the final (instead of the risk weights that would
similar to that in the New Accord. rule), and unsettled transactions (as otherwise be produced under the IRB
In view of commenters’ concerns calculated under section 35 of the final risk-based capital formulas): (i) A 50
about cost and regulatory burden, the rule and described in section V.D. of the percent risk weight for one-to four-
final rule treats defaulted wholesale preamble) minus the amounts deducted family residential construction loans if
exposures the same as defaulted retail from capital pursuant to the general the residences have been pre-sold under
exposures. The dollar risk-based capital risk-based capital rules (excluding those firm contracts to purchasers who have
requirement of a wholesale exposure to deductions reversed in section 12 of the obtained firm commitments for
a defaulted obligor equals 0.08 final rule). permanent qualifying mortgages and
multiplied by the EAD of the exposure. have made substantial earnest money
The agencies will review banks’ 5. Statutory Provisions on the deposits, and the loans meet the other
practices to ensure that banks are not Regulatory Capital Treatment of Certain underwriting characteristics established
moving exposures from non-defaulted to Mortgage Loans by the agencies in the general risk-based
defaulted status for the primary purpose The general risk-based capital rules capital rules; 63 (ii) a 50 percent risk
of obtaining a reduction in risk-based assign 50 percent and 100 percent risk weight for multifamily residential loans
capital requirements. weights to certain one-to four-family that meet certain statutory loan-to-value,
To convert the dollar risk-based residential pre-sold construction loans debt-to-income, amortization, and
capital requirements for defaulted and multifamily residential loans.60 The performance requirements, and meet the
exposures into a risk-weighted asset agencies adopted these provisions as a other underwriting characteristics
amount, the bank must sum the dollar result of the Resolution Trust established by the agencies in the
risk-based capital requirements for all Corporation Refinancing, Restructuring, general risk-based capital rules; 64 and
wholesale exposures to defaulted and Improvement Act of 1991 (RTCRRI (iii) a 100 percent risk weight for one-
obligors and segments of defaulted retail Act).61 The RTCRRI Act mandates that to four-family residential pre-sold
exposures and multiply the sum by each agency provide in its capital construction loans for a residence for
12.5. regulations (i) A 50 percent risk weight which the purchase contract is
A bank may assign a risk-weighted for certain one-to four-family residential cancelled.65 Under the proposal,
asset amount of zero to cash owned and pre-sold construction loans and mortgage loans that did not meet the
held in all offices of the bank or in relevant criteria would not qualify for
transit, and for gold bullion held in the 60 See 12 CFR part 3, Appendix A, section
the statutory risk weights and would be
bank’s own vaults or held in another 3(a)(3)(iii) (national banks); 12 CFR part 208, risk-weighted according to the IRB risk-
bank’s vaults on an allocated basis, to Appendix A, section III.C.3. (state member banks);
based capital formulas.
the extent the gold bullion assets are 12 CFR part 225, Appendix A, section III.C.3. (bank
holding companies); 12 CFR part 325, Appendix A, Commenters generally opposed the
offset by gold bullion liabilities. The section II.C. (state nonmember banks); 12 CFR proposed assignment of a 50 percent
risk-weighted asset amount for an on- 567.6(a)(1)(iii) and (iv) (savings associations). risk weight to multifamily and pre-sold
balance sheet asset that does not meet 61 See §§ 618(a) and (b) of the RTCRRI Act, Pub.
single family residential construction
the definition of a wholesale, retail, L. 102–233. The first class includes loans for the
construction of a residence consisting of 1-to-4 exposures. Commenters maintained that
securitization, or equity exposure—for family dwelling units that have been pre-sold under the RTCRRI Act capital requirements do
example, property, plant, and firm contracts to purchasers who have obtained not align with risk, are contrary to the
equipment and mortgage servicing firm commitments for permanent qualifying
rights—is its carrying value. The risk- mortgages and have made substantial earnest 62 See
money deposits. The second class includes loans §§ 618(a) and (b) of the RTCRRI Act.
weighted asset amount for a portfolio of that are secured by a first lien on a residence
63 See § 618(a)(1)((B) of the RTCRRI Act.
exposures that the bank has consisting of more than 4 dwelling units if the loan 64 See § 618(b)(1)(B) of the RTCRRI Act.
demonstrated to its primary Federal meets certain criteria outlined in the RTCRRI Act. 65 See § 618(a)(2) of the RTCRRI Act.
intent of the New Accord and to its underwriting characteristics established 100 percent risk weight for single-family
implementation in other jurisdictions, by the agencies. The agencies have residential construction loans for which
and would impose additional concluded that the additional the purchase contract is cancelled.
compliance burdens on banks without underwriting characteristics imposed in
C. Credit Risk Mitigation (CRM)
any associated benefit. the final rule are ‘‘consistent with the
The agencies agree with these Techniques
purposes of the minimum acceptable
concerns and have decided to adopt in capital requirements to maintain the Banks use a number of techniques to
the final rule an alternative described in safety and soundness of financial mitigate credit risk. This section of the
the preamble to the proposed rule. The institution,’’ because the criteria will preamble describes how the final rule
proposed rule’s preamble noted the make the risk-based capital requirement recognizes the risk-mitigating effects of
tension between the statutory risk for these loans a function of each bank’s both financial collateral (defined below)
weights provided by the RTCRRI Act historical loss experience for the loans and nonfinancial collateral, as well as
and the more risk-sensitive IRB and will therefore more accurately guarantees and credit derivatives, for
approaches to risk-based capital reflect the performance and risk of loss risk-based capital purposes. To
requirements. The preamble observed for these loans. The additional recognize credit risk mitigants for risk-
that the RTCRRI Act permits the underwriting characteristics are also based capital purposes, a bank should
agencies to prescribe additional consistent with the purposes and have in place operational procedures
underwriting characteristics for legislative history of RTCRRI Act, which and risk management processes that
identifying loans that are subject to the was designed to reflect the true level of ensure that all documentation used in
50 percent statutory risk weights, risk associated with these types of collateralizing or guaranteeing a
provided these underwriting mortgage loans and to do so in transaction is legal, valid, binding, and
characteristics are ‘‘consistent with the accordance with the Basel Accord.66 enforceable under applicable law in the
purposes of the minimum acceptable A capital-related provision of the relevant jurisdictions. The bank should
capital requirements to maintain the Federal Deposit Insurance Corporation have conducted sufficient legal review
safety and soundness of financial Improvement Act of 1991 (‘‘FDICIA’’), to reach a well-founded conclusion that
institutions.’’ The agencies asked enacted by Congress just four days after the documentation meets this standard
whether they should impose the its adoption of the RTCRRI Act, also and should reconduct such a review as
following additional underwriting supports the addition of the new necessary to ensure continuing
criteria as additional requirements for a underwriting characteristics. Section enforceability.
core or opt-in bank to qualify for the 305(b)(1)(B) of FDICIA 67 directs each Although the use of CRM techniques
statutory 50 percent risk weight for a agency to revise its risk-based capital may reduce or transfer credit risk, it
particular mortgage loan: (i) That the standards for insured depository simultaneously may increase other
bank has an IRB risk measurement and institutions to ensure that those risks, including operational, liquidity,
management system in place that standards ‘‘reflect the actual and market risks. Accordingly, it is
assesses the PD and LGD of prospective performance and expected risk of loss of imperative that banks employ robust
residential mortgage exposures; and (ii) multifamily mortgages.’’ Although this procedures and processes to control
that the bank’s IRB system generates a addresses only multifamily mortgage risks, including roll-off risk and
50 percent risk weight for the loan loans (and not one-to four-family concentration of risks, arising from the
under the IRB risk-based capital residential pre-sold construction loans), bank’s use of CRM techniques and to
formula. If the bank’s IRB system does monitor the implications of using CRM
it provides the agencies with a
not generate a 50 percent risk weight for techniques for the bank’s overall credit
Congressional mandate—equal in force
a particular loan, the loan would not risk profile.
and power to section 618 of the RTCRRI
qualify for the statutory risk weight and
Act—to enhance the risk sensitivity of 1. Collateral
would receive the risk weight generated
the regulatory capital treatment of Under the final rule, a bank generally
by the IRB system.
A few commenters opposed this multifamily mortgage loans. Crucially, recognizes collateral that secures a
alternative approach and indicated that the IRB approach required of core and wholesale exposure as part of the LGD
the additional underwriting criteria opt-in banks will produce capital estimation process and generally
would increase operational burden. requirements that more accurately recognizes collateral that secures a retail
Other commenters, however, observed reflect both performance and risk of loss exposure as part of the PD and LGD
that compliance with the additional for multifamily mortgage loans than estimation process, as described above
underwriting criteria would not be either the Basel I risk weight or the in section V.B.3. of the preamble.
burdensome. RTCRRI Act risk weight. However, in certain limited
After careful consideration of the As noted above, section 618(a)(2) of circumstances described in the next
comments and further analysis of the the RTCRRI Act mandates that each section, a bank may adjust EAD to
text, spirit and legislative history of the agency amend its capital regulations to reflect the risk mitigating effect of
RTCRRI Act, the agencies have provide a 100 percent risk weight to any financial collateral.
concluded that they should impose the single-family residential construction Although the final rule does not
additional underwriting criteria loan for which the purchase contract is contain specific regulatory requirements
described in the preamble to the cancelled. Because the statute does not about how a bank incorporates collateral
proposed rule as minimum authorize the agencies to establish into PD or LGD estimates, a bank
requirements for a core or opt-in bank additional underwriting characteristics should, when reflecting the credit risk
to use the statutory 50 percent risk for this small category of loans, the final mitigation benefits of collateral in its
rule, like the proposed rule, provides a
weight for particular loans. The agencies estimation of the risk parameters of a
believe that the imposition of these wholesale or retail exposure:
66 See, e.g., Floor debate for the Resolution Trust
criteria is consistent with the plain (i) Conduct sufficient legal review to
Corporation Refinancing, Restructuring, and
language of the RTCRRI Act, which Improvement Act of 1991, p. H11853, House of ensure, at inception and on an ongoing
allows a bank to use the 50 percent risk Representatives, Nov. 26, 1991 (Rep. Wylie) basis, that all documentation used in the
weight only if it meets the additional 67 12 U.S.C. 1828. collateralized transaction is binding on
all parties and legally enforceable in all deterioration of the collateral), and (B) market risk rule. In response to
relevant jurisdictions; where applicable, periodically verifying comments requesting broader
(ii) Consider the correlation between the collateral (for example, through application of the EAD-based
obligor risk and collateral risk in the physical inspection of collateral such as methodologies for recognizing the risk-
transaction; inventory and equipment); and mitigating effect of collateral, the
(iii) Consider any currency and/or (v) The bank has in place systems for agencies added this flexibility to the
maturity mismatch between the hedged promptly requesting and receiving final rule to enhance international
exposure and the collateral; additional collateral for transactions consistency and reduce regulatory
(iv) Ground its risk parameter whose terms require maintenance of burden.
estimates for the transaction in collateral values at specified thresholds. A bank may use any combination of
historical data, using historical recovery the three methodologies for collateral
2. Counterparty Credit Risk of Repo-
rates where available; and recognition; however, it must use the
(v) Fully take into account the time Style Transactions, Eligible Margin
Loans, and OTC Derivative Contracts same methodology for similar
and cost needed to realize the
This section describes two EAD-based exposures. This means that, as a general
liquidation proceeds and the potential
methodologies—a collateral haircut matter, the agencies expect a bank to use
for a decline in collateral value over this
approach and an internal models one of the three methodologies for all its
time period.
methodology—that a bank may use repo-style transactions, one of the three
The bank also should ensure that:
(i) The legal mechanism under which instead of an LGD estimation methodologies for all its eligible margin
the collateral is pledged or transferred methodology to recognize the benefits of loans, and one of the three
ensures that the bank has the right to financial collateral in mitigating the methodologies for all its OTC derivative
liquidate or take legal possession of the counterparty credit risk associated with contracts. A bank may, however, apply
collateral in a timely manner in the repo-style transactions, eligible margin a different methodology to subsets of
event of the default, insolvency, or loans, collateralized OTC derivative repo-style transactions, eligible margin
bankruptcy (or other defined credit contracts, and single product groups of loans, or OTC derivatives by product
event) of the obligor and, where such transactions with a single type or geographical location if its
applicable, the custodian holding the counterparty subject to a qualifying application of different methodologies is
collateral; master netting agreement (netting designed to separate transactions that do
(ii) The bank has taken all steps sets).68 A third methodology, the simple not have similar risk profiles and is not
necessary to fulfill legal requirements to VaR methodology, is also available to designed to arbitrage the rule. For
secure its interest in the collateral so recognize financial collateral mitigating example, a bank may choose to use one
that it has and maintains an enforceable the counterparty credit risk of single methodology for agency securities
security interest; product netting sets of repo-style lending transactions—that is, repo-style
(iii) The bank has clear and robust transactions and eligible margin loans. transactions in which the bank, acting
procedures to ensure observation of any These methodologies are substantially as agent for a customer, lends the
legal conditions required for declaring the same as those in the proposal, customer’s securities and indemnifies
the default of the borrower and prompt except for a few differences identified the customer against loss—and another
liquidation of the collateral in the event below. methodology for all other repo-style
of default; One difference from the proposal is transactions.
(iv) The bank has established that, consistent with the New Accord, This section also describes the
procedures and practices for (A) under the final rule these three methodology for calculating EAD for an
conservatively estimating, on a regular methodologies may also be used to OTC derivative contract or set of OTC
ongoing basis, the market value of the recognize the benefits of any collateral derivative contracts subject to a
collateral, taking into account factors (not only financial collateral) mitigating qualifying master netting agreement.
that could affect that value (for example, the counterparty credit risk of repo-style Table C illustrates which EAD
the liquidity of the market for the transactions that are included in a estimation methodologies may be
collateral and obsolescence or bank’s VaR-based measure under the applied to particular types of exposure.
TABLE C
Models approach
Current expo- Collateral hair-
sure method- Internal mod-
cut approach Simple VaR 69
ology els method-
methodology ology
OTC derivative ................................................................................................. X ........................ ........................ X

Recognition of collateral for OTC derivatives .................................................. ........................ 70 X ........................ X
Repo-style transaction ..................................................................................... ........................ X X X
Eligible margin loan ......................................................................................... ........................ X X X
Cross-product netting set ................................................................................ ........................ ........................ ........................ X
68 For purposes of the internal models counterparty that are subject to a qualifying cross- master netting agreement are eligible for the simple
methodology in section 32(d) of the rule, discussed product master netting agreement. VaR methodology.
below in section V.C.4. of this preamble, netting set 69 Only repo-style transactions and eligible 70 In conjunction with the current exposure
also means a group of transactions with a single margin loans subject to a single-product qualifying methodology.
(iii) The bank has conducted qualifying master netting agreement: the
sufficient legal review to conclude with jurisdiction in which each counterparty
Qualifying Master Netting Agreement
a well-founded basis (and has is chartered or the equivalent location in
Under the final rule, consistent with maintained sufficient written the case of non-corporate entities, and if
the proposal, a qualifying master netting documentation of that legal review) that a branch of a counterparty is involved,
agreement is defined to mean any the agreement meets the requirements of then also the jurisdiction in which the
written, legally enforceable bilateral paragraph (ii) of this definition and that branch is located; the jurisdiction that
agreement, provided that: in the event of a legal challenge governs the individual transactions
(i) The agreement creates a single (including one resulting from default or covered by the agreement; and the
legal obligation for all individual from bankruptcy, insolvency, or similar jurisdiction that governs the agreement.
transactions covered by the agreement proceeding) the relevant court and
upon an event of default, including EAD for Repo-Style Transactions and
administrative authorities would find
bankruptcy, insolvency, or similar Eligible Margin Loans
the agreement to be legal, valid, binding,
proceeding, of the counterparty; and enforceable under the law of the Under the final rule, a bank may
(ii) The agreement provides the bank relevant jurisdictions; recognize the risk-mitigating effect of
the right to accelerate, terminate, and (iv) The bank establishes and financial collateral that secures a repo-
close-out on a net basis all transactions maintains procedures to monitor style transaction, eligible margin loan,
under the agreement and to liquidate or possible changes in relevant law and to or single-product netting set of such
set off collateral promptly upon an ensure that the agreement continues to transactions and the risk-mitigating
event of default, including upon an satisfy the requirements of this effect of any collateral that secures a
event of bankruptcy, insolvency, or definition; and repo-style transaction that is included in
similar proceeding, of the counterparty, (v) The agreement does not contain a a bank’s VaR-based measure under the
provided that, in any such case, any walkaway clause (that is, a provision market risk rule through an adjustment
exercise of rights under the agreement that permits a non-defaulting to EAD rather than LGD. The bank may
will not be stayed or avoided under counterparty to make lower payments use a collateral haircut approach or one
applicable law in the relevant than it would make otherwise under the of two models approaches: a simple VaR
jurisdictions; agreement, or no payment at all, to a methodology (for single-product netting
defaulter or the estate of a defaulter, sets of repo-style transactions or eligible
69 Only repo-style transactions and eligible
even if the defaulter or the estate of the margin loans) or an internal models
margin loans subject to a single-product qualifying defaulter is a net creditor under the methodology. Figure 2 illustrates the
master netting agreement are eligible for the simple
VaR methodology. agreement). methodologies available for calculating
70 In conjunction with the current exposure The agencies consider the following EAD and LGD for eligible margin loans
methodology. jurisdictions to be relevant for a and repo-style transactions.
The proposed rule defined a repo- (iv) The bank has conducted and style transaction definition in
style transaction as a repurchase or documented sufficient legal review to accordance with the 2006 interagency
reverse repurchase transaction, or a conclude with a well-founded basis that securities borrowing rule.72 Under the
securities borrowing or securities the agreement meets the requirements of securities borrowing rule, the agencies
lending transaction (including a paragraph (iii) of this definition and is accorded preferential risk-based capital
transaction in which the bank acts as legal, valid, binding, and enforceable treatment for cash-collateralized
agent for a customer and indemnifies under applicable law in the relevant securities borrowing transactions that
the customer against loss), provided jurisdictions. either met a bankruptcy standard such
that: In the proposal, the agencies as the standard in criterion (iii) above or
(i) The transaction is based solely on recognized that criterion (iii) above may were overnight or unconditionally
liquid and readily marketable securities pose challenges for certain transactions cancelable at any time by the bank.
or cash; that would not be eligible for certain Commenters maintained that banks are
(ii) The transaction is marked to exemptions from bankruptcy or able to terminate promptly a repo-style
market daily and subject to daily margin receivership laws because the transaction with a counterparty whose
maintenance requirements; counterparty—for example, a sovereign financial condition is deteriorating so
(iii) The transaction is executed under entity or a pension fund—is not subject long as the transaction is done on an
an agreement that provides the bank the to such laws. The agencies sought overnight basis or is unconditionally
right to accelerate, terminate, and close- comment on ways this criterion could cancelable by the bank. As a result,
out the transaction on a net basis and to be crafted to accommodate such these commenters contended that events
liquidate or set off collateral promptly transactions when justified on of default and losses on such
upon an event of default (including prudential grounds, while ensuring that transactions are very rare.
upon an event of bankruptcy, the requirements in criterion (iii) are
insolvency, or similar proceeding) of the The agencies have decided to modify
met for transactions that are eligible for
counterparty, provided that, in any such the definition of repo-style transaction
those exemptions.
case, any exercise of rights under the Several commenters responded to this consistent with this suggestion by
agreement will not be stayed or avoided question by urging the agencies to commenters and consistent with the
under applicable law in the relevant modify the third component of the repo- 2006 securities borrowing rule. The
jurisdictions;71 and agencies believe that this modification
will resolve, in a manner that preserves
11(e)(8) of the Federal Deposit Insurance Act (12

71 This requirement is met where all transactions U.S.C. 1821(e)(8)), or netting contracts between or safety and soundness, technical
under the agreement (i) are executed under U.S. law among financial institutions under sections 401– difficulties that banks would have had
and (ii) constitute ‘‘securities contracts’’ or 407 of the Federal Deposit Insurance Corporation in meeting the proposed rule’s
‘‘repurchase agreements’’ under section 555 or 559, Improvement Act of 1991 (12 U.S.C. 4401–4407) or
respectively, of the Bankruptcy Code (11 U.S.C. 555 the Federal Reserve Board’s Regulation EE (12 CFR
ER07DE07.002</GPH>
or 559), qualified financial contracts under section part 231). 72 71 FR 8932, February 22, 2006.
definition for a material proportion of date far in the future is more not explicit in the New Accord. Other
their repo-style transactions. Consistent appropriately reflected as a discounted commenters asked the agencies to
with the 2006 securities borrowing rule, positive cash flow in LGD estimation. clarify that the requirement would be
a reasonably short notice period, Criterion (iii) is satisfied when the bank met for all or certain forms of collateral
typically no more than the standard has conducted sufficient legal review to if the bank had possession and control
settlement period associated with the conclude with a well-founded basis of the collateral and a reasonable basis
securities underlying the repo-style (and has maintained sufficient written to believe it could promptly liquidate
transaction, would not detract from the documentation of that legal review) that the collateral.
unconditionality of the bank’s a margin loan would be exempt from the The agencies believe that in order to
termination rights. With regard to bankruptcy auto-stay. The agencies are use the EAD adjustment approaches for
overnight transactions, the counterparty therefore maintaining substantially the exposures within the United States, a
generally should have no expectation, same definition of eligible margin loan bank must have a perfected, first
either explicit or implicit, that the bank in the final rule. priority security interest in collateral,
will automatically roll over the With the exception of repo-style with the exception of cash on deposit
transaction. The agencies are transactions that are included in a with the bank and certain custodial
maintaining in substance all the other bank’s VaR-based measure under the arrangements. The agencies have
components of the proposed definition market risk rule (as discussed above), modified the proposed requirement to
of repo-style transaction. for purposes of determining EAD for address a concern raised by several
The proposed rule defined an eligible repo-style transactions, eligible margin commenters that a bank could fail to
margin loan as an extension of credit loans, and OTC derivatives, and satisfy the first priority security interest
where: recognizing collateral mitigating the requirement because of the senior
(i) The credit extension is counterparty credit risk of such security interest of a third-party
collateralized exclusively by debt or exposures, the final rule (consistent custodian involved as an intermediary
equity securities that are liquid and with the proposed rule) allows banks to in the transaction. Under the final rule,
readily marketable; take into account only financial a bank meets the security interest
(ii) The collateral is marked to market collateral. The proposed rule defined requirement so long as the bank has a
daily and the transaction is subject to financial collateral as collateral in the perfected, first priority security interest
daily margin maintenance requirements; form of any of the following instruments in the collateral notwithstanding the
(iii) The extension of credit is in which the bank has a perfected, first prior security interest of any custodial
conducted under an agreement that priority security interest or the legal agent. Outside of the United States, the
provides the bank the right to accelerate equivalent thereof: (i) Cash on deposit definition of financial collateral can be
and terminate the extension of credit with the bank (including cash held for satisfied as long as the bank has the
and to liquidate or set off collateral the bank by a third-party custodian or legal equivalent of a perfected, first
promptly upon an event of default trustee); (ii) gold bullion; (iii) long-term priority security interest. For example,
(including upon an event of bankruptcy, debt securities that have an applicable cash on deposit with the bank is an
insolvency, or similar proceeding) of the external rating of one category below example of the legal equivalent of a
counterparty, provided that, in any such investment grade or higher (for example, perfected, first priority security interest.
case, any exercise of rights under the at least BB–); (iv) short-term debt The agencies intend to apply this ‘‘legal
agreement will not be stayed or avoided instruments that have an applicable equivalent’’ standard flexibly to deal
under applicable law in the relevant external rating of at least investment with non-U.S. collateral access regimes.
jurisdictions; 73 and grade (for example, at least A–3); (v) The agencies also invited comment on
(iv) The bank has conducted and equity securities that are publicly the extent to which assets that do not
documented sufficient legal review to traded; (vi) convertible bonds that are meet the definition of financial
conclude with a well-founded basis that publicly traded; and (vii) mutual fund collateral are the basis of repo-style
the agreement meets the requirements of shares and money market mutual fund transactions engaged in by banks or are
paragraph (iii) of this definition and is shares if a price for the shares is taken by banks as collateral for eligible
legal, valid, binding, and enforceable publicly quoted daily. margin loans or OTC derivatives. The
under applicable law in the relevant In connection with this definition, the agencies also inquired as to whether the
jurisdictions. agencies asked for comment on the definition of financial collateral should
Commenters generally supported this appropriateness of requiring that a bank be expanded to reflect any other asset
definition, but some objected to the have a perfected, first priority security types.
prescriptiveness of criterion (iii). interest, or the legal equivalent thereof, A substantial number of commenters
Criterion (iii) is necessary to ensure that in the definition of financial collateral. asked the agencies to add asset types to
a bank is quickly able to realize the A couple of commenters supported this the list of financial collateral. The
value of its collateral in the event of requirement, but several other principal recommended additions
obligor default. Collateral stayed by commenters objected. The objecting included: (i) Non-investment-grade
bankruptcy and not liquidated until a commenters acknowledged that the externally rated bonds; (ii) bonds that
requirement would generally be are not externally rated; (iii) all financial
73 This requirement is met under the consistent with current U.S. collateral instruments; (iv) letters of credit; (v)
circumstances described in footnote 73. Under the practices for repo-style transactions, mortgages loans; and (vi) certificates of
U.S. Bankruptcy Code, ‘‘margin loans’’ are a type eligible margin loans, and OTC deposit. Some commenters that
of securities contract, but the term ‘‘margin loan’’ derivatives, but they criticized the advocated inclusion of a wider range of
does not encompass all loans that happen to be
secured by securities collateral. Rather, Congress
requirement on the grounds that: (i) bonds admitted that it may be
intended the term ‘‘margin loan’’ to include only Obtaining a perfected, first priority reasonable to impose some sort of
those loans commonly known in the industry as security interest may not be the current liquidity requirement on the additional
margin loans, such as credit permitted in an market practice outside the United bonds and to impose a 25–50 percent
account under the Board’s Regulation T or where
a financial intermediary extends credit for the
States; (ii) U.S. practices may evolve in standard supervisory haircut for such
purchase, sale, carrying, or trading of securities. See such a fashion as to not meet this additional bonds. Some of the
H.R. Rep. No. 109–131, at 119, 130 (2005). requirement; and (iii) the requirement is commenters that advocated inclusion of
a broader range of bonds and mortgages collateralized by other types of financial numbers, even if issued by the same
asserted that such inclusion would be collateral. Due to concerns about both issuer with the same maturity date. The
warranted by the exemption from competitive equity and the liquidity and agencies sought comment on alternative
bankruptcy auto-stay accorded to repo- price availability of other types of approaches for determining a given
style transactions involving such assets collateral, the agencies are not otherwise security for purposes of the collateral
by the U.S. Bankruptcy Code.74 expanding the proposed definition of haircut approach. A few commenters
As described above, to enhance financial collateral in the final rule. expressed support for the proposed
international consistency and conform CUSIP approach to defining a given
Collateral Haircut Approach
the final rule more closely to the New security, but one commenter asked the
Accord, the agencies have decided to Under the collateral haircut approach agencies to permit each bank the
permit a bank to use the EAD approach of the final rule, similar to the proposed flexibility to define given security. The
for all repo-style transactions that are rule, a bank must set EAD equal to the collateral haircut approach in the final
included in a bank’s VaR-based measure sum of three quantities: (i) The value of rule is based on a bank’s net position in
under the market risk rule, regardless of the exposure less the value of the a ‘‘given instrument or gold’’ rather than
the underlying collateral type. The collateral; (ii) the absolute value of the in a ‘‘given security’’ to more precisely
agencies are satisfied that such repo- net position in a given instrument or in capture the positions to which a bank
style transactions would be based on gold (where the net position in a given must apply the haircuts. To enhance
collateral that is sufficiently liquid to instrument or in gold equals the sum of safety and soundness and comparability
justify applying the EAD approach. the current market values of the across banks, the agencies believe that it
The agencies have included instrument or gold the bank has lent, is important to preserve the relatively
conforming residential mortgages in the sold subject to repurchase, or posted as clear CUSIP approach to defining a
definition of financial collateral and as collateral to the counterparty minus the given instrument for purposes of the
acceptable underlying instruments in sum of the current market values of that collateral haircut approach.
the definitions of repo-style transaction same instrument or gold the bank has Accordingly, the agencies are
and eligible margin loan based on the borrowed, purchased subject to resale, maintaining the CUSIP approach as
liquidity of such mortgages and their or taken as collateral from the appropriate for determining a given
widespread use as collateral in repo- counterparty) multiplied by the market instrument for instruments that are
style transactions. However, because price volatility haircut appropriate to securities.
this inclusion goes beyond the New the instrument or gold; and (iii) the sum Standard supervisory haircuts. Under
Accord’s recognition of financial of the absolute values of the net position the final rule, as under the proposed
collateral, the agencies decided to take of any cash or instruments in each rule, if a bank chooses to use standard
a conservative approach and require currency that is different from the supervisory haircuts, it must use an 8
banks to use the standard supervisory settlement currency multiplied by the percent haircut for each currency
haircut approach, with a 25 percent haircut appropriate to each currency mismatch and the haircut appropriate to
haircut and minimum ten-business-day mismatch. To determine the appropriate each security in Table D below. These
holding period, in order to recognize haircuts, a bank may choose to use haircuts are based on the ten-business-
conforming residential mortgage standard supervisory haircuts or, with day holding period for eligible margin
collateral in EAD (other than for repo- prior written approval from its primary loans and must be multiplied by the
style transactions that are included in a Federal supervisor, its own estimates of square root of 1⁄2 to convert the standard
bank’s VaR-based measure under the haircuts. supervisory haircuts to the five-
market risk rule). Use of the standard In the preamble to the proposed rule, business-day minimum holding period
supervisory haircut approach for repo- for purposes of the collateral haircut for repo-style transactions. A bank must
style transactions, eligible margin loans, approach, the agencies clarified that a adjust the standard supervisory haircuts
and OTC derivatives collateralized by given security would include, for upward on the basis of a holding period
conforming mortgages does not preclude example, all securities with a single longer than ten business days for
a bank’s use of the other EAD Committee on Uniform Securities eligible margin loans or five business
adjustment approaches for exposures Identification Procedures (CUSIP) days for repo-style transactions where
number and would not include and as appropriate to take into account
74 11 U.S.C. 559. securities with different CUSIP the illiquidity of an instrument.
As an example, assume a bank that calculate security type and currency less frequently than quarterly and
uses standard supervisory haircuts has mismatch haircuts using its own reassess data sets and haircuts whenever
extended an eligible margin loan of internal estimates of market price market prices change materially. A bank
$100 that is collateralized by five-year volatility and foreign exchange must estimate individually the
U.S. Treasury notes with a market value volatility. The bank’s primary Federal volatilities of the exposure, the
of $100. The value of the exposure less supervisor would base approval to use collateral, and foreign exchange rates,
the value of the collateral would be internally estimated haircuts on the and may not take into account the
zero, and the net position in the security satisfaction of certain minimum correlations between them.
($100) times the supervisory haircut qualitative and quantitative standards. Under the final rule, as under the
(.02) would be $2. There is no currency These standards include: (i) The bank proposal, a bank that uses internally
mismatch. Therefore, the EAD of the must use a 99th percentile one-tailed estimated haircuts must adhere to the
exposure would be $0 + $2 = $2. confidence interval and a minimum following rules. The bank may calculate
Own estimates of haircuts. Under the five-business-day holding period for internally estimated haircuts for
final rule, as under the proposal, with repo-style transactions and a minimum categories of debt securities that have an
the prior written approval of the bank’s ten-business-day holding period for all applicable external rating of at least
primary Federal supervisor, a bank may other transactions; (ii) the bank must investment grade. The haircut for a
75 The proposed and final rules define a ‘‘main
adjust holding periods upward where category of securities must be
index’’ as the S&P 500 Index, the FTSE All-World and as appropriate to take into account representative of the internal volatility
Index, and any other index for which the bank the illiquidity of an instrument; (iii) the estimates for securities in that category
demonstrates to the satisfaction of its primary bank must select a historical observation that the bank has lent, sold subject to
Federal supervisor that the equities represented in
the index have comparable liquidity, depth of
period for calculating haircuts of at least repurchase, posted as collateral,
market, and size of bid-ask spreads as equities in one year; and (iv) the bank must update borrowed, purchased subject to resale,
ER07DE07.003</GPH>
the S&P 500 Index and the FTSE All-World Index. its data sets and recompute haircuts no or taken as collateral. In determining
relevant categories, the bank must at a Simple VaR Methodology transactions or over a ten-business-day
minimum take into account (i) the type As noted above, under the final rule, holding period for eligible margin loans
of issuer of the security; (ii) the as under the proposal, a bank may use using a minimum one-year historical
applicable external rating of the one of two internal models approaches observation period of price data
security; (iii) the maturity of the to recognize the risk mitigating effects of representing the instruments that the
security; and (iv) the interest rate financial collateral that secures a repo- bank has lent, sold subject to
sensitivity of the security. A bank must style transaction or eligible margin loan. repurchase, posted as collateral,
calculate a separate internally estimated This section of the preamble describes borrowed, purchased subject to resale,
haircut for each individual debt security the simple VaR methodology; a later or taken as collateral.
that has an applicable external rating section of the preamble describes the The qualification requirements for the
below investment grade and for each internal models methodology (which use of a VaR model are less stringent
individual equity security. In addition, also may be used to determine the EAD than the qualification requirements for
a bank must internally estimate a for OTC derivative contracts). The the internal models methodology
separate currency mismatch haircut for agencies received no material comments described below. The main ongoing
each individual mismatch between each on the simple VaR methodology and are qualification requirement for using a
net position in a currency that is adopting the methodology without VaR model is that the bank must
different from the settlement currency. change from the proposal. validate its VaR model by establishing
One commenter recommended that With the prior written approval of its and maintaining a rigorous and regular
the agencies permit banks to use primary Federal supervisor, a bank may backtesting regime.
category-based internal estimate estimate EAD for repo-style transactions 3. EAD for OTC Derivative Contracts
haircuts for non-investment-grade bonds and eligible margin loans subject to a
and equity securities. The agencies have single product qualifying master netting Under the final rule, as under the
decided to adopt the proposed rule’s agreement using a VaR model. Under proposed rule, a bank may use either the
provisions on category-based haircuts the simple VaR methodology, a bank’s current exposure methodology or the
because they are consistent with the EAD for the transactions subject to such internal models methodology to
New Accord and because the volatilities a netting agreement is equal to the value determine the EAD for OTC derivative
of non-investment-grade bonds and of of the exposures minus the value of the contracts. An OTC derivative contract is
equity securities are more dependent on collateral plus a VaR-based estimate of defined as a derivative contract that is
idiosyncratic, issuer-specific events potential future exposure (PFE). The not traded on an exchange that requires
than the volatility of investment-grade value of the exposures is the sum of the the daily receipt and payment of cash-
bonds. current market values of all securities variation margin. A derivative contract
and cash the bank has lent, sold subject is defined to include interest rate
Under the final rule, as under the to repurchase, or posted as collateral to derivative contracts, exchange rate
proposal, when a bank calculates an a counterparty under the netting set. derivative contracts, equity derivative
internally estimated haircut on a TN-day The value of the collateral is the sum of contracts, commodity derivative
holding period, which is different from the current market values of all contracts, credit derivatives, and any
the minimum holding period for the securities and cash the bank has other instrument that poses similar
transaction type, the bank must borrowed, purchased subject to resale, counterparty credit risks. The rule also
calculate the applicable haircut (HM) or taken as collateral from a defines derivative contracts to include
using the following square root of time counterparty under the netting set. The unsettled securities, commodities, and
formula: VaR-based estimate of PFE is an foreign exchange trades with a
estimate of the bank’s maximum contractual settlement or delivery lag
TM exposure on the netting set over a fixed that is longer than the normal settlement
HM = HN , time horizon with a high level of period (which the rule defines as the
TN
confidence. lesser of the market standard for the
Where: Specifically, the VaR model must particular instrument or five business
(i) TM = five for repo-style transactions and estimate the bank’s 99th percentile, one- days). This includes, for example,
ten for eligible margin loans; tailed confidence interval for an agency mortgage-backed securities
(ii) TN = holding period used by the bank to increase in the value of the exposures transactions conducted in the To-Be-
derive HN; and minus the value of the collateral Announced market.
(iii) HN = haircut based on the holding period (SE¥SC) over a five-business-day Figure 3 illustrates the treatment of
TN. holding period for repo-style OTC derivative contracts.
ER07DE07.006</GPH>
Current Exposure Methodology not recognize netting agreements for derivative products and reliance on
OTC derivative contracts for risk-based commissioned legal opinions as to the
The final rule’s current exposure capital purposes unless it obtained a enforceability of these contracts should
methodology for determining EAD for written and reasoned legal opinion be a sufficient guarantor of
single OTC derivative contracts is representing that, in the event of a legal enforceability. These commenters added
similar to the methodology in the challenge, the bank’s exposure would be that reliance on such commissioned
general risk-based capital rules and is found to be the net amount in the legal opinions is standard market
the same as the current exposure relevant jurisdictions.76 The agencies practice.
methodology in the proposal. Under the The agencies continue to believe that
asked for comment on methods banks
current exposure methodology, the EAD the legal enforceability of netting
would use to ensure enforceability of
for an OTC derivative contract is equal agreements is a necessary condition for
single product OTC derivative netting
to the sum of the bank’s current credit a bank to recognize netting effects in its
agreements in the absence of an explicit
exposure and PFE on the derivative capital calculation. However, the
written legal opinion requirement.
contract. The current credit exposure for agencies have conducted additional
Although one commenter supported
a single OTC derivative contract is the analysis and agree that a unique, written
the proposed rule’s written legal
greater of the mark-to-market value of legal opinion is not necessary in all
opinion requirement, many other
the derivative contract or zero. cases to ensure the enforceability of an
commenters asked the agencies to
The final rule’s current exposure remove this requirement. These OTC derivative netting agreement.
methodology for OTC derivative commenters maintained that, provided a Accordingly, the agencies have removed
contracts subject to qualifying master transaction is conducted in a the requirement that a bank obtain a
netting agreements is also similar to the jurisdiction and with a counterparty written and well reasoned legal opinion
treatment in the agencies’ general risk- type that is covered by a commissioned for each of its qualifying master netting
based capital rules and, with one legal opinion, use of industry-developed agreements that cover OTC derivatives.
exception discussed below, is the same standardized contracts for certain OTC As a result, under the final rule, to
as the treatment in the proposal. Under obtain netting treatment for multiple
the general risk-based capital rules and 76 This requirement was found in footnote 8 of the OTC derivative contracts subject to a
ER07DE07.004</GPH>
under the proposed rule, a bank could proposed rule text (in section 32(b)(2)). qualifying master netting agreement, a
bank must conduct sufficient legal to-market and remargining, adjust the are subject to a qualifying master netting
review to conclude with a well-founded EAD of the contract using the collateral agreement from any measure used to
basis (and maintain sufficient written haircut approach for repo-style determine counterparty credit risk
documentation of that legal review) that transactions and eligible margin loans exposure to all relevant counterparties
the agreement would provide described above and in section 32(b) of for risk-based capital purposes. Where
termination netting benefits and is legal, the rule. the bank provides protection through a
valid, binding, and enforceable. In some Under part VI of the final rule, and of credit derivative treated as a covered
cases, this requirement could be met by the proposed rule, a bank must treat an position under the market risk rule, it
reasoned reliance on a commissioned equity derivative contract as an equity must compute a counterparty credit risk
legal opinion or an in-house counsel exposure and compute a risk-weighted capital requirement for the credit
analysis. In other cases, however—for asset amount for that exposure. If the derivative under section 31 of the rule.
example, involving certain new bank is using the internal models
derivative transactions or derivative approach for its equity exposures, it also 4. Internal Models Methodology
counterparties in unusual must compute a risk-weighted asset The final rule, like the proposed rule,
jurisdictions—the bank would need to amount for its counterparty credit risk includes an internal models
obtain an explicit written legal opinion exposure on the equity derivative methodology for the calculation of EAD
from external or internal legal counsel contract. However, if the bank is using for the counterparty credit exposure of
addressing the particular situation. the simple risk weight approach for its OTC derivatives, eligible margin loans,
The proposed rule’s conversion factor equity exposures, it may choose not to and repo-style transactions. The internal
(CF) matrix used to compute PFE was hold risk-based capital against the models methodology requires a risk
based on the matrices in the general counterparty credit risk of the equity model that estimates EAD at the level of
risk-based capital rules, with two derivative contract. Likewise, a bank a netting set. A transaction not subject
exceptions. First, under the proposed that purchases a credit derivative that is to a qualifying master netting agreement
rule, the CF for credit derivatives that recognized under section 33 or 34 of the is considered to be its own netting set
are not used to hedge the credit risk of rule as a credit risk mitigant for an and a bank must calculate EAD for each
exposures subject to an IRB credit risk exposure that is not a covered position such transaction individually.
capital requirement was specified to be under the market risk rule does not have A bank may use the internal models
5.0 percent for contracts with to compute a separate counterparty methodology for OTC derivatives
investment-grade reference obligors and credit risk capital requirement for the (collateralized or uncollateralized) and
10.0 percent for contracts with non- credit derivative.78 If a bank chooses not single-product netting sets thereof, for
investment-grade reference obligors.77 to hold risk-based capital against the eligible margin loans and single-product
The CF for a credit derivative contract counterparty credit risk of such equity netting sets thereof, or for repo-style
did not depend on the remaining or credit derivative contracts, it must do transactions and single-product netting
maturity of the contract. The second so consistently for all such equity sets thereof. A bank that uses the
change was that floating/floating basis derivative contracts or for all such credit internal models methodology for a
swaps were no longer exempted from derivative contracts. Further, where the particular transaction type (that is, OTC
the CF for interest rate derivative contracts are subject to a qualifying derivative contracts, eligible margin
contracts. The exemption was put into master netting agreement, the bank must
loans, or repo-style transactions) must
place when such swaps were very either include them all or exclude them
use the internal models methodology for
simple, and the agencies believed it was all from any measure used to determine
all transactions of that transaction type.
no longer appropriate given the counterparty credit risk exposure to all
However, a bank may choose whether or
evolution of the product. The relevant counterparties for risk-based
not to use the internal models
computation of the PFE of multiple OTC capital purposes.
In addition, where a bank provides methodology for each transaction type.
derivative contracts subject to a
qualifying master netting agreement did protection through a credit derivative A bank also may use the internal
not change from the general risk-based that is not treated as a covered position models methodology for OTC
capital rules. The agencies received no under the market risk rule, it must treat derivatives, eligible margin loans, and
material comment on these provisions the credit derivative as a wholesale repo-style transactions subject to a
of the proposed rule and have adopted exposure to the reference obligor and qualifying cross-product master netting
them as proposed. compute a risk-weighted asset amount agreement if (i) the bank effectively
Under the final rule, as under the for the credit derivative under section integrates the risk mitigating effects of
proposed rule, if an OTC derivative 31 of the rule. The bank need not cross-product netting into its risk
contract is collateralized by financial compute a counterparty credit risk management and other information
collateral and a bank uses the current capital requirement for the credit technology systems; and (ii) the bank
exposure methodology to determine derivative, so long as it does so obtains the prior written approval of its
EAD for the exposure, the bank must consistently for all such credit primary Federal supervisor.
first determine an unsecured EAD as derivatives and either includes all or The final rule tracks the proposed rule
described above and in section 32(c) of excludes all such credit derivatives that by defining a qualifying cross-product
the rule. To take into account the risk- master netting agreement as a qualifying
reducing effects of the financial 78 The agencies recognize that there are reasons master netting agreement that provides
collateral, the bank may either adjust why a bank’s credit portfolio might contain for termination and close-out netting
the LGD of the contract or, if the purchased credit protection on a reference name in across multiple types of financial
a notional principal amount that exceeds the bank’s transactions or qualifying master netting
transaction is subject to daily marking- currently measured EAD to that obligor. If the
agreements in the event of a
protection amount of the credit derivative is

77 The counterparty credit risk of a credit materially greater than the EAD of the exposure counterparty’s default, provided that:
derivative that is used to hedge the credit risk of being hedged, however, the bank generally must (i) The underlying financial
an exposure subject to an IRB credit risk capital treat the credit derivative as two separate exposures
requirement is captured in the IRB treatment of the and calculate a counterparty credit risk capital
transactions are OTC derivative
hedged exposure, as detailed in sections 33 and 34 requirement for the exposure that is not providing contracts, eligible margin loans, or repo-
of the proposed rule. credit protection to the hedged exposure. style transactions; and
(ii) The bank obtains a written legal risk) or may underestimate the internal estimates of alpha of 1.2.
opinion verifying the validity and exposures of eligible margin loans, repo- Commenters expressed a number of
enforceability of the netting agreement style transactions, and OTC derivatives objections to the proposed rule’s
under applicable law of the relevant with short maturities, the final rule, like internal models methodology.
jurisdictions if the counterparty fails to the proposed rule, uses a netting set’s Several commenters contended that
perform upon an event of default, effective EPE as the basis for calculating banks that use the internal models
including upon an event of bankruptcy, EAD for counterparty credit risk. methodology should be permitted to
insolvency, or similar proceeding. Consistent with the use of a one-year PD calculate effective EPE at the
As discussed in the proposal, banks horizon, effective EPE is the time- counterparty level and should not be
use several measures to manage their weighted average of effective EE over required to calculate effective EPE at the
exposure to the counterparty credit risk one year where the weights are the netting set level. These commenters
of repo-style transactions, eligible proportion that an individual effective indicated that while the New Accord
margin loans, and OTC derivatives, EE represents in a one-year time mandates calculation at the netting set
including PFE, expected exposure (EE), interval. If all contracts in a netting set level, those banks that currently use an
and expected positive exposure (EPE). mature before one year, effective EPE is EPE-style approach to measuring
PFE is the maximum exposure the average of effective EE until all counterparty credit risk for internal risk
estimated to occur over a future horizon contracts in the netting set mature. For management purposes typically use a
at a high level of statistical confidence. example, if the longest maturity contract counterparty-by-counterparty EPE
Banks often use PFE when measuring in the netting set matures in six months, approach. They asserted that forcing
counterparty credit risk exposure effective EPE would be the average of banks to use a netting-set-by-netting-set
against counterparty credit limits. EE is effective EE over six months. approach would be burdensome for
the expected value of the probability banks and would provide the agencies
Effective EE is defined as: no material regulatory benefits, as
distribution of non-negative credit risk
exposures to a counterparty at any Effective EEtk = max(Effective EEtk-1, netting effects are taken into account in
specified future date, whereas EPE is the EEtk) the calculation of EE.
time-weighted average of individual where exposure is measured at future dates The agencies have retained the netting
expected exposures estimated for a t1, t2, t3, * * * and effective EEt0 equals set focus of the calculation of effective
given forecasting horizon (one year in current exposure. Alternatively, a bank may EPE to preserve international
the proposed rule). The final rule use a measure that is more conservative than consistency. The agencies will continue
clarifies that, when estimating EE, a effective EPE for every counterparty (that is, to review the implications, particularly
a measure based on peak exposure) with with respect to the appropriate
bank must set any negative market prior approval of its primary Federal
values in the probability distribution of recognition of netting benefits, of
supervisor.
market values to a counterparty at a allowing banks to calculate effective
The final rule clarifies that if a bank EPE at the counterparty level.
specified future date to zero to convert
hedges some or all of the counterparty One commenter objected to the
the probability distribution of market
credit risk associated with a netting set proposed rule’s requirement that a bank
values to the probability distribution of
using an eligible credit derivative, the use effective EE (as opposed to EE). This
credit risk exposures. Banks typically
bank may take the reduction in commenter contended that effective EE
compute EPE, EE, and PFE using a
exposure to the counterparty into is an excessively conservative and
common stochastic model.
A paper published by the BCBS in account when estimating EE. If the bank imprecise mechanism to address
July 2005 titled ‘‘The Application of recognizes this reduction in exposure to rollover risk in a portfolio of short-term
Basel II to Trading Activities and the the counterparty in its estimate of EE, it transactions. The commenter
Treatment of Double Default Effects’’ must also use its internal model to represented that rollover risk should be
notes that EPE is an appropriate EAD estimate a separate EAD for the bank’s addressed under Pillar 2 rather than
measure for determining risk-based exposure to the protection provider of Pillar 1. The agencies continue to
capital requirements for counterparty the credit derivative. believe that rollover risk is a core credit
The EAD for instruments with risk that should be covered by explicit
credit risk because transactions with
counterparty credit risk must be risk-based capital requirements. The
counterparty credit risk ‘‘are given the
determined assuming economic agencies also remain concerned that EE
same standing as loans with the goal of
downturn conditions. To accomplish and EPE (as opposed to effective EE and
reducing the capital treatment’s
this determination in a prudent manner, effective EPE) would not adequately
influence on a firm’s decision to extend
the internal models methodology sets incorporate rollover risk and do not
an on-balance sheet loan rather than
EAD equal to EPE multiplied by a believe that bank internal estimates of
engage in an economically equivalent
scaling factor termed ‘‘alpha.’’ Alpha is rollover risk are sufficiently reliable at
transaction that involves exposure to
set at 1.4; a bank’s primary Federal this time to use for risk-based capital
counterparty credit risk.’’ 79 An
supervisor has the flexibility to raise purposes. To ensure consistency with
adjustment to EPE, called ‘‘effective
this value based on the bank’s specific the New Accord and in light of the lack
EPE’’ and described below, is used in
characteristics of counterparty credit of alternative prudent mechanisms to
the calculation of EAD under the
risk. In addition, with supervisory incorporate rollover risk, the agencies
internal models methodology. EAD is
approval, a bank may use its own continue to include effective EE and
calculated as a multiple of effective EPE.
To address the concern that EE and estimate of alpha, subject to a floor of effective EPE in the final rule.
1.2. Several commenters criticized the
EPE may not capture risk arising from
In the proposal, the agencies default alpha of 1.4 and the 1.2 floor on
the replacement of existing short-term
requested comment on all aspects of the internal estimates of alpha. These

positions over the one-year horizon
effective EPE approach to counterparty commenters contended that these
used for capital requirements (rollover
credit risk and, in particular, on the supervisory alphas were too
79 BCBS, ‘‘The Application of Basel II to Trading appropriateness of the monotonically conservative for many dealer banks with
Activities and the Treatment of Double Default increasing effective EE function, the large, diverse, and granular portfolios of
Effects,’’ July 2005, ¶ 15. alpha constant of 1.4, and the floor on repo-style transactions, eligible margin
loans, and OTC derivatives. Although appropriate. Non-normality of exposure data to estimate model parameters, the
the agencies acknowledge the distribution means high loss events bank must use at least three years of
possibility that certain banks with occur more frequently than would be data that cover a wide range of
certain types of portfolios at certain expected on the basis of a normal economic conditions. This requirement
times could warrant an alpha of less distribution, the statistical term for reflects the longer horizon for
than 1.2, the agencies believe it is which is leptokurtosis. In many counterparty credit risk exposures
important to have a supervisory floor on instances, there may not be a need to compared to market risk exposures. The
alpha. This floor will ensure account for this. Expected exposures are data must be updated at least quarterly
consistency with the New Accord, much less likely to be affected by or more frequently if market conditions
comparability among the various banks leptokurtosis than peak exposures or warrant. Banks should consider using
that use the internal models high percentile losses. However, the model parameters based on forward
methodology, and sufficient capital bank must demonstrate that its EAD looking measures, where appropriate.
through the economic cycle for measure is not affected by leptokurtosis
securities financing transactions and or must account for it within the model. Ninth, the bank must subject its
OTC derivatives. Therefore, the agencies Fifth, the bank must measure, models used in the calculation of EAD
are retaining the alpha floor as monitor, and control the exposure to a to an initial validation and annual
proposed. counterparty over the whole life of all model review process. The model
Similar to the proposal, under the contracts in the netting set, in addition review should consider whether the
final rule a bank’s primary Federal to accurately measuring and actively inputs and risk factors, as well as the
supervisor must determine that the bank monitoring the current exposure to model outputs, are appropriate. The
meets certain qualifying criteria before counterparties. The bank should review of outputs should include a
the bank may use the internal models exercise active management of both rigorous program of backtesting model
methodology. These criteria consist of existing exposure and exposure that outputs against realized exposures.
the following operational requirements, could change in the future due to Maturity Under the Internal Models
modeling standards, and model market moves. Methodology
validation requirements. Sixth, the bank must be able to
First, the bank must have the systems measure and manage current exposures Like corporate loan exposures,
capability to estimate EE on a daily gross and net of collateral held, where counterparty exposure on netting sets is
basis. While this requirement does not appropriate. The bank must estimate susceptible to changes in economic
require the bank to report EE daily, or expected exposures for OTC derivative value that stem from deterioration in the
even estimate EE daily, the bank must contracts both with and without the counterparty’s creditworthiness short of
demonstrate that it is capable of effect of collateral agreements. By default. The effective maturity
performing the estimation daily. contrast, under the proposed rule, a parameter (M) reflects the impact of
Second, the bank must estimate EE at bank would have to measure and these changes on capital. The formula
enough future time points to accurately manage current exposure gross and net used to compute M for netting sets with
reflect all future cash flows of contracts of collateral held. Some commenters maturities greater than one year must be
in the netting set. To accurately reflect criticized this requirement as different than that generally applied to
the exposure arising from a transaction, inconsistent with the New Accord and wholesale exposures in order to reflect
the model should incorporate those bank internal risk management
how counterparty credit exposures
contractual provisions, such as reset practices. The agencies agree and have
change over time. The final rule’s
dates, that can materially affect the revised the rule to only require a bank
definition of M under the internal
timing, probability, or amount of any to ‘‘be able to’’ measure and manage
models methodology is identical to that
payment. The requirement reflects the current exposures gross and net of
of the proposed rule and is based on a
need for an accurate estimate of EPE. collateral.
Seventh, the bank must have weighted average of expected exposures
However, in order to balance the ability
procedures to identify, monitor, and over the life of the transactions relative
to calculate exposures with the need for
control specific wrong-way risk to their one year exposures. Consistent
information on timely basis, the number
throughout the life of an exposure. In with the New Accord, the final rule
of time points is not specified.
Third, the bank must have been using this context, wrong-way risk is the risk expands upon the proposal by providing
an internal model that broadly meets the that future exposure to a counterparty that a bank that uses an internal model
minimum standards to calculate the will be high when the counterparty’s to calculate a one-sided credit valuation
distributions of exposures upon which probability of default is also high. adjustment may use the effective credit
the EAD calculation is based for a Wrong-way risk generally arises from duration estimated by the model as
period of at least one year prior to events specific to the counterparty, M(EPE) in place of the formula in the
approval. This requirement is to ensure rather than broad market downturns. paragraph below.
that the bank has integrated the Eighth, the data used by the bank If the remaining maturity of the
modeling into its counterparty credit should be adequate for the measurement exposure or the longest-dated contract
risk management process. and modeling of the exposures. In contained in a netting set is greater than
Fourth, the bank’s model must particular, the model must use current one year, the bank must set M for the
account for the non-normality of market data to compute current exposure or netting set equal to the
exposure distribution where exposures. When a bank uses historical lower of 5 years or M(EPE), where:
and (ii) dfk is the risk-free discount legal equivalent thereof, in the collateral concerned as a separate netting set with
factor for future time period tk. The cap posted by the counterparty under the the counterparty or apply the alternative
of five years on M is consistent with the agreement. This security interest must model to the entire original netting set.
treatment of wholesale exposures under provide the bank with a right to close The agencies recognize that for new
section 31 of the rule. out the financial positions and the OTC derivative products a bank may
If the remaining maturity of the collateral upon an event of default of or need a transition period during which to
exposure or the longest-dated contract failure to perform by the counterparty incorporate a new product into its
in the netting set is one year or less, the under the collateral agreement. A internal models methodology or to
bank must set M for the exposure or contract would not satisfy this demonstrate that an alternative method
netting set equal to one year except as requirement if the bank’s exercise of is more conservative than an alpha of
provided in section 31(d)(7) of the rule. rights under the agreement may be 1.4 (or higher) times effective EPE. The
In this case, repo-style transactions, stayed or avoided under applicable law final rule therefore provides that for
eligible margin loans, and collateralized in the relevant jurisdictions. material portfolios of new OTC
OTC derivative transactions subject to If a bank’s internal model does not derivative products, a bank may assume
daily remargining agreements may use capture the effects of collateral that the current exposure methodology
the effective maturity of the longest agreements, the final rule provides a in section 32(c) of the rule meets the
maturity transaction in the netting set as ‘‘shortcut’’ method to provide the bank conservatism requirement for a period
M. with some benefit, in the form of a not longer than 180 days. As a general
smaller EAD, for collateralized matter, the agencies expect that the
Collateral Agreements Under the counterparties. Under the shortcut current exposure methodology in
Internal Models Methodology method, effective EPE is the lesser of a section 32(c) of the rule would be an
The provisions of the final rule on threshold amount (linked to the acceptable, more conservative method
collateral agreements under the internal exposure amount at which a for immaterial portfolios of OTC
models methodology are the same as counterparty must post collateral) plus derivatives.
those of the proposed rule. Under the an add-on and effective EPE without a
final rule, if a bank has prior written 5. Guarantees and Credit Derivatives
collateral agreement. Although any bank
approval from its primary Federal That Cover Wholesale Exposures
may use this ‘‘shortcut’’ method under
supervisor, it may capture within its the internal models methodology, the The New Accord specifies that a bank
internal model the effect on EAD of a agencies expect banks that make may adjust either the PD or the LGD of
collateral agreement that requires extensive use of collateral agreements to a wholesale exposure to reflect the risk
receipt of collateral when exposure to develop the modeling capacity to mitigating effects of a guarantee or
the counterparty increases. In no measure the impact of such agreements credit derivative. Similarly, under the
circumstances, however, may a bank on EAD. The shortcut method provided final rule, as under the proposed rule,
take into account in EAD collateral in the final rule is identical to the a bank may choose either a PD
agreements triggered by deterioration of shortcut method provided in the substitution or an LGD adjustment
counterparty credit quality. Several proposed rule. approach to recognize the risk
commenters asked the agencies to mitigating effects of an eligible
Alternative Methods
permit banks to incorporate in EAD guarantee or eligible credit derivative on
collateral agreements that are dependent Under the final rule, consistent with a wholesale exposure (or in certain
on a decline in the external rating of the the proposed rule, a bank using the circumstances may choose to use a
counterparty. The agencies do not internal models methodology may use double default treatment, as discussed
believe that banks are able to model the an alternative method to determine EAD below). In all cases a bank must use the
necessary correlations with sufficient for certain transactions, provided that same risk parameters for calculating
reliability to accept these types of the bank can demonstrate to its primary ECL for a wholesale exposure as it uses
collateral agreements under the internal Federal supervisor that the method’s for calculating the risk-based capital
models methodology at this time. output is more conservative than an requirement for the exposure. Moreover,
In the context of the internal models alpha of 1.4 (or higher) times effective in all cases, a bank’s ultimate PD and
methodology, the rule defines a EPE. LGD for the hedged wholesale exposure
collateral agreement as a legal contract Use of an alternative method may be may not be lower than the PD and LGD
that: (i) Specifies the time when, and appropriate where a new product or floors discussed above and described in
circumstances under which, the business line is being developed, where section 31(d) of the rule.
counterparty is required to exchange a recent acquisition has occurred, or
collateral with the bank for a single where the bank believes that other more Eligible Guarantees and Eligible Credit
financial contract or for all financial conservative methods to measure Derivatives
contracts covered under a qualifying counterparty credit risk for a category of Under the proposed rule, guarantees
master netting agreement; and (ii) transactions are prudent. The alternative and credit derivatives had to meet
confers upon the bank a perfected, first method should be applied to all similar specific eligibility requirements to be
priority security interest transactions. When an alternative recognized as CRM for a wholesale
(notwithstanding the prior security method is used, the bank should either exposure. The proposed rule defined an
ER07DE07.007</GPH>
interest of any custodial agent), or the treat the particular transactions eligible guarantee as a guarantee that:
(i) Is written and unconditional; CRM benefits under the wholesale an affiliate of the bank (other than an
(ii) Covers all or a pro rata portion of framework where the extent of the loss affiliated depository institution, bank,
all contractual payments of the obligor coverage of the credit exposure is not so securities broker or dealer, or insurance
on the reference exposure; easily quantifiable. Accordingly, for company that does not control the bank
(iii) Gives the beneficiary a direct example, if a bank obtains a principal- and that is subject to consolidated
claim against the protection provider; only or interest-only guarantee of a supervision and regulation comparable
(iv) Is non-cancelable by the corporate bond, the guarantee will not to that imposed on U.S. depository
protection provider for reasons other qualify as an eligible guarantee and the institutions, securities broker-dealers, or
than the breach of the contract by the bank will not be able to obtain any CRM insurance companies). For purposes of
beneficiary; benefits from the guarantee. the definition, an affiliate of a bank is
(v) Is legally enforceable against the Some commenters asked the agencies defined as a company that controls, is
protection provider in a jurisdiction to modify the fourth criterion of the controlled by, or is under common
where the protection provider has eligible guarantee definition to clarify, control with, the bank. Control of a
sufficient assets against which a consistent with the New Accord, that a company is defined as (i) ownership,
judgment may be attached and enforced; guarantee that is terminable by the bank control, or holding with power to vote
and and the protection provider by mutual 25 percent or more of a class of voting
(vi) Requires the protection provider consent may qualify as an eligible securities of the company; or (ii)
to make payment to the beneficiary on guarantee. This is an appropriate consolidation of the company for
the occurrence of a default (as defined clarification of the definition and, financial reporting purposes.
in the guarantee) of the obligor on the therefore, the agencies have amended The strong correlations among the
reference exposure without first the fourth criterion of the definition to
requiring the beneficiary to demand financial conditions of affiliated parties
require that the guarantee be non- would typically render guarantees from
payment from the obligor. cancelable by the protection provider
Commenters suggested a number of affiliates of the bank of little value
unilaterally. precisely when the bank would need
improvements to the proposed One commenter asked the agencies to
definition of eligible guarantee. One them most—when the bank itself is in
modify the fifth criterion of the eligible financial distress.81 For example, a
commenter asked the agencies to clarify guarantee definition, which requires the
that the unconditionality requirement in guarantee that a bank might receive
guarantee to be legally enforceable in a from its parent shell bank holding
criterion (i) of the definition would be jurisdiction where the protection
interpreted consistently with the New company would provide little credit risk
provider has sufficient assets, by mitigation to the bank as the bank
Accord’s requirement that ‘‘there should deleting the word ‘‘sufficient.’’ The
be no clause in the protection contract approached insolvency because the
agencies have preserved the fifth
outside the direct control of the bank financial condition of the holding
criterion of the proposed definition
that could prevent the protection company would depend critically on
intact. The agencies do not think that it
provider from being obliged to pay out the financial health of the subsidiary
would be consistent with safety and
in a timely manner in the event that the bank. Moreover, the holding company
soundness to permit a bank to obtain
original counterparty fails to make the typically would experience no increase
CRM benefits under the rule if the
payment(s) due.’’ 80 The agencies are not in its regulatory capital requirement for
guarantee were not legally enforceable
providing the requested clarification. issuing the guarantee because the
against the protection provider in a
The agencies have acquired guarantee would be on behalf of a
jurisdiction where the protection
considerable experience in the intricate consolidated subsidiary and would be
provider has sufficient available assets.
issue of the conditionality of guarantees Finally, some commenters objected to eliminated in the consolidation of the
under the general risk-based capital the sixth and final criterion of the holding company’s financial
rules and intend to address the meaning eligible guarantee definition, which statements.82
of ‘‘unconditional’’ in the context of requires the protection provider to make The agencies have decided, however,
eligible guarantees under this final rule payments to the beneficiary upon that a bank should be able to recognize
on a case-by-case basis going forward. default of the obligor without first CRM benefits by obtaining a guarantee
This same commenter also asked the requiring the beneficiary to demand from an affiliated insured depository
agencies to revise the second criterion of payment from the obligor. The agencies institution, bank, securities broker or
the definition from coverage of ‘‘all or have decided to modify this criterion to dealer, or insurance company that does
a pro rata portion of all contractual make it more consistent with the New not control the bank and that is subject
payments of the obligor on the reference Accord and actual market practice. The to consolidated supervision and
exposure’’ to coverage of ‘‘all or a pro final rule’s sixth criterion requires only regulation comparable to that imposed
rata portion of all principal or due and that the guarantee permit the bank to on U.S. depository institutions,
payable amounts on the reference obtain payment from the protection securities broker-dealers, or insurance
exposure.’’ The agencies have decided provider in the event of an obligor companies (as the case may be). A
to preserve the second criterion of the default in a timely manner and without 81 This concern of the agencies is the same
eligible guarantee definition without first having to take legal actions to concern that led the agencies to exclude from the
change to ensure that a bank only pursue the obligor for payment. definition of tier 1 capital any instrument that has
obtains CRM benefits from credit risk The agencies also have performed credit-sensitive features—such as an interest rate or
mitigants that cover all sources of credit additional analysis and review of the dividend rate that increases as the credit quality of
definition of eligible guarantee and have the bank issuer declines or an investor put right that
exposure to the obligor. Although it is is triggered by a decline in issuer credit quality.
appropriate to provide partial CRM decided to add two additional criteria to See, e.g., 12 CFR part 208, appendix A, section
benefits under the wholesale framework the definition. The first additional II.A.1.b.
for partial but pro rata guarantees of all criterion prevents guarantees from 82 Although the Board’s Regulation W places
contractual payments, the agencies are certain affiliated companies from being strict quantitative and qualitative limits on
guarantees issued by a bank on behalf of an affiliate,
less comfortable with providing partial eligible guarantees. Under the final rule, it does not restrict all guarantees issued by an
a guarantee will not be an eligible affiliate on behalf of a bank. See, e.g., 12 CFR
80 New Accord, ¶189. guarantee if the protection provider is 223.3(e).
depository institution for this purpose (vi) If the contract requires the the eligible credit derivative definition
includes all subsidiaries of the protection purchaser to transfer an to the current standard market practice.
depository institution except financial exposure to the protection provider at Under the final rule, therefore, a credit
subsidiaries. The final rule recognizes settlement, the terms of the exposure derivative will satisfy the definition of
guarantees from these types of affiliates provide that any required consent to an eligible credit derivative if the
because they are financial institutions transfer may not be unreasonably protection provider’s obligation to make
subject to prudential regulation by withheld; default payments to the protection
national or state supervisory authorities. (vii) If the credit derivative is a credit purchaser is triggered only if the
The agencies expect that the prudential default swap or nth-to-default swap, the reference obligor’s failure to pay
regulation of the affiliate would help contract clearly identifies the parties exceeds any applicable minimal
prevent the affiliate from exposing itself responsible for determining whether a payment threshold that is consistent
excessively to the credit exposures of credit event has occurred, specifies that with standard market practice.
the bank. Similarly, these affiliates this determination is not the sole Finally, a commenter asked for
would be subject to regulatory capital responsibility of the protection clarification of the meaning of the sixth
requirements of their own and should provider, and gives the protection criterion of the definition of eligible
experience an increase in their purchaser the right to notify the credit derivative, which states that if the
regulatory capital requirements for protection provider of the occurrence of contract requires the protection
issuing the guarantee. a credit event; and purchaser to transfer an exposure to the
The second additional criterion (viii) If the credit derivative is a total protection provider at settlement, the
precludes a guarantee from eligible return swap and the bank records net terms of the exposure provide that any
guarantee status if the guarantee payments received on the swap as net required consent to transfer may not be
increases the beneficiary’s cost of credit income, the bank records offsetting unreasonably withheld. To address any
protection in response to deterioration deterioration in the value of the hedged potential ambiguity about which
in the credit quality of the reference exposure (either through reductions in exposure’s transferability must be
exposure. This additional criterion is fair value or by an addition to reserves). analyzed, the agencies have amended
consistent with the New Accord’s Commenters generally supported the the sixth component to read: ‘‘If the
treatment of guarantees and with the proposed rule’s definition of eligible contract requires the protection
proposed rule’s operational credit derivative, but two commenters purchaser to transfer an exposure to the
requirements for synthetic asked for a series of changes. These protection provider at settlement, the
securitizations. commenters asked that the final rule terms of at least one of the exposures
The proposed rule defined an eligible specifically reference contingent credit that is permitted to be transferred under
credit derivative as a credit derivative in default swaps (CCDSs) in the list of the contract must provide that any
the form of a credit default swap, nth-to- eligible forms of credit derivatives. required consent to transfer may not be
CCDS are a relatively new type of credit unreasonably withheld.’’
default swap, or total return swap
derivative, and the agencies are still The proposed rule also provided that
provided that:
considering their appropriate role a bank may recognize an eligible credit
(i) The contract meets the derivative that hedges an exposure that
requirements of an eligible guarantee within the risk-based capital rules.
However, to enable the rule to adapt to is different from the credit derivative’s
and has been confirmed by the reference exposure used for determining
protection purchaser and the protection future market innovations, the agencies
have revised the definition of eligible the derivative’s cash settlement value,
provider; deliverable obligation, or occurrence of
(ii) Any assignment of the contract credit derivative to add to the list of
eligible credit derivative forms ‘‘any a credit event only if:
has been confirmed by all relevant (i) The reference exposure ranks pari
parties; other form of credit derivative approved
by’’ the bank’s primary Federal passu (that is, equal) or junior to the
(iii) If the credit derivative is a credit hedged exposure; and
default swap or nth-to-default swap, the supervisor.83
One commenter asked that the (ii) The reference exposure and the
contract includes the following credit hedged exposure are exposures to the
agencies amend the third criterion of the
events: same legal entity, and legally
eligible credit derivative definition,
(A) Failure to pay any amount due enforceable cross-default or cross-
which applies to credit default swaps
under the terms of the reference acceleration clauses are in place.
and nth-to-default swaps. The
exposure (with a grace period that is One commenter acknowledged that
commenter indicated that standard
closely in line with the grace period of the proposal’s pari passu ceiling is
practice in the credit derivatives market
the reference exposure); and consistent with the New Accord but
is for a credit default swap to contain
(B) Bankruptcy, insolvency, or asked for clarification that the provision
provisions that exempt the protection
inability of the obligor on the reference only requires reference exposure
provider from making default payments
exposure to pay its debts, or its failure equality or subordination with respect
to the protection purchaser if the
or admission in writing of its inability to priority of payments. Although the
reference obligor’s failure to pay is in an
generally to pay its debts as they agencies have concluded that it is not
amount below a de minimis threshold.
become due, and similar events; necessary to amend the rule to provide
The agencies do not believe that safety
(iv) The terms and conditions this clarification, the agencies agree that
and soundness would be materially
dictating the manner in which the the pari passu ceiling relates to priority
impaired by conforming this criterion of
contract is to be settled are incorporated of payments only.
into the contract; 83 One commenter also asked the agencies to Two commenters also asked the
(v) If the contract allows for cash clarify that a bank should translate the phrase agencies to provide an exception to the
settlement, the contract incorporates a ‘‘beneficiary’’ in the definition of eligible guarantee cross-default/cross-acceleration
robust valuation process to estimate loss to ‘‘protection purchaser’’ when confirming that a requirement where the hedged exposure
credit derivative meets all the requirements of the
reliably and specifies a reasonable definition of eligible guarantee. The agencies have
is an OTC derivative contract or a
period for obtaining post-credit event not amended the rule to address this point, but do qualifying master netting agreement that
valuations of the reference exposure; confirm that such translation is appropriate. covers OTC derivative contracts.
Although some parts of the debt markets hedged exposure), the bank must use based capital requirement for the
have incorporated obligations from OTC the LGD of the guarantee or credit exposure as calculated under section 31
derivative contracts in cross-default/ derivative. of the rule (with the LGD of the
cross-acceleration clauses, the If the protection amount of the exposure adjusted to reflect the
commenter asserted that the practice is eligible guarantee or eligible credit guarantee or credit derivative); or (ii) the
not prevalent in many parts of the derivative is less than the EAD of the risk-based capital requirement for a
market. In addition, the commenter hedged exposure, however, the bank direct exposure to the protection
maintained that, unlike a failure to pay must treat the hedged exposure as two provider as calculated under section 31
on a loan or a bond, failure to pay on separate exposures (protected and of the rule (using the bank’s PD for the
an OTC derivative contract generally unprotected) to recognize the credit risk protection provider, the bank’s LGD for
would not trigger a credit event with mitigation benefit of the guarantee or the guarantee or credit derivative, and
respect to the reference exposure of the credit derivative. The bank must an EAD equal to the EAD of the hedged
credit default swap. The agencies have calculate its risk-based capital exposure).
not made this change. The proposed requirement for the protected exposure If the protection amount of the
cross-default/cross-acceleration under section 31 of the rule (using a PD eligible guarantee or eligible credit
requirement is consistent with the New equal to the protection provider’s PD, an derivative is less than the EAD of the
Accord. In addition, the agencies are LGD determined as described above, hedged exposure, however, the bank
reluctant to permit a bank to obtain and an EAD equal to the protection must treat the hedged exposure as two
CRM benefits for an exposure hedged by amount of the guarantee or credit separate exposures (protected and
a credit derivative whose reference derivative). If the bank determines that unprotected) in order to recognize the
exposure is different than the hedged full substitution leads to an credit risk mitigation benefit of the
exposure unless the hedged and inappropriate degree of risk mitigation, guarantee or credit derivative. The
reference exposures would default the bank may use a higher PD than that bank’s risk-based capital requirement
simultaneously. If the hedged exposure of the protection provider. The bank for the protected exposure would be the
could default prior to the default of the must calculate its risk-based capital greater of (i) the risk-based capital
reference exposure, the bank may suffer requirement for the unprotected requirement for the protected exposure
losses on the hedged exposure and not exposure under section 31 of the rule as calculated under section 31 of the
be able to collect default payments on (using a PD equal to the obligor’s PD, an rule (with the LGD of the exposure
the credit derivative. The final rule LGD equal to the hedged exposure’s adjusted to reflect the guarantee or
clarifies that, in order to recognize the LGD not adjusted to reflect the credit derivative and EAD set equal to
credit risk mitigation benefits of an guarantee or credit derivative, and an the protection amount of the guarantee
eligible credit derivative, cross-default/ EAD equal to the EAD of the original or credit derivative); or (ii) the risk-
cross-acceleration provisions must hedged exposure minus the protection based capital requirement for a direct
assure payments under the credit amount of the guarantee or credit exposure to the protection provider as
derivative are triggered if the obligor derivative). calculated under section 31 of the rule
fails to pay under the terms of the The protection amount of an eligible (using the bank’s PD for the protection
hedged exposure. guarantee or eligible credit derivative is provider, the bank’s LGD for the
defined as the effective notional amount guarantee or credit derivative, and an
PD Substitution Approach of the guarantee or credit derivative EAD set equal to the protection amount
Under the PD substitution approach reduced by any applicable haircuts for of the guarantee or credit derivative).
of the final rule, as under the proposal, maturity mismatch, lack of The bank must calculate its risk-based
if the protection amount (as defined restructuring, and currency mismatch capital requirement for the unprotected
below) of the eligible guarantee or (each described below). The effective exposure under section 31 of the rule
eligible credit derivative is greater than notional amount of a guarantee or credit using a PD set equal to the obligor’s PD,
or equal to the EAD of the hedged derivative is the lesser of the contractual an LGD set equal to the hedged
exposure, a bank may substitute for the notional amount of the credit risk exposure’s LGD (not adjusted to reflect
PD of the hedged exposure the PD mitigant and the EAD of the hedged the guarantee or credit derivative), and
associated with the rating grade of the exposure, multiplied by the percentage an EAD set equal to the EAD of the
protection provider. If the bank coverage of the credit risk mitigant. For original hedged exposure minus the
determines that full substitution leads to example, the effective notional amount protection amount of the guarantee or
an inappropriate degree of risk of a guarantee that covers, on a pro rata credit derivative.
mitigation, the bank may substitute a basis, 40 percent of any losses on a $100 The agencies received no material
higher PD for that of the protection bond would be $40. comments on the above-described
provider. The agencies received no material structure of the LGD adjustment
If the guarantee or credit derivative comments on the above-described approach, and the final rule’s LGD
provides the bank with the option to structure of the PD substitution adjustment approach is substantially the
receive immediate payout on triggering approach, and the final rule’s PD same as that of the proposed rule.
the protection, then the bank must use substitution approach is substantially The PD substitution approach allows
the lower of the LGD of the hedged the same as that of the proposed rule. a bank to effectively assess risk-based
exposure (not adjusted to reflect the capital against a hedged exposure as if
guarantee or credit derivative) and the LGD Adjustment Approach it were a direct exposure to the
LGD of the guarantee or credit Under the LGD adjustment approach protection provider, and the LGD
derivative. If the guarantee or credit of the final rule, as under the proposal, adjustment approach produces a risk-
derivative does not provide the bank if the protection amount of the eligible based capital requirement for a hedged
with the option to receive immediate guarantee or eligible credit derivative is exposure that is never lower than that
payout on triggering the protection (and greater than or equal to the EAD of the of a direct exposure to the protection
instead provides for the guarantor to hedged exposure, the bank’s risk-based provider. Accordingly, these approaches
assume the payment obligations of the capital requirement for the hedged do not fully reflect the risk mitigation
obligor over the remaining life of the exposure is the greater of (i) the risk- benefits certain types of guarantees and
credit derivatives may provide because guarantee is less than that of the hedged (iv) T = lesser of 5 or effective residual
the resulting risk-based capital exposure. maturity of the hedged exposure, expressed
requirement does not consider the joint in years.
The residual maturity of a hedged
probability of default of the obligor of exposure is the longest possible Other than as discussed above with
the hedged exposure and the protection remaining time before the obligor is respect to pools of hedged exposures
provider, sometimes referred to as the scheduled to fulfil its obligation on the with different residual maturities, the
‘‘double default’’ benefit. The agencies exposure. When determining the final rule’s provisions on maturity
have decided, consistent with the New residual maturity of the guarantee or mismatch do not differ from those of the
Accord and the proposed rule, to credit derivative, embedded options that proposed rule.
recognize double default benefits in the may reduce the term of the credit risk
wholesale framework only for certain mitigant must be taken into account so Restructuring Haircut
hedged exposures covered by certain that the shortest possible residual
guarantees and credit derivatives. A Under the final rule, as under the
maturity for the credit risk mitigant is
proposed rule, a bank that seeks to
later section of the preamble describes used to determine the potential maturity
recognize an eligible credit derivative
which hedged exposures are eligible for mismatch. Where a call is at the
that does not include a distressed
the double default treatment and discretion of the protection provider,
restructuring as a credit event that
describes the double default treatment the residual maturity of the guarantee or
triggers payment under the derivative
that is available to those exposures. credit derivative is the first call date. If
must reduce the recognition of the
the call is at the discretion of the bank
Maturity Mismatch Haircut credit derivative by 40 percent. A
purchasing the protection, but the terms
distressed restructuring is a
Under the final rule, a bank that seeks of the arrangement at inception of the
restructuring of the hedged exposure
to reduce the risk-based capital guarantee or credit derivative contain a
involving forgiveness or postponement
requirement on a wholesale exposure by positive incentive for the bank to call
of principal, interest, or fees that results
recognizing an eligible guarantee or the transaction before contractual
in a charge-off, specific provision, or
eligible credit derivative must adjust the maturity, the remaining time to the first
other similar debit to the profit and loss
effective notional amount of the credit call date is the residual maturity of the
account.
risk mitigant downward to reflect any credit risk mitigant. For example, where
there is a step-up in the cost of credit In other words, the effective notional
maturity mismatch between the hedged amount of the credit derivative adjusted
exposure and the credit risk mitigant. A protection in conjunction with a call
feature or where the effective cost of for lack of restructuring credit event
maturity mismatch occurs when the (and maturity mismatch, if applicable)
residual maturity of a credit risk protection increases over time even if
credit quality remains the same or is: Pr = Pm × 0.60, where:
mitigant is less than that of the hedged
exposure(s). improves, the residual maturity of the (i) Pr = effective notional amount of the
credit risk mitigant is the remaining credit risk mitigant, adjusted for lack of
The proposed rule provided, time to the first call. restructuring credit event (and maturity
consistent with the New Accord, that mismatch, if applicable); and
when the hedged exposures have Eligible guarantees and eligible credit
derivatives with maturity mismatches (ii) Pm = effective notional amount of the
different residual maturities, the longest credit risk mitigant adjusted for maturity
residual maturity of any of the hedged may only be recognized if their original
mismatch (if applicable).
exposures would be used as the residual maturities are equal to or greater than
one year. As a result, a guarantee or Two commenters opposed the 40
maturity of all hedged exposures. One
credit derivative is not recognized for a percent restructuring haircut. One
commenter criticized this provision as
hedged exposure with an original commenter contended that the 40
excessively conservative. The agencies
maturity of less than one year unless the percent haircut is too punitive. The
agree and have decided to restrict the
credit risk mitigant has an original other commenter contended that the 40
application of this provision to
maturity of equal to or greater than one percent haircut should not apply when
securitization CRM.84 Accordingly,
year or an effective residual maturity the hedged exposure is an OTC
under the final rule, to calculate the
equal to or greater than that of the derivative contract or a qualifying
risk-based capital requirement for a
hedged exposure. In all cases, credit risk master netting agreement that covers
group of hedged wholesale exposures
mitigants with maturity mismatches OTC derivative contracts. The 40
that are covered by a single eligible may not be recognized when they have
guarantee under which the protection percent haircut is a rough estimate of
an effective residual maturity of three the reduced CRM benefits that accrue to
provider has agreed to backstop all months or less.
contractual payments associated with a bank that purchases a credit derivative
each hedged exposure, a bank should When a maturity mismatch exists, a without restructuring coverage.
treat each hedged exposure as if it were bank must apply the following maturity Nonetheless, the agencies recognize that
fully covered by a separate eligible mismatch adjustment to determine the restructuring events could result in
guarantee. To determine whether any of effective notional amount of the substantial economic losses to a bank.
the hedged wholesale exposures has a guarantee or credit derivative adjusted Moreover, the 40 percent haircut is
maturity mismatch with the eligible for maturity mismatch: Pm = E × consistent with the New Accord and is
guarantee, the bank must assess whether (t¥0.25)/(T¥0.25), where: a reasonably prudent mechanism for
the residual maturity of the eligible ensuring that banks do not receive
(i) Pm = effective notional amount of the
credit risk mitigant adjusted for maturity
excessive CRM benefits for purchasing
credit protection that does not cover all
84 Under the final rule, if an eligible guarantee mismatch;

provides tranched credit protection to a group of (ii) E = effective notional amount of the
material sources of economic loss to the
hedged exposures—for example, the guarantee credit risk mitigant; bank on the hedged exposure.
covers the first 2 percent of aggregate losses for the
group—the bank must determine the risk-based
(iii) t = lesser of T or effective residual The final rule’s provisions on lack of
capital requirements for the hedged exposures maturity of the credit risk mitigant, expressed restructuring as a credit event do not
under the securitization framework. in years; and differ from those of the proposed rule.
Currency Mismatch Haircut amount to $100 × (3¥.25)÷(5¥.25) or $57.89. basis (that is, there must be no tranching
The haircut for lack of restructuring would of credit risk) by an uncollateralized
Under the final rule, as under the reduce the protection amount to $57.89 × 0.6
proposed rule, where the eligible single-reference-obligor credit derivative
or $34.74. So the bank would treat the $100
guarantee or eligible credit derivative is or guarantee (or certain nth-to-default
corporate exposure as two exposures: (i) An
denominated in a currency different exposure of $34.74 with the PD of the credit derivatives) provided by an
from that in which any hedged exposure protection provider, an LGD of 80 percent, eligible double default guarantor (as
is denominated, the effective notional and an M of five; and (ii) an exposure of defined below). Moreover, the hedged
amount of the guarantee or credit $65.26 with the PD of the obligor, an LGD of exposure must be a wholesale exposure
derivative must be adjusted for currency
30 percent, and an M of five. other than a sovereign exposure.87 In
mismatch (and maturity mismatch and addition, the obligor of the hedged
Multiple Credit Risk Mitigants
exposure must not be an eligible double
lack of restructuring credit event, if The New Accord provides that if default guarantor, an affiliate of an
applicable). The adjusted effective multiple credit risk mitigants (for eligible double default guarantor, or an
notional amount is calculated as: Pc = example, two eligible guarantees) cover affiliate of the guarantor.
Pr × (1¥Hfx), where: a single exposure, a bank must The proposed rule defined eligible
(i) Pc = effective notional amount of the disaggregate the exposure into portions double default guarantor to include a
credit risk mitigant, adjusted for currency covered by each credit risk mitigant (for depository institution (as defined in
mismatch (and maturity mismatch and lack example, the portion covered by each section 3 of the Federal Deposit
of restructuring credit event, if applicable); guarantee) and must calculate separately Insurance Act (12 U.S.C. 1813)); a bank
(ii) Pr = effective notional amount of the
the risk-based capital requirement of holding company (as defined in section
credit risk mitigant (adjusted for maturity
mismatch and lack of restructuring credit each portion.85 The New Accord also 2 of the Bank Holding Company Act (12
event, if applicable); and indicates that when credit risk mitigants U.S.C. 1841)); a savings and loan
(iii) Hfx = haircut appropriate for the provided by a single protection provider holding company (as defined in 12
currency mismatch between the credit risk have differing maturities, they should be U.S.C. 1467a) provided all or
mitigant and the hedged exposure. subdivided into separate layers of substantially all of the holding
A bank may use a standard protection.86 In the proposal, the company’s activities are permissible for
supervisory haircut of 8 percent for Hfx agencies invited comment on whether a financial holding company under 12
(based on a ten-business-day holding and how the agencies should address U.S.C. 1843(k)); a securities broker or
period and daily marking-to-market and these and other similar situations in dealer registered (under the Securities
remargining). Alternatively, a bank may which multiple credit risk mitigants Exchange Act of 1934) with the
use internally estimated haircuts for Hfx cover a single exposure. Securities and Exchange Commission
based on a ten-business-day holding Commenters generally agreed that the (SEC); an insurance company in the
period and daily marking-to-market and agencies should provide additional business of providing credit protection
remargining if the bank qualifies to use guidance about how to address (such as a monoline bond insurer or re-
the own-estimates haircuts in paragraph situations where multiple credit risk insurer) that is subject to supervision by
(b)(2)(iii) of section 32, the simple VaR mitigants cover a single exposure. a state insurance regulator; a foreign
Although one commenter recommended bank (as defined in section 211.2 of the
methodology in paragraph (b)(3) of
that the agencies permit banks Federal Reserve Board’s Regulation K
section 32, or the internal models
effectively to recognize triple default (12 CFR 211.2)); a non-U.S. securities
methodology in paragraph (d) of section
benefits in situations where two credit firm; or a non-U.S. based insurance
32 of the rule. The bank must scale
risk mitigants cover a single exposure, company in the business of providing
these haircuts up using a square root of
commenters did not provide material credit protection. The proposal required
time formula if the bank revalues the
specific suggestions as to their preferred an eligible double default guarantor to
guarantee or credit derivative less
approach to addressing these situations. (i) have a bank-assigned PD that, at the
frequently than once every ten business
Thus, the agencies have decided to time the guarantor issued the guarantee
days.
adopt the New Accord’s principles for or credit derivative, was equal to or
The agencies received no comments
dealing with multiple credit risk lower than the PD associated with a
on the currency mismatch provisions
mitigant situations. The agencies have long-term external rating of at least the
discussed above, and the final rule’s
added several additional provisions to third highest investment-grade rating
provisions on currency mismatch do not category; and (ii) have a current bank-
differ from those of the proposed rule. section 33(a) of the final rule to provide
clarity in this area. assigned PD that is equal to or lower
Example than the PD associated with a long-term
Double Default Treatment external rating of at least investment
Assume that a bank holds a five-year $100
corporate exposure, purchases a $100 credit As noted above, the final rule, like the grade. In addition, the proposal
derivative to mitigate its credit risk on the proposed rule, contains a separate risk- permitted a non-U.S. based bank,
exposure, and chooses to use the PD based capital methodology for hedged securities firm, or insurance company to
substitution approach. The unsecured LGD of exposures eligible for double default qualify as an eligible double default
the corporate exposure is 30 percent; the LGD treatment. The final rule’s double guarantor only if the firm were subject
of the credit derivative is 80 percent. The default provisions are identical to those to consolidated supervision and
credit derivative is an eligible credit of the proposed rule, with the exception regulation comparable to that imposed
derivative, has the bank’s exposure as its of some limited changes to the on U.S. depository institutions,
reference exposure, has a three-year maturity, securities firms, or insurance companies
definition of an eligible double default
no restructuring provision, no currency
guarantor discussed below. (as the case may be) or had issued an
mismatch with the bank’s hedged exposure,
and the protection provider assumes the To be eligible for double default
payment obligations of the obligor upon treatment, a hedged exposure must be 87 The New Accord permits certain retail small
fully covered or covered on a pro rata business exposures to be eligible for double default
default. The effective notional amount and treatment. Under the final rule, however, a bank
initial protection amount of the credit must effectively desegment a retail small business
derivative would be $100. The maturity 85 New Accord, ¶206. exposure (thus rendering it a wholesale exposure)
mismatch would reduce the protection 86 Id. to make it eligible for double default treatment.
outstanding and unsecured long-term creditworthiness of a sovereign and that the hedged exposure (not adjusted to
debt security without credit of a guarantor. reflect the guarantee or credit
enhancement that had a long-term One commenter urged the agencies to derivative) or the LGD of the guarantee
applicable external rating in one of the delete the requirement that the obligor or credit derivative if the guarantee or
three highest investment-grade rating of a hedged exposure that qualifies for credit derivative provides the bank with
categories. double default treatment not be an the option to receive immediate payout
Commenters expressed two principal eligible double default guarantor or an on the occurrence of a credit event.
criticisms of the proposed definition of affiliate of such an entity. This Otherwise, the bank must set LGD equal
an eligible double default guarantor. commenter represented that this to the LGD of the guarantee or credit
First, commenters asked the agencies to requirement significantly constrained derivative. Accordingly, in order to
conform the definition to the New the scope of application of double apply the double default treatment, the
Accord by permitting a foreign financial default treatment and assumed bank must estimate a PD for the
firm to qualify so long as it had an inappropriately that there is an protection provider and an LGD for the
outstanding long-term debt security excessive amount of correlation among guarantee or credit derivative. Finally, a
with an external rating of investment all financial firms. The agencies bank using the double default treatment
grade or higher (for example, BBB¥ or acknowledge that this requirement is a must make applicable adjustments to
higher) instead of in one of the three crude mechanism to prevent excessive the protection amount of the guarantee
highest investment-grade rating wrong-way risk, but the agencies have or credit derivative to reflect maturity
categories (for example, A¥ or higher). decided to retain the requirement in mismatches, currency mismatches, and
In light of the other eligibility criteria, light of its consistency with the New lack of restructuring coverage (as under
the agencies have concluded that it Accord and the limited ability of banks the PD substitution and LGD adjustment
would be appropriate to conform this to measure accurately correlations approaches in section 33 of the rule).
provision of the definition to the New among obligors. One commenter objected that the
Accord. In addition to limiting the types of calibration of the double default formula
Commenters also requested that the guarantees, credit derivatives, under the proposed rule was too
agencies conform the definition of guarantors, and hedged exposures conservative because it assumed an
eligible double default guarantor to the eligible for double default treatment, the excessive amount of correlation between
New Accord by permitting a financial rule limits wrong-way risk further by the obligor of the hedged exposure and
firm to qualify so long as it had a bank- requiring a bank to implement a process the protection provider. The agencies
assigned PD, at the time the guarantor to detect excessive correlation between have decided to leave the calibration
issued the guarantee or credit derivative the creditworthiness of the obligor of unaltered in light of its consistency with
or at any time thereafter, that was equal the hedged exposure and the protection the New Accord. The agencies will
to or lower than the PD associated with provider. The bank must receive prior evaluate this decision over time and
a long-term external rating of at least the written approval from its primary will raise this issue with the BCBS if
third highest investment-grade rating Federal supervisor for this process in appropriate.
category. In light of the other eligibility order to recognize double default
criteria, the agencies have concluded benefits for risk-based capital purposes. 6. Guarantees and Credit Derivatives
that it would be appropriate to conform To apply double default treatment to a That Cover Retail Exposures
this provision of the definition to the particular hedged exposure, the bank Like the proposal, the final rule
New Accord. must determine that there is not provides a different treatment for
Effectively, under the final rule, the excessive correlation between the guarantees and credit derivatives that
scope of an eligible double default creditworthiness of the obligor of the cover retail exposures than for those
guarantor is limited to financial firms hedged exposure and the protection that cover wholesale exposures. The
whose normal business includes the provider. For example, the approach set forth above for guarantees
provision of credit protection, as well as creditworthiness of an obligor and a and credit derivatives that cover
the management of a diversified protection provider would be wholesale exposures is an exposure-by-
portfolio of credit risk. This restriction excessively correlated if the obligor exposure approach consistent with the
arises from the agencies’ concern to derives a high proportion of its income overall exposure-by-exposure approach
limit double default recognition to or revenue from transactions with the the rule takes to wholesale exposures.
financial institutions that have a high protection provider. If excessive The agencies believe that a different
level of credit risk management correlation is present, the bank may not treatment for guarantees that cover retail
expertise and that provide sufficient use the double default treatment for the exposures is necessary and appropriate
market disclosure. The restriction is also hedged exposure. because of the rule’s segmentation
designed to limit the risk of excessive The risk-based capital requirement for approach to retail exposures. The
correlation between the a hedged exposure subject to double approaches to retail guarantees
creditworthiness of the guarantor and default treatment is calculated by described in this section generally apply
the obligor of the hedged exposure due multiplying a risk-based capital only to guarantees of individual retail
to their performance depending on requirement for the hedged exposure (as exposures. Guarantees of multiple retail
common economic factors beyond the if it were unhedged) by an adjustment exposures (such as pool private
systematic risk factor. As a result, factor that considers the PD of the mortgage insurance (PMI)) are typically
hedged exposures to potential credit protection provider (see section 34 of tranched (that is, they cover less than
protection providers or affiliates of the rule). Thus, the PDs of both the the full amount of the hedged
credit protection providers are not obligor of the hedged exposure and the exposures) and, therefore, are
eligible for the double default treatment. protection provider are factored into the securitization exposures under the final
In addition, the agencies have excluded hedged exposure’s risk-based capital rule.
hedged exposures to sovereign entities requirement. In addition, as under the The rule does not specify the ways in
from eligibility for double default PD substitution treatment in section 33 which guarantees and credit derivatives
treatment because of the potential high of the rule, the bank is allowed to set may be taken into account in the
correlation between the LGD equal to the lower of the LGD of segmentation of retail exposures.
Likewise, the rule does not explicitly recognize non-eligible retail guarantees D. Unsettled Securities, Foreign
limit the extent to which a bank may provided by a wholesale guarantor by Exchange, and Commodity Transactions
take into account the credit risk treating the hedged retail exposure as a Section 35 of the final rule describes
mitigation benefits of guarantees and direct exposure to the guarantor and the risk-based capital requirements for
credit derivatives in its estimation of the applying the appropriate wholesale IRB unsettled and failed securities, foreign
PD and LGD of retail segments, except risk-based capital formula. In other exchange, and commodities
by the application of overall floors on words, for retail exposures covered by transactions. The agencies did not
certain PD and LGD assignments. This non-eligible retail guarantees, a bank receive any material comments on this
approach has the principal advantage of would be permitted to reflect the aspect of the proposed rule and are
being relatively easy for banks to guarantee by ‘‘desegmenting’’ the retail adopting it as proposed.
implement—the approach generally exposures (which effectively would Under the final rule, certain
would not disrupt the existing retail convert the retail exposures into transaction types are excluded from the
segmentation practices of banks and wholesale exposures) and then applying scope of section 35, including:
would not interfere with banks’ the rules set forth above for guarantees (i) Transactions accepted by a
quantification of PD and LGD for retail that cover wholesale exposures. Thus, qualifying central counterparty that are
segments. under this approach, a bank would not subject to daily marking-to-market and
In the proposal, the agencies be allowed to recognize either double daily receipt and payment of variation
expressed some concern, however, that default or double recovery effects for margin (which do not have a risk-based
this approach would provide banks with non-eligible retail guarantees. capital requirement); 88
substantial discretion to incorporate A second alternative that the agencies (ii) Repo-style transactions (the risk-
double default and double recovery described in the preamble to the based capital requirements of which are
effects. To address these concerns, the proposed rule would permit a bank to determined under sections 31 and 32 of
preamble to the proposed rule described recognize the credit risk mitigation the final rule);
two possible alternative treatments for benefits of all eligible guarantees (iii) One-way cash payments on OTC
guarantees of retail exposures. The first (whether eligible retail guarantees or derivative contracts (the risk-based
alternative distinguished between not) that cover retail exposures by capital requirements of which are
eligible retail guarantees and all other adjusting its estimates of LGD for the determined under sections 31 and 32 of
(non-eligible) guarantees of retail relevant segments, but would subject a the final rule); and
exposures. Under this alternative, an bank’s risk-based capital requirement (iv) Transactions with a contractual
eligible retail guarantee would be an for a segment of retail exposures that are settlement period that is longer than the
eligible guarantee that applies to a covered by one or more non-eligible normal settlement period (defined
single retail exposure and is (i) PMI retail guarantees to a floor. Under this below), which transactions are treated
issued by a highly creditworthy second alternative, the agencies could as OTC derivative contracts and
insurance company; or (ii) issued by a impose a floor on risk-based capital assessed a risk-based capital
sovereign entity or a political requirements of between 2 percent and requirement under sections 31 and 32 of
subdivision of a sovereign entity. 6 percent on such a segment of retail the final rule. The final rule also
Under this alternative, a bank would exposures. provides that, in the case of a system-
be able to recognize the credit risk A substantial number of commenters wide failure of a settlement or clearing
mitigation benefits of eligible retail supported the flexible approach in the system, the bank’s primary Federal
guarantees that cover retail exposures in text of the proposed rule. A few supervisor may waive risk-based capital
a segment by adjusting its estimates of commenters also supported the first
requirements for unsettled and failed
LGD for the segment to reflect recoveries alternative approach in the preamble of
transactions until the situation is
from the guarantor. However, the bank the proposed rule. Commenters
rectified.
would have to estimate the PD of a uniformly urged the agencies not to The final rule contains separate
segment without reflecting the benefit of adopt the second alternative approach. treatments for delivery-versus-payment
guarantees. Specifically, a segment’s PD The agencies have decided to adopt the (DvP) and payment-versus-payment
would be an estimate of the stand-alone approach to retail guarantees in the text (PvP) transactions with a normal
probability of default for the retail of the proposed rule and not to adopt
settlement period, on the one hand, and
exposures in the segment, before taking either alternative approach described in
non-DvP/non-PvP transactions with a
account of any guarantees. Accordingly, the proposed rule preamble. Although
normal settlement period, on the other
for this limited set of traditional the first alternative approach addresses
hand. The final rule provides the
guarantees of retail exposures by high prudential concerns, the agencies have
following definitions of a DvP
credit quality guarantors, a bank would concluded that it is excessively
transaction, a PvP transaction, and a
be allowed to recognize the benefit of conservative and prescriptive and
normal settlement period. A DvP
the guarantee when estimating LGD but would not harmonize with banks’
transaction is a securities or
not when estimating PD. internal risk measurement and
This alternative approach would commodities transaction in which the
management practices. The agencies
provide a different treatment for non- also have determined that the second buyer is obligated to make payment only
eligible retail guarantees. In short, alternative approach is insufficiently if the seller has made delivery of the
within the retail framework, a bank risk sensitive and is not consistent with securities or commodities and the seller
would not be able to recognize non- the New Accord. In light of the final is obligated to deliver the securities or
eligible retail guarantees when rule’s flexible approach to retail commodities only if the buyer has made
estimating PD and LGD for any segment guarantees, the agencies expect banks to payment. A PvP transaction is a foreign
exchange transaction in which each
of retail exposures. A bank would be limit their use of guarantees in the retail
required to estimate PD and LGD for segmentation process and retail risk counterparty is obligated to make a final
segments containing retail exposures parameter estimation process to 88 The agencies consider a qualifying central
with non-eligible guarantees as if the situations where the bank has counterparty to be the functional equivalent of an
exposures were not guaranteed. particularly reliable data about the CRM exchange, and have long exempted exchange-traded
However, a bank would be permitted to benefits of such guarantees. contracts from risk-based capital requirements.
transfer of one or more currencies only external rating of any outstanding information, where available, to
if the other counterparty has made a unsecured long-term debt security determine risk-based capital
final transfer of one or more currencies. without credit enhancement issued by requirements: (i) An assessment of the
A transaction has a normal settlement the counterparty. A bank may estimate securitization exposure’s credit risk
period if the contractual settlement a loss severity rating or LGD for the made by a nationally recognized
period for the transaction is equal to or exposure, or may use a 45 percent LGD statistical rating organization (NRSRO);
less than the market standard for the for the exposure provided the bank uses or (ii) the risk-based capital requirement
instrument underlying the transaction the 45 percent LGD for all such for the underlying exposures as if the
and equal to or less than five business exposures (that is, for all non-DvP/non- exposures had not been securitized
days. PvP transactions subject to a risk-based (along with certain other objective
A bank must hold risk-based capital capital requirement other than information about the securitization
against a DvP or PvP transaction with a deduction under section 35 of the final exposure, such as the size and relative
normal settlement period if the bank’s rule). Alternatively, a bank may use a seniority of the exposure).
counterparty has not made delivery or 100 percent risk weight for all non-DvP/
payment within five business days after 1. Hierarchy of Approaches
non-PvP transactions subject to a risk-
the settlement date. The bank must based capital requirement other than The securitization framework
determine its risk-weighted asset deduction under section 35 of the final contains three general approaches for
amount for such a transaction by rule. determining the risk-based capital
multiplying the positive current If, in a non-DvP/non-PvP transaction requirement for a securitization
exposure of the transaction for the bank with a normal settlement period, the exposure: a ratings-based approach
by the appropriate risk weight in Table bank has not received its deliverables by (RBA), an internal assessment approach
E. The positive current exposure of a the fifth business day after counterparty (IAA), and a supervisory formula
transaction of a bank is the difference delivery was due, the bank must deduct approach (SFA). Consistent with the
between the transaction value at the the current market value of the New Accord and the proposal, under
agreed settlement price and the current deliverables owed to the bank 50 the final rule a bank generally must
market price of the transaction, if the percent from tier 1 capital and 50 apply the following hierarchy of
difference results in a credit exposure of percent from tier 2 capital. approaches to determine the risk-based
the bank to the counterparty. The total risk-weighted asset amount capital requirement for a securitization
for unsettled transactions equals the exposure.
TABLE E.—RISK WEIGHTS FOR UNSET- sum of the risk-weighted asset amount Gains-on-Sale and CEIOs
TLED DVP AND PVP TRANSACTIONS for each DvP and PvP transaction with
Under the proposed rule, a bank
a normal settlement period and the risk-
Risk weight to be would deduct from tier 1 capital any
Number of business weighted asset amount for each non-
applied to positive after-tax gain-on-sale resulting from a
days after contractual current exposure DvP/non-PvP transaction with a normal
settlement date securitization and would deduct from
(percent) settlement period.
total capital any portion of a CEIO that
From 5 to 15 ............... 100 E. Securitization Exposures does not constitute a gain-on-sale, as
From 16 to 30 ............. 625 This section describes the framework described in section 42(a)(1) and (c) of
From 31 to 45 ............. 937.5 for calculating risk-based capital the proposed rule. Thus, if the after-tax
46 or more .................. 1,250 requirements for securitization gain-on-sale associated with a
exposures (the securitization securitization equaled $100 while the
A bank must hold risk-based capital framework). In contrast to the amount of CEIOs associated with that
against any non-DvP/non-PvP framework for wholesale and retail same securitization equaled $120, the
transaction with a normal settlement exposures, the securitization framework bank would deduct $100 from tier 1
period if the bank has delivered cash, does not permit a bank to rely on its capital and $20 from total capital ($10
securities, commodities, or currencies to internal assessments of the risk from tier 1 capital and $10 from tier 2
its counterparty but has not received its parameters of a securitization capital).
corresponding deliverables by the end exposure.89 For securitization Several commenters asserted that the
of the same business day. The bank proposed deductions of gains-on-sale
exposures, which typically are tranched
must continue to hold risk-based capital and CEIOs were excessively
exposures to a pool of underlying
against the transaction until the bank conservative, because such deductions
exposures, such assessments would
has received its corresponding are not reflected in an originating bank’s
require implicit or explicit estimates of
deliverables. From the business day maximum risk-based capital
correlations among the losses on the
after the bank has made its delivery requirement associated with a single
underlying exposures and estimates of
until five business days after the securitization transaction (described
the credit risk-transfering consequences
counterparty delivery is due, the bank below). Commenters noted that while
of tranching. Such correlation and
must calculate its risk-based capital securitization does not increase an
tranching effects are difficult to estimate
requirement for the transaction by originating bank’s overall risk exposure
and validate in an objective manner and
treating the current market value of the to the securitized assets, in some
on a going-forward basis. Instead, the
deliverables owed to the bank as a circumstances the proposal would result
securitization framework relies
wholesale exposure. in a securitization transaction increasing
principally on two sources of
For purposes of computing a bank’s an originating bank’s risk-based capital
risk-based capital requirement for 89 Although the IAA described below does allow requirement. To address this concern,
unsettled non-DvP/non-PvP a bank to use an internal-ratings-based approach to some commenters suggested deducting
transactions, a bank may assign an determine its risk-based capital requirement for an CEIOs from total capital only when the
internal obligor rating to a counterparty exposure to an ABCP program, banks are required CEIOs constitute a gain-on-sale. Others
to follow NRSRO rating criteria and therefore are
for which it is not otherwise required required implicitly to use the NRSRO’s
urged adopting the treatment of CEIOs
under the final rule to assign an obligor determination of the correlation of the underlying in the general risk-based capital rules.
rating on the basis of the applicable exposures in the ABCP program. Under this treatment, the entire amount
of CEIOs beyond a concentration requirement for the underlying capital requirements for retained
threshold is deducted from total capital exposures as if they were held directly securitization exposures.
and there is no separate gain-on-sale by the bank. A bank that qualifies for
Deduction
deduction. and chooses to use the IAA must use the
The final rule retains the proposed IAA for all exposures that qualify for the If a securitization exposure is not a
deduction of gains-on-sale and CEIOs. IAA. gain-on-sale or a CEIO and does not
These deductions are consistent with A number of commenters asserted qualify for the RBA, the IAA, or the
the New Accord, and the agencies that a bank should be permitted to use SFA, the bank must deduct the exposure
believe they are warranted given the IAA for a securitization exposure to from total capital.
historical supervisory concerns with the an ABCP conduit even when the Numerous commenters requested an
subjectivity involved in valuations of exposure has an inferred rating, alternative to deducting the
gains-on-sale and CEIOs. Furthermore, provided all other IAA eligibility securitization exposure from capital.
although the treatments of gains-on-sale criteria were met. The commenters Some of these commenters noted that if
and CEIOs can increase an originating maintained that the RBA would produce a bank does not service the underlying
bank’s risk-based capital requirement an excessive risk-based capital assets, the bank may not be able to
following a securitization, the agencies requirement for an unrated produce highly accurate estimates of a
believe that such anomalies will be rare securitization exposure, such as a key SFA risk parameter, KIRB, which is
where a securitization transfers liquidity facility, when the inferred the risk-based capital requirement as if
significant credit risk from the rating is based on a rated security that the underlying assets were held directly
originating bank to third parties. is very junior to the unrated exposure. by the bank. Commenters expressed
Commenters suggested that allowing a concern that, under the proposal, a bank
Ratings-Based Approach (RBA) bank to use the IAA instead of the RBA would be required to deduct from
If a securitization exposure is not a in such circumstances would lead to a capital some structured lending
gain-on-sale or CEIO, a bank must apply risk-based capital requirement that was products that have long histories of low
the RBA to a securitization exposure if better aligned with the unrated credit losses. Commenters maintained
the exposure qualifies for the RBA. As exposure’s actual risk. that a bank should be allowed to
a general matter, an exposure qualifies Like the New Accord, the final rule calculate the securitization exposure’s
for the RBA if the exposure has an does not allow a bank to use the IAA for risk-based capital requirement using the
external rating from an NRSRO or has securitization exposures that qualify for rules for wholesale exposures or using
an inferred rating (that is, the exposure the RBA based on an inferred rating. an IAA-like approach under which the
is senior to another securitization While in some cases the IAA might bank’s internal risk rating for the
exposure in the transaction that has an produce a more risk-sensitive capital exposure would be mapped into an
external rating from an NRSRO).90 For treatment relative to an inferred rating NRSRO’s rating category.
example, a bank generally must use the under the RBA, the agencies—as well as Like the proposal, the final rule
RBA approach to determine the risk- the majority of commenters—believe contains only those securitization
that it is important to retain as much approaches in the New Accord. As
based capital requirement for an asset-
consistency as possible with the New already noted, the agencies—and most
backed security that has an applicable
Accord to provide a level international commenters—believe that it is
external rating of AA+ from an NRSRO
playing field for financial services important to minimize substantive
and for another tranche of the same
providers in a competitive line of differences between the final rule and
securitization that is unrated but senior
business. The commenters’ concerns the New Accord to foster international
in all respects to the asset-backed
relating to inferred ratings apply only to consistency. Furthermore, the agencies
security that was rated. In this example,
a small proportion of outstanding ABCP believe that the hierarchy of
the senior unrated tranche would be
liquidity facilities. In many cases, a securitization approaches is sufficiently
treated as if it were rated AA+.
bank may mitigate such concerns by comprehensive to accommodate
Internal Assessment Approach (IAA) having the ABCP program issue an demonstrably low-risk structured
If a securitization exposure does not additional, intermediate layer of lending arrangements in a risk-sensitive
qualify for the RBA but the exposure is externally rated securities, which would manner. As described in greater detail
to an ABCP program—such as a credit provide a more accurate reference for below, for securitization exposures that
enhancement or liquidity facility—the inferring a rating on the unrated are not eligible for the RBA or the IAA,
bank may apply the IAA (if the bank, liquidity facility. The agencies intend to a bank has flexibility under the SFA to
the exposure, and the ABCP program monitor developments in this area and, tailor its procedures for estimating KIRB
qualify for the IAA) or the SFA (if the as appropriate, will coordinate any to the data that are available. The
bank and the exposure qualify for the reassessment of the hierarchy of agencies recognize that, in light of data
SFA) to the exposure. As a general securitization approaches with the shortcomings, a bank may have to use
matter, a bank will qualify to use the BCBS and other supervisory and approaches to estimating KIRB that are
IAA if the bank establishes and regulatory authorities. less sophisticated than what the bank
maintains an internal risk rating system might use for similar assets that it
Supervisory Formula Approach (SFA) originates, services, and holds directly.
for exposures to ABCP programs that
If a securitization exposure is not a Supervisors generally will review the
has been approved by the bank’s
gain-on-sale or a CEIO, does not qualify reasonableness of KIRB estimates in the
primary Federal supervisor.
for the RBA, and is not an exposure to context of available data, and will
Alternatively, a bank may use the SFA
an ABCP program for which the bank is expect estimates of KIRB to incorporate
if the bank is able to calculate a set of
applying the IAA, the bank may apply appropriate conservatism to address any
risk factors relating to the securitization,
the SFA to the exposure if the bank is data shortcomings.
including the risk-based capital
able to calculate the SFA risk Total risk-weighted assets for
90 A securitization exposure held by an parameters for the securitization. In securitization exposures equals the sum
originating bank must have two or more external many cases, an originating bank would of risk-weighted assets calculated under
ratings or inferred ratings to qualify for the RBA. use the SFA to determine its risk-based the RBA, IAA, and SFA, plus any risk-
weighted asset amounts calculated significantly heightened risk sensitivity approach for exposures to ABCP
under the early amortization provisions of the IRB approach, the agencies conduits. The final rule permits a bank
in section 47 of the final rule. believe that the maximum risk-based to use the IAA for a securitization
capital requirement in the final rule is exposure for which any underlying
Exceptions to the General Hierarchy of
appropriate. exposure of the securitization is not a
Approaches The securitization framework also wholesale, retail, securitization or
Consistent with the New Accord and includes provisions to limit the double equity exposure, provided the
the proposed rule, the final rule counting of risks in situations involving securitization exposure is not gain-on-
includes a mechanism that generally overlapping securitization exposures. sale, not a CEIO, and not eligible for the
prevents a bank’s effective risk-based While the proposal addressed only RBA, and all of the IAA qualification
capital requirement from increasing as a those overlapping exposures arising in criteria are met.
result of the bank securitizing its assets. the context of exposures to ABCP
Specifically, the rule limits a bank’s programs and mortgage loan swaps with As described in section V.A.3. of this
effective risk-based capital requirement recourse, the final rule addresses preamble, a few commenters asserted
for all of its securitization exposures to overlapping exposures for that OTC derivatives with a
a single securitization to the applicable securitizations more generally. If a bank securitization SPE as the counterparty
risk-based capital requirement if the has multiple securitization exposures should be excluded from the definition
underlying exposures were held directly that provide duplicative coverage of the of securitization exposure. These
by the bank. Under the rule, unless one underlying exposures of a securitization commenters objected to the burden of
or more of the underlying exposures (such as when a bank provides a using the securitization framework to
does not meet the definition of a program-wide credit enhancement and calculate a capital requirement for
wholesale, retail, securitization, or multiple pool-specific liquidity facilities counterparty credit risk for OTC
equity exposure, the total risk-based to an ABCP program), the bank is not derivatives with a securitization SPE.
capital requirement for all securitization required to hold duplicative risk-based The agencies continue to believe that
exposures held by a single bank capital against the overlapping position. the securitization framework is the most
associated with a single securitization Instead, the bank would apply to the appropriate way to assess the
(including any regulatory capital overlapping position the applicable risk- counterparty credit risk of such
requirement that relates to an early based capital treatment under the exposures, and that in many cases the
amortization provision, but excluding securitization framework that results in relatively simple RBA will apply to
any capital requirements that relate to the highest capital requirement. If such exposures. In response to
the bank’s gain-on-sale or CEIOs different banks have overlapping commenter concerns about burden, the
associated with the securitization) exposures to a securitization, however, agencies have decided to add an
cannot exceed the sum of (i) the bank’s each bank must hold capital against the optional simple risk weight approach
total risk-based capital requirement for entire maximum amount of its exposure. for certain OTC derivatives. Under the
the underlying exposures as if the bank Although duplication of capital final rule, if a securitization exposure is
directly held the underlying exposures; requirements will not occur for an OTC derivative contract (other than
and (ii) the bank’s total ECL for the individual banks, some systemic a credit derivative) that has a first
underlying exposures. duplication may occur where multiple priority claim on the cash flows from
One commenter urged the agencies to banks have overlapping exposures to the the underlying exposures
delete the reference to ECL in the capital same securitization. (notwithstanding amounts due under
calculation. However, the agencies The proposed rule also addressed the interest rate or currency derivative
believe it is appropriate to include the risk-based capital treatment of a contracts, fees due, or other similar
ECL of the underlying exposures in this securitization of non-IRB assets. Claims payments), a bank may choose to apply
calculation because ECL is included in to future music concert and film an effective 100 percent risk weight to
the New Accord’s limit, and because the receivables are examples of financial the exposure rather than the general
bank would have had to estimate the assets that are not wholesale, retail, securitization hierarchy of approaches.
ECL of the exposures and hold reserves securitization, or equity exposures. In This treatment is subject to supervisory
or capital against the ECL if the bank these cases, the SFA cannot be used approval.
held the underlying exposures on its because of the absence of a risk-
balance sheet. sensitive measure of the credit risk of Like the proposed rule, the final rule
This maximum risk-based capital the underlying exposures. Specifically, contains three additional exceptions to
requirement is different from the general under the proposed rule, if a bank had the general hierarchy. Each exception
risk-based capital rules. Under the a securitization exposure and any parallels the general risk-based capital
general risk-based capital rules, banks underlying exposure of the rules. First, an interest-only mortgage-
generally are required to hold a dollar securitization was not a wholesale, backed security must be assigned a risk
in capital for every dollar in residual retail, securitization or equity exposure, weight that is no less than 100 percent.
interest, regardless of the effective risk- the bank would (i) apply the RBA if the Although a number of commenters
based capital requirement on the securitization exposure qualifies for the objected to this risk weight floor on the
underlying exposures. The agencies RBA and is not gain-on-sale or a CEIO; grounds that it was not risk sensitive,
adopted this dollar-for-dollar capital or (ii) otherwise, deduct the exposure the agencies believe that a minimum
treatment for a residual interest to from total capital. risk weight of 100 percent is prudent in
recognize that in many instances the Numerous commenters asserted that a light of the uncertainty implied by the
relative size of the residual interest bank should be allowed to use the IAA substantial price volatility of these
securities. Second, a sponsoring bank
retained by the originating bank reveals in these situations since, unlike the
market information about the quality of SFA, the IAA is tied to NRSRO rating that qualifies as a primary beneficiary
the underlying exposures and methodologies rather than to the risk- and must consolidate an ABCP program
transaction structure that may not have based capital requirement for the as a variable interest entity under GAAP
been captured under the general risk- underlying exposures. The agencies generally may exclude the consolidated
based capital rules. Given the believe that this is a reasonable ABCP program assets from risk-
weighted assets.91 In such cases, the unlikely to be repaid. Consistent with exposure is based on whether or not the
bank must hold risk-based capital the general risk-based capital rules with exposure is classified as an available for
against any securitization exposures of respect to residential mortgage servicer sale security.
the bank to the ABCP program. Third, cash advances, a servicing bank is not Under the proposal, when a
as required by Federal statute, a special required to hold risk-based capital securitization exposure to an ABCP
set of rules applies to transfers of small against the undrawn portion of an program takes the form of a
business loans and leases with recourse eligible servicer cash advance facility. A commitment, such as a liquidity facility,
by well-capitalized depository bank that provides a non-eligible the notional amount could be reduced
institutions.92 servicer cash advance facility must to the maximum potential amount that
determine its risk-based capital the bank currently would be required to
Servicer Cash Advances
requirement for the undrawn portion of fund under the arrangement’s
A traditional securitization typically the facility in the same manner as the documentation (the maximum potential
employs a servicing bank that—on a bank would determine its risk-based amount that could be drawn given the
day-to-day basis—collects principal, capital requirement for any other assets currently held by the program).
interest, and other payments from the undrawn securitization exposure. Within some ABCP programs, however,
underlying exposures of the certain commitments, such as liquidity
securitization and forwards such Amount of a Securitization Exposure
facilities, may be dynamic in that the
payments to the securitization SPE or to Under the proposed rule, the amount maximum amount that can be drawn at
investors in the securitization. Such of an on-balance sheet securitization any moment depends on the current
servicing banks often provide to the exposure was the bank’s carrying value, credit quality of the program’s
securitization a credit facility under if the exposure was held-to-maturity or underlying assets. That is, if the
which the servicing bank may advance for trading, or the bank’s carrying value underlying assets were to remain fixed,
cash to ensure an uninterrupted flow of minus any unrealized gains and plus but their credit quality deteriorated, the
payments to investors in the any unrealized losses on the exposure, maximum amount that could be drawn
securitization (including advances made if the exposure was available-for-sale. In against the liquidity facility could
to cover foreclosure costs or other general, the amount of an off-balance increase.
expenses to facilitate the timely sheet securitization exposure was the
The final rule clarifies that in such
collection of the underlying exposures). notional amount of the exposure. For an
circumstances the notional amount of
These servicer cash advance facilities OTC derivative contract that was not a
an off-balance sheet securitization
are securitization exposures. credit derivative, the notional amount
Under the final rule, as under the exposure to an ABCP program may be
was the EAD of the derivative contract
proposed rule, a servicing bank must reduced to the maximum potential
(as calculated in section 32).
determine its risk-based capital In the final rule the agencies are amount that the bank could be required
requirement for any advances under maintaining the substance of the to fund given the program’s current
such a facility using the hierarchy of proposed provision on the amount of a assets (calculated without regard to the
securitization approaches described securitization exposure with one current credit quality of these assets).
above. The treatment of the undrawn exception. The final rule provides that Thus, if $100 is the maximum amount
portion of the facility depends on the amount of a securitization exposure that could be drawn given the current
whether the facility is an ‘‘eligible’’ that is a repo-style transaction, eligible volume and current credit quality of the
servicer cash advance facility. An margin loan, or OTC derivative (other program’s assets, but the maximum
eligible servicer cash advance facility is than a credit derivative) is the EAD of potential draw against these same assets
a servicer cash advance facility in which the exposure as calculated in section 32 could increase to as much as $200 if
(i) the servicer is entitled to full of the final rule. The agencies believe their credit quality were to deteriorate,
reimbursement of advances (except that this change is consistent with the way then the exposure amount is $200.
a servicer may be obligated to make banks manage these exposures, more Some commenters recommended
non-reimburseable advances for a appropriately reflects the collateral that capping the securitization amount for an
particular underlying exposure if any directly supports these exposures, and ABCP liquidity facility at the amount of
such advance is limited to an recognizes the credit risk mitigation the outstanding commercial paper
insignificant amount of the outstanding benefits of netting where these covered by that facility. The agencies
principal balance of that exposure); (ii) exposures are part of a cross-product believe, however, that this would be
the servicer’s right to reimbursement is netting set. Because the collateral inappropriate if the liquidity provider
senior in right of payment to all other associated with a repo-style transaction could be required to advance a larger
claims on the cash flows from the or eligible margin loan is reflected in the amount. The agencies note that when
underlying exposures of the determination of exposure amount calculating the exposure amount of a
securitization; and (iii) the servicer has under section 32 of the rule, these liquidity facility, a bank may take into
no legal obligation to, and does not, transactions are not eligible for the account any limits on advances—
make advances to the securitization if general securitization collateral including limits based on the amount of
the servicer concludes the advances are approach in section 46(b) of the final commercial paper outstanding—that are
rule. Similarly, if a bank chooses to contained in the program’s
91 See Financial Accounting Standards Board, reflect collateral associated with an OTC documentation.
Interpretation No. 46: Consolidation of Variable derivative contract in its determination Implicit Support
Interest Entities (January 2003). of exposure amount under section 32 of
92 See 12 U.S.C. 1835, which places a cap on the
the rule, it may not also apply the Like the proposed rule, the final rule
risk-based capital requirement applicable to a well-
sets forth the regulatory capital
capitalized DI that transfers small business loans general securitization collateral

with recourse. The final rule does not expressly approach in section 46(b) of the final consequences if a bank provides support
state that the agencies may permit adequately rule. Similar to the definition of EAD for to a securitization in excess of the
capitalized banks to use the small business recourse bank’s predetermined contractual
rule on a case-by-case basis because the agencies
on-balance sheet exposures, the
may do this under the general reservation of agencies are clarifying that the amount obligation to provide credit support to
authority contained in section 1 of the rule. of an on-balance sheet securitization the securitization. First, consistent with
the general risk-based capital rules,93 a that the agencies conform the proposed and eligible clean-up call. One
bank that provides such implicit operational requirements for traditional commenter observed that prudential
support must hold regulatory capital securitizations to those in the New concerns would also be satisfied if the
against all of the underlying exposures Accord. The agencies believe that the call were at the discretion of the
associated with the securitization as if current conditions to qualify for sale originator of the underlying exposures.
the exposures had not been securitized, treatment under GAAP are broadly The agencies concur with this view and
and must deduct from tier 1 capital any consistent with the guiding principles have modified the final rule to state that
after-tax gain-on-sale resulting from the enumerated in the New Accord. a clean-up call may permit the servicer
securitization. Second, the bank must However, if GAAP in this area were to or originating bank to call the
disclose publicly (i) that it has provided change materially in the future, the securitization exposures before the
implicit support to the securitization, agencies would reassess, and possibly stated maturity or call date, and that an
and (ii) the regulatory capital impact to revise, the operational standards. eligible clean-up call must be
the bank of providing the implicit exercisable solely at the discretion of
Clean-Up Calls
support. The bank’s primary Federal the servicer or the originating bank.
supervisor also may require the bank to To satisfy the operational Commenters also requested clarification
hold regulatory capital against all the requirements for securitizations and whether, for a securitization that
underlying exposures associated with enable an originating bank to exclude involves a master trust, the 10 percent
some or all the bank’s other the underlying exposures from the requirement described above in criteria
securitizations as if the exposures had calculation of its risk-based capital (iii)(A) and (iii)(B) would be interpreted
not been securitized, and to deduct from requirements, any clean-up call as applying to each series or tranche of
tier 1 capital any after-tax gain-on-sale associated with a securitization must be securities issued from the master trust.
resulting from such securitizations. an eligible clean-up call. The proposal The agencies believe this is a reasonable
defined a clean-up call as a contractual interpretation. Thus, where a
Operational Requirements for provision that permits a servicer to call securitization SPE is structured as a
Traditional Securitizations securitization exposures (for example, master trust, a clean-up call with respect
In a traditional securitization, an asset-backed securities) before the stated to a particular series or tranche issued
originating bank typically transfers a (or contractual) maturity or call date. by the master trust would meet criteria
portion of the credit risk of exposures to The preamble to the proposed rule (iii)(A) and (iii)(B) so long as the
third parties by selling them to a explained that, in the case of a outstanding principal amount in that
securitization SPE. Under the final rule, traditional securitization, a clean-up call series was 10 percent or less of its
consistent with the proposed rule, banks is generally accomplished by original amount at the inception of the
engaging in a traditional securitization repurchasing the remaining series.
may exclude the underlying exposures securitization exposures once the
from the calculation of risk-weighted Additional Supervisory Guidance
amount of underlying exposures or
assets only if each of the following outstanding securitization exposures Over the last several years, the
conditions is met: (i) The transfer is a falls below a specified level. In the case agencies have published a significant
sale under GAAP; (ii) the originating of a synthetic securitization, the clean- amount of supervisory guidance to
bank transfers to third parties credit risk up call may take the form of a clause assist banks with assessing the extent to
associated with the underlying that extinguishes the credit protection which they have transferred credit risk
exposures; and (iii) any clean-up calls once the amount of underlying and, consequently, may recognize any
relating to the securitization are eligible exposures has fallen below a specified reduction in required regulatory capital
clean-up calls (as discussed below). level. as a result of a securitization or other
Originating banks that meet these Under the proposed rule, an eligible form of credit risk transfer. 94 In general,
conditions must hold regulatory capital clean-up call would be a clean-up call the agencies expect banks to continue to
against any securitization exposures that: use this guidance, most of which
they retain in connection with the (i) Is exercisable solely at the remains applicable to the advanced
securitization. Originating banks that discretion of the servicer; approaches securitization framework.
fail to meet these conditions must hold (ii) Is not structured to avoid Banks are encouraged to consult with
regulatory capital against the transferred allocating losses to securitization their primary Federal supervisor about
exposures as if they had not been exposures held by investors or transactions that require additional
securitized and must deduct from tier 1 otherwise structured to provide credit guidance.
capital any gain-on-sale resulting from enhancement to the securitization (for 2. Ratings-Based Approach (RBA)
the transaction. The operational example, to purchase non-performing
requirements for synthetic securitization underlying exposures); and Under the final rule, as under the
are described in preamble section (iii) (A) For a traditional proposal, a bank must determine the
V.E.7., below. securitization, is only exercisable when risk-weighted asset amount for a
Consistent with the general risk-based 10 percent or less of the principal securitization exposure that is eligible
capital rules, the above operational amount of the underlying exposures or for the RBA by multiplying the amount
requirements refer specifically to GAAP securitization exposures (determined as of the exposure by the appropriate risk-
for the purpose of determining whether of the inception of the securitization) is weight provided in the tables in section
a securitization transaction should be outstanding. 43 of the rule. Under the proposal,
treated as an asset sale or a financing. (B) For a synthetic securitization, is whether a securitization exposure was
In contrast, the New Accord stipulates only exercisable when 10 percent or less eligible for the RBA would depend on
whether the bank holding the
guiding principles for use in of the principal amount of the reference

determining whether sale treatment is portfolio of underlying exposures
94 See, e.g., OCC Bulletin 99–46 (Dec. 13, 1999)
warranted. One commenter requested (determined as of the inception of the
(OCC); FDIC Financial Institution Letter 109–99
securitization) is outstanding. (Dec. 13, 1999) (FDIC); SR Letter 99–37 (Dec. 13,
93 Interagency Guidance on Implicit Recourse in A number of comments addressed the 1999) (Board); CEO Ltr. 99–119 (Dec. 14, 1999)
Asset Securitizations, May 23, 2002. proposed definitions of clean-up call (OTS).
securitization exposure is an originating originating banks. The agencies The agencies do not believe there is
bank or an investing bank. An continue to believe that external ratings a compelling need at this time to
originating bank would be eligible to for securitization exposures retained by supplement the New Accord’s methods
use the RBA for a securitization an originating bank, which typically are for determining an inferred rating.
exposure if (i) the exposure had two or not traded, are subject to less market However, if a need develops in the
more external ratings, or (ii) the discipline than ratings for exposures future, the agencies will seek to revise
exposure had two or more inferred sold to third parties. This disparity in the New Accord in coordination with
ratings. In contrast, an investing bank market discipline warrants more the BCBS and other supervisory and
would be eligible to use the RBA for a stringent conditions on use of the regulatory authorities. In the situations
securitization exposure if the exposure former for risk-based capital purposes. cited above, the framework already
has one or more external or inferred Accordingly, the final rule retains the provides simplified methods for
ratings. A bank would be an originating two-rating requirement for originating calculating a securitization exposure’s
bank if it (i) directly or indirectly banks. risk-based capital requirement. For
originated or securitized the underlying Consistent with the New Accord, the example, when a securitization
exposures included in the final rule states that an unrated exposure benefits from a full guarantee,
securitization, or (ii) serves as an ABCP securitization exposure has an inferred such as from an externally rated
program sponsor to the securitization. rating if another securitization exposure monoline insurance company, the
The proposed rule defined an external issued by the same issuer and secured exposure’s external rating often will
rating as a credit rating assigned by a by the same underlying exposures has reflect that guarantee. When the
NRSRO to an exposure, provided (i) the an external rating and this rated guaranteed securitization exposure is
credit rating fully reflects the entire reference exposure (i) is subordinate in not externally rated, subject to the rules
amount of credit risk with regard to all all respects to the unrated securitization for recognition of guarantees of
payments owed to the holder of the exposure; (ii) does not benefit from any securitization exposures in section 46,
exposure, and (ii) the external rating is credit enhancement that is not available the unrated securitization exposure may
published in an accessible form and is to the unrated securitization exposure; be treated as a direct (wholesale)
included in the transition matrices and (iii) has an effective remaining exposure to the guarantor. In addition,
made publicly available by the NRSRO maturity that is equal to or longer than when a securitization exposure to an
that summarize the historical the unrated securitization exposure. ABCP program is secured by a single,
performance of positions it has rated. Under the RBA, securitization externally rated asset, a look-through
For example, if a holder is owed exposures with an inferred rating are approach may be possible under the
principal and interest on an exposure, treated the same as securitization IAA provided that such a look-through
the credit rating must fully reflect the exposures with an identical external is no less conservative than the
credit risk associated with timely rating. This definition does not permit applicable NRSRO rating
repayment of principal and interest. a bank to assign an inferred rating based methodologies.
Under the proposed rule, an exposure’s on the ratings of the underlying Under the proposal, if a securitization
applicable external rating was the exposures in a securitization, even exposure had multiple external ratings
lowest external rating assigned to the when the unrated securitization or multiple inferred ratings, a bank
exposure by any NRSRO. exposure is secured by a single, would be required to use the lowest
The proposed two-rating requirement externally rated security. In particular, rating (the rating that would produce
for originating banks was the only such a look-through approach would the highest risk-based capital
material difference between the fail to meet the requirements that the requirement). Commenters objected that
treatment of originating banks and rated reference exposure must be issued this treatment was significantly more
investing banks under the proposed by the same issuer, secured by the same conservative than required by the New
securitization framework. Although the underlying assets, and subordinated in Accord, which permits use of the
two-rating requirement is not included all respects to the unrated securitization second most favorable rating, and would
in the New Accord, it is generally exposure. unfairly penalize banks in situations
consistent with the treatment of The agencies sought comment on where the lowest rating was unsolicited
originating and investing banks in the whether they should consider other or an outlier. The agencies recognize
general risk-based capital rules. The bases for inferring a rating for an commenters’ concerns regarding
agencies sought comment on whether unrated securitization position, such as unsolicited ratings, and note that the
this treatment was appropriate, and on using an applicable credit rating on New Accord states banks should use
possible alternative mechanisms that outstanding long-term debt of the issuer solicited ratings. To maintain
could be employed to ensure the or guarantor of the securitization consistency with the general risk-based
reliability of external and inferred exposure. In situations where an capital rules, the final rule defines the
ratings on securitization exposures unrated securitization exposure applicable external rating of a
retained by originating banks. benefited from a guarantee that covered securitization exposure to be its lowest
Commenters generally objected to the all contractual payments associated solicited external rating and the
two-rating requirement for originating with the securitization exposure, several applicable inferred rating of a
banks. Many asserted that since the commenters advocated allowing an securitization exposure to be the
credit risk of a given securitization inferred rating to be assigned based on inferred rating based on its lowest
exposure was the same regardless of the the long-term rating of the guarantor. In solicited external rating.
holder, the risk-based capital treatments addition, some commenters For securitization exposures eligible
also should be the same. Because recommended that if a senior, unrated for the RBA, the risk-based capital
external ratings would be publicly securitization exposure is secured by a requirement per dollar of securitization
available, some commenters contended single externally rated underlying exposure depends on four factors: (i)
that NRSROs will have strong security, a bank should be permitted to The applicable rating of the exposure;
reputational reasons to give unbiased assign an inferred rating for the unrated (ii) whether the rating reflects a long-
ratings—even to non-traded exposure using a look-through term or short-term assessment of the
securitization exposures retained by approach. exposure’s credit risk; (iii) whether the
exposure is a ‘‘senior’’ exposure; and points. First, in the context of an ABCP senior. A bank must apply the risk
(iv) a measure of the effective number program, the final rule specifically weights in column 3 of Table F to the
(‘‘N’’) of underlying exposures. In states that both the most senior securitization exposure if N is less than
response to a specific question posed by commercial paper issued by the six.
the agencies, commenters generally program and a liquidity facility In certain situations the rule provides
supported linking risk weights under supporting the program may be ‘‘senior’’ a simplified approach for determining
the RBA to these factors. exposures if the liquidity facility
In the proposed rule, a ‘‘senior N. If the notional number of underlying
provider’s right to reimbursement of any exposures of a securitization is 25 or
securitization exposure’’ was defined as drawn amounts is senior to all claims on
a securitization exposure that has a first more or if all the underlying exposures
the cash flow from the underlying
priority claim on the cash flows from are retail exposures, a bank may assume
exposures. Second, the final rule
the underlying exposures, disregarding that N is six or more (unless the bank
clarifies that when determining whether
the claims of a service provider (such as knows or has reason to know that N is
a securitization exposure is senior, a
a swap counterparty or trustee, less than six). However, if the notional
bank is not required to consider any
custodian, or paying agent for the number of underlying exposures of a
amounts due under interest rate or
securitization) to fees from the currency derivative contracts, fees due, securitization is less than 25 and one or
securitization. Generally, only the most or other similar payments. more of the underlying exposures is a
senior tranche of a securitization would non-retail exposure, the bank must
be a senior securitization exposure. For Consistent with the New Accord, a compute N as described in the SFA
example, if multiple tranches of a bank must use Table F below when a section below.
securitization share the transaction’s securitization exposure qualifies for the
RBA based on a long-term external A few commenters wanted to
highest rating, only the tranche with the
rating or an inferred rating based on a determine N only at the inception of a
shortest remaining maturity would be
long-term external rating. A bank may securitization transaction, due to the
treated as senior, since other tranches
apply the risk weights in column 1 of burden of tracking N over time. The
with the same rating would not have a
first claim to cash flows throughout Table F to the securitization exposure agencies believe that a bank must track
their lifetimes. A liquidity facility that only if the N is six or more and the N over time to ensure an appropriate
supports an ABCP program would be a securitization exposure is a senior risk-based capital requirement. The
senior securitization exposure if the securitization exposure. If N is six or number of underlying exposures in a
liquidity facility provider’s right to more but the securitization exposure is securitization typically changes over
reimbursement of the drawn amounts not a senior securitization exposure, the time as some underlying exposures are
was senior to all claims on the cash bank must apply the risk weights in repaid or default. As the number of
flows from the underlying exposures column 2 of Table F. Applying the underlying exposures changes, the risk
except claims of a service provider to principle of conservatism, however, if N profile of the associated securitization
fees. is six or more a bank may use the risk exposures changes, and a bank must
In the final rule, the agencies weights in column 2 of Table F without reflect this change in risk profile in its
modified this definition to clarify two determining whether the exposure is risk-based capital requirement.
TABLE F.—LONG-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA
Column 1 Column 2 Column 3
Risk weights for Risk weights for Risk weights for

Applicable external or inferred rating senior non-senior securitization ex-
(illustrative rating example) securitization ex- securitization exposures backed
posures backed posures backed by non-granular
by granular pools by granular pools pools
(percent) (percent) (percent)
Highest investment grade (for example, AAA) .............................................. 7 12 20
Second highest investment grade (for example, AA) ................................... 8 15 25
Third-highest investment grade—positive designation (for example, A+) .... 10 18 35
Third-highest investment grade (for example, A) .......................................... 12 20
Third-highest investment grade—negative designation (for example, A¥) 20 35
Lowest investment grade—positive designation (for example, BBB+) ......... 35 50
Lowest investment grade (for example, BBB) ............................................... 60 75
Lowest investment grade—negative designation (for example, BBB¥) ...... 100
One category below investment grade—positive designation (for example,

BB+) ........................................................................................................... 250
One category below investment grade (for example, BB) ............................ 425
One category below investment grade—negative designation (for example,

BB¥) .......................................................................................................... 650
TABLE F.—LONG-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA—Continued

More than one category below investment grade ......................................... Deduction from tier 1 and tier 2 capital.
A bank must apply the risk weights in a short-term external rating or an decision rules outlined in the previous
Table G when the securitization inferred rating based on a short-term paragraph to determine which column
exposure qualifies for the RBA based on external rating. A bank must apply the of Table G applies.
TABLE G.—SHORT-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA

Highest investment grade (for example, A1) ................................................. 7 12 20
Second highest investment grade (for example, A2) .................................... 12 20 35
Third highest investment grade (for example, A3) ........................................ 60 75 75
All other ratings .............................................................................................. Deduction from tier 1 and tier 2 capital.
Within Tables G and H, risk weights range—much more rapidly than for discipline because these positions
increase as rating grades decline. Under similarly rated corporate bonds. generally are retained by the bank and
column 2 of Table F, for example, the Under the RBA, a securitization are not traded.
risk weights range from 12 percent for exposure that has an investment-grade The most senior tranches of granular
exposures with the highest investment- rating and has fewer than six effective securitizations with long-term
grade rating to 650 percent for underlying exposures generally receives investment-grade external ratings
exposures rated one category below a higher risk weight than a similarly receive a more favorable risk weight as
investment grade with a negative rated securitization exposure with six or compared to more subordinated
designation. This pattern of risk weights more effective underlying exposures. tranches of the same securitizations. To
is broadly consistent with analyses This treatment is intended to discourage be considered granular, a securitization
employing standard credit risk models a bank from engaging in regulatory must have an N of at least six.
and a range of assumptions regarding capital arbitrage by securitizing very Consistent with the New Accord, the
correlation effects and the types of high-quality wholesale exposures lowest possible risk-weight, 7 percent,
exposures being securitized.95 These (wholesale exposures with a low PD and applies only to senior securitization
LGD), obtaining external ratings on the exposures receiving the highest external
analyses imply that, compared with a
securitization exposures issued by the rating (for example, AAA) and backed
corporate bond having a given level of
securitization, and retaining essentially by a granular asset pool.
stand-alone credit risk (for example, as
all the credit risk of the pool of The agencies sought comment on how
measured by its expected loss rate), a underlying exposures. well the risk weights in Tables G and H
securitization tranche having the same A bank must deduct from regulatory capture the most important risk factors
level of stand-alone credit risk—but capital any securitization exposure with for securitization exposures of varying
backed by a reasonably granular and an external or inferred rating lower than degrees of seniority and granularity. A
diversified pool—will tend to exhibit one category below investment grade for number of commenters contended that,
more systematic risk.96 This effect is long-term ratings or below investment in the interest of competitive equity, the
most pronounced for below-investment- grade for short-term ratings. Although risk weight for senior securitization
grade tranches and is the primary reason this treatment is more conservative than exposures having the highest rating and
why the RBA risk-weights increase suggested by credit risk modeling backed by a granular asset pool should
rapidly as ratings deteriorate over this analyses, the agencies believe that be 6 percent, the level specified in the
deducting such exposures from European Union’s Capital Requirements

95 See Vladislav Peretyatkin and William
regulatory capital is appropriate in light Directive (CRD). The agencies decided
Perraudin, ‘‘Capital for Asset-Backed Securities,’’ of significant modeling uncertainties for against making this change. There is no
Bank of England, February 2003.
96 See, e.g., Michael Pykhtin and Ashish Dev, such low-rated securitization tranches. compelling empirical evidence to
‘‘Credit Risk in Asset Securitizations: An Analytical Moreover, external ratings of these support a 6 percent risk weight for all
Model,’’ Risk (May 2002) S16–S20. tranches are subject to less market exposures satisfying these conditions
and, further, a 6 percent risk weight is opportunity to review a bank’s practices would not normally be covered by
inconsistent with the New Accord. relative to the final rule before allowing NRSRO rating criteria, which focus on
Moreover, estimates of the credit risk a bank to use the optional approach. If the risks of the underlying assets and
associated with such positions tend to a bank chooses to implement the IAA at the exposure’s vulnerability to those
be highly sensitive to subjective the same time that it implements the risks. The agencies agree that such
modeling assumptions and to the advanced approaches, the IAA review ancillary obligations of the seller need
specific types of underlying assets and and approval process will be part of the not be covered by the applicable NRSRO
structure of the transaction, which overall qualification process. If a bank rating criteria for an exposure to be
supports the use of the more chooses to implement the IAA after it eligible for the IAA.
conservative approach in the New has qualified for the advanced To be eligible for the IAA, a bank
Accord. approaches, prior written approval is a must also demonstrate that its internal
necessary safeguard for ensuring credit assessments of securitization
3. Internal Assessment Approach (IAA) exposures used for regulatory capital
appropriate application of the IAA.
Under the final rule, as under the Furthermore, the agencies believe this purposes are consistent with those used
proposal, a bank is permitted to requirement can be implemented in its internal risk management process,
compute its risk-based capital without impeding future innovations in capital adequacy assessment process,
requirement for a securitization ABCP programs. and management information reporting
exposure to an ABCP program (such as Similar to the proposed rule, under systems. The bank must also
a liquidity facility or credit the final rule a bank must demonstrate demonstrate that its internal credit
enhancement) using the bank’s internal that its internal credit assessment assessment process has sufficient
assessment of the credit quality of the process satisfies all the following granularity to identify gradations of risk.
securitization exposure. The ABCP criteria in order to receive approval to Each of the bank’s internal credit
program may be sponsored by the bank use the IAA. assessment categories must correspond
itself or by a third party. To apply the The bank’s internal credit assessments to an external credit rating of an
IAA, the bank’s internal assessment of securitization exposures to ABCP NRSRO. In addition, the bank’s internal
process and the ABCP program must programs must be based on publicly credit assessment process, particularly
meet certain qualification requirements available rating criteria used by an the stress test factors for determining
in section 44 of the final rule, and the NRSRO for evaluating the credit risk of credit enhancement requirements, must
securitization exposure must initially be the underlying exposures. The be at least as conservative as the most
internally rated at least equivalent to requirement that an NRSRO’s rating conservative of the publicly available
investment grade. A bank that elects to criteria be publicly available does not rating criteria of the NRSROs that have
use the IAA for any securitization mean that these criteria must be provided external credit ratings to the
exposure to an ABCP program must use published formally by the NRSRO. commercial paper issued by the ABCP
the IAA to compute risk-based capital While the agencies expect banks to rely program. In light of recent events in the
requirements for all securitization on published rating criteria when these securitization market, the agencies
exposures that qualify for the IAA. criteria are available, an NRSRO often emphasize that if an NRSRO that
Under the IAA, a bank maps its internal delays publication of rating criteria for provides an external rating to an ABCP
credit assessment of a securitization securitizations involving new asset program’s commercial paper changes its
exposure to an equivalent external types until the NRSRO builds sufficient methodology, the bank must evaluate
credit rating from an NRSRO. The bank experience with such assets. Similarly, whether to revise its internal assessment
must determine the risk-weighted asset as securitization structures evolve over process.
amount for a securitization exposure by time, published criteria may be revised Moreover, the bank must have an
multiplying the amount of the exposure with some lag. Especially for effective system of controls and
(using the methodology set forth above securitizations involving new structures oversight that ensures compliance with
in the RBA section) by the appropriate or asset types, the requirement that these operational requirements and
risk weight provided in Table F or G rating criteria be publicly available maintains the integrity and accuracy of
above. should be interpreted broadly to the internal credit assessments. The
Under the proposal, a bank required encompass not only published criteria, bank must also have an internal audit
prior written approval from its primary but also criteria that are obtained function independent from the ABCP
Federal supervisor before it could use through written correspondence or other program business line and internal
the IAA. Several commenters objected communications with an NRSRO. In credit assessment process that assesses
to this requirement maintaining that such cases, these communications at least annually whether the controls
approval is not required under the New should be documented and available for over the internal credit assessment
Accord and would likely delay a bank review by the bank’s primary Federal process function as intended. The bank
being authorized to use the IAA for new supervisor. The agencies believe this must review and update each internal
ABCP programs. Instead, commenters flexibility is appropriate only for unique credit assessment whenever new
requested a submission and non- situations when published rating material information is available, but no
objection approach, under which a bank criteria are not generally applicable. less frequently than annually. The bank
would be allowed to use the IAA in the A commenter asked whether the must also validate its internal credit
absence of any objection from its applicable NRSRO rating criteria must assessment process on an ongoing basis,
supervisor based on examination cover all contractual payments owed to but not less frequently than annually.
findings. The final rule retains the the bank holding the exposure, or only Under the proposed rule, in order for
requirement for prior written approval contractual principal and interest. For a bank to use the IAA on a specific
before a bank can use the IAA. Like example, liquidity facilities typically exposure to an ABCP program, the
other optional approaches in the final obligate the seller to make certain future program had to satisfy the following
rule (for example, the double default fee and indemnity payments directly to requirements:
treatment and the internal models the liquidity bank. These ancillary (i) All commercial paper issued by the
methodology), it is important that the obligations, however, are not an ABCP program must have an external
primary Federal supervisor have an exposure to the ABCP program and rating.
(ii) The ABCP program must have New Accord, the final rule prohibits the securitization exposure by multiplying
robust credit and investment guidelines ABCP program from purchasing the SFA risk-based capital requirement
(underwriting standards). significantly past-due or defaulted for the exposure (as determined by the
(iii) The ABCP program must perform assets in order to ensure that the IAA is supervisory formula set forth below) by
a detailed credit analysis of the asset applied only to securitization exposures 12.5. If the SFA risk weight for a
sellers’ risk profiles. that are relatively low-risk at inception. securitization exposure was 1,250
(iv) The ABCP program’s This criterion would be met if the ABCP percent or greater, however, the bank
underwriting policy must establish program does not fund underlying would deduct the exposure from total
minimum asset eligibility criteria that assets that are significantly past due or capital rather than risk weight the
include a prohibition of the purchase of defaulted when placed into the program exposure. The agencies noted that
assets that are significantly past due or (that is, the program’s advance rate deduction is consistent with the
defaulted, as well as limitations on against such assets is 0 percent) and the treatment of other high-risk
concentrations to an individual obligor securitization exposure is not subject to securitization exposures, such as CEIOs.
or geographic area and the tenor of the potential losses associated with these The SFA capital requirement for a
assets to be purchased. assets. The agencies observe that the securitization exposure depends on the
(v) The aggregate estimate of loss on rule does not set a specific number-of- following seven inputs:
an asset pool that the ABCP program is days-past due criterion. In addition, the
considering purchasing must consider (i) The amount of the underlying
term ‘defaulted assets’ in criterion (iv) exposures (UE);
all sources of potential risk, such as does not refer to the wholesale and
credit and dilution risk. (ii) The securitization exposure’s
retail definitions of default in the final proportion of the tranche that contains
(vi) The ABCP program must
rule, but rather may be interpreted as the securitization exposure (TP);
incorporate structural features into each
referring to assets that have been (iii) The sum of the risk-based capital
purchase of assets to mitigate potential
charged off or written down by the requirement and ECL for the underlying
credit deterioration of the underlying
seller prior to being placed into the exposures (as determined under the
exposures. Such features may include
ABCP program or to assets that would final rule as if the underlying exposures
wind-down triggers specific to a pool of
be charged off or written down under were held directly on the bank’s balance
underlying exposures.
Commenters suggested that the the program’s governing contracts. sheet) divided by the amount of the
In addition, commenters asked the
program-level eligibility criteria should underlying exposures (KIRB);
apply only to those elements of the agencies to clarify that a bank may
ignore one or more of the eligibility (iv) The tranche’s credit enhancement
ABCP program that are relevant to the level (L);
securitization exposure held by the bank requirements where the requirement is
not relevant to a particular exposure. (v) The tranche’s thickness (T);
in order to prevent an ABCP program’s (vi) The securitization’s effective
purchase of a single asset pool that does For example, in the case of a liquidity
facility supporting a static pool of term number of underlying exposures (N);
not meet the above criteria from
loans, it may not be possible to and
disallowing the IAA for securitization
exposures to that program that are incorporate features into the transaction (vii) The securitization’s exposure-
unrelated to the non-qualifying asset that mitigate against a potential weighted average loss given default
pool. The agencies agree that this is a deterioration in these assets, and there (EWALGD).
reasonable approach. Accordingly, the may be no use for detailed credit A bank may only use the SFA to
final rule applies criteria (ii) through analyses of the seller following the determine its risk-based capital
(vi) to the exposures underlying a securitization if the seller has no further requirement for a securitization
securitization exposure, rather than to involvement with the transaction. The exposure if the bank can calculate each
the entire ABCP program. For a agencies have modified the final of these seven inputs on an ongoing
program-wide credit enhancement criterion for determining whether an basis. In particular, if a bank cannot
facility, all of the separate seller-specific exposure qualifies for the IAA, to compute KIRB because the bank cannot
arrangements benefiting from that specify that where relevant, the ABCP compute the risk-based capital
facility must meet the above program must incorporate structural requirement for all underlying
requirements for the facility to be features into each purchase of exposures exposures, the bank may not use the
eligible for the IAA. underlying the securitization exposure SFA to compute its risk-based capital
Several commenters objected to the to mitigate potential credit deterioration requirement for the securitization
requirement that the ABCP program of the underlying exposures. exposure. In those cases, the bank must
prohibit purchases of significantly past- 4. Supervisory Formula Approach (SFA) deduct the exposure from regulatory
due or defaulted assets. Commenters capital.
contended that such purchases should General Requirements The SFA capital requirement for a
be allowed so long as the applicable Under the proposed rule, a bank using securitization exposure is UE multiplied
NRSRO rating criteria permit and deal the SFA would determine the risk- by TP multiplied by the greater of (i)
appropriately with such assets. Like the weighted asset amount for a 0.0056 * T; or (ii) S[L+T] ¥ S[L], where:
In these expressions, b[Y; a, b] refers risk-weight to fall below 1,250 percent. respectively. The bank must deduct
to the cumulative beta distribution with As a result, the bank would not deduct from total capital $5 (UE × TP × (KIRB
parameters a and b evaluated at Y. In any part of the exposure from capital –L)), and the exposure’s risk-weighted
the case where N = 1 and EWALGD = and would, instead, reflect the entire asset amount would be $125 (($15–$5)
100 percent, S[Y] in formula (1) must be amount of the SFA risk-based capital × 12.5).
calculated with K[Y] set equal to the requirement in its risk-weighted assets.
The specific securitization exposures
product of KIRB and Y, and d set equal Consistent with the New Accord,97 the
that are subject to this deduction
to 1–KIRB. The major inputs to the SFA agencies have removed this anomaly
treatment under the SFA may change
formula (UE, TP, KIRB, L, T, EWALGD, from the final rule. Under the final rule
over time in response to variations in
and N) are defined below and in section a bank must deduct from total capital
any part of a securitization exposure the credit quality of the underlying
45 of the final rule. exposures. For example, if the pool’s
that incurs a 1,250 percent risk weight
The agencies are modifying the SFA under the SFA (that is, any part of a IRB capital requirement were to increase
treatment of certain high risk securitization exposure covering loss after the inception of a securitization,
securitization exposures in the final rates on the underlying assets between additional portions of unrated
rule. Under the proposed treatment zero and KIRB). Any part of a securitization exposures may fall below
described above, a bank would have to securitization exposure that incurs less KIRB and thus become subject to
deduct from total capital any than a 1,250 percent risk weight must be deduction under the SFA. Therefore, if
securitization exposure with a SFA risk risk weighted rather than deducted. at the inception of a securitization a
weight equal to 1,250 percent. Under To illustrate, suppose that an bank owns an unrated securitization
certain circumstances, however, a slight exposure’s SFA capital requirement exposure well in excess of KIRB, the
increase in the thickness of the tranche equaled $15, and UE, TP, KIRB, and L capital requirement on the exposure
that contains the securitization exposure equaled $1000, 1.0, 0.10, and 0.095, could climb rapidly in the event of
(T), holding other SFA risk parameters marked deterioration in the credit
ER07DE07.008</GPH>
fixed, could cause the exposure’s SFA 97 New Accord, Annex 7. quality of the underlying exposures and
the bank may be required to deduct the its various tranches. In this way, S[Y] a reserve account (such as a cash
exposure. embodies precisely the same asset collateral account).
The SFA formula effectively imposes correlations as are assumed elsewhere In practice, a bank’s ability to
a 56 basis point minimum risk-based within the IRB approach. In addition, calculate KIRB will often determine
capital requirement (8 percent of the 7 this specification embodies the result whether it can use the SFA or whether
percent risk weight) per dollar of that a pool’s systematic risk (KIRB) tends it must instead deduct an unrated
securitization exposure. Although such to be redistributed toward more senior securitization exposure from total
a floor may impose a capital tranches as N declines.99 The capital. As noted above, there is a need
requirement that is too high for some importance of pool granularity depends for flexibility when the estimation of
securitization exposures, the agencies on the pool’s average loss severity rate, KIRB is constrained by data
continue to believe that some minimum EWALGD. For small values of N, the shortcomings, such as when the bank
prudential capital requirement is framework implies that, as EWALGD holding the securitization exposure is
appropriate in the securitization increases, systematic risk is shifted not the servicer of the underlying assets.
context. This 7 percent risk-weight floor toward senior tranches. For highly The final rule clarifies that the
is also consistent with the lowest capital granular pools, such as securitizations simplified approach for eligible
requirement available under the RBA of retail exposures, EWALGD would purchased wholesale exposures (Section
and, thus, should reduce incentives for have no influence on the SFA capital 31) may be used for calculating KIRB.
regulatory capital arbitrage. requirement. To reduce the operational burden of
The SFA formula is a blend of credit estimating KIRB, several commenters
risk modeling results and supervisory Inputs to the SFA Formula
urged the agencies to develop a simple
judgment. The function S[Y] Consistent with the proposal, the final look-through approach such that when
incorporates two distinct features. The rule defines the seven inputs into the all of the assets held by the SPE are
first is a pure model-based estimate of SFA formula as follows: externally rated, KIRB could be
the pool’s aggregate systematic or non- (i) Amount of the underlying
determined directly from the external
diversifiable credit risk that is exposures (UE). This input (measured in
ratings of theses assets. The agencies
attributable to a first loss position dollars) is the EAD of any underlying
believe that a look-through approach for
covering losses up to and including Y. wholesale and retail exposures plus the
estimating KIRB would be inconsistent
Because the tranche of interest covers amount of any underlying exposures
with the New Accord and would
losses over a specified range (defined in that are securitization exposures (as
increase the potential for capital
terms of L and T), the tranche’s defined in section 42(e) of the proposed
arbitrage. The agencies note that several
systematic risk can be represented as rule) plus the adjusted carrying value of
simplified methods for estimating risk-
S[L+T] ¥ S[L]. The second feature any underlying equity exposures (as
weighted assets for the underlying
involves a supervisory add-on primarily defined in section 51(b) of the proposed
exposures for the purposes of
intended to avoid behavioral distortions rule). UE also includes any funded
computing KIRB are provided in other
associated with what would otherwise spread accounts, cash collateral
parts of the framework. For example, the
be a discontinuity in capital accounts, and other similar funded
simplified approach for eligible
requirements for relatively thin credit enhancements.
purchased wholesale exposures in
mezzanine tranches lying just below (ii) Tranche percentage (TP). TP is the
section 31 may be available when a
and just above the KIRB boundary. ratio of (i) the amount of the bank’s
bank can estimate risk parameters for
Without this add-on, all tranches at or securitization exposure to (ii) the
segments of underlying wholesale
below KIRB would be deducted from amount of the securitization tranche
exposures but not for each of the
capital, whereas a very thin tranche just that contains the bank’s securitization
individual exposures. If the assets held
above KIRB would incur a pure model- exposure.
(iii) KIRB. KIRB is the ratio of (i) the by the SPE are securitization exposures
based percentage capital requirement with external ratings, the RBA would be
that could vary between zero and one, risk-based capital requirement for the
underlying exposures plus the ECL of used to determine risk-weighted assets
depending on the number of effective for the underlying exposures based on
underlying exposures (N). The the underlying exposures (all as
determined as if the underlying these ratings. If the assets held by the
supervisory add-on applies primarily to SPE represent shares in an investment
positions just above KIRB, and its exposures were directly held by the
bank) to (ii) UE. The definition of KIRB company (that is, unleveraged, pro rata
quantitative effect diminishes rapidly as ownership interests in a pool of
the distance from KIRB widens. includes the ECL of the underlying
exposures in the numerator because if financial assets), the bank may be
Apart from the risk-weight floor and eligible to determine risk-weighted
other supervisory adjustments described the bank held the underlying exposures
on its balance sheet, the bank also assets for the underlying exposures
above, the supervisory formula attempts using the Alternative Modified Look-
to be as consistent as possible with the would hold reserves against the
exposures. Through Approach of Section 54 (d)
parameters and assumptions of the IRB based on investment limits specified in
approach that would apply to the The calculation of KIRB must reflect
the effects of any credit risk mitigant the program’s prospectus or similar
underlying exposures if held directly by documentation.
a bank.98 The specification of S[Y] applied to the underlying exposures
(either to an individual underlying (iv) Credit enhancement level (L). L is
assumes that KIRB is an accurate the ratio of (i) the amount of all
measure of the total systematic credit exposure, a group of underlying
exposures, or to the entire pool of securitization exposures subordinated to
risk of the pool of underlying exposures the securitization tranche that contains
and that a securitization merely underlying exposures). In addition, all
assets related to the securitization must the bank’s securitization exposure to (ii)
redistributes this systematic risk among UE. Banks must determine L before
be treated as underlying exposures for
98 The conceptual basis for specification of K[x] purposes of the SFA, including assets in considering the effects of any tranche-
is developed in Michael B. Gordy and David Jones,
specific credit enhancements (such as
‘‘Random Tranches,’’ Risk (March 2003), 16(3), 78– 99 See Michael Pykhtin and Ashish Dev, ‘‘Coarse- third-party guarantees that benefit only
83. grained CDOs,’’ Risk (January 2003), 16(1), 113–116. a single tranche). Any after-tax gain-on-
sale or CEIOs associated with the counts the gross number of underlying (vii) Exposure-weighted average loss
securitization may not be included in L. exposures in a pool treats all exposures given default (EWALGD). The EWALGD
Any reserve account funded by in the pool equally. This simplifying is calculated as:
accumulated cash flows from the assumption could radically overestimate
underlying exposures that is the granularity of a pool with numerous
subordinated to the tranche that small exposures and one very large
contains the bank’s securitization exposure. The effective exposure
exposure may be included in the approach captures the notion that the
numerator and denominator of L to the risk profile of such an unbalanced pool
extent cash has accumulated in the is more like a pool of several medium- where LGDi represents the average LGD
account. Unfunded reserve accounts sized exposures than like a pool of a
associated with all exposures to the ith
(reserve accounts that are to be funded large number of equally sized small
obligor. In the case of a re-securitization,
from future cash flows from the exposures.
underlying exposures) may not be For example, suppose Pool A contains an LGD of 100 percent must be assumed
included in the calculation of L. four loans with EADs of $100 each. for any underlying exposure that is a
In some cases, the purchase price of Under the formula set forth above, N for securitization exposure.
receivables will reflect a discount that Pool A would be four, precisely equal to Although this treatment of EWALGD
provides credit enhancement (for the actual number of exposures. is consistent with the New Accord,
example, first loss protection) for all or Suppose Pool B also contains four loans: several commenters asserted that
certain tranches. When this arises, L One loan with an EAD of $100 and three assigning an LGD of 100 percent to all
should be calculated inclusive of this loans with an EAD of $1. Although both securitization exposures in the
discount if the discount provides credit pools contain four loans, Pool B is much underlying pool was excessively
enhancement for the securitization less diverse and granular than Pool A conservative, particularly for underlying
exposure. because Pool B is dominated by the exposures that are senior, highly rated
(v) Thickness of tranche (T). T is the presence of a single $100 loan. asset-backed securities. The agencies
ratio of (i) the size of the tranche that Intuitively, therefore, N for Pool B acknowledge that in many situations an
contains the bank’s securitization should be closer to one than to four. LGD significantly lower than 100
exposure to (ii) UE. Under the formula in the rule, N for percent may be appropriate. However,
(vi) Effective number of exposures (N). Pool B is calculated as follows: determination of the appropriate LGD
As a general matter, the effective depends on many complex factors,
number of exposures is calculated as
(100 + 1 + 1 + 1) including the characteristics of the
2
follows: 10, 609
N= = = 1.06 underlying assets and structural features
1002 + 12 + 12 + 12 10, 003 of the securitization, such as the
As noted above, when calculating N securitization exposure’s thickness.
for a re-securitization, a bank must treat Moreover, for thin securitization
each underlying securitization exposure exposures or certain mezzanine
as an exposure to a single obligor. This positions backed by low-quality assets,
where EADi represents the EAD conservative treatment addresses the the LGD may in fact be close to 100
associated with the ith instrument in the concern that AVCs among securitization percent. In this light, the agencies
pool of underlying exposures. For exposures can be much greater than the believe that any simple alternative to
purposes of computing N, multiple AVCs among the underlying individual the New Accord’s measurement of
exposures to one obligor must be treated assets securing these securitization EWALGD would increase the potential
as a single underlying exposure. In the exposures. Because the framework’s for capital arbitrage, and any more risk-
case of a re-securitization (a simple approach to re-securitizations sensitive alternative would take
securitization in which some or all of may result in the differential treatment considerable time to develop. Thus, the
the underlying exposures are of economically similar securitization agencies have retained the proposed
themselves securitization exposures), a exposures, the agencies sought comment treatment, consistent with the New
bank must treat each underlying on alternative approaches for Accord.
securitization exposure as a single determining the N of a re-securitization. Under certain conditions, a bank may
exposure and must not look through to While a number of commenters urged employ the following simplifications to
the exposures that secure the underlying that a bank be permitted to calculate N the SFA. First, for securitizations all of
securitization exposures. for re-securitizations of asset-backed whose underlying exposures are retail
N represents the granularity of a pool securities by looking through to the exposures, a bank may set h=0 and v=0.
ER07DE07.012</MATH>
of underlying exposures using an underlying pools of assets securing In addition, if the share of a
‘‘effective’’ number of exposures these securities, none provided securitization corresponding to the
concept rather than a ‘‘gross’’ number of theoretical or empirical evidence to largest underlying exposure (C1) is no
exposures concept to appropriately support this recommendation. Absent more than 0.03 (or 3 percent of the
assess the diversification of pools that such evidence, the final rule remains underlying exposures), then for
ER07DE07.011</GPH>
have individual underlying exposures of consistent with New Accord’s purposes of the SFA the bank may set
different sizes. An approach that simply measurement of N for re-securitizations. N equal to the following amount:
ER07DE07.010</MATH>
ER07DE07.009</GPH>
where Cm is the ratio of (i) the sum of appropriate capital requirement for The securitization CRM rules, like the
the amounts of the largest ‘‘m’’ market disruption liquidity facilities. wholesale and retail CRM rules, address
underlying exposures of the collateral separately from guarantees
6. CRM for Securitization Exposures
securitization; to (ii) UE. A bank may and credit derivatives. A bank is not
select the level of ‘‘m’’ using its The treatment of CRM for permitted to recognize collateral other
discretion. For example, if the three securitization exposures differs from than financial collateral as a credit risk
largest underlying exposures of a that applicable to wholesale and retail mitigant for securitization exposures. A
securitization represent 15 percent of exposures, and is largely unchanged bank may recognize financial collateral
the pool of underlying exposures, C3 for from the proposal. An originating bank in determining the bank’s risk-based
the securitization is 0.15. As an that has obtained a credit risk mitigant capital requirement for a securitization
alternative simplification option, if only to hedge its securitization exposure to a exposure that is not a repo-style
C1 is available, and C1 is no more than synthetic or traditional securitization transaction, an eligible margin loan, or
0.03, then the bank may set N=1/C1. that satisfies the operational criteria in an OTC derivative for which the bank
Under both simplification options a section 41 of the final rule may has reflected collateral in its
bank may set EWALGD=0.50 unless one recognize the credit risk mitigant, but determination of exposure amount
or more of the underlying exposures is only as provided in section 46 of the under section 32 of the rule by using a
a securitization exposure. If one or more final rule. An investing bank that has collateral haircut approach. The bank’s
of the underlying exposures is a obtained a credit risk mitigant to hedge risk-based capital requirement for a
securitization exposure, a bank using a a securitization exposure also may collateralized securitization exposure is
simplification option must set recognize the credit risk mitigant, but equal to the risk-based capital
EWALGD=1. only as provided in section 46. A bank requirement for the securitization
that has used the RBA or IAA to exposure as calculated under the RBA
5. Eligible Market Disruption Liquidity
calculate its risk-based capital or the SFA multiplied by the ratio of
Facilities
requirement for a securitization adjusted exposure amount (SE*) to
Under the proposed SFA, there was original exposure amount (SE),
exposure whose external or inferred
no special treatment provided for ABCP
rating (or equivalent internal rating Where:
liquidity facilities that could be drawn
under the IAA) reflects the benefits of a (i) SE* = max {0, [SE¥C × (1¥Hs¥Hfx)]};
upon only during periods of general
particular credit risk mitigant provided (ii) SE = the amount of the securitization
market disruption. In contrast, the New exposure (as calculated under section
to the associated securitization or that
Accord provides a more favorable 42(e) of the rule);
supports some or all of the underlying
capital treatment within the SFA for (iii) C = the current market value of the
exposures, however, may not use the
eligible market disruption liquidity collateral;
securitization credit risk mitigation (iv) Hs = the haircut appropriate to the
facilities than for other liquidity
rules to further reduce its risk-based collateral type; and
facilities. Under the New Accord, an
eligible market disruption liquidity capital requirement for the exposure (v) Hfx = the haircut appropriate for any
facility is a liquidity facility that based on that credit risk mitigant. For currency mismatch between the
example, a bank that owns a AAA-rated collateral and the exposure.
supports an ABCP program and that (i)
is subject to an asset quality test that asset-backed security that benefits from Where the collateral is a basket of
precludes funding of underlying an insurance wrap that is part of the different asset types or a basket of assets
exposures that are in default; (ii) can be securitization transaction must calculate denominated in different currencies, the
used to fund only those exposures that its risk-based capital requirement for the haircut on the basket is
have an investment-grade external security strictly under the RBA. No
rating at the time of funding, if the additional credit is given for the H = ∑ a i Hi ,
underlying exposures that the facility presence of the insurance wrap. On the i
must fund against are externally rated other hand, if a bank owns a BBB-rated where ai is the current market value of
exposures at the time that the exposures asset-backed security and obtains a the asset in the basket divided by the
are sold to the program; and (iii) may credit default swap from a AAA-rated current market value of all assets in the
only be drawn in the event of a general counterparty to protect the bank from basket and Hi is the haircut applicable
market disruption. losses on the security, the bank would to that asset.
The agencies sought comment on the be able to apply the securitization CRM With the prior written approval of its
prevalence of eligible market disruption rules to recognize the risk mitigating primary Federal supervisor, a bank may
liquidity facilities that might be subject effects of the credit default swap and calculate haircuts using its own internal
to the SFA and, by implication, whether determine the risk-based capital estimates of market price volatility and
the final rule should incorporate the requirement for the position. foreign exchange volatility, subject to
treatment provided in the New Accord. As under the proposal, the final rule the requirements for use of own-
Commenters responded that eligible contains a treatment of CRM for estimates haircuts contained in section
market disruption liquidity facilities securitization exposures separate from 32 of the rule. Banks that use own-
currently are not a material product line the treatment for wholesale and retail estimates haircuts for collateralized
for U.S. banks, but urged international exposures because the wholesale and securitization exposures must assume a
consistency in this area. To limit retail exposure CRM approaches rely on minimum holding period (TM) for
additional complexity in the final rule, substitutions of, or adjustments to, the securitization exposures of 65 business
and because U.S. banks have limited risk parameters of the hedged exposure. days.
exposure to eligible market disruption Because the securitization framework A bank that does not qualify for and
liquidity facilities, the agencies are not does not rely on risk parameters to use own-estimates haircuts must use the
including a separate treatment of determine risk-based capital collateral type haircuts (Hs) in Table 3
eligible market disruption liquidity requirements for securitization of the final rule and must use a currency
facilities in the final rule. The agencies exposures, a different treatment of CRM mismatch haircut (Hfx) of 8 percent if
believe that the final rule provides for securitization exposures is the exposure and the collateral are
ER07DE07.022</MATH>
adequate flexibility to determine an necessary. denominated in different currencies. To
reflect the longer-term nature of determining the bank’s risk-based exposures that have different residual
securitization exposures as compared to capital requirement for a securitization maturities, the bank must use the
securities financing transactions, exposure. If the protection amount of longest residual maturity of any of the
however, these standard supervisory the eligible guarantee or eligible credit hedged exposures as the residual
haircuts (which are based on a ten- derivative equals or exceeds the amount maturity of all the hedged exposures. If
business-day holding period and daily of the securitization exposure, the bank the risk-weighted asset amount for a
marking-to-market and remargining) must set the risk-weighted asset amount guaranteed securitization exposure is
must be adjusted to a 65-business-day for the securitization exposure equal to greater than the risk-weighted asset
holding period (the approximate the risk-weighted asset amount for a amount for the securitization exposure
number of business days in a calendar direct exposure to the eligible without the guarantee or credit
quarter) by multiplying them by the securitization guarantor (as determined derivative, a bank may elect not to
square root of 6.5 (2.549510). A bank in the wholesale risk weight function recognize the guarantee or credit
also must adjust the standard described in section 31 of the final rule), derivative.
supervisory haircuts upward on the using the bank’s PD for the guarantor, When a bank recognizes an eligible
basis of a holding period longer than 65 the bank’s LGD for the guarantee or guarantee or eligible credit derivative
business days where and as appropriate credit derivative, and an EAD equal to provided by an eligible securitization
to take into account the illiquidity of the the amount of the securitization guarantor in determining the bank’s
collateral. exposure (as determined in section 42(e) risk-based capital requirement for a
A bank may only recognize an eligible of the final rule). securitization exposure, the bank also
guarantee or eligible credit derivative If the protection amount of the must (i) calculate ECL for the protected
provided by an eligible securitization eligible guarantee or eligible credit portion of the exposure using the same
guarantor in determining the bank’s derivative is less than the amount of the risk parameters that it uses for
risk-based capital requirement for a securitization exposure, the bank must calculating the risk-weighted asset
securitization exposure. The definitions divide the securitization exposure into amount of the exposure (that is, the PD
of eligible guarantee and eligible credit two exposures in order to recognize the associated with the guarantor’s rating
derivative apply to both the wholesale guarantee or credit derivative. The risk- grade, the LGD of the guarantee, and an
and retail frameworks and the weighted asset amount for the EAD equal to the protection amount of
securitization framework. An eligible securitization exposure is equal to the the credit risk mitigant); and (ii) add
securitization guarantor is defined to sum of the risk-weighted asset amount this ECL to the bank’s total ECL.
mean (i) a sovereign entity, the Bank for for the covered portion and the risk-
International Settlements, the weighted asset amount for the 7. Synthetic Securitizations
International Monetary Fund, the uncovered portion. The risk-weighted Background
European Central Bank, the European asset amount for the covered portion is
Commission, a Federal Home Loan equal to the risk-weighted asset amount In a synthetic securitization, an
Bank, the Federal Agricultural Mortgage for a direct exposure to the eligible originating bank uses credit derivatives
Corporation (Farmer Mac), a multilateral securitization guarantor (as determined or guarantees to transfer the credit risk,
development bank, a depository in the wholesale risk weight function in whole or in part, of one or more
institution (as defined in section 3 of the described in section 31 of the rule), underlying exposures to third-party
Federal Deposit Insurance Act (12 using the bank’s PD for the guarantor, protection providers. The credit
U.S.C. 1813)), a bank holding company the bank’s LGD for the guarantee or derivative or guarantee may be either
(as defined in section 2 of the Bank credit derivative, and an EAD equal to collateralized or uncollateralized. In the
Holding Company Act (12 U.S.C. 1841)), the protection amount of the credit risk typical synthetic securitization, the
a savings and loan holding company (as mitigant. The risk-weighted asset underlying exposures remain on the
defined in 12 U.S.C. 1467a) provided all amount for the uncovered portion is balance sheet of the originating bank,
or substantially all of the holding equal to the product of (i) 1.0 minus the but a portion of the originating bank’s
company’s activities are permissible for ratio of the protection amount of the credit exposure is transferred to the
a financial holding company under 12 eligible guarantee or eligible credit protection provider or covered by
U.S.C. 1843(k)), a foreign bank (as derivative divided by the amount of the collateral pledged by the protection
defined in section 211.2 of the Federal securitization exposure; and (ii) the risk- provider.
Reserve Board’s Regulation K (12 CFR weighted asset amount for the In general, the final rule’s treatment of
211.2)), or a securities firm; (ii) any securitization exposure without the synthetic securitizations is identical to
other entity (other than a securitization credit risk mitigant (as determined in that of traditional securitizations and to
SPE) that has issued and outstanding an sections 42–45 of the final rule). that described in the proposal. The
unsecured long-term debt security For any hedged securitization operational requirements for synthetic
without credit enhancement that has a exposure, the bank must make securitizations are more detailed than
long-term applicable external rating in applicable adjustments to the protection those for traditional securitizations and
one of the three highest investment- amount as required by the maturity are intended to ensure that the
grade rating categories; or (iii) any other mismatch, currency mismatch, and lack originating bank has truly transferred
entity (other than a securitization SPE) of restructuring provisions in credit risk of the underlying exposures
that has a PD assigned by the bank that paragraphs (d), (e), and (f) of section 33 to one or more third-party protection
is lower than or equivalent to the PD of the final rule. The agencies have providers.
associated with a long-term external clarified in the final rule that the Although synthetic securitizations
rating in the third-highest investment- mismatch provisions apply to any typically employ credit derivatives,
grade rating category. hedged securitization exposure and any which might suggest that such
A bank must use the following more senior securitization exposure that transactions would be subject to the
procedures if the bank chooses to benefits from the hedge. In the context CRM rules in section 33 of the final rule,
recognize an eligible guarantee or of a synthetic securitization, when an banks must apply the securitization
eligible credit derivative provided by an eligible guarantee or eligible credit framework when calculating risk-based
eligible securitization guarantor in derivative covers multiple hedged capital requirements for a synthetic
securitization exposure. Banks may exposures to the synthetic securitization from an eligible securitization
ultimately be redirected to the even if the originating bank failed to guarantor, the bank generally will treat
securitization CRM rules to adjust the meet one or more of the operational the notional amount of the credit
securitization framework capital requirements for a synthetic derivative or guarantee (as adjusted to
requirement for an exposure to reflect securitization. reflect any maturity mismatch, lack of
the CRM technique used in the Consistent with the treatment of restructuring coverage, or currency
transaction. traditional securitization exposures, a mismatch) as a wholesale exposure to
bank must use the RBA for synthetic the protection provider and use the IRB
Operational Requirements for Synthetic securitization exposures that have an approach for wholesale exposures to
Securitizations appropriate number of external or determine the bank’s risk-based capital
For synthetic securitizations, an inferred ratings. For an originating bank, requirement for the exposure. A bank
originating bank may recognize for risk- the RBA will typically be used only for that creates the synthetic mezzanine
based capital purposes the use of CRM the most senior tranche of the tranche by obtaining from a non-eligible
to hedge, or transfer credit risk securitization, which often has an securitization guarantor a guarantee or
associated with, underlying exposures inferred rating. If a bank has a synthetic credit derivative that is collateralized by
only if each of the following conditions securitization exposure that does not financial collateral generally will (i) first
is satisfied: have an external or inferred rating, the use the SFA to calculate the risk-based
(i) The credit risk mitigant is financial bank must apply the SFA to the capital requirement on the exposure
collateral, an eligible credit derivative exposure (if the bank and the exposure (ignoring the guarantee or credit
from an eligible securitization guarantor qualify for use of the SFA) without derivative and the associated collateral);
(defined above), or an eligible guarantee considering any CRM obtained as part of and (ii) then use the securitization CRM
from an eligible securitization the synthetic securitization. Then, if the rules to calculate any reductions to the
guarantor. bank has obtained a credit risk mitigant risk-based capital requirement resulting
(ii) The bank transfers credit risk on the exposure as part of the synthetic from the associated collateral. The bank
associated with the underlying securitization, the bank may apply the may look only to the protection provider
exposures to third-party investors, and securitization CRM rules to reduce its from which it obtains the guarantee or
the terms and conditions in the credit risk-based capital requirement for the credit derivative when determining its
risk mitigants employed do not include exposure. For example, if the credit risk risk-based capital requirement for the
provisions that: mitigant is financial collateral, the bank exposure (that is, if the protection
(A) Allow for the termination of the may use the standard supervisory or provider hedges the guarantee or credit
credit protection due to deterioration in own-estimates haircuts to reduce its derivative with a guarantee or credit
the credit quality of the underlying risk-based capital requirement. If the derivative from a third party, the bank
exposures; bank is a protection provider to a may not look through the protection
(B) Require the bank to alter or synthetic securitization and has provider to that third party when
replace the underlying exposures to obtained a credit risk mitigant on its calculating its risk-based capital
improve the credit quality of the exposure, the bank may also apply the requirement for the exposure).
underlying exposures; securitization CRM rules in section 46 For a bank providing credit protection
(C) Increase the bank’s cost of credit of the final rule to reduce its risk-based on a mezzanine tranche of a synthetic
protection in response to deterioration capital requirement on the exposure. If securitization, the bank must use the
in the credit quality of the underlying neither the RBA nor the SFA is RBA to determine the risk-based capital
exposures; available, a bank must deduct the requirement for the exposure if the
(D) Increase the yield payable to exposure from regulatory capital. exposure has an external or inferred
parties other than the bank in response rating. If the exposure does not have an
to a deterioration in the credit quality of First-Loss Tranches external or inferred rating and the
the underlying exposures; or If a bank has a first-loss position in a exposure qualifies for use of the SFA,
(E) Provide for increases in a retained pool of underlying exposures in the bank may use the SFA to calculate
first loss position or credit enhancement connection with a synthetic the risk-based capital requirement for
provided by the bank after the inception securitization, the bank must deduct the the exposure. If neither the RBA nor the
of the securitization. position from regulatory capital unless SFA are available, the bank must deduct
(iii) The bank obtains a well-reasoned (i) the position qualifies for use of the the exposure from regulatory capital. If
opinion from legal counsel that RBA or (ii) the bank and the position a bank providing credit protection on
confirms the enforceability of the credit qualify for use of the SFA and KIRB is the mezzanine tranche of a synthetic
risk mitigant in all relevant greater than L. securitization obtains a credit risk
jurisdictions. mitigant to hedge its exposure, the bank
(iv) Any clean-up calls relating to the Mezzanine Tranches may apply the securitization CRM rules
securitization are eligible clean-up calls In a typical synthetic securitization, to reflect the risk reduction achieved by
(as discussed above). an originating bank obtains credit the credit risk mitigant.
Failure to meet the above operational protection on a mezzanine, or second-
requirements for a synthetic loss, tranche of a synthetic Super-Senior Tranches
securitization prevents the originating securitization by either (i) obtaining a A bank that has the most senior
bank from using the securitization credit default swap or financial position in a pool of underlying
framework and requires the originating guarantee from a third-party financial exposures in connection with a
bank to hold risk-based capital against institution; or (ii) obtaining a credit synthetic securitization must use the
the underlying exposures as if they had default swap or financial guarantee from RBA to calculate its risk-based capital
not been synthetically securitized. A an SPE whose obligations are secured by requirement for the exposure if the
bank that provides credit protection to financial collateral. exposure has at least one external or
a synthetic securitization must use the For a bank that creates a synthetic inferred rating (in the case of an
securitization framework to compute mezzanine tranche by obtaining an investing bank) or at least two external
risk-based capital requirements for its eligible credit derivative or guarantee or inferred ratings (in the case of an
originating bank). If the super-senior for the derivative equal to the product sheet sources of funding. The payment
tranche does not have an external or of (i) the protection amount of the allocations used to distribute principal
inferred rating and the bank and the derivative; (ii) 12.5; and (iii) the sum of and finance charge collections during
exposure qualify for use of the SFA, the the risk-based capital requirements of the amortization phase of these
bank may use the SFA to calculate the the individual underlying exposures, up transactions also can expose a bank to
risk-based capital requirement for the to a maximum of 100 percent. If a bank greater risk of loss than in other
exposure. If neither the RBA nor the provides credit protection on a group of securitization transactions. The final
SFA are available, the bank must deduct underlying exposures through an nth-to- rule, consistent with the proposed rule,
the exposure from regulatory capital. If default credit derivative (other than a assesses a risk-based capital
an investing bank in the super-senior first-to-default credit derivative), the requirement that, in general, is linked to
tranche of a synthetic securitization bank must determine its risk-weighted the likelihood of an early amortization
obtains a credit risk mitigant to hedge asset amount for the derivative by event to address the risks that early
its exposure, however, the investing applying the RBA (if the derivative amortization of a securitization poses to
bank may apply the securitization CRM qualifies for the RBA) or, if the originating banks.
rules to reflect the risk reduction derivative does not qualify for the RBA, Consistent with the proposed rule, the
achieved by the credit risk mitigant. by setting the risk-weighted asset final rule defines an early amortization
amount for the derivative equal to the provision as a provision in a
8. Nth-to-Default Credit Derivatives securitization’s governing
product of (i) the protection amount of
Credit derivatives that provide credit the derivative; (ii) 12.5; and (iii) the sum documentation that, when triggered,
protection only for the nth defaulting of the risk-based capital requirements of causes investors in the securitization
reference exposure in a group of the individual underlying exposures exposures to be repaid before the
reference exposures (nth-to-default (excluding the n-1 underlying exposures original stated maturity of the
credit derivatives) are similar to with the lowest risk-based capital securitization exposure, unless the
synthetic securitizations that provide requirements), up to a maximum of 100 provision is solely triggered by events
credit protection only after the first-loss percent. not related to the performance of the
tranche has defaulted or become a loss. For example, a bank provides credit underlying exposures or the originating
A simplified treatment is available to protection in the form of a second-to- bank (such as material changes in tax
banks that purchase and provide such default credit derivative on a basket of laws or regulations).
credit protection. A bank that obtains five reference exposures. The derivative Under the proposed rule, a bank
credit protection on a group of is unrated and the protection amount of would not be required to hold
underlying exposures through a first-to- the derivative is $100. The risk-based regulatory capital against the investors’
default credit derivative must determine capital requirements of the underlying interest if early amortization is solely
its risk-based capital requirement for the exposures are 2.5 percent, 5.0 percent, triggered by events not related to the
underlying exposures as if the bank had 10.0 percent, 15.0 percent, and 20 performance of the underlying
synthetically securitized only the percent. The risk-weighted asset amount exposures or the originating bank, such
underlying exposure with the lowest of the derivative would be $100 × 12.5 as material changes in tax laws or
capital requirement and had obtained × (.05 + .10 + .15 + .20) or $625. If the regulation. Under the New Accord, a
no credit risk mitigant on the other derivative were externally rated in the bank is also not required to hold
(higher capital requirement) underlying lowest investment-grade rating category regulatory capital against the investors’
exposures. If the bank purchases credit with a positive designation, the risk- interest if (i) the securitization has a
protection on a group of underlying weighted asset amount would be $100 × replenishment structure in which the
exposures through an nth-to-default 0.50 or $50. individual underlying exposures do not
credit derivative (other than a first-to- revolve and the early amortization ends
default credit derivative), it may only 9. Early Amortization Provisions the ability of the originating bank to add
recognize the credit protection for risk- Background new underlying exposures to the
based capital purposes either if it has securitization; (ii) the securitization
obtained credit protection on the same Many securitizations of revolving involves revolving assets and contains
underlying exposures in the form of credit facilities (for example, credit card early amortization features that mimic
first-through-(n-1)-to-default credit receivables) contain provisions that term structures; or (iii) investors in the
derivatives, or if n-1 of the underlying require the securitization to be wound securitization remain fully exposed to
exposures have already defaulted. In down and investors to be repaid if the future draws by borrowers on the
such a case, the bank must again excess spread falls below a certain underlying exposures even after the
determine its risk-based capital threshold.100 This decrease in excess occurrence of early amortization. The
requirement for the underlying spread may, in some cases, be caused by agencies sought comment on the
exposures as if the bank had only deterioration in the credit quality of the appropriateness of these additional
synthetically securitized the n-1 underlying exposures. An early exemptions in the U.S. markets for
underlying exposures with the lowest amortization event can increase a bank’s revolving securitizations. Most
capital requirement and had obtained capital needs if new draws on the commenters asserted that the
no credit risk mitigant on the other revolving credit facilities need to be exemptions provided in the New
underlying exposures. financed by the bank using on-balance Accord are prudent and should be
A bank that provides credit protection adopted by the agencies in order to
100 The final rule defines excess spread for a
on a group of underlying exposures avoid placing U.S. banking
period as gross finance charge collections and other
through a first-to-default credit income received by the securitization SPE
organizations at a competitive
derivative must determine its risk- (including market interchange fees) over the period disadvantage relative to foreign
weighted asset amount for the derivative minus interest paid to holders of securitization competitors. The agencies generally
by applying the RBA (if the derivative exposures, servicing fees, charge-offs, and other agree with this view of exemption (iii),
senior trust similar expenses of the securitization
qualifies for the RBA) or, if the SPE over the period, divided by the principal
above, and the definition of early
derivative does not qualify for the RBA, balance of the underlying exposures at the end of amortization provision in the final rule
by setting its risk-weighted asset amount the period. incorporates this exemption. The
agencies have not included exemption (ii) The outstanding principal amount a controlled early amortization
(i) or (ii). The agencies do not believe of underlying exposures. provision, including in particular the
that the exemption for non-revolving In general, the applicable CF depends 18-month period set forth above.
exposures is meaningful because the on whether the early amortization Commenters generally believed that
early amortization provisions apply provision repays investors through a very few, if any, revolving
only to securitizations with revolving controlled or non-controlled mechanism securitizations would meet the criteria
underlying exposures. The agencies also and whether the underlying exposures needed to qualify for treatment as a
do not believe that the exemption for are revolving retail credit facilities that controlled early amortization structure.
early amortization features that mimic are uncommitted (unconditionally One commenter maintained that a fixed
term structures is meaningful in the U.S. cancelable by the bank to the fullest 18-month straight-line amortization
market. extent of Federal law, such as credit period was too long for certain
Under the final rule, as under the card receivables) or are other revolving exposures, such as prime credit cards.
proposed rule, an originating bank must credit facilities (for example, revolving The final rule is unchanged from the
generally hold risk-based capital against corporate credit facilities). Consistent proposal with respect to controlled and
the sum of the originating bank’s with the New Accord, under the non-controlled early amortization
interest and the investors’ interest proposed rule a controlled early provisions. The agencies believe that the
arising from a securitization that amortization provision would meet each proposed eligibility criteria for a
contains an early amortization of the following conditions: controlled early amortization are
provision. An originating bank must (i) The originating bank has important indicators of the risks to
compute its capital requirement for its appropriate policies and procedures to which an originating bank would be
interest using the hierarchy of ensure that it has sufficient capital and
exposed in the event of any early
approaches for securitization exposures liquidity available in the event of an
amortization. While a fixed 18-month
as described above. The originating early amortization;
(ii) Throughout the duration of the straight-line amortization period is
bank’s risk-weighted asset amount for unlikely to be the most appropriate
securitization (including the early
the investors’ interest in the period in all cases, it is a reasonable
amortization period) there is the same
securitization is equal to the product of period for the vast majority of cases. The
pro rata sharing of interest, principal,
the following five quantities: (i) The lower operational burden of using a
expenses, losses, fees, recoveries, and
EAD associated with the investors’ single, fixed amortization period
other cash flows from the underlying
interest; (ii) the appropriate CF as warrants the potential diminution in
exposures, based on the originating
determined below; (iii) KIRB; (iv) 12.5; bank’s and the investors’ relative shares risk-sensitivity.
and (v) the proportion of the underlying of the underlying exposures outstanding
exposures in which the borrower is Controlled Early Amortization
measured on a consistent monthly basis;
permitted to vary the drawn amount (iii) The amortization period is Under the proposed rule, to calculate
within an agreed limit under a line of sufficient for at least 90 percent of the the appropriate CF for a securitization of
credit. The agencies added (v) to the total underlying exposures outstanding uncommitted revolving retail exposures
final rule because, for securitizations at the beginning of the early that contains a controlled early
containing both revolving and non- amortization period to have been repaid amortization provision, a bank would
revolving underlying exposures, only or recognized as in default; and compare the three-month average
the revolving underlying exposures give (iv) The schedule for repayment of annualized excess spread for the
rise to the risk of early amortization. investor principal is not more rapid securitization to the point at which the
Under the final rule, consistent with than would be allowed by straight-line bank is required to trap excess spread
the proposal, the investors’ interest with amortization over an 18-month period. under the securitization transaction. In
respect to a revolving securitization An early amortization provision that securitizations that do not require
captures both the drawn balances and does not meet any of the above criteria excess spread to be trapped, or that
undrawn lines of the underlying is a non-controlled early amortization specify a trapping point based primarily
exposures that are allocated to the provision. on performance measures other than the
investors in the securitization. The EAD The agencies solicited comment on three-month average annualized excess
associated with the investors’ interest is the distinction between controlled and spread, the excess spread trapping point
equal to the EAD of the underlying non-controlled early amortization was 4.5 percent. The bank would divide
exposures multiplied by the ratio of: provisions and on the extent to which the three-month average annualized
(i) The total amount of securitization banks use controlled early amortization excess spread level by the excess spread
exposures issued by the securitization provisions. The agencies also invited trapping point and apply the
SPE to investors; divided by comment on the proposed definition of appropriate CF from Table H.
TABLE H.—CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed
Retail Credit Lines ....................................... Three-month average annualized excess spread, Conversion Factor (CF) ................... 90% CF
133.33% of trapping point or more, 0% CF.
less than 133.33% to 100% of trapping point, 1% CF.
less than 100% to 75% of trapping point, 2% CF.
less than 50% to 25% of trapping point, 20% CF less than 25% of trapping point,
40% CF.
Non-retail Credit Lines ................................ 90% CF ............................................................................................................................ 90% CF
A bank would apply a 90 percent CF curtail promptly uncommitted retail Non-controlled Early Amortization
for all other revolving underlying credit lines for customers of
exposures (committed exposures and deteriorating credit quality. Such Under the proposed rule, to calculate
nonretail exposures) in securitizations account management tools are the appropriate CF for securitizations of
containing a controlled early unavailable for committed lines, and uncommitted revolving retail exposures
amortization provision. The proposed banks may be less proactive about using that contain a non-controlled early
CFs for uncommitted revolving retail such tools in the case of uncommitted amortization provision, a bank would
credit lines were much lower than for non-retail credit lines owing to lender perform the excess spread calculations
committed retail credit lines or for non- liability concerns and the prominence of described in the controlled early
retail credit lines because of the broad-based, longer-term customer amortization section above and then
demonstrated ability of banks to relationships. apply the CFs in Table I.
monitor and, when appropriate, to
TABLE I.—NON-CONTROLLED EARLY AMORTIZATION PROVISIONS

Retail Credit Lines ....................................... Three-month average annualized excess spread, Conversion Factor (CF) ................... 100% CF
less than 50% of trapping point, 100% CF.
Non-retail Credit Lines ................................ 100% CF .......................................................................................................................... 100% CF
A bank would use a 100 percent CF Securitizations of Revolving Residential underlying exposures are revolving
for all other revolving underlying Mortgage Exposures residential mortgage exposures. The
exposures (committed exposures and The agencies sought comment on the agencies will monitor the
nonretail exposures) in securitizations appropriateness of the proposed 4.5 implementation of this alternative
containing a non-controlled early percent excess spread trapping point approach to ensure that it is consistent
amortization provision. In other words, and on whether there were other types with safety and soundness.
no risk transference would be and levels of early amortization triggers F. Equity Exposures
recognized for these transactions; an used in securitizations of revolving
originating bank’s IRB capital retail exposures that should be 1. Introduction and Exposure
requirement would be the same as if the addressed by the agencies. Although Measurement
underlying exposures had not been some commenters believed the 4.5 This section describes the final rule’s
securitized. percent trapping point assumption was risk-based capital treatment for equity
A few commenters asserted that the reasonable, others believed that it was exposures. Consistent with the proposal,
proposed CFs were too high. The inappropriate for securitizations of under the final rule, a bank has the
agencies believe, however, that the HELOCs. Unlike credit card option to use either a simple risk-weight
proposed CFs appropriately capture the securitizations, U.S. HELOC approach (SRWA) or an internal models
risk to the bank of a potential early securitizations typically do not generate approach (IMA) for equity exposures
amortization event. The agencies also material excess spread and typically are that are not exposures to an investment
believe that the proposed CFs, which structured with credit enhancements fund. A bank must use a look-through
and early amortization triggers based on approach for equity exposures to an
are consistent with the New Accord,
other factors, such as portfolio loss investment fund.
foster consistency across national
rates. Under the proposed treatment, Although the New Accord provides
jurisdictions. Therefore, the agencies are
banks would be required to hold capital national supervisors the option to
maintaining the proposed CFs in the
against the potential early amortization provide a grandfathering period for
final rule with one exception, discussed
of most U.S. HELOC securitizations at equity exposures—whereby for a
below.
their inception, rather than only if the maximum of ten years, supervisors
In circumstances where a credit quality of the underlying could permit banks to exempt from the
securitization contains a mix of retail exposures deteriorated. Although the IRB treatment equity investments held
and nonretail exposures or a mix of New Accord does not provide an at the time of the publication of the New
committed and uncommitted exposures, alternative methodology, the agencies Accord—the proposed rule did not
a bank may take a pro rata approach to concluded that the features of the U.S. include such a grandfathering provision.
determining the CF for the HELOC securitization market warrant an A number of commenters asserted that
securitization’s early amortization alternative approach. Accordingly, the the proposal was inconsistent with the
provision. If a pro rata approach is not final rule allows a bank the option of New Accord and would subject banks
feasible, a bank must treat the applying either (i) the CFs in Tables I using the agencies’ advanced
securitization as a securitization of and J, as appropriate, or (ii) a fixed CF approaches to significant competitive
nonretail exposures if a single equal to 10 percent to its securitizations inequity.
underlying exposure is a nonretail for which all or substantially all of the The agencies continue to believe that
exposure and must treat the underlying exposures are revolving it is not appropriate or necessary to
securitization as a securitization of residential mortgage exposures. If a incorporate the New Accord’s optional
committed exposures if a single bank chooses the fixed CF of 10 percent, ten-year grandfathering period for
underlying exposure is a committed it must use that CF for all securitizations equity exposures. The grandfathering
exposure. for which all or substantially all of the concept would reduce the risk
sensitivity of the SRWA and IMA. capital requirements and not for risk carrying value but excluded from the
Moreover, the IRB approach does not management purposes. In addition, bank’s tier 1 and tier 2 capital; 101 and
provide grandfathering for other types of because of concerns about lack of (ii) For the off-balance sheet
exposures, and the agencies see no transparency, it is not prudent to allow component of an equity exposure, the
compelling reason to do so for equity a bank to apply the IMA only to its non- effective notional principal amount of
exposures. Further, the agencies believe publicly traded equity exposures and
the exposure, the size of which is
that the overall final rule approach to not its publicly traded equity exposures.
The proposed rule defined publicly equivalent to a hypothetical on-balance
equity exposures sufficiently mitigates
traded to mean traded on (i) any sheet position in the underlying equity
potential competitive issues.
exchange registered with the SEC as a instrument that would evidence the
Accordingly, the final rule does not
provide a grandfathering period for national securities exchange under same change in fair value (measured in
equity exposures. section 6 of the Securities Exchange Act dollars) for a given small change in the
Under the proposed SRWA, a bank of 1934 (15 U.S.C. 78f) or (ii) any non- price of the underlying equity
generally would assign a 300 percent U.S.-based securities exchange that is instrument, minus the adjusted carrying
risk weight to publicly traded equity registered with, or approved by, a value of the on-balance sheet
exposures and a 400 percent risk weight national securities regulatory authority component of the exposure as
to non-publicly traded equity exposures. and that provides a liquid, two-way calculated in (i).
Certain equity exposures to sovereigns, market for the exposure (that is, there Commenters generally supported the
multilateral institutions, and public are enough independent bona fide offers proposed definition of adjusted carrying
sector enterprises would have a risk to buy and sell so that a sales price value and the agencies are adopting the
weight of 0 percent, 20 percent, or 100 reasonably related to the last sales price definition as proposed with one minor
percent; and certain community or current bona fide competitive bid and clarification regarding unfunded equity
development equity exposures, hedged offer quotations can be determined commitments (discussed below).
equity exposures, and, up to certain promptly and a trade can be settled at
limits, non-significant equity exposures such a price within five business days). The agencies created the definition of
would receive a 100 percent risk weight. Several commenters explicitly the effective notional principal amount
Alternatively, under the proposed supported the proposed definition of of the off-balance sheet portion of an
rule, a bank that met certain minimum publicly traded, noting that it is equity exposure to provide a uniform
quantitative and qualitative reasonable and consistent with industry method for banks to measure the on-
requirements on an ongoing basis and practice. Other commenters requested balance sheet equivalent of an off-
obtained the prior written approval of that the agencies revise the proposed balance sheet exposure. For example, if
its primary Federal supervisor could use definition by eliminating the the value of a derivative contract
the IMA to determine its risk-based requirement that a non-U.S.-based referencing the common stock of
capital requirement for all modeled securities exchange provide a liquid, company X changes the same amount as
equity exposures. A bank that qualified two-way market for the exposure. the value of 150 shares of common stock
to use the IMA could apply the IMA to Commenters asserted that this of company X, for a small (for example,
its publicly traded and non-publicly requirement goes beyond the definition 1 percent) change in the value of the
traded equity exposures, or could apply in the New Accord, which defines a common stock of company X, the
the IMA only to its publicly traded publicly traded equity exposure as any effective notional principal amount of
equity exposures. However, if the bank equity security traded on a recognized the derivative contract is the current
applied the IMA to its publicly traded security exchange. They asserted that value of 150 shares of common stock of
equity exposures, it would be required registration with or approval by the company X regardless of the number of
to apply the IMA to all such exposures. national securities regulatory authority shares the derivative contract
Similarly, if a bank applied the IMA to should suffice, as registration or references. The adjusted carrying value
both publicly traded and non-publicly approval generally would be predicated of the off-balance sheet component of
traded equity exposures, it would be on the existence of a two-way market. the derivative is the current value of 150
required to apply the IMA to all such The agencies have retained the shares of common stock of company X
exposures. If a bank did not qualify to definition of publicly traded as minus the adjusted carrying value of
use the IMA, or elected not to use the proposed. The agencies believe that the any on-balance sheet amount associated
IMA, to compute its risk-based capital liquid, two-way market requirement is with the derivative.
requirements for equity exposures, the not in addition to the requirements of
bank would apply the SRWA to assign the New Accord. Rather, this The final rule clarifies the
risk weights to its equity exposures. requirement clarifies the intent of determination of the effective notional
Several commenters objected to the ‘‘traded’’ in the New Accord and helps principal amount of unfunded equity
proposed restrictions on the use of the to ensure that a sales price reasonably commitments. Under the final rule, for
IMA. Commenters asserted that banks related to the last sales price or an unfunded equity commitment that is
should be able to apply the SRWA and competitive bid and offer quotations can unconditional, a bank must use the
the IMA for different portfolios or be determined promptly and settled notional amount of the commitment. If
subsets of equity exposures, provided within five business days. the unfunded equity commitment is
that banks’ choices are consistent with A bank using either the IMA or the conditional, the bank must use its best
internal risk management practices. SRWA must determine the adjusted estimate of the amount that would be
The agencies have not relaxed the carrying value for each equity exposure. funded during economic downturn
proposed restrictions regarding use of The proposed rule defined the adjusted conditions.
the SRWA and IMA. The agencies carrying value of an equity exposure as:
remain concerned that if banks are (i) For the on-balance sheet 101 The potential downward adjustment to the
permitted to employ either the SRWA or component of an equity exposure, the carrying value of an equity exposure reflects the fact
that 100 percent of the unrealized gains on
IMA to different equity portfolios, banks bank’s carrying value of the exposure available-for-sale equity exposures are included in
could choose one approach over the reduced by any unrealized gains on the carrying value but only up to 45 percent of any such
other to manipulate their risk-based exposure that are reflected in such unrealized gains are included in regulatory capital.
Hedge Transactions the variability-reduction method, or the determine the ratio of the cumulative
The agencies proposed specific rules regression method. sum of the periodic changes in the value
It is possible that only part of a bank’s of one equity exposure to the
for recognizing hedged equity
exposure to a particular equity cumulative sum of the periodic changes
exposures; they received no substantive
instrument is part of a hedge pair. For in the value of the other equity
comment on these rules and are
example, assume a bank has an equity exposure, termed the ratio of value
adopting these rules as proposed. For
exposure A with a $300 adjusted change (RVC). If the changes in the
purposes of determining risk-weighted
carrying value and chooses to hedge a values of the two exposures perfectly
assets under both the SRWA and the
portion of that exposure with an equity
IMA, a bank may identify hedge pairs, offset each other, the RVC will be ¥1.
exposure B with an adjusted carrying
which the final rule defines as two If RVC is positive, implying that the
value of $100. Also assume that the
equity exposures that form an effective values of the two equity exposures move
combination of equity exposure B and
hedge provided each equity exposure is $100 of the adjusted carrying value of in the same direction, the hedge is not
publicly traded or has a return that is equity exposure A form an effective effective and E = 0. If RVC is negative
primarily based on a publicly traded hedge with an E of 0.8. In this situation and greater than or equal to ¥1 (that is,
equity exposure. A bank may risk the bank would treat $100 of equity between zero and ¥1), then E equals the
weight only the effective and ineffective exposure A and $100 of equity exposure absolute value of RVC. If RVC is
portions of a hedge pair rather than the B as a hedge pair, and the remaining negative and less than ¥1, then E
entire adjusted carrying value of each $200 of its equity exposure A as a equals 2 plus RVC.
exposure that makes up the pair. Two separate, stand-alone equity position.
equity exposures form an effective The variability-reduction method of
The effective portion of a hedge pair measuring effectiveness compares
hedge if the exposures either have the is E multiplied by the greater of the
same remaining maturity or each has a changes in the value of the combined
adjusted carrying values of the equity position of the two equity exposures in
remaining maturity of at least three exposures forming the hedge pair, and
months; the hedge relationship is the hedge pair (labeled X) to changes in
the ineffective portion is (1-E) the value of one exposure as though that
documented formally before the bank multiplied by the greater of the adjusted
acquires at least one of the equity one exposure were not hedged (labeled
carrying values of the equity exposures
exposures; the documentation specifies A). This measure of E expresses the
forming the hedge pair. In the above
the measure of effectiveness (E) (defined example, the effective portion of the time-series variability in X as a
below) the bank will use for the hedge hedge pair would be 0.8 × $100 = $80 proportion of the variability of A. As the
relationship throughout the life of the and the ineffective portion of the hedge variability described by the numerator
transaction; and the hedge relationship pair would be (1¥0.8) × $100 = $20. becomes small relative to the variability
has an E greater than or equal to 0.8. A described by the denominator, the
bank must measure E at least quarterly Measures of Hedge Effectiveness measure of effectiveness improves, but
and must use one of three alternative Under the dollar-offset method of is bounded from above by a value of
measures of E—the dollar-offset method, measuring effectiveness, the bank must one. E is computed as:
Xt = At ¥ Bt of this regression, which is the multiplying the adjusted carrying value

At = the value at time t of the one exposure proportion of the variation in the of the equity exposure, or the effective
in a hedge pair, and dependent variable explained by portion and ineffective portion of a
Bt = the value at time t of the other exposure
in the hedge pair. variation in the independent variable. hedge pair as described above, by the
However, if the estimated regression lowest applicable risk weight in Table J.
The value of t will range from zero to coefficient is positive, then the value of A bank would determine the risk-
T, where T is the length of the E is zero. The closer the relationship weighted asset amount for an equity
observation period for the values of A between the values of the two exposure to an investment fund under
and B, and is comprised of shorter exposures, the higher E will be. section 54 of the proposed rule.
values each labeled t.
The regression method of measuring 2. Simple Risk-Weight Approach If a bank exclusively uses the SRWA
effectiveness is based on a regression in (SRWA) for its equity exposures, the bank’s
which the change in value of one aggregate risk-weighted asset amount for
exposure in a hedge pair is the Under the SRWA in section 52 of the its equity exposures (other than equity
dependent variable and the change in proposed rule, a bank would determine exposures to investment funds) would
value of the other exposure in the hedge the risk-weighted asset amount for each be equal to the sum of the risk-weighted
pair is the independent variable. E equity exposure, other than an equity asset amounts for each of the bank’s
equals the coefficient of determination exposure to an investment fund, by individual equity exposures.
TABLE J
Risk weight Equity exposure
ER07DE07.013</GPH>
0 Percent .......... An equity exposure to an entity whose credit exposures are exempt from the 0.03 percent PD floor.
TABLE J—Continued
20 Percent ........ An equity exposure to a Federal Home Loan Bank or Farmer Mac if the equity exposure is not publicly traded and is held as
a condition of membership in that entity.
100 Percent ...... • Community development equity exposures.
• An equity exposure to a Federal Home Loan Bank or Farmer Mac not subject to a 20 percent risk weight.
• The effective portion of a hedge pair.
• Non-significant equity exposures to the extent less than 10 percent of tier 1 plus tier 2 capital.
300 Percent ...... A publicly traded equity exposure (including the ineffective portion of a hedge pair).
400 Percent ...... An equity exposure that is not publicly traded.
Several commenters addressed the Several commenters objected to the 10 inappropriate for equity exposures to
proposed risk weights under the SRWA. percent materiality threshold for investment firms with greater than
A few commenters asserted that the 100 determining significance. They asserted immaterial leverage.
percent risk weight for the effective that this standard is more conservative Under the final rule, to compute the
portion of a hedge pair is too high. than the 15 percent threshold under the aggregate adjusted carrying value of a
These commenters suggested that the OCC, FDIC, and Board general risk- bank’s equity exposures for determining
risk weight for such exposures should based capital rules for nonfinancial non-significance, the bank may exclude
be zero or no more than 7 percent equity investments. (i) equity exposures that receive less
because the effectively hedged portion The agencies note that the applicable than a 300 percent risk weight under the
of a hedge pair involves negligible credit general risk-based capital rules address SRWA (other than equity exposures
risk. One commenter remarked that it only nonfinancial equity investments; determined to be non-significant); (ii)
does not believe there is an economic that the 15 percent threshold is a the equity exposure in a hedge pair with
basis for the different risk weight for an percentage only of tier 1 capital; and the smaller adjusted carrying value; and
equity exposure to a Federal Home Loan that the 15 percent threshold was (iii) a proportion of each equity
Bank depending on whether the equity designed for that particular rule. The exposure to an investment fund equal to
exposure is held as a condition of proposed materiality threshold of 10 the proportion of the assets of the
membership. percent of tier 1 plus tier 2 capital is investment fund that are not equity
The agencies do not agree with consistent with the New Accord and is exposures or that qualify as community
commenters’ assertion that the effective intended to identify non-significant development equity exposures. If a bank
portion of a hedge pair entails negligible holdings of equity exposures under a does not know the actual holdings of the
credit risk. The agencies believe the 100 different type of capital framework. investment fund, the bank may calculate
Thus, the two threshold limits are not the proportion of the assets of the fund
percent risk weight under the proposal
directly comparable. The agencies that are not equity exposures based on
is an appropriate and prudential
believe that the proposed 10 percent the terms of the prospectus, partnership
safeguard; thus, it is maintained in the
threshold for determining non- agreement, or similar contract that
final rule. Banks that seek to more
significant equity exposures is
accurately account for equity hedging in defines the fund’s permissible
appropriate for the advanced
their risk-based capital requirements investments. If the sum of the
approaches and, thus, are adopting it as
should use the IMA. investment limits for all exposure
proposed.
The agencies agree that different risk As discussed above in preamble classes within the fund exceeds 100
weights for an equity exposure to a section V.A.3., the agencies have percent, the bank must assume that the
Federal Home Loan Bank or Farmer Mac discretion under the final rule to investment fund invests to the
depending on whether the equity exclude from the definition of a maximum extent possible in equity
exposure is held as a condition of traditional securitization those exposures.
membership do not have an economic investment firms that exercise When determining which of a bank’s
justification, given the similar risk substantially unfettered control over the equity exposures qualify for a 100
profile of the exposures. Accordingly, size and composition of their assets, percent risk weight based on non-
under the final rule SRWA, all equity liabilities, and off-balance sheet significance, a bank first must include
exposures to a Federal Home Loan Bank exposures. Equity exposures to equity exposures to unconsolidated
or to Farmer Mac receive a 20 percent investment firms that would otherwise small business investment companies or
risk weight. be a traditional securitization were it held through consolidated small
not for the specific agency exclusion are business investment companies
Non-significant Equity Exposures described in section 302 of the Small
leveraged exposures to the underlying
Under the SRWA, a bank may apply financial assets of the investment firm. Business Investment Act of 1958 (15
a 100 percent risk weight to non- The agencies believe that equity U.S.C. 682), then must include publicly
significant equity exposures. The exposure to such firms with greater than traded equity exposures (including
proposed rule defined non-significant immaterial leverage warrant a 600 those held indirectly through
equity exposures as equity exposures to percent risk weight under the SRWA, investment funds), and then must
the extent that the aggregate adjusted due to their particularly high risk. include non-publicly traded equity
carrying value of the exposures did not Moreover, the agencies believe that the exposures (including those held
exceed 10 percent of the bank’s tier 1 100 percent risk weight assigned to non- indirectly through investment funds).
capital plus tier 2 capital. significant equity exposures is The SRWA is summarized in Table K:
TABLE K
0 Percent .......... An equity exposure to an entity whose credit exposures are exempt from the 0.03 percent PD floor.
20 Percent ........ An equity exposure to a Federal Home Loan Bank or Farmer Mac.
100 Percent ...... • Community development equity exposures.102
• The effective portion of a hedge pair.
• Non-significant equity exposures to the extent less than 10 percent of tier 1 plus tier 2 capital.
300 Percent ...... A publicly traded equity exposure (other than an equity exposure that receives a 600 percent risk weight and including the in-
effective portion of a hedge pair).
400 Percent ...... An equity exposure that is not publicly traded (other than an equity exposure that receives a 600 percent risk weight).
600 percent ...... An equity exposure to an investment firm that (1) would meet the definition of a traditional securitization were it not for the pri-
mary Federal supervisor’s application of paragraph (8) of that definition and (2) has greater than immaterial leverage.
102 The final rule generally defines these exposures as exposures that would qualify as community development investments under 12 U.S.C.
24(Eleventh), excluding equity exposures to an unconsolidated small business investment company and equity exposures held through a consoli-
dated small business investment company described in section 302 of the Small Business Investment Act of 1958 (15 U.S.C. 682). For savings
associations, community development investments would be defined to mean equity investments that are designed primarily to promote commu-
nity welfare, including the welfare of low- and moderate-income communities or families, such as by providing services or jobs, and excluding eq-
uity exposures to an unconsolidated small business investment company and equity exposures held through a consolidated small business in-
vestment company described in section 302 of the Small Business Investment Act of 1958 (15 U.S.C. 682).
3. Internal Models Approach (IMA) term sample period. Banks with equity equity investments are more relevant
The IMA is designed to provide banks portfolios containing equity exposures than public market proxies and should
with a more sophisticated and risk- with values that are highly nonlinear in be permitted even if they are only
sensitive mechanism for calculating nature (for example, equity derivatives available on a monthly basis. The
risk-based capital requirements for or convertibles) must employ an agencies agree with commenters on this
equity exposures. To qualify to use the internal model designed to issue. Accordingly, under the final rule,
IMA, a bank must receive prior written appropriately capture the risks banks are not required to have daily
approval from its primary Federal associated with these instruments. market prices for all modeled equity
supervisor. To receive such approval, In addition, the number of risk factors exposures, either direct holdings or
the bank must demonstrate to its and exposures in the sample and the proxies. However, to ensure sufficient
primary Federal supervisor’s data period used for quantification in rigor in the modeling process, the final
satisfaction that the bank meets the the bank’s models and benchmarking rule requires that a bank’s
quantitative and qualitative criteria exercise must be sufficient to provide benchmarking exercise be based on
discussed below. As noted earlier, a confidence in the accuracy and daily market prices for the benchmark
bank may model both publicly traded robustness of the bank’s estimates. The portfolio, as noted above.
and non-publicly traded equity bank’s model and benchmarking Finally, the bank must be able to
exposures or model only publicly traded exercise also must incorporate data that demonstrate, using theoretical
equity exposures. are relevant in representing the risk
arguments and empirical evidence, that
In the final rule, the agencies clarify profile of the bank’s modeled equity
any proxies used in the modeling
that under the IMA, a bank may use exposures, and must include data from
process are comparable to the bank’s
more than one model, as appropriate for at least one equity market cycle
modeled equity exposures, and that the
its equity exposures, provided that it containing adverse market movements
bank has made appropriate adjustments
has received supervisory approval for relevant to the risk profile of the bank’s
modeled equity exposures. In addition, for differences. The bank must derive
use of the IMA, and each model meets any proxies for its modeled equity
the qualitative and quantitative criteria for the reasons described below, the
final rule adds that the bank’s exposures or benchmark portfolio using
specified below and in section 53 of the historical market data that are relevant
rule. benchmarking exercise must be based
on daily market prices for the to the bank’s modeled equity exposures
IMA Qualification benchmark portfolio. If the bank’s or benchmark portfolio (or, where not,
model uses a scenario methodology, the must use appropriately adjusted data),
The bank must have one or more
bank must demonstrate that the model and such proxies must be robust
models that (i) assess the potential
produces a conservative estimate of estimates of the risk of the bank’s
decline in value of its modeled equity
potential losses on the bank’s modeled modeled equity exposures.
exposures; (ii) are commensurate with
the size, complexity, and composition of equity exposures over a relevant long- In evaluating whether a bank has met
the bank’s modeled equity exposures; term market cycle. If the bank employs the criteria described above, the bank’s
and (iii) adequately capture both general risk factor models, the bank must primary Federal supervisor may
market risk and idiosyncratic risks. The demonstrate through empirical analysis consider, among other factors, (i) the
bank’s models must produce an estimate the appropriateness of the risk factors nature of the bank’s equity exposures,
of potential losses for its modeled equity used. including the number and types of
exposures that is no less than the Under the proposed rule, the agencies equity exposures (for example, publicly
estimate of potential losses produced by also required that daily market prices be traded, non-publicly traded, long,
a VaR methodology employing a 99.0 available for all modeled equity short); (ii) the risk characteristics and
percent one-tailed confidence interval of exposures. The proposed requirement makeup of the bank’s equity exposures,
the distribution of quarterly returns for applied to either direct holdings or including the extent to which publicly
a benchmark portfolio of equity proxies. Several commenters objected to available price information is obtainable
exposures comparable to the bank’s the requirement of daily market prices. on the exposures; and (iii) the level and
modeled equity exposures using a long- A few asserted that proxies for private degree of concentration of, and
correlations among, the bank’s equity given underlying positions in both suggested that the agencies incorporate
exposures. publicly traded and non-publicly traded a materiality threshold into the IMA.
The agencies do not intend to dictate equities. At a minimum, banks that use The agencies do not believe that it is
the form or operational details of a a VaR model should employ stress tests necessary or appropriate to incorporate
bank’s internal model for equity to provide information about the effect such a threshold under the IMA. The
exposures. Accordingly, the agencies are of tail events beyond the level of agencies are concerned that a bank
not prescribing any particular type of confidence assumed in the IMA. could manipulate significantly its risk-
model for determining risk-based capital Banks using non-VaR internal models based capital requirements based on the
requirements. Although the final rule that are based on stress tests or scenario exposures it chooses to model and those
requires a bank that uses the IMA to analyses should estimate losses under which it would deem immaterial (and to
ensure that its internal model produces worst-case modeled scenarios. These which it would apply a 100 percent risk
an estimate of potential losses for its scenarios should reflect the composition weight). The agencies also believe that
modeled equity exposures that is no less of the bank’s equity portfolio and a flat 100 percent risk weight is
than the estimate of potential losses should produce risk-based capital inconsistent with the risk sensitivity of
produced by a VaR methodology requirements at least as large as those the IMA.
employing a 99.0 percent one-tailed that would be required to be held Under the proposal, if a bank applied
confidence interval of the distribution of against a representative market index or the IMA to both publicly traded and
quarterly returns for a benchmark other relevant benchmark portfolio non-publicly traded equity exposures,
portfolio of equity exposures, the rule under a VaR approach. For example, for the bank’s aggregate risk-weighted asset
does not require a bank to use a VaR- a portfolio consisting primarily of amount for its equity exposures would
based model. The agencies recognize publicly held equity securities that are be equal to the sum of the risk-weighted
that the type and sophistication of actively traded, risk-based capital asset amount of excluded equity
internal models will vary across banks requirements produced using historical exposures (calculated outside of the
due to differences in the nature, scope, scenario analyses should be greater than IMA) and the risk-weighted asset
and complexity of business lines in or equal to risk-based capital amount of the non-excluded equity
general and equity exposures in requirements produced by a baseline exposures (calculated under the IMA).
particular. The agencies also recognize VaR approach for a major index or sub- The risk-weighted asset amount of the
that some banks employ models for index that is representative of the bank’s non-excluded equity exposures
internal risk management and capital holdings. generally would be set equal to the
allocation purposes that can be more The loss estimate derived from the estimate of potential losses on the
relevant to the bank’s equity exposures bank’s internal model constitutes the bank’s non-excluded equity exposures
than some VaR models. For example, risk-based capital requirement for the generated by the bank’s internal model
some banks employ rigorous historical modeled equity exposures (subject to multiplied by 12.5. To ensure that a
scenario analysis and other techniques the supervisory floors described below). bank holds a minimum amount of risk-
for assessing the risk of their equity The equity capital requirement is based capital against its modeled equity
portfolios. incorporated into a bank’s risk-based exposures, however, the proposed rule
Banks that choose to use a VaR-based capital ratio through the calculation of contained a supervisory floor on the
internal model under the IMA should risk-weighted equivalent assets. To risk-weighted asset amount of the non-
use a historical observation period that convert the equity capital requirement excluded equity exposures. As a result
includes a sufficient amount of data into risk-weighted equivalent assets, a of this floor, the risk-weighted asset
points to ensure statistically reliable and bank must multiply the capital amount of the non-excluded equity
robust loss estimates relevant to the requirement by 12.5. exposures could not fall below the sum
long-term risk profile of the bank’s of (i) 200 percent multiplied by the
Risk-Weighted Assets Under the IMA
specific holdings. The data used to aggregate adjusted carrying value or
represent return distributions should Under the proposed and final rules, as ineffective portion of hedge pairs, as
reflect the longest sample period for noted above, a bank may apply the IMA appropriate, of the bank’s non-excluded
which data are available and should only to its publicly traded equity publicly traded equity exposures; and
meaningfully represent the risk profile exposures or may apply the IMA to its (ii) 300 percent multiplied by the
of the bank’s specific equity holdings. publicly traded and non-publicly traded aggregate adjusted carrying value of the
The data sample should be long-term in equity exposures. In either case, a bank bank’s non-excluded non-publicly
nature and, at a minimum, should is not allowed to apply the IMA to traded equity exposures.
encompass at least one complete equity equity exposures that receive a 0 or 20 Also under the proposal, if a bank
market cycle containing adverse market percent risk weight under the SRWA, applied the IMA only to its publicly
movements relevant to the risk profile of community development equity traded equity exposures, the bank’s
the bank’s modeled exposures. The data exposures, and equity exposures to aggregate risk-weighted asset amount for
used should be sufficient to provide investment funds (collectively, its equity exposures would be equal to
conservative, statistically reliable, and excluded equity exposures). Unlike the the sum of (i) the risk-weighted asset
robust loss estimates that are not based SRWA, the IMA does not provide for a amount of excluded equity exposures
purely on subjective or judgmental 10 percent materiality threshold for (calculated outside of the IMA); (ii) 400
considerations. non-significant equity exposures. percent multiplied by the aggregate
The parameters and assumptions used Several commenters objected to the adjusted carrying value of the bank’s
in a VaR model should be subject to a fact that the IMA does not provide a 100 non-excluded non-publicly traded
rigorous and comprehensive regime of percent risk weight for non-significant equity exposures; and (iii) the aggregate
stress-testing. Banks utilizing VaR equity exposures up to a 10 percent risk-weighted asset amount of its non-
models should subject their internal materiality threshold. These excluded publicly traded equity
model and estimation procedures, commenters maintained that the lack of exposures. The risk-weighted asset
including volatility computations, to a materiality threshold under the IMA amount of the non-excluded publicly
either hypothetical or historical will discourage use of this methodology traded equity exposures would be equal
scenarios that reflect worst-case losses relative to the SRWA. Commenters to the estimate of potential losses on the
bank’s non-excluded publicly traded three alternatives to different equity based capital requirement per dollar of
equity exposures generated by the exposures to investment funds. securitization exposure under the SFA.
bank’s internal model multiplied by The agencies proposed a separate Several commenters objected to the
12.5. Under the proposed rule, the risk- treatment for equity exposures to an proposed 7 percent risk weight floor. A
weighted asset amount for the non- investment fund to prevent banks from few commenters suggested that the floor
excluded publicly traded equity arbitraging the proposed rule’s risk- should be decreased or eliminated,
exposures would be subject to a floor of based capital requirements for certain particularly for low-risk investment
200 percent multiplied by the aggregate high-risk exposures and to ensure that funds that receive the highest rating
adjusted carrying value or ineffective banks do not receive a punitive risk- from an NRSRO. Others recommended
portion of hedge pairs, as appropriate, of based capital requirement for equity that the 7 percent risk weight floor
the bank’s non-excluded publicly traded exposures to investment funds that hold should be applied on an aggregate basis
equity exposures. only low-risk assets. Under the rather than on a fund-by-fund basis.
Several commenters did not support proposal, the agencies defined an The agencies proposed the 7 percent
the concept of floors in a risk-sensitive investment fund as a company (i) all or risk weight floor as a minimum risk-
approach that requires a comparison to substantially all of the assets of which based capital requirement for exposures
estimates of potential losses produced are financial assets and (ii) that has no not directly held by a bank. However,
by a VaR methodology. If floors are material liabilities. the agencies believe the comments on
required in the final rule, however, Generally, commenters supported the this issue have merit and recognize that
these commenters noted that the separate treatment for equity exposures the floor would provide banks with an
calculation at the aggregate level would to investment funds. However, several incentive to invest in higher-risk
not pose significant operational issues. commenters objected to the exclusion of investment funds. Consistent with the
New Accord, the final rule does not
A few commenters, in contrast, objected investment funds with material
impose a 7 percent risk weight floor on
to the proposed aggregate floors, liabilities from this separate treatment,
equity exposures to investment funds,
asserting that it would be operationally observing that it would exclude equity
on either an individual or aggregate
difficult to determine compliance with exposures to hedge funds. Several
basis.
such floors. commenters suggested that investment
The agencies believe that it is prudent funds with material liabilities should be Full Look-Through Approach
to retain the floor requirements in the eligible for the look-through approaches. A bank may use the full look-through
IMA and, thus, are adopting the floor One commenter suggested that the approach only if the bank is able to
requirements as described above. The agencies should adopt the following compute a risk-weighted asset amount
agencies note that the New Accord also definition of investment fund: ‘‘A for each of the exposures held by the
imposes a 200 percent and 300 percent company in which all or substantially investment fund. Under the proposed
floor for publicly traded and non- all of the assets are pooled financial rule, a bank would be required to
publicly traded equity exposures, assets that are collectively managed in calculate the risk-weighted asset amount
respectively. Regarding the proposal to order to generate a financial return, for each of the exposures held by the
calculate the floors on an aggregate including investment companies or investment fund as if the exposures
basis, the agencies believe it is funds with material liabilities.’’ A few were held directly by the bank.
appropriate to maintain this approach, commenters suggested that equity Depending on whether the exposures
given that for most banks it does not exposures to investment funds with were wholesale, retail, securitization, or
seem to pose significant operational material liabilities should be treated equity exposures, a bank would apply
issues. under the SRWA or IMA as non- the appropriate IRB risk-based capital
publicly traded equity exposures rather treatment.
4. Equity Exposures to Investment than the separate treatment developed
Funds Several commenters suggested that
for equity exposures to investment the agencies should allow a bank with
The proposed rule included a separate funds. supervisory approval to use the IMA to
treatment for equity exposures to The agencies do not agree with model the underlying assets of an
investment funds. As proposed, a bank commenters that the look-through investment fund by including the bank’s
would determine the risk-weighted asset approaches for investment funds should pro rata share of the investment fund’s
amount for equity exposures to apply to investment vehicles with assets in its equities model. The
investment funds using one of three material liabilities. The look-through commenters believed there is no basis
approaches: the full look-through treatment is designed to capture the for preventing a bank from using the
approach, the simple modified look- risks of an indirect holding of the IMA, a sophisticated and risk-sensitive
through approach, or the alternative underlying assets of the investment approach, when a bank has full position
modified look-through approach, unless fund. Investment vehicles with material data for an investment fund.
the equity exposure to an investment liabilities provide a leveraged exposure The agencies agree with commenters’
fund is a community development to the underlying financial assets and views in this regard. If a bank has full
equity exposure. Such equity exposures have a risk profile that may not be position data for an investment fund
would be subject to a 100 percent risk appropriately captured by a look- and has been approved by its primary
weight. If an equity exposure to an through approach. Federal supervisor for use of the IMA,
investment fund is part of a hedge pair, Under the proposal, each of the it may include the underlying equity
a bank could use the ineffective portion approaches to equity exposures to exposures held by an investment fund,
of the hedge pair as the adjusted investment funds imposed a 7 percent after adjustment for proportional
carrying value for the equity exposure to minimum risk weight on such ownership, in its equities model under
the investment fund. The risk-weighted exposures. This proposed minimum risk the IMA. Therefore, in the final rule,
asset amount of the effective portion of weight was similar to the minimum 7 under the full look-through approach, a
the hedge pair is equal to its adjusted percent risk weight under the RBA for bank must either (i) set the risk-
carrying value. A bank could choose to securitization exposures and the weighted asset amount of the bank’s
apply a different approach among the effective 56 basis point minimum risk- equity exposure to the investment fund
equal to product of (A) the aggregate permitted to hold under its prospectus, funds that are subject to SEC rule 2a-7
risk-weighted asset amounts of the partnership agreement, or similar governing portfolio maturity, quality,
exposures held by the fund as if they contract that defines the fund’s diversification and liquidity. This
were held directly by the bank and (B) permissible investments. The bank commenter asserted that a 7 percent risk
the bank’s proportional ownership share could exclude derivative contracts that weight for such exposures would be
of the fund; or (ii) include the bank’s are used for hedging, not speculative appropriate.
proportional ownership share of each purposes, and do not constitute a The agencies agree that the proposed
exposure held by the fund in the bank’s material portion of the fund’s exposures. risk-weighting for highly-rated money
IMA. If the bank chooses (ii), the risk- Commenters generally supported the market mutual funds subject to SEC rule
weighted asset amount for the equity simple modified look-through approach 2a-7 is conservative, given the generally
exposure to the investment fund is as a low-burden yet moderately risk- low risk of such funds. Accordingly, the
determined together with the risk- sensitive way of treating equity agencies added a new investment fund
weighted asset amount for the bank’s exposures to an investment fund. approach—the Money Market Fund
other non-excluded equity exposures However, several commenters objected Approach—which applies a 7 percent
and is subject to the aggregate floors to the large jump in risk weights (from risk weight to a bank’s equity exposure
under this approach. a 400 percent to a 1,250 percent risk to a money market fund that is subject
weight) between investment funds to SEC rule 2a-7 and that has an
Simple Modified Look-Through
permitted to hold non-publicly traded applicable external rating in the highest
Approach
equity exposures and investment funds investment-grade rating category.
Under the proposed simple modified permitted to hold OTC derivative The agencies have made no changes
look-through approach, a bank would contracts and/or exposures that must be to address commenters’ concerns about
set the risk-weighted asset amount for deducted from regulatory capital or a lack of intermediate risk weights
its equity exposure to an investment receive a risk weight greater than 400 between 400 percent and 1,250 percent.
fund equal to the adjusted carrying percent under the IRB approach. In The agencies believe the range of risk
value of the equity exposure multiplied addition, one commenter objected to the weights is sufficiently granular to
by the highest risk weight in Table L proposed 20 percent risk weight for the accommodate most equity exposures to
that applies to any exposure the fund is most highly rated money market mutual investment funds.
TABLE L.—MODIFIED LOOK-THROUGH APPROACHES FOR EQUITY EXPOSURES TO INVESTMENT FUNDS

Risk weight Exposure class or investment fund type
0 Percent ................... Sovereign exposures with a long-term external rating in the highest investment-grade rating category and sovereign ex-
posures of the United States.
20 Percent ................. Exposures with a long-term external rating in the highest or second-highest investment-grade rating category; exposures
with a short-term external rating in the highest investment-grade rating category; and exposures to, or guaranteed by,
depository institutions, foreign banks (as defined in 12 CFR 211.2), or securities firms subject to consolidated super-
vision or regulation comparable to that imposed on U.S. securities broker-dealers that are repo-style transactions or
bankers’ acceptances.
50 Percent ................. Exposures with a long-term external rating in the third-highest investment-grade rating category or a short-term external
rating in the second-highest investment-grade rating category.
100 Percent ............... Exposures with a long-term or short-term external rating in the lowest investment-grade rating category.
200 Percent ............... Exposures with a long-term external rating one rating category below investment grade.
300 Percent ............... Publicly traded equity exposures.
400 Percent ............... Non-publicly traded equity exposures; exposures with a long-term external rating two or more rating categories below in-
vestment grade; and unrated exposures (excluding publicly traded equity exposures).
1,250 Percent ............ OTC derivative contracts and exposures that must be deducted from regulatory capital or receive a risk weight greater
than 400 percent under this appendix.
Alternative Modified Look-Through exposure class with the next highest VI. Operational Risk
Approach risk-weight under Table L until the
maximum total investment level is This section describes features of the
Under this approach, a bank may reached. If more than one exposure class AMA framework for determining the
assign the adjusted carrying value of an risk-based capital requirement for
applies to an exposure, the bank must
equity exposure to an investment fund operational risk. A bank meeting the
use the highest applicable risk weight.
on a pro rata basis to different risk- AMA qualifying criteria uses its internal
A bank may exclude derivative
weight categories in Table L based on operational risk quantification system to
contracts held by the fund that are used calculate its risk-based capital
the investment limits in the fund’s
for hedging, not speculative, purposes requirement for operational risk.
prospectus, partnership agreement, or
and do not constitute a material portion
similar contract that defines the fund’s Currently, the agencies’ general risk-
of the fund’s exposures. Other than
permissible investments. If the sum of based capital rules do not include an
comments addressing the risk weight
the investment limits for all exposure explicit capital charge for operational
classes within the fund exceeds 100 table and the 7 percent floor (addressed
risk. Rather, the existing risk-based
above), the agencies did not receive
percent, the bank must assume that the capital rules were designed to broadly
fund invests to the maximum extent significant comment on this approach cover all risks, and therefore implicitly
permitted under its investment limits in and have adopted it without significant cover operational risk. With the
the exposure class with the highest risk change. adoption of the more risk-sensitive
weight under Table L, and continues to treatment under the IRB approach for
make investments in the order of the credit risk in this final rule, there no
longer is an implicit capital buffer for cover EOL with a high degree of for operational risk due to qualifying
other risks. certainty over a one-year horizon. operational risk mitigants may not
The agencies recognize that Supervisory recognition of EOL offsets exceed 20 percent of the bank’s risk-
operational risk is a key risk in banks, would be limited to those business lines based capital requirement for
and evidence indicates that a number of and event types with highly predictable, operational risk, after approved
factors are driving increases in routine losses. The preamble noted that adjustments for EOL offsets.
operational risk. These factors include based on discussions with the industry A risk mitigant must be able to absorb
greater use of automated technology, and supervisory experience, highly losses with sufficient certainty to
proliferation of new and highly complex predictable and routine losses appear to warrant inclusion as a qualifying
products, growth of e-banking be limited to those relating to securities operational risk mitigant. For insurance
transactions and related business processing and to credit card fraud. to meet this standard, it must:
applications, large-scale acquisitions, The majority of commenters on this (i) be provided by an unaffiliated
mergers, and consolidations, and greater issue recommended that the agencies company that has a claims paying
use of outsourcing arrangements. should allow banks to present evidence ability that is rated in one of the three
Furthermore, the experience of a of additional areas with highly highest rating categories by an NRSRO;
number of high-profile, high-severity predictable and reasonably stable losses (ii) have an initial term of at least one
operational losses across the banking for which eligible operational risk year and a residual term of more than
industry, including those resulting from offsets could be considered. These 90 days;
legal settlements, highlight operational commenters identified fraud losses (iii) have a minimum notice period for
risk as a major source of unexpected pertaining to debit or ATM cards, cancellation of 90 days;
losses. Because the implicit regulatory commercial or business credit cards, (iv) have no exclusions or limitations
capital buffer for operational risk is HELOCs, and external checks in retail based upon regulatory action or for the
removed under the final rule, the banking as additional events that have receiver or liquidator of a failed bank;
agencies are requiring banks using the highly predictable and reasonably stable and
IRB approach for credit risk to use the losses. Commenters also identified legal (v) be explicitly mapped to an actual
AMA to address operational risk when reserves set aside for small, predictable operational risk exposure of the bank.
computing their risk-based capital legal loss events, budgeted funds, and A bank must receive prior written
requirement. forecasted funds as other items that approval from its primary Federal
As discussed previously, operational should be considered eligible supervisor to recognize an operational
risk exposure is the 99.9th percentile of operational risk offsets. Several risk mitigant other than insurance as a
the distribution of potential aggregate commenters also highlighted that the qualifying operational risk mitigant. In
operational losses as generated by the proposed rule was inconsistent with the evaluating an operational risk mitigant
bank’s operational risk quantification New Accord regarding the ability of other than insurance, a primary Federal
system over a one-year horizon. EOL is budgeted funds to serve as EOL offsets. supervisor will consider whether the
the expected value of the same One commenter proposed eliminating operational risk mitigant covers
distribution of potential aggregate EOL altogether because the commenter potential operational losses in a manner
operational losses. Under the proposal, already factors it into its pricing equivalent to holding regulatory capital.
a bank’s risk-based capital requirement practices. The bank’s methodology for
for operational risk would be the sum of The New Accord permits a supervisor incorporating the effects of insurance
EOL and UOL. A bank would be to accept expected loss offsets provided must capture, through appropriate
allowed to recognize (i) certain offsets a bank is ‘‘able to demonstrate to the discounts in the amount of risk
for EOL (such as certain reserves and satisfaction of its national supervisor mitigation, the residual term of the
other internal business practices), and that it has measured and accounted for policy, where less than one year; the
(ii) the effect of risk mitigants such as its EL exposure.’’ 103 To the extent a policy’s cancellation terms, where less
insurance in calculating its regulatory bank is permitted to adjust its estimate than one year; the policy’s timeliness of
capital requirement for operational risk. of operational risk exposure to reflect payment; and the uncertainty of
Under the proposed rule, the agencies potential operational risk offsets, it is payment as well as mismatches in
recognized that a bank’s risk-based appropriate to consider the degree to coverage between the policy and the
capital requirement for operational risk which such offsets meet U.S. accounting hedged operational loss event. The bank
could be based on UOL alone if the bank standards and can be viewed as may not recognize for regulatory capital
could demonstrate it has offset EOL regulatory capital substitutes. The final purposes insurance with a residual term
with eligible operational risk offsets. rule retains the proposed definition of 90 days or less.
Eligible operational risk offsets were described above. The agencies believe Several commenters criticized the
defined as amounts, not to exceed EOL, that this definition allows for the proposal for limiting recognition of non-
that (i) are generated by internal supervisory consideration of EOL offsets insurance operational risk mitigants to
business practices to absorb highly in a flexible and prudent manner. those mitigants that would cover
predictable and reasonably stable In determining its operational risk potential operational losses in a manner
operational losses, including reserves exposure, the bank may also take into equivalent to holding regulatory capital.
calculated in a manner consistent with account the effects of qualifying The commenters noted that similar
GAAP; and (ii) are available to cover operational risk mitigants such as limitations are not included in the New
EOL with a high degree of certainty over insurance. To recognize the effects of Accord. Other commenters asserted that
a one-year horizon. Eligible operational qualifying operational risk mitigants qualifying operational risk mitigants
risk offsets could only be used to offset such as insurance for risk-based capital should be broader than insurance.
EOL, not UOL. purposes, the bank must estimate its The New Accord discusses the use of
The preamble to the proposed rule operational risk exposure with and insurance explicitly as an operational
stated that in determining whether to without such effects. The reduction in a risk mitigant and notes that the BCBS
accept a proposed EOL offset, the bank’s risk-based capital requirement ‘‘in due course, may consider revising
agencies would consider whether the the criteria for and limits on the
proposed offset would be available to 103 103 New Accord, ¶669(b). recognition of operational risk mitigants
on the basis of growing experience.’’ 104 The agencies view public disclosure sufficient time to ensure usefulness of
Similarly, under the proposed rule, the as an important complement to the the public disclosure requirements and
agencies provided flexibility that advanced approaches to calculating comparability across banks.
recognizes the potential for developing minimum regulatory risk-based capital The agencies believe that it is
operational risk mitigants other than requirements, which will be heavily important to retain the vast majority of
insurance over time. The agencies based on internal systems and the proposed disclosures, which are
continue to believe it is appropriate to methodologies. With enhanced consistent with the New Accord. These
consider the degree to which such transparency regarding banks’ disclosures will enable market
mitigants can be viewed as regulatory experiences with the advanced participants to gain key insights
capital substitutes. Therefore, under the approaches, investors can better regarding a bank’s capital structure, risk
final rule, in evaluating such mitigants, evaluate a bank’s capital structure, risk exposures, risk assessment processes,
the agencies will consider whether the exposures, and capital adequacy. With and ultimately, the capital adequacy of
operational risk mitigant covers sufficient and relevant information, the institution. The agencies also note
potential operational losses in a manner market participants can better evaluate that many of the disclosure
equivalent to holding regulatory capital. a bank’s risk management performance, requirements are already required by, or
earnings potential and financial are consistent with, existing GAAP, SEC
Under the final rule, as under the
strength. disclosure requirements, or regulatory
proposal, if a bank does not qualify to
Improvements in public disclosures reporting requirements for banks. More
use or does not have qualifying
come not only from regulatory generally, the agencies view the public
operational risk mitigants, the bank’s
standards, but also through efforts by disclosure requirements as an integral
dollar risk-based capital requirement for
bank management to improve part of the advanced approaches and the
operational risk is its operational risk
communications to public shareholders New Accord and are continuing to
exposure minus eligible operational risk
and other market participants. In this require their implementation beginning
offsets (if any). If a bank qualifies to use
regard, improvements to risk with a bank’s first transitional floor
operational risk mitigants and has management processes and internal period.
qualifying operational risk mitigants, reporting systems provide opportunities The agencies are sympathetic,
the bank’s dollar risk-based capital to significantly improve public however, to commenters’ concerns
requirement for operational risk is the disclosures over time. Accordingly, the about cross-border comparability. The
greater of: (i) The bank’s operational risk agencies strongly encourage the agencies believe that many of the
exposure adjusted for qualifying management of each bank to regularly changes they have made to the final rule
operational risk mitigants minus eligible review its public disclosures and (such as eliminating the ELGD risk
operational risk offsets (if any); and (ii) enhance these disclosures, where parameter and adopting the New
0.8 multiplied by the difference between appropriate, to clearly identify all Accord’s definition of default for
the bank’s operational risk exposure and significant risk exposures—whether on- wholesale exposures, as discussed
its eligible operational risk offsets (if or off-balance sheet—and their effects above) will address commenters’
any). The dollar risk-based capital on the bank’s financial condition and concerns regarding comparability. In
requirement for operational risk is performance, cash flow, and earnings addition, the agencies have made
multiplied by 12.5 to convert it into an potential. several changes to the disclosure
equivalent risk-weighted asset amount. requirements to make them more
The resulting amount is added to the Comments on the Proposed Rule
consistent with the New Accord. These
comparable amount for credit risk in Many commenters expressed concern changes should increase cross-border
calculating the institution’s risk-based that the proposed disclosures were comparability and reduce
capital denominator. excessive, burdensome and overly implementation and compliance
VII. Disclosure prescriptive and would hinder—rather burden. These changes are discussed in
than facilitate—market discipline by the relevant sections below.
1. Overview requiring banks to disclose items that
would not be well understood or 2. General Requirements
The agencies have long supported provide useful information to market Under the proposed rule, the public
meaningful public disclosure by banks participants. In particular, commenters disclosure requirements would apply to
with the objective of improving market were concerned that the differences the top-tier legal entity that is a core or
discipline. The agencies recognize the between the proposed rule and the New opt-in bank within a consolidated
importance of market discipline in Accord (such as the proposed ELGD risk banking group—the top-tier U.S. BHC or
encouraging sound risk management parameter and proposed wholesale DI that is a core or opt-in bank.
practices and fostering financial definition of default) would not be Several commenters objected to this
stability. meaningful for cross-border comparative proposal, noting that it is inconsistent
Pillar 3 of the New Accord, market purposes, and would increase with the New Accord, which requires
discipline, complements the minimum compliance burden for banks subject to such disclosures at the global top
capital requirements and the the agencies’ risk-based capital rules. consolidated level of a banking group to
supervisory review process by Some commenters also believed that the which the framework applies.
encouraging market discipline through information provided in the disclosures Commenters asserted that public
enhanced and meaningful public would not be comparable across banks disclosure at the U.S. BHC or DI level
disclosure. The public disclosure because each bank would use distinct for U.S. banking organizations owned by
requirements in the final rule are internal methodologies to generate the a foreign banking organization is not
intended to allow market participants to
disclosures. Several commenters meaningful and could generate

assess key information about a bank’s suggested that the agencies should delay confusion or misunderstanding in the
risk profile and its associated level of the disclosure requirements until U.S. market.
capital. implementation of the IRB approach has The agencies agree that commenters’
gained some maturity. This would allow concerns have merit and believe that it
104 New Accord, footnote 110. the agencies and banking industry is important to be consistent with the
New Accord. Accordingly, under the under the proposed and final rules, each The proposal stated that the
final rule, the public disclosure bank that is subject to the disclosure disclosures must be timely and that the
requirements will generally be required requirements must have a formal agencies would consider a disclosure to
only at the top-tier global consolidated disclosure policy approved by its board be timely if it was made no later than
level. Under exceptional circumstances, of directors that addresses the bank’s the reporting deadlines for regulatory
a primary Federal supervisor may approach for determining the reports (for example, FR Y–9C) and
require some or all of the public disclosures it should make. The policy financial reports (for example, SEC
disclosures at the top-tier U.S. level if should address the associated internal Forms 10–Q and 10–K). When these
the primary Federal supervisor controls and disclosure controls and deadlines differ, the later deadline
determines that such disclosures are procedures. The board of directors and should be used.
important for market participants to senior management must ensure that Several commenters expressed
form appropriate insights regarding the appropriate review of the disclosures concern that the tight timeframe for
bank’s risk profile and associated level takes place and that effective internal public disclosure requirements would
of capital. A factor the agencies will controls and disclosure controls and be a burden and requested that the
consider, for example, is whether a U.S. procedures are maintained. agencies provide greater flexibility, such
subsidiary of a foreign banking A bank should decide which as by setting the deadline for public
organization has debt or equity disclosures are relevant for it based on disclosures at 60 days after quarter-end.
registered and actively traded in the the materiality concept. Information The agencies believe commenters’
United States. would be regarded as material if its concerns must be balanced against the
In addition, the proposed rule stated omission or misstatement could change importance of allowing market
that, in general, a DI that is a subsidiary or influence the assessment or decision participants to have access to timely
of a BHC or another DI would not be of a user relying on that information for information that is reflective of a bank’s
subject to the disclosure requirements the purpose of making investment risk profile and associated capital levels.
except that every DI would be required decisions. Accordingly, the agencies have decided
to disclose total and tier 1 capital ratios to interpret the requirement for timely
To the extent applicable, a bank may
and their components, similar to current public disclosures for purposes of this
fulfill its disclosure requirements under
requirements. Nonetheless, these final rule to mean within 45 days after
this final rule by relying on disclosures
entities must file applicable bank calendar quarter-end.
made in accordance with accounting
regulatory reports and thrift financial In some cases, management may
standards or SEC mandates that are very
reports. In addition, as described below determine that a significant change has
similar to the disclosure requirements in
in the regulatory reporting section, the occurred, such that the most recent
this final rule. In these situations, a
agencies will require certain additional reported amounts do not reflect the
bank must explain material differences
regulatory reporting from banks bank’s capital adequacy and risk profile.
applying the advanced approaches, and between the accounting or other
disclosure and the disclosures required In those cases, banks should disclose
a limited amount of the reported the general nature of these changes and
information will be publicly disclosed. under this final rule.
briefly describe how they are likely to
If a DI that is a core or opt-in bank and Frequency/Timeliness affect public disclosures going forward.
is not a subsidiary of a BHC or another These interim disclosures should be
DI that must make the full set of Under the proposed rule, the agencies
required that quantitative disclosures be made as soon as practicable after the
disclosures, the DI would be required to determination that a significant change
make the full set disclosures. made quarterly. Several commenters
objected to this requirement. These has occurred.
One commenter objected to the
supervisory flexibility provided to commenters asserted that banks subject Location of Disclosures and Audit/
require additional disclosures at the to the U.S. public disclosure Attestation Requirements
subsidiary level. The commenter requirements would be placed at a
competitive disadvantage because the Under the proposed and final rules,
maintained that in all cases DIs that are the disclosures must be publicly
a subsidiary of a BHC or another DI New Accord requires banks to make
Pillar 3 public disclosures on a available (for example, included on a
should not be subject to the disclosure public Web site) for each of the latest
requirements beyond disclosing their semiannual basis.
three years (12 quarters) or such shorter
total and tier 1 capital ratios and the The agencies believe that quarterly
time period since the bank entered its
ratio components, as proposed. The public disclosure requirements are
first transitional floor period. Except as
commenter suggested that the agencies important to ensure that the market has
discussed below, management has
clarify this issue in the final rule. access to timely and relevant
discretion to determine the appropriate
The agencies do not believe, however, information and therefore have decided
medium and location of the disclosures
that these changes are appropriate. The to retain quarterly quantitative
required by this final rule. Furthermore,
agencies believe that it is important to disclosure requirements in the final
banks have flexibility in formatting their
preserve some flexibility in the event rule. This disclosure frequency is
public disclosures. The agencies are not
that the primary Federal supervisor consistent with longstanding
specifying a fixed format for these
believes that disclosures from such a DI requirements in the United States for
disclosures.
are important for market participants to robust quarterly disclosures in financial
The agencies encourage management
form appropriate insights regarding the and regulatory reports, and is
to provide all of the required disclosures
bank’s risk profile and associated level appropriate considering the potential for
in one place on the entity’s public Web
of capital. rapid changes in risk profiles. Moreover,
site. The public Web site addresses are
The risks to which a bank is exposed, many of the existing SEC, regulatory
reported in the regulatory reports (for
and the techniques that it uses to reporting, and other disclosure
example, the FR Y–9C).105
identify, measure, monitor, and control requirements that a bank may use to
those risks are important factors that help meet its public disclosure 105 Alternatively, banks may provide the
market participants consider in their requirements in the final rule are disclosures in more than one place, as some of them
assessment of the bank. Accordingly, already required on a quarterly basis. Continued
Disclosure of tier 1 and total capital proposed requirements strike an and, hence, the capital adequacy of the
ratios must be provided in the footnotes appropriate balance between the need institution. The agencies are adopting
to the year-end audited financial for meaningful disclosure and the the tables as proposed, with the
statements.106 Accordingly, these protection of proprietary and exceptions noted below. Again, the
disclosures must be tested by external confidential information.107 Many agencies note that the substantive
auditors as part of the financial commenters, however, expressed content of the tables is the focus of the
statement audit. Disclosures that are not concern that the required disclosures disclosure requirements, not the tables
included in the footnotes to the audited would result in the release of themselves. The table numbers below
financial statements are not subject to proprietary information. Commenters refer to the table numbers in the final
external audit reports for financial expressed particular concerns about the rule.
statements or internal control reports granularity of the credit loss history and Table 11.1 disclosures (Scope of
from management and the external securitization disclosures, as well as Application) include a description of
auditor. disclosures for portfolios subject to the the level in the organization to which
The preamble to the proposed rule IRB risk-based capital formulas. the disclosures apply and an outline of
stated that due to the importance of As noted above, the final rule any differences in consolidation for
reliable disclosures, the agencies would provides banks with considerable accounting and regulatory capital
require the chief financial officer to discretion with regard to public purposes, as well as a description of any
certify that the disclosures required by disclosure requirements. Bank restrictions on the transfer of funds and
the proposed rule were appropriate and management determines which capital within the organization. These
that the board of directors and senior disclosures are relevant based on a disclosures provide the basic context
management were responsible for materiality concept. In addition, bank underlying regulatory capital
establishing and maintaining an management has flexibility regarding calculations.
effective internal control structure over formatting and the level of granularity of One commenter questioned item (e) in
financial reporting, including the disclosures, provided they meet certain Table 11.1, which would require the
information required by the proposed minimum requirements. Accordingly, disclosure of the aggregate amount of
rule. the agencies believe that banks generally capital deficiencies in all subsidiaries
Several commenters expressed can provide these disclosures without and the name(s) of such subsidiaries.
uncertainty regarding the proposed revealing proprietary and confidential The commenter asserted that the scope
certification requirement for the chief information. Only in rare circumstances of this item should be limited to those
financial officer. One commenter asked might disclosure of certain items of legal subsidiaries that are subject to
the agencies to articulate the standard of information required in the final rule banking, securities, or insurance
acceptance required for the certification compel a bank to reveal confidential regulators’ capital adequacy rules and
of disclosure standards compared with and proprietary information. In these should not include unregulated entities
what is required for financial reporting unusual situations, the final rule that are consolidated into the top
purposes. Another commenter requires that if a bank believes that corporate entity or unconsolidated
questioned whether the chief financial disclosure of specific commercial or affiliate and joint ventures.
officer would have sufficient familiarity financial information would prejudice As stated in a footnote to Table 11.1
with the risk management disclosures to seriously the position of the bank by in the proposed rule, the agencies
make such a certification. making public information that is either limited the proposed requirement to
To address commenter uncertainty, proprietary or confidential in nature, the legal subsidiaries that are subject to
the agencies have simplified and banking, securities, or insurance
bank need not disclose those specific
clarified the final rule’s accountability regulators’ capital adequacy rules. The
items, but must disclose more general
requirements. Specifically, the final rule agencies are further clarifying this
information about the subject matter of
modifies the certification requirement disclosure in Table 11.1.
the requirement, together with the fact
and instead requires one or more senior Table 11.2 disclosures (Capital
that, and the reason why, the specific
officers of the bank to attest that the Structure) provide information on
items of information have not been
disclosures meet the requirements of the various components of regulatory
disclosed. This provision of the final
final rule. The senior officer may be the capital available to absorb losses and
rule applies only to those disclosures
chief financial officer, the chief risk allow for an evaluation of the quality of
required by the final rule and does not
officer, an equivalent senior officer, or a the capital available to absorb losses
combination thereof. apply to disclosure requirements
within the bank.
imposed by accounting standards or Table 11.3 disclosures (Capital
Proprietary and Confidential other regulatory agencies. Adequacy) provide information about
Information
3. Summary of Specific Public how a bank assesses the adequacy of its
The agencies stated in the preamble to Disclosure Requirements capital and require that the bank
the proposed rule that they believed the disclose its minimum capital
As in the proposed rule, the public
disclosure requirements are comprised requirements for significant risk areas
may be included in public financial reports (for and portfolios. The table also requires
example, in Management’s Discussion and Analysis of 11 tables that provide important
included in SEC filings) or other regulatory reports information to market participants on disclosure of the regulatory capital
(for example, FR Y–9C Reports). Banks must the scope of application, capital, risk ratios of the consolidated group and
provide a summary table on their public Web site
exposures, risk assessment processes, each DI subsidiary. Such disclosures
that specifically indicates where all the disclosures provide insight into the overall
may be found (for example, regulatory report
schedules or page numbers in annual reports). 107 Proprietary information encompasses adequacy of capital based on the risk
106 These ratios are required to be disclosed in the information that, if shared with competitors, would profile of the organization.
footnotes to the audited financial statements render a bank’s investment in these products/ Tables 11.4, 11.5, and 11.7 disclosures
pursuant to existing GAAP requirements in Chapter systems less valuable, and, hence, could undermine (Credit Risk) provide market
17 of the ‘‘AICPA Audit and Accounting Guide for its competitive position. Information about
Depository and Lending Institutions: Banks, customers is often confidential, in that it is
participants with insight into different
Savings institutions, Credit unions, Finance provided under the terms of a legal agreement or types and concentrations of credit risk
companies and Mortgage companies.’’ counterparty relationship. to which the bank is exposed and the
techniques the bank uses to measure, practice, GAAP or regulatory reports Commenters provided feedback on a
monitor, and mitigate those risks. These (such as the FR Y–9C). As noted in the few aspects of Table 11.7 (Credit Risk
disclosures are intended to enable proposal, for major types of credit Mitigation). One commenter asserted
market participants to assess the credit exposure a bank could apply a that the table appears to overlap with
risk exposures under the IRB approach, breakdown similar to that used for the information on credit risk mitigation
without revealing proprietary accounting purposes, such as (a) loans, required in Table 11.5, item (a) and
information. off-balance sheet commitments, and requested that the agencies consolidate
Several commenters made suggestions other non-derivative off-balance sheet and simplify the requirements. In
related to Table 11.4. One commenter exposures, (b) debt securities, and (c) addition, several commenters objected
addressed item (b), which requires the OTC derivatives. The agencies do not to Table 11.7 item (b), which would
disclosure of total and average gross believe it is appropriate to make an require public disclosure of the risk-
credit risk exposures over the period exception to the general quarterly weighted asset amount associated with
broken down by major types of credit requirement for quantitative disclosures credit risk exposures that are covered by
exposure. The commenter asked the for the disclosure in Table 11.4. credit risk mitigation in the form of
agencies to clarify that methods used for Commenters provided extensive guarantees and credit derivatives. The
financial reporting purposes are allowed feedback on several aspects of Table commenter noted that this requirement
for determining averages. Another 11.5 (Disclosures for Portfolios Subject is not contained in the New Accord,
commenter requested that the agencies to IRB Risk-Based Capital Formulas). which only requires the total exposure
clarify what is meant by ‘‘gross’’ in item Several commenters were concerned amount of such credit risk exposures.
(b), given that a related footnote that the required level of detail may The agencies recognize that there is
describes net credit risk exposures in compel banks to disclose proprietary some duplication between Tables 11.7
accordance with GAAP. information. With respect to item (c), a and 11.5. At the same time, both
As with most of the disclosure requirements are part of the New
couple of commenters noted that the
requirements, the agencies are not Accord. The agencies have decided to
proposal differs from the New Accord in
prescriptive regarding the address this issue by inserting in Table
requiring exposure-weighted average
methodologies a bank must use for 11.5, item (a), a note that the disclosures
capital requirements instead of risk
determining averages. Rather, the bank can be met by completing the
weight percentages for groups of
must choose whatever methodology it disclosures in Table 11.7. With regard to
wholesale and retail exposures. One
believes to be most reflective of its risk Table 11.7, item (b), the agencies have
commenter also suggested that the term
position. That methodology may be the decided that there is no strong policy
‘‘actual losses’’ required in item (d)
one the bank uses for financial reporting reason for requiring banks to disclose
needs to be defined. Finally, several
purposes. The agencies have deleted risk-weighted assets associated with
‘‘gross’’ and otherwise simplified the commenters objected to the proposal in
credit risk exposures that are covered by
wording of item (b) in Table 11.4 to item (e) to disclose backtesting results,
credit risk mitigation in the form of
enhance clarity. Item (b) now reads asserting that such results would not be
guarantees and credit derivatives. The
‘‘total credit risk exposures and average understood by the market. Commenters
agencies have removed this requirement
credit risk exposures, after accounting suggested that disclosure of this item be
from the final rule, consistent with the
offsets in accordance with GAAP, and delayed beyond the proposed
New Accord.
without taking into account the effects commencement date of year-end 2010, Table 11.6 (General Disclosure for
of credit risk mitigation techniques (for to commence instead ten years after a Counterparty Credit Risk of OTC
example collateral and netting not bank exits from the parallel run period. Derivative Contracts, Repo-Style
included in GAAP for disclosure), over As discussed above, the agencies Transaction, and Eligible Margin Loans)
the period broken down by major types believe that, in most cases, a bank can provides the disclosure requirements
of credit exposure.’’ make the required disclosures without related to credit exposures from
In addition, a commenter noted that revealing proprietary information and derivatives. See the July 2005 BCBS
the requirements in Table 11.4 regarding that the rule contains appropriate publication entitled ‘‘The Application of
the breakdown of disclosures by ‘‘major provisions to deal with specific bank Basel II to Trading Activities and the
types of credit exposure’’ in items (b) concerns. With regard to item (c), the Treatment of Double Default Effects.’’
through (e) and by ‘‘counterparty type’’ agencies agree that there is no strong Commenters raised a few issues with
for items (d) and (f) are unclear. policy reason to differ from the New respect to Table 11.6. One commenter
Moreover, with respect to items (d), (e), Accord and have changed item (c) to requested that the agencies clarify item
and (f), the commenter recommended require the specified disclosures in risk (a), which requires a discussion of the
that disclosures should be provided on weight percentages rather than impact of the amount of collateral the
an annual rather than quarterly basis. weighted-average capital requirements. bank would have to provide given a
The same commenter also asserted that With respect to item (d), the agencies credit rating downgrade. The
the disclosure of remaining contractual are not imposing a prescriptive commenter asked whether this
maturity breakdown in item (e) should definition of actual losses and believe disclosure refers to credit downgrade of
be required annually. Finally, regarding that banks should determine actual the bank, the counterparty, or some
items (f) and (g), a few commenters losses consistent with internal practice. other entity. Another commenter
wanted clarification of the definition of Finally, regarding item (e), the agencies objected to item (b), which would
impaired and past due loans. believe that public disclosure of require the breakdown of counterparty
The agencies are not prescriptive with backtesting results provides important credit exposure by type of exposure.
regard to what is meant by ‘‘major types information to the market and should The commenter asserted that this
of credit exposure,’’ disclosure by not be delayed. However, the agencies proposed requirement is burdensome,
counterparty type, or impaired and past have slightly modified the requirement, infeasible for netted exposures and
due loans. Bank management has the consistent with the New Accord, to duplicative of other information
discretion to determine the most reinforce that disclosure of individual generally available in existing GAAP
appropriate disclosure for the bank’s risk parameter backtesting is not always and U.S. bank regulatory financial
risk profile consistent with internal required. statements.
The agencies have decided to clarify 4. Regulatory Reporting instances where the same or similar
that item (a) refers in part to the credit In addition to the public disclosures disclosures may be required by both sets
rating downgrade of the bank making required by the consolidated banking of requirements. Many of the public
the disclosure. This is consistent with organization subject to the advanced disclosures cover only a subset of the
the intent of this disclosure requirement approaches, the agencies will require information sought in the proposed
in the New Accord. With respect to item certain additional regulatory reporting regulatory reporting templates. For
(b), the agencies recognize that this from BHCs, their subsidiary DIs, and DIs instance, banks are required only to
proposed requirement may be applying the advanced approaches that disclose publicly information ‘‘across a
problematic for banks that have are not subsidiaries of BHCs. The sufficient number of PD grades to allow
implemented the internal models agencies believe that the reporting of a meaningful differentiation of credit
methodology. Accordingly, the agencies key risk parameter estimates by each DI risk,’’ whereas the proposed reporting
have decided to modify the rule to note templates contemplate a much more
applying the advanced approaches will
that this disclosure item is only required granular collection of data by specified
provide the primary Federal supervisor
for banks not using the internal models PD bands. Such aggregation of data so
and other relevant supervisors with data
methodology in section 32(d). as to mask the confidential nature of
Table 11.8 disclosures (Securitization) important for assessing the
reasonableness and accuracy of the more granular information that is
provide information to market reported to regulators is not unique to
participants on the amount of credit risk bank’s calculation of its minimum
capital requirements under this final the advanced approaches reporting. In
transferred and retained by the addition, the agencies believe that a
organization through securitization rule and the adequacy of the
institution’s capital in relation to its bank may be able to comply with some
transactions and the types of products of the public disclosure requirements
securitized by the organization. These risks. This information will be collected
through regulatory reports. The agencies under this final rule by publicly
disclosures provide users a better disclosing, at the bank’s discretion and
understanding of how securitization believe that requiring certain common
reporting across banks will facilitate judgment, certain information found in
transactions impact the credit risk of the the reporting templates that otherwise
bank. comparable application of the final rule.
The agencies will publish in the would be held confidential by the
One commenter asked the agencies to agencies. A bank could disclose this
explicitly acknowledge that they will Federal Register reporting schedules
based on the reporting templates issued information on its Web site (as
accept the definitions and described in ‘‘location and audit
interpretations of the components of for comment in September 2006.
Consistent with the proposed reporting requirements’’ above) if it believes that
securitization exposures that a bank such disclosures will meet the public
uses for financial reporting purposes schedules, these reporting schedules
will include a summary schedule with disclosure requirements required by the
(FAS 140 reporting disclosures).
aggregate data that will be available to rule.
Generally, as noted above, the
agencies expect that a bank will be able the general public. It also will include List of Acronyms
to fulfill some of its disclosure supporting schedules that will be
ABCP Asset-Backed Commercial Paper
requirements by relying on disclosures viewed as confidential supervisory
ALLL Allowance for Loan and Lease Losses
made in accordance with accounting information. These schedules will be AMA Advanced Measurement Approaches
standards, SEC mandates, or regulatory broken out by exposure category and ANPR Advance Notice of Proposed
reports. In these situations, a bank must will collect risk parameter and other Rulemaking
explain any material differences pertinent data in a systematic manner. AVC Asset Value Correlation
between the accounting or other Under the final rule, banks must begin BCBS Basel Committee on Banking
disclosure and the disclosures required reporting this information during their Supervision
parallel run on a confidential basis. The BHC Bank Holding Company
under the final rule. The agencies do not
agencies will share this information CCDS Contingent Credit Default Swap
believe any changes to the rule are CF Conversion Factor
necessary to accommodate the with each other for calibration and other CEIO Credit-Enhancing Interest-Only Strip
commenter’s concern. analytical purposes. CRM Credit Risk Mitigation
Table 11.9 disclosures (Operational One commenter expressed concerns CUSIP Committee on Uniform Securities
Risk) provide insight into the bank’s that some of the confidential Identification Procedures
application of the AMA for operational information requested in the proposed DI Depository Institution
risk and what internal and external reporting templates was also contained DvP Delivery versus Payment
factors are considered in determining in the public disclosure requirements E Measure of Effectiveness
the amount of capital allocated to under the proposal. As a result, some EAD Exposure at Default
information would be classified as ECL Expected Credit Loss
operational risk. EE Expected Exposure
Table 11.10 disclosures (Equities Not confidential in the reporting templates
EL Expected Loss
Subject to Market Risk Rule) provide and public under the disclosure ELGD Expected Loss Given Default
market participants with an requirements in the final rule. EOL Expected Operational Loss
understanding of the types of equity The agencies recognize that there may EPE Expected Positive Exposure
securities held by the bank and how be some overlap between confidential EWALGD Exposure-Weighted Average Loss
they are valued. The table also provides information required in the regulatory Given Default
information on the capital allocated to reports and public information required FAS Financial Accounting Standard
different equity products and the in the disclosure requirements of the FDIC Federal Deposit Insurance
amount of unrealized gains and losses. final rule. The agencies will address Corporation
FFIEC Federal Financial Institutions
Table 11.11 disclosures (Interest Rate specific comments on the reporting

Examination Council
Risk in Non-Trading Activities) provide templates separately. In general, the GAAP Generally Accepted Accounting
information about the potential risk of agencies believe that given the different Principles
loss that may result from changes in purposes of the regulatory reporting and GAO Government Accountability Office
interest rates and how the bank public disclosure requirements under HELOC Home Equity Line of Credit
measures such risk. the final rule, there may be some HOLA Home Owners’ Loan Act
HVCRE High-Volatility Commercial Real (i) has consolidated total assets (as ratings-based approach to calculate
Estate reported on its most recent year-end regulatory credit risk capital
IAA Internal Assessment Approach regulatory report) equal to $250 billion requirements and advanced
ICAAP Internal Capital Adequacy
or more; (ii) has consolidated total on- measurement approaches to calculate
Assessment Process
IMA Internal Models Approach balance sheet foreign exposures at the regulatory operational risk capital
IRB Internal Ratings-Based most recent year-end equal to $10 requirements. The collections of
KIRB Capital Requirement for Underlying billion or more; or (iii) is a subsidiary information are necessary in order to
Pool of Exposures (securitizations) of a bank holding company, bank, or implement the proposed advanced
LGD Loss Given Default savings association that would be capital adequacy framework. The
LTV Loan-to-Value Ratio required to use the proposed rule to agencies received approximately ninety
M Effective Maturity calculate its risk-based capital public comments. None of the comment
NRSRO Nationally Recognized Statistical
requirements. letters specifically addressed the
Rating Organization
OCC Office of the Comptroller of the
The agencies estimate that zero small proposed burden estimates; therefore,
Currency bank holding companies (out of a total the burden estimates will remain
OTC Over-the-Counter of approximately 2,919 small bank unchanged, as published in the notice of
OTS Office of Thrift Supervision holding companies), 16 small national proposed rulemaking (71 FR 55830).
PCA Prompt Corrective Action banks (out of a total of approximately The affected public are: national
PD Probability of Default 948 small national banks), one small banks and Federal branches and
PFE Potential Future Exposure state member bank (out of a total of
PMI Private Mortgage Insurance agencies of foreign banks (OCC); state
approximately 468 small state member member banks, bank holding
PvP Payment versus Payment
QIS–3 Quantitative Impact Study 3
banks), one small state nonmember bank companies, affiliates and certain non-
QIS–4 Quantitative Impact Study 4 (out of a total of approximately 3,242 bank subsidiaries of bank holding
QIS–5 Quantitative Impact Study 5 small state nonmember banks), and zero companies, uninsured state agencies
QRE Qualifying Revolving Exposure small savings associations (out of a total and branches of foreign banks,
RBA Ratings-Based Approach of approximately 419 small savings commercial lending companies owned
RVC Ratio of Value Change associations) would be subject to the
SEC Securities and Exchange Commission or controlled by foreign banks, and Edge
final rule on a mandatory basis. In and agreement corporations (Board);
SFA Supervisory Formula Approach addition, each of the small banking
SME Small- and Medium-Size Enterprise insured nonmember banks, insured state
SPE Special Purpose Entity
organizations subject to the final rule on branches of foreign banks, and certain
SRWA Simple Risk-Weight Approach a mandatory basis is a subsidiary of a subsidiaries of these entities (FDIC); and
TFR Thrift Financial Report bank holding company with over $250 savings associations and certain of their
UL Unexpected Loss billion in consolidated total assets or subsidiaries (OTS).
UOL Unexpected Operational Loss over $10 billion in consolidated total
VaR Value-at-Risk on-balance sheet foreign exposure. Comment Request
Regulatory Flexibility Act Analysis Therefore, the agencies believe that the The agencies have an ongoing interest
final rule will not result in a significant in your comments. They should be sent
The Regulatory Flexibility Act (RFA) economic impact on a substantial
requires an agency that is issuing a final to [Agency] Desk Officer, [OMB No.], by
number of small entities. mail to U.S. Office of Management and
rule to prepare and make available a
regulatory flexibility analysis that Paperwork Reduction Act Budget, 725 17th Street, NW., #10235,
describes the impact of the final rule on In accordance with the requirements Washington, DC 20503, or by fax to
small entities. 5 U.S.C. 603(a). The RFA of the Paperwork Reduction Act of 1995, (202) 395–6974.
provides that an agency is not required the agencies may not conduct or Comments submitted in response to
to prepare and publish a regulatory sponsor, and respondents are not this notice will be shared among the
flexibility analysis if the agency certifies required to respond to, an information agencies. All comments will become a
that the final rule will not have a collection unless it displays a currently matter of public record. Written
significant economic impact on a valid Office of Management and Budget comments should address the accuracy
substantial number of small entities. 5 (OMB) control number. OMB assigned of the burden estimates and ways to
U.S.C. 605(b). the following control numbers to the minimize burden including the use of
Pursuant to section 605(b) of the RFA collections of information: 1557–0234 automated collection techniques or the
(5 U.S.C. 605(b)), the agencies certify (OCC), 3064–0153 (FDIC), and 1550– use of other forms of information
that this final rule will not have a 0115 (OTS). The Board assigned control technology as well as other relevant
significant economic impact on a number 7100–0313. aspects of the information collection
substantial number of small entities. In September 2006 the OCC, FDIC, request.
Pursuant to regulations issued by the and OTS submitted the information OCC Executive Order 12866
Small Business Administration (13 CFR collections contained in this rule to
121.201), a ‘‘small entity’’ includes a OMB for review and approval once the Executive Order 12866 requires
bank holding company, commercial proposed rule was published. The Federal agencies to prepare a regulatory
bank, or savings association with assets Board, under authority delegated to it by impact analysis for agency actions that
of $165 million or less (collectively, OMB, also submitted the proposed are found to be ‘‘significant regulatory
small banking organizations). The final information collection to OMB. actions.’’ ‘‘Significant regulatory
rule requires a bank holding company, The agencies (OCC, FDIC, the Board, actions’’ include, among other things,
national bank, state member bank, state and OTS) determined that sections 21– rulemakings that ‘‘have an annual effect
on the economy of $100 million or more
nonmember bank, or savings association 24, 42, 44, 53, and 71 of the final rule
to calculate its risk-based capital contain collections of information. The or adversely affect in a material way the
requirements according to certain final rule sets forth a new risk-based economy, a sector of the economy,
internal-ratings-based and internal capital adequacy framework that would productivity, competition, jobs, the
model approaches if the bank holding require some banks and allow other environment, public health or safety, or
company, bank, or savings association qualifying banks to use an internal State, local, or tribal governments or
communities.’’108 Regulatory actions environment), together with, to the Revised Framework’’ (New Accord), and
that satisfy one or more of these criteria extent feasible, a quantification of those its implementation in the United States,
are referred to as ‘‘economically costs; and reflects an appropriate step forward in
significant regulatory actions.’’ • An assessment, including the addressing these changes.
The OCC anticipates that the final underlying analysis, of costs and
rule will meet the $100 million criterion benefits of potentially effective and II. Regulatory Background
and therefore is an economically reasonably feasible alternatives to the The capital regulation examined in
significant regulatory action. In planned regulation, identified by the this analysis will apply to commercial
conducting the regulatory analysis for agencies or the public (including banks and savings associations
an economically significant regulatory improving the current regulation and (collectively, banks). Three banking
action, Executive Order 12866 requires reasonably viable nonregulatory agencies, the OCC, the Board of
each Federal agency to provide to the actions), and an explanation why the Governors of the Federal Reserve
Administrator of the Office of planned regulatory action is preferable System (Board), and the FDIC regulate
Management and Budget’s (OMB) Office to the identified potential alternatives. commercial banks, while the Office of
of Information and Regulatory Affairs Set forth below is a summary of the Thrift Supervision (OTS) regulates all
(OIRA): OCC’s regulatory impact analysis, which federally chartered and many state-
• The text of the draft regulatory can be found in its entirety at http:// chartered savings associations.
action, together with a reasonably www.occ.treas.gov/law/basel.htm under Throughout this document, the four are
detailed description of the need for the the link of ‘‘Regulatory Impact Analysis jointly referred to as the Federal banking
regulatory action and an explanation of for Risk-Based Capital Standards: agencies.
how the regulatory action will meet that Revised Capital Adequacy Guidelines The New Accord comprises three
need; (Basel II: Advanced Approach) 2007’’. mutually reinforcing ‘‘pillars’’ as
• An assessment of the potential costs summarized below.
and benefits of the regulatory action, I. The Need for the Regulatory Action
1. Minimum Capital Requirements
including an explanation of the manner Federal banking law directs Federal (Pillar 1)
in which the regulatory action is banking agencies including the Office of
consistent with a statutory mandate and, the Comptroller of the Currency (OCC) The first pillar establishes a method
to the extent permitted by law, promotes to require banking organizations to hold for calculating minimum regulatory
the President’s priorities and avoids adequate capital. The law authorizes capital. It sets new requirements for
undue interference with State, local, Federal banking agencies to set assessing credit risk and operational risk
and tribal governments in the exercise minimum capital levels to ensure that while retaining the approach to market
of their governmental functions; banking organizations maintain risk as developed in the 1996
• An assessment, including the adequate capital. The law also gives amendments to the 1988 Accord.
underlying analysis, of benefits Federal banking agencies broad The New Accord offers banks a choice
anticipated from the regulatory action discretion with respect to capital of three methodologies for calculating a
(such as, but not limited to, the regulation by authorizing them to also capital charge for credit risk. The first
promotion of the efficient functioning of use any other methods that they deem approach, called the Standardized
the economy and private markets, the appropriate to ensure capital adequacy. Approach, essentially refines the risk-
enhancement of health and safety, the Capital regulation seeks to address weighting framework of the 1988
protection of the natural environment, market failures that stem from several Accord. The other two approaches are
and the elimination or reduction of sources. Asymmetric information about variations on an internal ratings-based
discrimination or bias) together with, to the risk in a bank’s portfolio creates a (IRB) approach that leverages banks’
the extent feasible, a quantification of market failure by hindering the ability internal credit-rating systems: a
those benefits; of creditors and outside monitors to ‘‘foundation’’ methodology in which
• An assessment, including the discern a bank’s actual risk and capital banks estimate the probability of
underlying analysis, of costs anticipated adequacy. Moral hazard creates market borrower or obligor default, and an
from the regulatory action (such as, but failure in which the bank’s creditors fail ‘‘advanced’’ approach in which banks
not limited to, the direct cost both to the to restrain the bank from taking also supply other inputs needed for the
government in administering the excessive risks because deposit capital calculation. In addition, the new
regulation and to businesses and others insurance either fully or partially framework uses more risk-sensitive
in complying with the regulation, and protects them from losses. Public policy methods for dealing with collateral,
any adverse effects on the efficient addresses these market failures because guarantees, credit derivatives,
functioning of the economy, private individual banks fail to adequately securitizations, and receivables.
markets (including productivity, consider the positive externality or The New Accord also introduces an
employment, and competitiveness), public benefit that adequate capital explicit capital requirement for
health, safety, and the natural brings to financial markets and the operational risk.109 The New Accord
economy as a whole. offers banks a choice of three
108 108 Executive Order 12866 (September 30,
Capital regulations cannot be static. methodologies for calculating their
1993), 58 FR 51735 (October 4, 1993), as amended
Innovation in and transformation of capital charge for operational risk. The
by Executive Order 13258 (February 26, 2002), 67 first method, called the Basic Indicator
FR 9385 (February 28, 2002) and by Executive financial markets require periodic
Order 13422 (January 18, 2007), 72 FR 2763 reassessments of what may count as Approach, requires banks to hold
(January 23, 2007). For the complete text of the capital and what amount of capital is capital for operational risk equal to 15
definition of ‘‘significant regulatory action,’’ see
adequate. Continuing changes in percent of annual gross income
E.O. 12866 at § 3(f). A ‘‘regulatory action’’ is ‘‘any (averaged over the most recent three
substantive action by an agency (normally financial markets create both a need and
published in the Federal Register) that promulgates an opportunity to refine capital years). The second option, called the
or is expected to lead to the promulgation of a final standards in banking. The Basel
rule or regulation, including notices of inquiry, 109 Operational risk is the risk of loss resulting
advance notices of proposed rulemaking, and

Committee on Banking Supervision’s from inadequate or failed processes, people, and
notices of proposed rulemaking.’’ E.O. 12866 at ‘‘International Convergence of Capital systems or from external events. It includes legal
§ 3(e). Measurement and Capital Standards: A risk, but excludes strategic risk and reputation risk.
Standardized Approach, uses a formula billion or consolidated on-balance-sheet likely incur some of these costs as part
that divides a bank’s activities into eight foreign exposures of $10 billion or more. of their ongoing efforts to improve risk
business lines, calculates the capital Mandatory banks will have to use the measurement and management systems.
charge for each business line as a fixed New Accord’s most advanced methods On the benefits side, measurement
percentage of gross income (12 percent, only: the Advanced IRB approach to problems are even greater because the
15 percent, or 18 percent depending on determine capital for credit risk and the benefits of the rule are more qualitative
the nature of the business, again AMA to determine capital for than quantitative. Measurement
averaged over the most recent three operational risk. A second category of problems exist even with an apparently
years), and then sums across business banks, called ‘‘opt-in’’ banks, includes measurable effect such as lower
lines. The third option, called the banks that do not meet either size minimum capital because lower
Advanced Measurement Approaches criteria of a mandatory bank but choose minimum requirements do not
(AMA), uses an bank’s internal voluntarily to comply with the necessarily mean lower capital levels
operational risk measurement system to advanced approaches specified under held by banks. Healthy banks generally
determine the capital requirement. the New Accord. The third category, hold capital well above regulatory
called ‘‘general’’ banks, encompasses all minimums for a variety of reasons, and
2. Supervisory Review Process (Pillar 2)
other banks, and these will continue to the effect of reducing the regulatory
The second pillar calls upon banks to operate under existing risk-based capital minimum is uncertain and may vary
have an internal capital assessment rules, subject to any amendments. across regulated banks.
process and banking supervisors to Various changes to the rules that
evaluate each bank’s overall risk profile apply to non-mandatory banks are Benefits of the Rule
as well as its risk management and under consideration. The Federal 1. Better allocation of capital and
internal control processes. This pillar banking agencies have decided to issue reduced impact of moral hazard
establishes an expectation that banks for comment a proposal that would through reduction in the scope for
hold capital beyond the minimums allow the voluntary adoption of the regulatory arbitrage: By assessing the
computed under Pillar 1, including standardized approach for credit risk amount of capital required for each
additional capital for any risks that are and the basic indicator approach for exposure or pool of exposures, the
not adequately captured under Pillar 1. operational risk for non-mandatory advanced approaches do away with the
It encourages banks to develop better banks (referred to hereafter as the simplistic risk buckets of current capital
risk management techniques for Standardized Option). Because the rules. Getting rid of categorical risk
monitoring and managing their risks. Standardized Option would be a weighting and assigning capital based
Pillar 2 also charges supervisors with separate rulemaking, our analysis will on measured risk instead greatly curtails
the responsibility to ensure that banks focus just on the implementation of the or eliminates the ability of troubled
using advanced Pillar 1 techniques, Advanced Approaches. However, we banks to ‘‘game’’ regulatory capital
such as the IRB approach to credit risk will note how the Standardized Option requirements by finding ways to comply
and the AMA for operational risk might affect the outcome of our analysis technically with the requirements while
(collectively, advanced approaches), if we anticipate the possibility that its evading their intent and spirit.
comply with the minimum standards adoption could lead to a significantly 2. Improved signal quality of capital
and disclosure requirements of those different outcome. as an indicator of solvency: The
methods, and take action promptly if While introducing many significant advanced approaches are designed to
capital is not adequate. changes, the U.S. implementation of the more accurately align regulatory capital
New Accord retains many components with risk, which should improve the
3. Market Discipline (Pillar 3) of the capital rules currently in effect. signal quality of capital as an indicator
The third pillar of the New Accord For example, it preserves existing of solvency. The improved signaling
sets minimum disclosure requirements Prompt Corrective Action provisions for quality of capital will enhance banking
for banks. The disclosures, covering the all banks. The U.S. implementation of supervision and market discipline.
composition and structure of the bank’s the New Accord also keeps intact most 3. Encourages banks to improve credit
capital, the nature of its risk exposures, elements of the definition of what risk management: One of the principal
its risk management and internal control comprises regulatory capital. objectives of the rule is to more closely
processes, and its capital adequacy, are align capital charges and risk. For any
intended to improve transparency and III. Costs and Benefits of the Rule type of credit, risk increases as either
strengthen market discipline. By This analysis considers the costs and the probability of default or the loss
establishing a common set of disclosure benefits of the fully phased-in rule. given default increases. Under the final
requirements, Pillar 3 seeks to provide Under the rule, current capital rules will rule, the capital charge for credit risk
a consistent and understandable remain in effect in 2008 during a depends on these risk parameter
disclosure framework that market parallel run using both old and new measures and consequently capital
participants can use to assess key pieces capital rules. For three years following requirements will more closely reflect
of information on the risks and capital the parallel run, the final rule will apply risk. This enhanced link between capital
adequacy of a bank. limits on the amount by which requirements and risk will encourage
minimum required capital may banks to improve credit risk
4. U.S. Implementation decrease. This analysis, however, management.
The rule for implementing the New considers the costs and benefits of the 4. More efficient use of required bank
Accord’s advanced approaches in the rule as fully phased in. capital: Increased risk sensitivity and
United States will apply the new Cost and benefit analysis of changes improvements in risk measurement will
framework to the largest and most in minimum capital requirements entail allow prudential objectives to be
internationally active banks. All banks considerable measurement problems. achieved more efficiently. If capital
will fall into one of three regulatory On the cost side, it can be difficult to rules can better align capital with risk
categories. The first category, called attribute particular expenditures across the system, a given level of
‘‘mandatory’’ banks, consists of banks incurred by banks to the costs of capital will be able to support a higher
with consolidated assets of at least $250 implementation because banks would level of banking activity while
maintaining the same degree of consistency of capital requirements for these banks will spend a total of $791
confidence regarding the safety and banks competing in global markets. The million over several years to implement
soundness of the banking system. Social New Accord continues to pursue this the rule. Estimated costs for nine
welfare is enhanced by either the objective. Because achieving this respondents meeting one of the
stronger condition of the banking objective depends on the consistency of mandatory thresholds come to $412
system or the increased economic implementation in the United States million.
activity the additional banking services and abroad, the Basel Committee on 2. Estimate of costs specific to the
facilitate. Banking Supervision (BCBS) has rule: Ten QIS–4 respondents provided
5. Incorporates and encourages established an Accord Implementation estimates of the portion of costs they
advances in risk measurement and risk Group to promote consistency in the would have incurred even if current
management: The rule seeks to improve implementation of the New Accord. capital rules remain in effect. Those ten
upon existing capital regulations by 11. Ability to opt in offers long-term indicated that they would have spent 45
incorporating advances in risk flexibility to nonmandatory banks: The percent on average, or roughly half of
measurement and risk management U.S. implementation of the New Accord their advanced approaches expenditures
made over the past 15 years. An allows non-mandatory banks to on improving risk management anyway.
objective of the rule is to speed adoption individually judge when the benefits This suggests that of the $42 million
of new risk management techniques and they expect to realize from adopting the banks expect to spend on
to promote the further development of advanced approaches outweigh their implementation, approximately $21
risk measurement and management costs. Even though the cost and million may represent expenditures
through the regulatory process. complexity of adopting the advanced each bank would have undertaken even
6. Recognizes new developments and methods may present non-mandatory without the New Accord. Thus, pure
accommodates continuing innovation in banks with a substantial hurdle to implementation costs may be closer to
financial products by focusing on risk: opting in at present, the potential long- roughly $395 million for the 19 QIS–4
The rule also has the benefit of term benefits of allowing non- respondents.
facilitating recognition of new mandatory banks to partake in the 3. Ongoing costs: Seven QIS–4
developments in financial products by benefits described above may be respondents were able to estimate what
focusing on the fundamentals behind similarly substantial. their recurring costs might be under the
risk rather than on static product U.S implementation of the New Accord.
categories. Costs of the Rule On average, the seven banks estimate
7. Better aligns capital and Because banks are constantly that annual recurring expenses
operational risk and encourages banks developing programs and systems to attributable to the revised capital
to mitigate operational risk: Introducing improve how they measure and manage framework will be $2.4 million per
an explicit capital calculation for risk, it is difficult to distinguish bank. Banks indicated that the ongoing
operational risk eliminates the implicit between expenditures explicitly caused costs to maintain related technology
and imprecise ‘‘buffer’’ that covers by adoption of this final rule and costs reflect costs for increased personnel and
operational risk under current capital that would have occurred irrespective of system maintenance. The larger one-
rules. Introducing an explicit capital any new regulation. In an effort to time expenditures to adopt this final
requirement for operational risk identify how much banks expect to rule primarily involve money for system
improves assessments of the protection spend to comply with the U.S. development and software purchases.
capital provides, particularly at banks implementation of the New Accord’s 4. Implicit costs: In addition to
where operational risk dominates other advanced approaches, the Federal explicit setup and recurring costs, banks
risks. The explicit treatment also banking agencies included several may also face implicit costs arising from
increases the transparency of questions related to compliance costs in the time and inconvenience of having to
operational risk, which could encourage the fourth Quantitative Impact Study adapt to new capital regulations. At a
banks to take further steps to mitigate (QIS–4).110 minimum this involves the increased
operational risk. 1. Overall Costs: According to the 19 time and attention required of senior
8. Enhanced supervisory feedback: out of 26 QIS–4 questionnaire bank management to introduce new
Although U.S. banks have long been respondents that provided estimates of programs and procedures and the need
subject to close supervision, aspects of their implementation costs, banks will to closely monitor the new activities
all three pillars of the rule aim to spend roughly $42 million on average to during the inevitable rough patches
enhance supervisory feedback from adapt to capital requirements when the rule first takes effect.
Federal banking agencies to managers of implementing the New Accord’s 5. Government Administrative Costs:
banks. Enhanced feedback could further OCC expenditures fall into three broad
advanced approaches. Not all of these
strengthen the safety and soundness of categories: training, guidance, and
respondents are likely mandatory banks.
the banking system. supervision. Training includes expenses
Counting just the likely mandatory
9. Enhanced disclosure promotes for AMA and IRB workshops, and other
banks, the average is approximately $46
market discipline: The rule seeks to aid training courses and seminars for
million, so there is little difference
market discipline through the regulatory examiners. Guidance expenses reflect
between banks that meet a mandatory
framework by requiring specific expenditures on the development of IRB
threshold and those that do not.
disclosures relating to risk measurement and AMA guidance. Supervision
Aggregating estimated expenditures
and risk management. Market discipline expenses reflect bank-specific
from all 19 respondents indicates that
could complement regulatory supervisory activities related to the
supervision to bolster safety and 110 For more information on QIS–4, see Office of development and implementation of the
soundness. the Comptroller of the Currency, Board of New Accord. The largest OCC
10. Preserves the benefits of Governors of the Federal Reserve System, Federal expenditures have been on the
international consistency and Deposit Insurance Corporation, and Office of Thrift development of IRB and AMA policy
Supervision, ‘‘Summary Findings of the Fourth
coordination achieved with the 1988 Quantitative Impact Study,’’ February 2006,
guidance. The $5.4 million spent on
Basel Accord: An important objective of available online at http://www.occ.treas.gov/ftp/ guidance represents 54 percent of the
the 1988 Accord was competitive release/2006-23a.pdf. estimated total OCC advanced
approaches-related expenditure of $10.0 available evidence related to those mortgage holdings at banks operating
million through the 2006 fiscal year. In potential effects. under the advanced approaches rule,
part, this large share reflects the absence 1. Explicit Capital for Operational and they see this increase primarily as
of data for training and supervision Risk: Some have noted that the explicit a shift away from the large government
costs for several years, but it also is computation of required capital for sponsored mortgage enterprises.
indicative of the large guidance operational risk could lead to an 3. Small Business Lending: One
expenses in 2002 and 2003 when the increase in total minimum regulatory potential avenue for competitive effects
New Accord was in development. To capital for U.S. ‘‘processing’’ banks, is small-business lending. Smaller
date, New Accord expenditures have generally defined as banks that tend to banks—those that are less likely to
not been a large part of overall OCC engage in a variety of activities related adopt the advanced approaches to
expenditures. The $3 million spent on to securities clearing, asset management, regulatory capital under the rule—tend
the advanced approaches in fiscal year and custodial services. Some have to rely more heavily on smaller loans
2006 represents less than one percent of suggested that the increase in required within their commercial loan portfolios.
the OCC’s $579 million budget for the capital could place such firms at a To the extent that the rule reduces
year. competitive disadvantage relative to required capital for such loans, general
6. Total Cost: The OCC’s estimate of competitors that do not face a similar banks not operating under the rule
the total cost of the rule includes capital requirement. A careful analysis might be placed at a competitive
expenditures by banks and the OCC by Fontnouvelle et al.111 considers the disadvantage. A study by Berger114 finds
from the present through 2011, the final potential competitive impact of the some potential for a relatively small
year of the transition period. Combining explicit capital requirement for
competitive effect on smaller banks in
expenditures by mandatory banks and operational risk. Overall, the study
small business lending. However, Berger
the OCC provides a present value concludes that competitive effects from
concludes that the small business
estimate of $498.9 million for the total an explicit operational risk capital
market for large banks is very different
cost of the rule. requirement should be, at most,
7. Procyclicality: Procyclicality refers from the small business market for
extremely modest.
to the possibility that banks may reduce 2. Residential Mortgage Lending: The smaller banks. For instance, a ‘‘small
lending during economic downturns issue of competitive effects has received business’’ at a larger bank is usually
and increase lending during economic substantial attention with respect to the much larger than small businesses at
expansions as a consequence of residential mortgage market. The focus community banks.
minimum capital requirements. There is on the residential mortgage market 4. Mergers and Acquisitions: Another
some concern that the risk-sensitivity of stems from the size and importance of concern related to potential changes in
the Advanced IRB approach may cause the market in the United States, and the competitive conditions under the rule is
capital requirements for credit risk to fact that the rule may lead to substantial that bifurcation of capital standards
increase during an economic downturn. reductions in credit-risk capital for might change the landscape with regard
Although procyclicality may be inherent residential mortgages. To the extent that to mergers and acquisitions in banking
in banking to some extent, elements of corresponding operational-risk capital and financial services. For example,
the advanced approaches could reduce requirements do not offset these credit- banks operating under this final rule
inherent procyclicality. Risk risk-related reductions, overall capital might be placed in a better position to
management and information systems requirements for residential mortgages acquire banks operating under the old
may provide bank managers with more could decline under the rule. Studies by rules, possibly leading to an undesirable
forward-looking information about risk Calem and Follain112 and Hancock, consolidation of the banking sector.
that will allow them to adjust portfolios Lennert, Passmore, and Sherlund 113 Research by Hannan and Pilloff 115
gradually and with more foresight as the suggest that banks operating under rules suggests that the rule is unlikely to have
economic outlook changes over the based on the New Accord’s advance a significant impact on merger and
business cycle. Regulatory stress-testing approaches may increase their holdings acquisition activity in banking.
requirements included in the rule also of residential mortgages. Calem and 5. Credit Card Competition: The U.S.
will help ensure that banks anticipate Follain argue that the increase would be implementation of the New Accord
cyclicality in capital requirements to the significant and come at the expense of might also affect competition in the
greatest extent possible, reducing the general banks. Hancock et al. foresee a credit card market. Overall capital
potential economic impact of changes in more modest increase in residential requirements for credit card loans could
capital requirements. increase under the rule. This raises the
111 Patrick de Fontnouvelle, Victoria Garrity,
IV. Competition Among Providers of possibility of a change in the
Scott Chu, and Eric Rosengren, ‘‘The Potential
Financial Services Impact of Explicit Basel II Operational Risk Capital competitive environment among banks
Charges on the Competitive Environment of subject to the new rules, nonbank credit
One potential concern with any Processing Banks in the United States,’’ manuscript, card issuers, and banks not subject to
regulatory change is the possibility that Federal Reserve Bank of Boston, January 12, 2005. this final rule. A study by Lang, Mester,
it might create a competitive advantage Available at http://www.federalreserve.gov/
generalinfo/basel2/whitepapers.htm.
for some banks relative to others, a 112 Paul S. Calem and James R. Follain, 114 Allen N. Berger, ‘‘Potential Competitive Effects
possibility that certainly applies to a ‘‘Regulatory Capital Arbitrage and the Potential of Basel II on Banks in SME Credit Markets in the
change with the scope of this final rule. Competitive Impact of Basel II in the Market for United States,’’ Journal of Financial Services
However, measurement difficulties Residential Mortgages’’, The Journal of Real Estate Research, 29:1, pp. 5–36, 2006. Also available at
described in the preceding discussion of Finance and Economics, Vol. 35, pp. 197–219, http://www.federalreserve.gov/generalinfo/basel2/
August 2007. whitepapers.htm.
costs and benefits also extend to any 113 Diana Hancock, Andreas Lennert, Wayne 115 Timothy H. Hannan and Steven J. Pilloff,
consideration of the impact on Passmore, and Shane M. Sherlund, ‘‘An Analysis of ‘‘Will the Proposed Application of Basel II in the
competition. Despite the inherent the Potential Competitive Impact of Basel II Capital United States Encourage Increased Bank Merger
difficulty of drawing definitive Standards on U.S. Mortgage Rates and Mortgage Activity? Evidence from Past Merger Activity,’’
Securitization’’, manuscript, Federal Reserve Board, Federal Reserve Board Finance and Economics
conclusions, this section considers April 2005. Available at http:// Discussion Series, 2004–13, February 2004.
various ways in which competitive www.federalreserve.gov/generalinfo/basel2/ Available at http://www.federalreserve.gov/
effects might be manifest, as well as whitepapers.htm. generalinfo/basel2/whitepapers.htm.
and Vermilyea116 finds that countries with internationally active the final rule. Banks that are not
implementation of a rule based on the banks do adopt the New Accord.118 prepared for the adoption of the
New Accord will not affect credit card 1. Baseline Scenario: Current capital advanced approach to credit risk under
competition at most community and standards based on the 1988 Basel the final rule could choose to use the
regional banks. The authors also suggest Accord continue to apply to banks Foundation IRB methodology or even
that higher capital requirements for operating in the United States, but the the Standardized Approach. How
credit cards may only pose a modest rest of the world adopts the New Alternative A might affect benefits
disadvantage to banks that are subject to Accord: Abandoning the New Accord in depends entirely on how many banks
this final rule. favor of current capital rules would select each of the three available
Overall, the evidence regarding the eliminate essentially all of the benefits options. The most significant drawback
impact of this final rule on competitive of the rule described earlier. In place of to Alternative A is the increased cost of
equity is mixed. The body of recent these lost or diminished benefits, the applying a new set of capital rules to all
economic research discussed in the only advantage of continuing to apply U.S. banks. The vast majority of banks
body of this report does not reveal current capital rules to all banks is that in the United States would incur no
persuasive evidence of any sizeable maintaining the status quo should direct costs from new capital rules.
competitive effects. Nonetheless, the alleviate concerns regarding Under Alternative A, direct costs would
Federal banking agencies recognize the competition among domestic financial increase for every U.S. bank that would
need to closely monitor the competitive service providers. Although the effect of have continued with current capital
landscape subsequent to any regulatory the rule on competition is uncertain in rules. Although it is not clear how high
change. In particular, the OCC and other our estimation, staying with current these costs might be, general banks
Federal banking agencies will be alert capital rules (or universally applying a would face higher costs because they
for early signs of competitive inequities revised rule that might emerge from the would be changing capital rules
that might result from this final rule. A Standardized Option) eliminates regardless of which option they choose
multi-year transition period before full bifurcation. Concerns regarding under Alternative A.
implementation of this final rule should competition usually center on this 3. Alternative B: Permit U.S. banks to
provide ample opportunity for the characteristic of the rule. However, the choose among all three New Accord
Federal banking agencies to identify any emergence of different capital rules operational risk approaches: The
emerging problems. In particular, after across national borders would at least operational risk approach that banks
the end of the second transition year, partially offset this advantage. Thus, ultimately selected would determine
the agencies will conduct and publish a while concerns regarding competition how the overall benefits of the new
study that evaluates the advanced among U.S. financial service providers capital regulations would change under
approaches to determine if there are any might diminish in this scenario, Alternative B. Just as Alternative A
material deficiencies.117 The Federal concerns regarding cross-border increases the flexibility of credit risk
banking agencies will consider any competition would likely increase. rules for mandatory banks, Alternative B
egregious competitive effects associated While continuing to use current capital is more flexible with respect to
with New Accord implementation, rules eliminates most of the benefits of operational risk. Because the
whether domestic or international in adopting the capital rule, it does not Standardized Approach tries to be more
context, to be a material deficiency. To eliminate many costs associated with sensitive to variations in operational
the New Accord. Because the New risk than the Basic Indicator Approach
the extent that undesirable competitive
Accord-related costs are difficult to and AMA is more sensitive than the
inequities emerge, the agencies have the
separate from the bank’s ordinary Standardized Approach, the effect of
power to respond to them through many
development costs and ordinary implementing Alternative B depends on
channels, including but not limited to
supervisory costs at the Federal banking how many banks select the more risk
suitable changes to the capital adequacy
agencies, not implementing the New sensitive approaches. As was the case
regulations.
Accord would reduce but not eliminate with Alternative A, the most significant
V. Analysis of Baseline and many of these costs associated with the drawback to Alternative B is the
Alternatives final rule.119 Furthermore, because increased cost of applying a new set of
In order to place the costs and banks in the United States would be capital rules to all U.S. banks.
operating under a set of capital rules Under Alternative B, direct costs
benefits of the rule in context, Executive
different from the rest of the world, U.S. would increase for every U.S. bank that
Order 12866 requires a comparison
banks that are internationally active would have continued with current
between this final rule, a baseline of capital rules. It is not clear how much
what the world would look like without may face higher costs because they will
have to track and comply with more it might cost banks to adopt these
this final rule, and several reasonable capital measures for operational risk,
alternatives to the rule. In this than one set of capital requirements.
2. Alternative A: Permit U.S. banks to but general banks would face higher
regulatory impact analysis, we analyze a costs because they would be changing
baseline and three alternatives to the choose among all three New Accord
credit risk approaches: The principal capital rules regardless of which option
rule. The baseline analyzes the situation they choose under Alternative B.
where the Federal banking agencies do benefit of Alternative A that the rule
does not achieve is the increased 4. Alternative C: Use a different asset
not adopt this final rule, but other amount to determine a mandatory bank:
flexibility of the regulation for banks
that would be mandatory banks under The number of mandatory banks
116 William W. Lang, Loretta J. Mester, and Todd
decreases slowly as the size thresholds
A. Vermilyea, ‘‘Potential Competitive Effects on
U.S. Bank Credit Card Lending from the Proposed 118 In addition to the United States, members of increase, and the number of banks
Bifurcated Application of Basel II,’’ manuscript, the BCBS implementing Basel II are Belgium, grows more quickly as the thresholds
Federal Reserve Bank of Philadelphia, December Canada, France, Germany, Italy, Japan, decrease. Under Alternative C, the
2005. Available at http://www.philadelphiafed.org/ Luxembourg, the Netherlands, Spain, Sweden, framework of the final rule would
files/wps/2005/wp05–29.pdf. Switzerland, and the United Kingdom.
117 The full text of the Regulatory Impact Analysis 119 Cost estimates for adopting a rule that might remain the same and only the number
describes the factors that the interagency study will result from the Standardized Option are not of mandatory banks would change.
consider. currently available. Because the structure of the
implementation would remain intact, seem to have fairly modest ongoing associations will differ in important
Alternative C would capture all of the expenses. Against these costs, the ways from OCC-regulated national
benefits of the final rule. However, significant benefits of the New Accord banks. These differences are the focus of
because these benefits derive from suggest that the final rule offers an OTS’s analysis.
applying the final rule to individual improvement over the baseline scenario. Benefits. Among the benefits of the
banks, changing the number of banks With regard to the three alternative final rule, OCC cites: (i) Better allocation
affected by the rule will change the approaches we consider, the final rule of capital and reduced impact of moral
cumulative level of the benefits offers an important degree of flexibility hazard through reduction in the scope
achieved. Generally, the benefits while significantly restricting costs by for regulatory arbitrage; (ii) improved
associated with the rule will rise and limiting its application to large, signal quality of capital as an indicator
fall with the number of mandatory internationally active banks. of institution solvency; and (iii) more
banks. Because Alternative C would Alternatives A and B introduce more efficient use of required bank capital.
change the number of mandatory banks flexibility from the perspective of the From OTS’s perspective, however, the
subject to the rule, aggregate costs will large mandatory banks, but each is less final rule may not provide the degree of
also rise or fall with the number of flexible with respect to other banks. benefits anticipated by OCC from these
mandatory banks. Either Alternative A or B would compel sources.
these non-mandatory banks to select a Because of the typically low credit
Overall Comparison of the Rule With new set of capital rules and require
Baselines and Alternatives risk associated with residential
them to undertake the time and expense mortgage-related assets, OTS believes
The New Accord and its U.S. of adjusting to this final rule. that the risk-insensitive leverage ratio,
implementation seek to incorporate risk Alternative C would change the number rather than the risk-based capital ratio,
measurement and risk management of mandatory banks. If the number of may be more binding on savings
advances into capital requirements. mandatory banks increases, then the association institutions.120 As a result,
Risk-sensitive capital requirements are new rule would lose some of the these institutions may be required to
integral to ensuring an adequate capital flexibility it achieves with the opt-in hold more capital than would be
cushion to absorb financial losses at option. Furthermore, costs would required under Basel II risk-based
large complex financial banks. In increase as the final rule would compel standards alone. Therefore, the final
implementing the New Accord’s more banks to incur the expense of rule may cause these institutions to
advanced approaches in the United adopting the advanced approaches. incur much the same implementation
States, the agencies’ intent is to achieve Decreasing the number of mandatory costs as banks with riskier assets, but
risk-sensitivity while maintaining a banks would decrease the aggregate with reduced benefits.
regulatory capital regime that is as social good of each benefit achieved Costs. OTS adopts the OCC cost
rigorous as the current system. Total with the final rule. The final rule offers analysis with the following
capital requirements under the a better balance between costs and supplemental information on OTS’s
advanced approaches, including capital benefits than any of the three administrative costs. OTS did not incur
for operational risk, will better allocate alternatives. a meaningful amount of direct
capital in the system. This will occur expenditures until 2002 when it
regardless of whether the minimum OTS Executive Order 12866
Determination transitioned from a monitoring role to
required capital at a particular bank is active involvement in Basel II.
greater or less than it would be under OTS commented on the development
Thereafter, expenditures increased
current capital rules. In order to ensure of, and concurs with, OCC’s RIA. Rather
rapidly. The OTS expenditures fall into
that we achieve our goal of increased than replicate that analysis, OTS drafted
two broad categories: policymaking
risk sensitivity without loss of rigor, the an RIA incorporating OCC’s analysis by
expenses incurred in the development
final rule provides a means for the reference and adding appropriate
of the ANPR, the NPR, the final rule and
agencies to identify and address material reflecting the unique aspects of
related guidance; and supervision
deficiencies in the capital requirements the thrift industry. The full text of OTS’s
expenses that reflect institution-specific
that may become apparent during the RIA is available at the locations for
supervisory activities. OTS estimates
transition period. viewing the OTS docket indicated in the
Although the anticipated benefits of that it incurred total expenses of
ADDRESSES section above. OTS believes
the final rule are difficult to quantify in $6,420,000 for fiscal years 2002 through
that its analysis meets the requirements
dollar terms because of measurement 2006, including $4,080,000 in
of Executive Order 12866.
problems, the OCC is confident that the The following discussion policymaking expenses and $2,340,000
anticipated benefits well exceed the supplements OCC’s summary of its RIA. in supervision expenses. OTS
anticipated costs of this regulation. On The final rule will apply to anticipates that supervision expenses
the basis of our analysis, we believe that approximately six mandatory and will continue to grow as a percentage of
the benefits of the final rule are potential opt-in savings associations the total expense as it moves from
significant, durable, and hold the representing approximately 52 percent policy development to implementation
potential to increase with time. The of total thrift industry assets. 120 The leverage ratio is the ratio of core capital
offsetting costs of implementing the Approximately 76 percent of the total to adjusted total assets. Under prompt corrective
final rule are also significant, but appear assets in these six institutions are action requirements, savings associations must
to be largely because of considerable concentrated in residential mortgage- maintain a leverage ratio of at least five percent to
start-up costs. However, much of the related assets. By contrast, national be well capitalized and at least four percent to be
adequately capitalized. Basel II will primarily affect
apparent start-up costs reflect activities banks tend to concentrate their assets in the calculation of risk-weighted assets, rather than
that the banks would undertake as part commercial loans and other kinds of the calculation of total assets and will have only a
of their ongoing efforts to improve the non-mortgage loans. Only about 35 modest impact on the calculation of core capital.
quality of their internal risk percent of national bank’s total assets Thus, the proposed Basel II changes should not
significantly affect the calculated leverage ratio and
measurement and management, even in are residential mortgage-related assets. a savings association that is currently constrained
the absence of the New Accord and this As a result, the costs and benefits of the by the leverage ratio would not significantly benefit
final rule. The advanced approaches final rule for OTS-regulated savings from the Basel II changes.
and training. To date, Basel II competitive advantage of Basel II http://www.occ.treas.gov/law/basel.htm

expenditures have not been a large part adopters. under the link of ‘‘Regulatory Impact
of overall expenditures. The final rule also has a ten percent Analysis for Risk-Based Capital
Competition. OTS agrees with OCC’s floor on loss given default parameter Standards: Revised Capital Adequacy
analysis of competition among estimates for residential mortgage Guidelines (Basel II: Advanced
providers of financial services. OTS segments that persists beyond the two- Approach) 2007’’.
adds, however, that some institutions year period articulated in the
with low credit risk portfolios face an international Basel II framework, OTS Unfunded Mandates Reform Act of
existing competitive disadvantage providing a disincentive for core 1995 Determination
because they are bound by a non-risk- institutions to hold the least risky The Unfunded Mandates Reform Act
based capital requirement—the leverage residential mortgages. This may have of 1995 (Pub. L. 104–4) (UMRA)
ratio. Thus, the agencies regulate a class the effect of reducing the core banks’’ requires cost-benefit and other analyses
of institutions that currently receive advantage vis-à-vis both non-adopters for a rule that would include any
fewer capital benefits from risk-based and their international competitors. Federal mandate that may result in the
capital rules because they are bound by Further, residential mortgages are expenditure by State, local, and tribal
the risk-insensitive leverage ratio. This subject to substantial interest rate risk. governments, in the aggregate, or by the
anomaly will likely continue under the The agencies will retain the authority to private sector of $100 million or more
final rule. require additional capital to cover (adjusted annually for inflation) in any
In addition, the results from QIS–3 interest rate risk. If regulatory capital one year. The current inflation-adjusted
and QIS–4 suggest that the largest requirements affect asset pricing, a expenditure threshold is $119.6 million.
reductions in regulatory credit-risk substantial regulatory capital interest The requirements of the UMRA include
capital requirements from the rate risk component could mitigate any assessing a rule’s effects on future
application of revised rules would occur competitive advantages of the proposed compliance costs; particular regions or
in the residential mortgage loan area. rule. Moreover, the capital requirement State, local, or tribal governments;
Thus, to the extent regulatory credit-risk for interest rate risk would be subject to communities; segments of the private
capital requirements affect pricing of interpretation by each agency. A sector; productivity; economic growth;
such loans, it is possible that core and consistent evaluation of interest rate risk full employment; creation of productive
opt-in institutions who are not by the supervisory agencies would jobs; and the international
constrained by the leverage ratio may present a level playing field among the competitiveness of U.S. goods and
experience an improvement in their adopters—an important consideration services. The final rule qualifies as a
competitive standing vis-à-vis non- given the potential size of the capital significant regulatory action under the
adopters and vis-à-vis adopters who are requirement. UMRA because its Federal mandates
bound by the leverage ratio. Two may result in the expenditure by the
OCC Unfunded Mandates Reform Act of
research papers—one by Calem and private sector of $119.6 or more in any
1995 Determination
Follain,121 and another by Hancock, one year. As permitted by section 202(c)
Lenhert, Passmore, and Sherlund122 The Unfunded Mandates Reform Act
of the UMRA, the required analyses
addressed this topic. The Calem and of 1995 (Pub. L. 104–4) (UMRA)
have been prepared in conjunction with
Follain paper argues that Basel II will requires cost-benefit and other analyses
the Executive Order 12866 analysis
significantly affect the competitive for a rule that would include any
document titled Regulatory Impact
environment in mortgage lending; Federal mandate that may result in the
Analysis for Risk-Based Capital
Hancock, et al. argue that it will not. expenditure by State, local, and tribal
Standards: Revised Capital Adequacy
Both papers are predicated, however, on governments, in the aggregate, or by the
Guidelines. The analysis is available at
the current capital regime for non- private sector of $100 million or more
the locations for viewing the OTS
adopters. The agencies recently (adjusted annually for inflation) in any
docket indicated in the ADDRESSES
announced that they have agreed to one year. The current inflation-adjusted
expenditure threshold is $119.6 million. section above.
issue a proposed rule that would
provide non-core banks with the option The requirements of the UMRA include Text of Common Appendix (All
to adopt an approach consistent with assessing a rule’s effects on future Agencies)
the standardized approach included in compliance costs; particular regions or The text of the agencies’’ common
the Basel II framework. The State, local, or tribal governments; appendix appears below:
standardized proposal will replace the communities; segments of the private
earlier proposed rule (the Basel IA sector; productivity; economic growth; [Appendix l to Part l]—Capital Adequacy
full employment; creation of productive Guidelines for [Banks]: Internal-Ratings-
proposed rule), and would be available Based and Advanced Measurement
as an alternative to the existing risk- jobs; and the international
Approaches
based capital rules for all U.S. banks competitiveness of U.S. goods and
services. The final rule qualifies as a Part I General Provisions
other than banks that adopt the final Section 1 Purpose, Applicability,
Basel II rule. Such modifications, if significant regulatory action under the Reservation of Authority, and Principle
implemented, would likely reduce the UMRA because its Federal mandates of Conservatism
may result in the expenditure by the Section 2 Definitions
121 Paul S. Calem and James R. Follain, ‘‘An private sector of $119.6 million or more Section 3 Minimum Risk-Based Capital
Examination of How the Proposed Bifurcated in any one year. As permitted by section Requirements
Implementation of Basel II in the U.S. May Affect 202(c) of the UMRA, the required Part II Qualifying Capital
Competition Among Banking Organizations for Section 11 Additional Deductions
Residential Mortgages,’’ manuscript, January 14, analyses have been prepared in
Section 12 Deductions and Limitations
2005. conjunction with the Executive Order

Not Required
122 Diana Hancock, Andreas Lenhert, Wayne 12866 analysis document titled Section 13 Eligible Credit Reserves
Passmore, and Shane M Sherlund, ‘‘An Analysis of Regulatory Impact Analysis for Risk-
the Competitive Impacts of Basel II Capital Part III Qualification
Standards on U.S. Mortgage Rates and Mortgage
Based Capital Standards: Revised Section 21 Qualification Process
Securitization, March 7, 2005, Board of Governors Capital Adequacy Guidelines. The Section 22 Qualification Requirements
of the Federal Reserve System, working paper. analysis is available on the Internet at Section 23 Ongoing Qualification
Section 24 Merger and Acquisition Income (Call Report) or Thrift Financial (ii) If the [AGENCY] determines that the
Transitional Arrangements Report (TFR), equal to $250 billion or more; risk-weighted asset amount for operational
Part IV Risk-Weighted Assets for General (ii) Has consolidated total on-balance sheet risk produced by the [bank] under this
Credit Risk foreign exposure at the most recent year-end appendix is not commensurate with the
Section 31 Mechanics for Calculating equal to $10 billion or more (where total on- operational risks of the [bank], the [AGENCY]
Total Wholesale and Retail Risk- balance sheet foreign exposure equals total may require the [bank] to assign a different
Weighted Assets cross-border claims less claims with head risk-weighted asset amount for operational
Section 32 Counterparty Credit Risk of office or guarantor located in another country risk, to change elements of its operational
Repo-Style Transactions, Eligible Margin plus redistributed guaranteed amounts to the risk analytical framework, including
Loans, and OTC Derivative Contracts country of head office or guarantor plus local distributional and dependence assumptions,
Section 33 Guarantees and Credit country claims on local residents plus or to make other changes to the [bank]’s
Derivatives: PD Substitution and LGD revaluation gains on foreign exchange and operational risk management processes, data
Adjustment Approaches derivative products, calculated in accordance and assessment systems, or quantification
Section 34 Guarantees and Credit with the Federal Financial Institutions systems, all as specified by the [AGENCY].
Derivatives: Double Default Treatment Examination Council (FFIEC) 009 Country (3) Other supervisory authority. Nothing in
Section 35 Risk-Based Capital Exposure Report); this appendix limits the authority of the
Requirement for Unsettled Transactions (iii) Is a subsidiary of a depository [AGENCY] under any other provision of law
Part V Risk-Weighted Assets for institution that uses 12 CFR part 3, Appendix or regulation to take supervisory or
Securitization Exposures C, 12 CFR part 208, Appendix F, 12 CFR part enforcement action, including action to
Section 41 Operational Criteria for 325, Appendix D, or 12 CFR part 567, address unsafe or unsound practices or
Recognizing the Transfer of Risk Appendix C, to calculate its risk-based conditions, deficient capital levels, or
capital requirements; or violations of law.
Section 42 Risk-Based Capital
(iv) Is a subsidiary of a bank holding (d) Principle of conservatism.
Requirement for Securitization
company that uses 12 CFR part 225, Notwithstanding the requirements of this
Exposures
Appendix G, to calculate its risk-based appendix, a [bank] may choose not to apply
Section 43 Ratings-Based Approach
capital requirements. a provision of this appendix to one or more
(RBA)
(2) Any [bank] may elect to use this exposures, provided that:
Section 44 Internal Assessment Approach
appendix to calculate its risk-based capital (1) The [bank] can demonstrate on an
(IAA)
requirements. ongoing basis to the satisfaction of the
Section 45 Supervisory Formula
(3) A [bank] that is subject to this appendix [AGENCY] that not applying the provision
Approach (SFA)
must use this appendix unless the [AGENCY] would, in all circumstances, unambiguously
Section 46 Recognition of Credit Risk
determines in writing that application of this generate a risk-based capital requirement for
Mitigants for Securitization Exposures
appendix is not appropriate in light of the each such exposure greater than that which
Section 47 Risk-Based Capital
[bank]’s asset size, level of complexity, risk would otherwise be required under this
Requirement for Early Amortization
profile, or scope of operations. In making a appendix;
Provisions
determination under this paragraph, the (2) The [bank] appropriately manages the
Part VI Risk-Weighted Assets for Equity
[AGENCY] will apply notice and response risk of each such exposure;
Exposures
procedures in the same manner and to the (3) The [bank] notifies the [AGENCY] in
Section 51 Introduction and Exposure
same extent as the notice and response writing prior to applying this principle to
Measurement
procedures in 12 CFR 3.12 (for national each such exposure; and
Section 52 Simple Risk Weight Approach
banks), 12 CFR 263.202 (for bank holding (4) The exposures to which the [bank]
(SRWA)
companies and state member banks), 12 CFR applies this principle are not, in the
Section 53 Internal Models Approach
325.6(c) (for state nonmember banks), and 12 aggregate, material to the [bank].
(IMA)
CFR 567.3(d) (for savings associations).
Section 54 Equity Exposures to Section 2. Definitions
(c) Reservation of authority—(1) Additional
Investment Funds
capital in the aggregate. The [AGENCY] may Advanced internal ratings-based (IRB)
Section 55 Equity Derivative Contracts
require a [bank] to hold an amount of capital systems means a [bank]’s internal risk rating
Part VII Risk-Weighted Assets for
greater than otherwise required under this and segmentation system; risk parameter
Operational Risk
appendix if the [AGENCY] determines that quantification system; data management and
Section 61 Qualification Requirements
the [bank]’s risk-based capital requirement maintenance system; and control, oversight,
for Incorporation of Operational Risk
under this appendix is not commensurate and validation system for credit risk of
Mitigants
with the [bank]’s credit, market, operational, wholesale and retail exposures.
Section 62 Mechanics of Risk-Weighted
or other risks. In making a determination Advanced systems means a [bank]’s
Asset Calculation
under this paragraph, the [AGENCY] will advanced IRB systems, operational risk
Part VIII Disclosure
apply notice and response procedures in the management processes, operational risk data
Section 71 Disclosure Requirements
same manner and to the same extent as the and assessment systems, operational risk
Part I. General Provisions notice and response procedures in 12 CFR quantification systems, and, to the extent the
3.12 (for national banks), 12 CFR 263.202 (for [bank] uses the following systems, the
Section 1. Purpose, Applicability, bank holding companies and state member internal models methodology, double default
Reservation of Authority, and Principle of banks), 12 CFR 325.6(c) (for state nonmember excessive correlation detection process, IMA
Conservatism banks), and 12 CFR 567.3(d) (for savings for equity exposures, and IAA for
(a) Purpose. This appendix establishes: associations). securitization exposures to ABCP programs.
(1) Minimum qualifying criteria for [banks] (2) Specific risk-weighted asset amounts. (i) Affiliate with respect to a company means
using [bank]-specific internal risk If the [AGENCY] determines that the risk- any company that controls, is controlled by,
measurement and management processes for weighted asset amount calculated under this or is under common control with, the
calculating risk-based capital requirements; appendix by the [bank] for one or more company.
(2) Methodologies for such [banks] to exposures is not commensurate with the risks Applicable external rating means:
calculate their risk-based capital associated with those exposures, the (1) With respect to an exposure that has
requirements; and [AGENCY] may require the [bank] to assign multiple external ratings assigned by
(3) Public disclosure requirements for such a different risk-weighted asset amount to the NRSROs, the lowest solicited external rating
[banks]. exposures, to assign different risk parameters assigned to the exposure by any NRSRO; and
(b) Applicability. (1) This appendix applies to the exposures (if the exposures are (2) With respect to an exposure that has a
to a [bank] that: wholesale or retail exposures), or to use single external rating assigned by an NRSRO,
(i) Has consolidated total assets, as different model assumptions for the the external rating assigned to the exposure
reported on the most recent year-end exposures (if relevant), all as specified by the by the NRSRO.
Consolidated Report of Condition and [AGENCY]. Applicable inferred rating means:
(1) With respect to an exposure that has (1) The originating [bank] has appropriate (3) Warranties that permit the return of
multiple inferred ratings, the lowest inferred policies and procedures to ensure that it has underlying exposures in instances of
rating based on a solicited external rating; sufficient capital and liquidity available in misrepresentation, fraud, or incomplete
and the event of an early amortization; documentation.
(2) With respect to an exposure that has a (2) Throughout the duration of the Credit risk mitigant means collateral, a
single inferred rating, the inferred rating. securitization (including the early credit derivative, or a guarantee.
Asset-backed commercial paper (ABCP) amortization period), there is the same pro Credit-risk-weighted assets means 1.06
program means a program that primarily rata sharing of interest, principal, expenses, multiplied by the sum of:
issues commercial paper that: losses, fees, recoveries, and other cash flows (1) Total wholesale and retail risk-weighted
(1) Has an external rating; and from the underlying exposures based on the assets;
(2) Is backed by underlying exposures held originating [bank]’s and the investors’ (2) Risk-weighted assets for securitization
in a bankruptcy-remote SPE. relative shares of the underlying exposures exposures; and
Asset-backed commercial paper (ABCP) outstanding measured on a consistent (3) Risk-weighted assets for equity
program sponsor means a [bank] that: monthly basis; exposures.
(1) Establishes an ABCP program; (3) The amortization period is sufficient for
Current exposure means, with respect to a
(2) Approves the sellers permitted to at least 90 percent of the total underlying
netting set, the larger of zero or the market
participate in an ABCP program; exposures outstanding at the beginning of the
value of a transaction or portfolio of
(3) Approves the exposures to be early amortization period to be repaid or
recognized as in default; and transactions within the netting set that would
purchased by an ABCP program; or be lost upon default of the counterparty,
(4) Administers the ABCP program by (4) The schedule for repayment of investor
principal is not more rapid than would be assuming no recovery on the value of the
monitoring the underlying exposures, transactions. Current exposure is also called
underwriting or otherwise arranging for the allowed by straight-line amortization over an
18-month period. replacement cost.
placement of debt or other obligations issued
Credit derivative means a financial contract Default—(1) Retail. (i) A retail exposure of
by the program, compiling monthly reports,
executed under standard industry credit a [bank] is in default if:
or ensuring compliance with the program
derivative documentation that allows one (A) The exposure is 180 days past due, in
documents and with the program’s credit and
party (the protection purchaser) to transfer the case of a residential mortgage exposure or
investment policy.
the credit risk of one or more exposures revolving exposure;
Backtesting means the comparison of a
(reference exposure) to another party (the (B) The exposure is 120 days past due, in
[bank]’s internal estimates with actual
protection provider). See also eligible credit the case of all other retail exposures; or
outcomes during a sample period not used in
derivative. (C) The [bank] has taken a full or partial
model development. In this context,
Credit-enhancing interest-only strip (CEIO) charge-off, write-down of principal, or
backtesting is one form of out-of-sample
means an on-balance sheet asset that, in form material negative fair value adjustment of
testing.
or in substance: principal on the exposure for credit-related
Bank holding company is defined in
(1) Represents a contractual right to receive reasons.
section 2 of the Bank Holding Company Act
some or all of the interest and no more than (ii) Notwithstanding paragraph (1)(i) of this
(12 U.S.C. 1841).
a minimal amount of principal due on the definition, for a retail exposure held by a
Benchmarking means the comparison of a underlying exposures of a securitization; and
[bank]’s internal estimates with relevant non-U.S. subsidiary of the [bank] that is
(2) Exposes the holder to credit risk subject to an internal ratings-based approach
internal and external data or with estimates directly or indirectly associated with the
based on other estimation techniques. to capital adequacy consistent with the Basel
underlying exposures that exceeds a pro rata Committee on Banking Supervision’s
Business environment and internal control share of the holder’s claim on the underlying
factors means the indicators of a [bank]’s ‘‘International Convergence of Capital
exposures, whether through subordination Measurement and Capital Standards: A
operational risk profile that reflect a current provisions or other credit-enhancement
and forward-looking assessment of the Revised Framework’’ in a non-U.S.
techniques. jurisdiction, the [bank] may elect to use the
[bank]’s underlying business risk factors and Credit-enhancing representations and
internal control environment. definition of default that is used in that
warranties means representations and jurisdiction, provided that the [bank] has
Carrying value means, with respect to an warranties that are made or assumed in
asset, the value of the asset on the balance obtained prior approval from the [AGENCY]
connection with a transfer of underlying to use the definition of default in that
sheet of the [bank], determined in accordance exposures (including loan servicing assets)
with GAAP. jurisdiction.
and that obligate a [bank] to protect another
Clean-up call means a contractual (iii) A retail exposure in default remains in
party from losses arising from the credit risk
provision that permits an originating [bank] default until the [bank] has reasonable
of the underlying exposures. Credit-
or servicer to call securitization exposures assurance of repayment and performance for
enhancing representations and warranties
before their stated maturity or call date. See all contractual principal and interest
include provisions to protect a party from
also eligible clean-up call. losses resulting from the default or payments on the exposure.
Commodity derivative contract means a nonperformance of the obligors of the (2) Wholesale. (i) A [bank]’s wholesale
commodity-linked swap, purchased underlying exposures or from an obligor is in default if:
commodity-linked option, forward insufficiency in the value of the collateral (A) The [bank] determines that the obligor
commodity-linked contract, or any other backing the underlying exposures. Credit- is unlikely to pay its credit obligations to the
instrument linked to commodities that gives enhancing representations and warranties do [bank] in full, without recourse by the [bank]
rise to similar counterparty credit risks. not include: to actions such as realizing collateral (if
Company means a corporation, (1) Early default clauses and similar held); or
partnership, limited liability company, warranties that permit the return of, or (B) The obligor is past due more than 90
depository institution, business trust, special premium refund clauses that cover, first-lien days on any material credit obligation(s) to
purpose entity, association, or similar residential mortgage exposures for a period the [bank].1
organization. not to exceed 120 days from the date of (ii) An obligor in default remains in default
Control. A person or company controls a transfer, provided that the date of transfer is until the [bank] has reasonable assurance of
company if it: within one year of origination of the repayment and performance for all
(1) Owns, controls, or holds with power to residential mortgage exposure; contractual principal and interest payments
vote 25 percent or more of a class of voting (2) Premium refund clauses that cover on all exposures of the [bank] to the obligor
securities of the company; or underlying exposures guaranteed, in whole (other than exposures that have been fully
(2) Consolidates the company for financial or in part, by the U.S. government, a U.S. written-down or charged-off).
reporting purposes. government agency, or a U.S. government
Controlled early amortization provision sponsored enterprise, provided that the 1 Overdrafts are past due once the obligor has
means an early amortization provision that clauses are for a period not to exceed 120 breached an advised limit or been advised of a limit
meets all the following conditions: days from the date of transfer; or smaller than the current outstanding balance.
Dependence means a measure of the (3) For repo-style transactions, eligible of at least one of the exposures that is
association among operational losses across margin loans, and OTC derivative contracts permitted to be transferred under the contract
and within units of measure. for which the [bank] applies the internal provides that any required consent to transfer
Depository institution is defined in section models approach in paragraph (d) of section may not be unreasonably withheld;
3 of the Federal Deposit Insurance Act (12 32 of this appendix, the value determined in (7) If the credit derivative is a credit default
U.S.C. 1813). paragraph (d)(4) of section 32 of this swap or nth-to-default swap, the contract
Derivative contract means a financial appendix. clearly identifies the parties responsible for
contract whose value is derived from the Effective notional amount means, for an determining whether a credit event has
values of one or more underlying assets, eligible guarantee or eligible credit occurred, specifies that this determination is
reference rates, or indices of asset values or derivative, the lesser of the contractual not the sole responsibility of the protection
reference rates. Derivative contracts include notional amount of the credit risk mitigant provider, and gives the protection purchaser
interest rate derivative contracts, exchange and the EAD of the hedged exposure, the right to notify the protection provider of
rate derivative contracts, equity derivative multiplied by the percentage coverage of the the occurrence of a credit event; and
contracts, commodity derivative contracts, credit risk mitigant. For example, the (8) If the credit derivative is a total return
credit derivatives, and any other instrument effective notional amount of an eligible swap and the [bank] records net payments
that poses similar counterparty credit risks. guarantee that covers, on a pro rata basis, 40 received on the swap as net income, the
Derivative contracts also include unsettled percent of any losses on a $100 bond would [bank] records offsetting deterioration in the
securities, commodities, and foreign be $40. value of the hedged exposure (either through
exchange transactions with a contractual Eligible clean-up call means a clean-up call reductions in fair value or by an addition to
settlement or delivery lag that is longer than that: reserves).
the lesser of the market standard for the (1) Is exercisable solely at the discretion of Eligible credit reserves means all general
particular instrument or five business days. the originating [bank] or servicer; allowances that have been established
Early amortization provision means a (2) Is not structured to avoid allocating through a charge against earnings to absorb
provision in the documentation governing a losses to securitization exposures held by credit losses associated with on- or off-
securitization that, when triggered, causes investors or otherwise structured to provide balance sheet wholesale and retail exposures,
investors in the securitization exposures to credit enhancement to the securitization; and including the allowance for loan and lease
be repaid before the original stated maturity (3) (i) For a traditional securitization, is losses (ALLL) associated with such exposures
of the securitization exposures, unless the only exercisable when 10 percent or less of but excluding allocated transfer risk reserves
provision: the principal amount of the underlying established pursuant to 12 U.S.C. 3904 and
(1) Is triggered solely by events not directly exposures or securitization exposures other specific reserves created against
related to the performance of the underlying (determined as of the inception of the recognized losses.
exposures or the originating [bank] (such as securitization) is outstanding; or Eligible double default guarantor, with
material changes in tax laws or regulations); (ii) For a synthetic securitization, is only respect to a guarantee or credit derivative
or exercisable when 10 percent or less of the obtained by a [bank], means:
(2) Leaves investors fully exposed to future principal amount of the reference portfolio of (1) U.S.-based entities. A depository
draws by obligors on the underlying underlying exposures (determined as of the institution, a bank holding company, a
exposures even after the provision is inception of the securitization) is savings and loan holding company (as
triggered. outstanding. defined in 12 U.S.C. 1467a) provided all or
Economic downturn conditions means, Eligible credit derivative means a credit substantially all of the holding company’s
with respect to an exposure held by the derivative in the form of a credit default activities are permissible for a financial
[bank], those conditions in which the swap, nth-to-default swap, total return swap, holding company under 12 U.S.C. 1843(k), a
aggregate default rates for that exposure’s or any other form of credit derivative securities broker or dealer registered with the
wholesale or retail exposure subcategory (or approved by the [AGENCY], provided that: SEC under the Securities Exchange Act of
subdivision of such subcategory selected by (1) The contract meets the requirements of 1934 (15 U.S.C. 78o et seq.), or an insurance
the [bank]) in the exposure’s national an eligible guarantee and has been confirmed company in the business of providing credit
jurisdiction (or subdivision of such by the protection purchaser and the protection (such as a monoline bond insurer
jurisdiction selected by the [bank]) are protection provider; or re-insurer) that is subject to supervision by
significantly higher than average. (2) Any assignment of the contract has a State insurance regulator, if:
Effective maturity (M) of a wholesale been confirmed by all relevant parties; (i) At the time the guarantor issued the
exposure means: (3) If the credit derivative is a credit default guarantee or credit derivative or at any time
(1) For wholesale exposures other than swap or nth-to-default swap, the contract thereafter, the [bank] assigned a PD to the
repo-style transactions, eligible margin loans, includes the following credit events: guarantor’s rating grade that was equal to or
and OTC derivative contracts described in (i) Failure to pay any amount due under lower than the PD associated with a long-
paragraph (2) or (3) of this definition: the terms of the reference exposure, subject term external rating in the third-highest
(i) The weighted-average remaining to any applicable minimal payment threshold investment-grade rating category; and
maturity (measured in years, whole or that is consistent with standard market (ii) The [bank] currently assigns a PD to the
fractional) of the expected contractual cash practice and with a grace period that is guarantor’s rating grade that is equal to or
flows from the exposure, using the closely in line with the grace period of the lower than the PD associated with a long-
undiscounted amounts of the cash flows as reference exposure; and term external rating in the lowest investment-
weights; or (ii) Bankruptcy, insolvency, or inability of grade rating category; or
(ii) The nominal remaining maturity the obligor on the reference exposure to pay (2) Non-U.S.-based entities. A foreign bank
(measured in years, whole or fractional) of its debts, or its failure or admission in (as defined in § 211.2 of the Federal Reserve
the exposure. writing of its inability generally to pay its Board’s Regulation K (12 CFR 211.2)), a non-
(2) For repo-style transactions, eligible debts as they become due, and similar events; U.S.-based securities firm, or a non-U.S.-
margin loans, and OTC derivative contracts (4) The terms and conditions dictating the based insurance company in the business of
subject to a qualifying master netting manner in which the contract is to be settled providing credit protection, if:
agreement for which the [bank] does not are incorporated into the contract; (i) The [bank] demonstrates that the
apply the internal models approach in (5) If the contract allows for cash guarantor is subject to consolidated
paragraph (d) of section 32 of this appendix, settlement, the contract incorporates a robust supervision and regulation comparable to
the weighted-average remaining maturity valuation process to estimate loss reliably that imposed on U.S. depository institutions,
(measured in years, whole or fractional) of and specifies a reasonable period for securities broker-dealers, or insurance
the individual transactions subject to the obtaining post-credit event valuations of the companies (as the case may be), or has issued
qualifying master netting agreement, with the reference exposure; and outstanding an unsecured long-term debt
weight of each individual transaction set (6) If the contract requires the protection security without credit enhancement that has
equal to the notional amount of the purchaser to transfer an exposure to the a long-term applicable external rating of at
transaction. protection provider at settlement, the terms least investment grade;
(ii) At the time the guarantor issued the (4) The [bank] has conducted sufficient Eligible servicer cash advance facility
guarantee or credit derivative or at any time legal review to conclude with a well-founded means a servicer cash advance facility in
thereafter, the [bank] assigned a PD to the basis (and maintains sufficient written which:
guarantor’s rating grade that was equal to or documentation of that legal review) that the (1) The servicer is entitled to full
lower than the PD associated with a long- agreement meets the requirements of reimbursement of advances, except that a
term external rating in the third-highest paragraph (3) of this definition and is legal, servicer may be obligated to make non-
investment-grade rating category; and valid, binding, and enforceable under reimbursable advances for a particular
(iii) The [bank] currently assigns a PD to applicable law in the relevant jurisdictions. underlying exposure if any such advance is
the guarantor’s rating grade that is equal to Eligible operational risk offsets means contractually limited to an insignificant
or lower than the PD associated with a long- amounts, not to exceed expected operational amount of the outstanding principal balance
term external rating in the lowest investment- loss, that: of that exposure;
grade rating category. (1) Are generated by internal business (2) The servicer’s right to reimbursement is
Eligible guarantee means a guarantee that: practices to absorb highly predictable and senior in right of payment to all other claims
(1) Is written and unconditional; reasonably stable operational losses, on the cash flows from the underlying
(2) Covers all or a pro rata portion of all exposures of the securitization; and
including reserves calculated consistent with
contractual payments of the obligor on the (3) The servicer has no legal obligation to,
GAAP; and
reference exposure; and does not, make advances to the
(2) Are available to cover expected
(3) Gives the beneficiary a direct claim securitization if the servicer concludes the
operational losses with a high degree of
against the protection provider; advances are unlikely to be repaid.
certainty over a one-year horizon.
(4) Is not unilaterally cancelable by the Equity derivative contract means an equity-
protection provider for reasons other than the Eligible purchased wholesale exposure linked swap, purchased equity-linked option,
breach of the contract by the beneficiary; means a purchased wholesale exposure that: forward equity-linked contract, or any other
(5) Is legally enforceable against the (1) The [bank] or securitization SPE instrument linked to equities that gives rise
protection provider in a jurisdiction where purchased from an unaffiliated seller and did to similar counterparty credit risks.
the protection provider has sufficient assets not directly or indirectly originate; Equity exposure means:
against which a judgment may be attached (2) Was generated on an arm’s-length basis (1) A security or instrument (whether
and enforced; between the seller and the obligor voting or non-voting) that represents a direct
(6) Requires the protection provider to (intercompany accounts receivable and or indirect ownership interest in, and is a
make payment to the beneficiary on the receivables subject to contra-accounts residual claim on, the assets and income of
occurrence of a default (as defined in the between firms that buy and sell to each other a company, unless:
guarantee) of the obligor on the reference do not satisfy this criterion); (i) The issuing company is consolidated
exposure in a timely manner without the (3) Provides the [bank] or securitization with the [bank] under GAAP;
beneficiary first having to take legal actions SPE with a claim on all proceeds from the (ii) The [bank] is required to deduct the
to pursue the obligor for payment; exposure or a pro rata interest in the ownership interest from tier 1 or tier 2 capital
(7) Does not increase the beneficiary’s cost proceeds from the exposure; under this appendix;
of credit protection on the guarantee in (4) Has an M of less than one year; and (iii) The ownership interest incorporates a
response to deterioration in the credit quality (5) When consolidated by obligor, does not payment or other similar obligation on the
of the reference exposure; and represent a concentrated exposure relative to part of the issuing company (such as an
(8) Is not provided by an affiliate of the the portfolio of purchased wholesale obligation to make periodic payments); or
[bank], unless the affiliate is an insured exposures. (iv) The ownership interest is a
depository institution, bank, securities broker Eligible securitization guarantor means: securitization exposure;
or dealer, or insurance company that: (1) A sovereign entity, the Bank for (2) A security or instrument that is
(i) Does not control the [bank]; and International Settlements, the International mandatorily convertible into a security or
(ii) Is subject to consolidated supervision Monetary Fund, the European Central Bank, instrument described in paragraph (1) of this
and regulation comparable to that imposed the European Commission, a Federal Home definition;
on U.S. depository institutions, securities Loan Bank, Federal Agricultural Mortgage (3) An option or warrant that is exercisable
broker-dealers, or insurance companies (as Corporation (Farmer Mac), a multilateral for a security or instrument described in
the case may be). development bank, a depository institution, a paragraph (1) of this definition; or
Eligible margin loan means an extension of bank holding company, a savings and loan (4) Any other security or instrument (other
credit where: holding company (as defined in 12 U.S.C. than a securitization exposure) to the extent
(1) The extension of credit is collateralized 1467a) provided all or substantially all of the the return on the security or instrument is
exclusively by liquid and readily marketable holding company’s activities are permissible based on the performance of a security or
debt or equity securities, gold, or conforming for a financial holding company under 12 instrument described in paragraph (1) of this
residential mortgages; U.S.C. 1843(k), a foreign bank (as defined in definition.
(2) The collateral is marked to market § 211.2 of the Federal Reserve Board’s Excess spread for a period means:
daily, and the transaction is subject to daily Regulation K (12 CFR 211.2)), or a securities (1) Gross finance charge collections and
margin maintenance requirements; firm; other income received by a securitization
(3) The extension of credit is conducted (2) Any other entity (other than a SPE (including market interchange fees) over
under an agreement that provides the [bank] securitization SPE) that has issued and a period minus interest paid to the holders
the right to accelerate and terminate the outstanding an unsecured long-term debt of the securitization exposures, servicing
extension of credit and to liquidate or set off
security without credit enhancement that has fees, charge-offs, and other senior trust or
collateral promptly upon an event of default
a long-term applicable external rating in one similar expenses of the SPE over the period;
(including upon an event of bankruptcy,
of the three highest investment-grade rating divided by
insolvency, or similar proceeding) of the
categories; or (2) The principal balance of the underlying
counterparty, provided that, in any such
(3) Any other entity (other than a exposures at the end of the period.
case, any exercise of rights under the
securitization SPE) that has a PD assigned by Exchange rate derivative contract means a
agreement will not be stayed or avoided
the [bank] that is lower than or equal to the cross-currency interest rate swap, forward
under applicable law in the relevant
PD associated with a long-term external foreign-exchange contract, currency option
jurisdictions; 2 and
rating in the third highest investment-grade purchased, or any other instrument linked to
rating category. exchange rates that gives rise to similar
2 This requirement is met where all transactions

counterparty credit risks.
under the agreement are (i) executed under U.S. law
and (ii) constitute ‘‘securities contracts’’ under financial institutions under sections 401–407 of the
Excluded mortgage exposure means any
section 555 of the Bankruptcy Code (11 U.S.C. 555), Federal Deposit Insurance Corporation one-to four-family residential pre-sold
qualified financial contracts under section 11(e)(8) Improvement Act of 1991 (12 U.S.C. 4401–4407) or construction loan for a residence for which
of the Federal Deposit Insurance Act (12 U.S.C. the Federal Reserve Board’s Regulation EE (12 CFR the purchase contract is cancelled that would
1821(e)(8)), or netting contracts between or among part 231). receive a 100 percent risk weight under
section 618(a)(2) of the Resolution Trust unrealized gains on the exposure or segment, External rating means a credit rating that
Corporation Refinancing, Restructuring, and and plus any unrealized losses on the is assigned by an NRSRO to an exposure,
Improvement Act and under 12 CFR part 3, exposure or segment; or provided:
Appendix A, section 3(a)(3)(iii) (for national (ii) If the exposure or segment is not a (1) The credit rating fully reflects the entire
banks), 12 CFR part 208, Appendix A, section security classified as available-for-sale, the amount of credit risk with regard to all
III.C.3. (for state member banks), 12 CFR part [bank]’s carrying value (including net payments owed to the holder of the exposure.
225, Appendix A, section III.C.3. (for bank accrued but unpaid interest and fees) for the If a holder is owed principal and interest on
holding companies), 12 CFR part 325, exposure or segment less any allocated an exposure, the credit rating must fully
Appendix A, section II.C.a. (for state transfer risk reserve for the exposure or reflect the credit risk associated with timely
nonmember banks), or 12 CFR 567.1 segment. repayment of principal and interest. If a
(definition of ‘‘qualifying residential (2) For the off-balance sheet component of holder is owed only principal on an
construction loan’’) and 12 CFR a wholesale exposure or segment of retail exposure, the credit rating must fully reflect
567.6(a)(1)(iv) (for savings associations). exposures (other than an OTC derivative only the credit risk associated with timely
Expected credit loss (ECL) means: contract, or a repo-style transaction or repayment of principal; and
(1) For a wholesale exposure to a non- (2) The credit rating is published in an
eligible margin loan for which the [bank]
defaulted obligor or segment of non-defaulted accessible form and is or will be included in
determines EAD under section 32 of this
retail exposures that is carried at fair value the transition matrices made publicly
appendix) in the form of a loan commitment,
with gains and losses flowing through available by the NRSRO that summarize the
line of credit, trade-related letter of credit, or historical performance of positions rated by
earnings or that is classified as held-for-sale transaction-related contingency, EAD means
and is carried at the lower of cost or fair the NRSRO.
the [bank]’s best estimate of net additions to Financial collateral means collateral:
value with losses flowing through earnings, the outstanding amount owed the [bank], (1) In the form of:
zero.
including estimated future additional draws (i) Cash on deposit with the [bank]
(2) For all other wholesale exposures to
of principal and accrued but unpaid interest (including cash held for the [bank] by a third-
non-defaulted obligors or segments of non-
and fees, that are likely to occur over a one- party custodian or trustee);
defaulted retail exposures, the product of PD
year horizon assuming the wholesale (ii) Gold bullion;
times LGD times EAD for the exposure or
exposure or the retail exposures in the (iii) Long-term debt securities that have an
segment.
segment were to go into default. This applicable external rating of one category
(3) For a wholesale exposure to a defaulted
estimate of net additions must reflect what below investment grade or higher;
obligor or segment of defaulted retail
would be expected during economic (iv) Short-term debt instruments that have
exposures, the [bank]’s impairment estimate
downturn conditions. Trade-related letters of an applicable external rating of at least
for allowance purposes for the exposure or
credit are short-term, self-liquidating investment grade;
segment.
instruments that are used to finance the (v) Equity securities that are publicly
(4) Total ECL is the sum of expected credit
movement of goods and are collateralized by traded;
losses for all wholesale and retail exposures
the underlying goods. Transaction-related (vi) Convertible bonds that are publicly
other than exposures for which the [bank]
contingencies relate to a particular traded;
has applied the double default treatment in
transaction and include, among other things, (vii) Money market mutual fund shares and
section 34 of this appendix. other mutual fund shares if a price for the
Expected exposure (EE) means the performance bonds and performance-based
letters of credit. shares is publicly quoted daily; or (viii)
expected value of the probability distribution Conforming residential mortgages; and
of non-negative credit risk exposures to a (3) For the off-balance sheet component of
a wholesale exposure or segment of retail (2) In which the [bank] has a perfected,
counterparty at any specified future date first priority security interest or, outside of
before the maturity date of the longest term exposures (other than an OTC derivative
contract, or a repo-style transaction or the United States, the legal equivalent thereof
transaction in the netting set. Any negative (with the exception of cash on deposit and
market values in the probability distribution eligible margin loan for which the [bank]
determines EAD under section 32 of this notwithstanding the prior security interest of
of market values to a counterparty at a any custodial agent).
specified future date are set to zero to convert appendix) in the form of anything other than
a loan commitment, line of credit, trade- GAAP means generally accepted
the probability distribution of market values accounting principles as used in the United
to the probability distribution of credit risk related letter of credit, or transaction-related
contingency, EAD means the notional States.
exposures. Gain-on-sale means an increase in the
Expected operational loss (EOL) means the amount of the exposure or segment.
equity capital (as reported on Schedule RC of
expected value of the distribution of (4) EAD for OTC derivative contracts is
the Call Report, Schedule HC of the FR Y–
potential aggregate operational losses, as calculated as described in section 32 of this
9C Report, or Schedule SC of the Thrift
generated by the [bank]’s operational risk appendix. A [bank] also may determine EAD
Financial Report) of a [bank] that results from
quantification system using a one-year for repo-style transactions and eligible
a securitization (other than an increase in
horizon. margin loans as described in section 32 of equity capital that results from the [bank]’s
Expected positive exposure (EPE) means this appendix. receipt of cash in connection with the
the weighted average over time of expected (5) For wholesale or retail exposures in securitization).
(non-negative) exposures to a counterparty which only the drawn balance has been Guarantee means a financial guarantee,
where the weights are the proportion of the securitized, the [bank] must reflect its share letter of credit, insurance, or other similar
time interval that an individual expected of the exposures’ undrawn balances in EAD. financial instrument (other than a credit
exposure represents. When calculating risk- Undrawn balances of revolving exposures for derivative) that allows one party (beneficiary)
based capital requirements, the average is which the drawn balances have been to transfer the credit risk of one or more
taken over a one-year horizon. securitized must be allocated between the specific exposures (reference exposure) to
Exposure at default (EAD). (1) For the on- seller’s and investors’ interests on a pro rata another party (protection provider). See also
balance sheet component of a wholesale basis, based on the proportions of the seller’s eligible guarantee.
exposure or segment of retail exposures and investors’ shares of the securitized High volatility commercial real estate
(other than an OTC derivative contract, or a drawn balances. (HVCRE) exposure means a credit facility
repo-style transaction or eligible margin loan Exposure category means any of the that finances or has financed the acquisition,
for which the [bank] determines EAD under wholesale, retail, securitization, or equity development, or construction (ADC) of real
section 32 of this appendix), EAD means: exposure categories. property, unless the facility finances:
(i) If the exposure or segment is a security External operational loss event data (1) One- to four-family residential
classified as available-for-sale, the [bank]’s means, with respect to a [bank], gross properties; or
carrying value (including net accrued but operational loss amounts, dates, recoveries, (2) Commercial real estate projects in
unpaid interest and fees) for the exposure or and relevant causal information for which:
segment less any allocated transfer risk operational loss events occurring at (i) The loan-to-value ratio is less than or
reserve for the exposure or segment, less any organizations other than the [bank]. equal to the applicable maximum
supervisory loan-to-value ratio in the (2) The outstanding principal amount of Nordic Investment Bank, the Caribbean
[AGENCY]’s real estate lending standards at underlying exposures. Development Bank, the Islamic Development
12 CFR part 34, Subpart D (OCC); 12 CFR Loss given default (LGD) means: Bank, the Council of Europe Development
part 208, Appendix C (Board); 12 CFR part (1) For a wholesale exposure, the greatest Bank, and any other multilateral lending
365, Subpart D (FDIC); and 12 CFR 560.100– of: institution or regional development bank in
560.101 (OTS); (i) Zero; which the U.S. government is a shareholder
(ii) The borrower has contributed capital to (ii) The [bank]’s empirically based best or contributing member or which the
the project in the form of cash or estimate of the long-run default-weighted [AGENCY] determines poses comparable
unencumbered readily marketable assets (or average economic loss, per dollar of EAD, the credit risk.
has paid development expenses out-of- [bank] would expect to incur if the obligor (or Nationally recognized statistical rating
pocket) of at least 15 percent of the real a typical obligor in the loss severity grade organization (NRSRO) means an entity
estate’s appraised ‘‘as completed’’ value; and assigned by the [bank] to the exposure) were registered with the SEC as a nationally
(iii) The borrower contributed the amount to default within a one-year horizon over a recognized statistical rating organization
of capital required by paragraph (2)(ii) of this mix of economic conditions, including under section 15E of the Securities Exchange
definition before the [bank] advances funds economic downturn conditions; or Act of 1934 (15 U.S.C. 78o–7).
under the credit facility, and the capital (iii) The [bank]’s empirically based best Netting set means a group of transactions
contributed by the borrower, or internally estimate of the economic loss, per dollar of with a single counterparty that are subject to
generated by the project, is contractually EAD, the [bank] would expect to incur if the a qualifying master netting agreement or
required to remain in the project throughout obligor (or a typical obligor in the loss qualifying cross-product master netting
the life of the project. The life of a project severity grade assigned by the [bank] to the agreement. For purposes of the internal
concludes only when the credit facility is exposure) were to default within a one-year models methodology in paragraph (d) of
converted to permanent financing or is sold horizon during economic downturn section 32 of this appendix, each transaction
or paid in full. Permanent financing may be conditions. that is not subject to such a master netting
provided by the [bank] that provided the (2) For a segment of retail exposures, the agreement is its own netting set.
ADC facility as long as the permanent greatest of: Nth-to-default credit derivative means a
financing is subject to the [bank]’s (i) Zero; credit derivative that provides credit
underwriting criteria for long-term mortgage (ii) The [bank]’s empirically based best protection only for the nth-defaulting
loans. estimate of the long-run default-weighted reference exposure in a group of reference
Inferred rating. A securitization exposure average economic loss, per dollar of EAD, the exposures.
has an inferred rating equal to the external [bank] would expect to incur if the exposures Obligor means the legal entity or natural
rating referenced in paragraph (2)(i) of this in the segment were to default within a one- person contractually obligated on a
definition if: year horizon over a mix of economic wholesale exposure, except that a [bank] may
(1) The securitization exposure does not conditions, including economic downturn treat the following exposures as having
have an external rating; and conditions; or separate obligors:
(2) Another securitization exposure issued (iii) The [bank]’s empirically based best (1) Exposures to the same legal entity or
by the same issuer and secured by the same estimate of the economic loss, per dollar of natural person denominated in different
underlying exposures: EAD, the [bank] would expect to incur if the currencies;
(i) Has an external rating; exposures in the segment were to default (2) (i) An income-producing real estate
(ii) Is subordinated in all respects to the within a one-year horizon during economic exposure for which all or substantially all of
unrated securitization exposure; downturn conditions. the repayment of the exposure is reliant on
(iii) Does not benefit from any credit (3) The economic loss on an exposure in the cash flows of the real estate serving as
enhancement that is not available to the the event of default is all material credit- collateral for the exposure; the [bank], in
unrated securitization exposure; and related losses on the exposure (including economic substance, does not have recourse
(iv) Has an effective remaining maturity accrued but unpaid interest or fees, losses on to the borrower beyond the real estate
that is equal to or longer than that of the the sale of collateral, direct workout costs, collateral; and no cross-default or cross-
unrated securitization exposure. and an appropriate allocation of indirect acceleration clauses are in place other than
Interest rate derivative contract means a workout costs). Where positive or negative clauses obtained solely out of an abundance
single-currency interest rate swap, basis cash flows on a wholesale exposure to a of caution; and
swap, forward rate agreement, purchased defaulted obligor or a defaulted retail (ii) Other credit exposures to the same legal
interest rate option, when-issued securities, exposure (including proceeds from the sale of entity or natural person; and
or any other instrument linked to interest collateral, workout costs, additional (3) (i) A wholesale exposure authorized
rates that gives rise to similar counterparty extensions of credit to facilitate repayment of under section 364 of the U.S. Bankruptcy
credit risks. the exposure, and draw-downs of unused Code (11 U.S.C. 364) to a legal entity or
Internal operational loss event data means, credit lines) occur after the date of default, natural person who is a debtor-in-possession
with respect to a [bank], gross operational the economic loss must reflect the net for purposes of Chapter 11 of the Bankruptcy
loss amounts, dates, recoveries, and relevant present value of cash flows as of the default Code; and
causal information for operational loss events date using a discount rate appropriate to the (ii) Other credit exposures to the same legal
occurring at the [bank]. risk of the defaulted exposure. entity or natural person.
Investing [bank] means, with respect to a Main index means the Standard & Poor’s Operational loss means a loss (excluding
securitization, a [bank] that assumes the 500 Index, the FTSE All-World Index, and insurance or tax effects) resulting from an
credit risk of a securitization exposure (other any other index for which the [bank] can operational loss event. Operational loss
than an originating [bank] of the demonstrate to the satisfaction of the includes all expenses associated with an
securitization). In the typical synthetic [AGENCY] that the equities represented in operational loss event except for opportunity
securitization, the investing [bank] sells the index have comparable liquidity, depth costs, forgone revenue, and costs related to
credit protection on a pool of underlying of market, and size of bid-ask spreads as risk management and control enhancements
exposures to the originating [bank]. equities in the Standard & Poor’s 500 Index implemented to prevent future operational
Investment fund means a company: and FTSE All-World Index. losses.
(1) All or substantially all of the assets of Multilateral development bank means the Operational loss event means an event that
which are financial assets; and International Bank for Reconstruction and results in loss and is associated with any of
(2) That has no material liabilities. Development, the International Finance the following seven operational loss event
Investors’ interest EAD means, with respect Corporation, the Inter-American type categories:
to a securitization, the EAD of the underlying Development Bank, the Asian Development (1) Internal fraud, which means the
exposures multiplied by the ratio of: Bank, the African Development Bank, the operational loss event type category that
(1) The total amount of securitization European Bank for Reconstruction and comprises operational losses resulting from
exposures issued by the securitization SPE to Development, the European Investment an act involving at least one internal party of
investors; divided by Bank, the European Investment Fund, the a type intended to defraud, misappropriate
property, or circumvent regulations, the law, with homogeneous risk characteristics, not Qualifying central counterparty means a
or company policy, excluding diversity- and on an individual-exposure basis, and is counterparty (for example, a clearinghouse)
discrimination-type events. either: that:
(2) External fraud, which means the (1) An exposure to an individual for non- (1) Facilitates trades between
operational loss event type category that business purposes; or counterparties in one or more financial
comprises operational losses resulting from (2) An exposure to an individual or markets by either guaranteeing trades or
an act by a third party of a type intended to company for business purposes if the [bank]’s novating contracts;
defraud, misappropriate property, or consolidated business credit exposure to the (2) Requires all participants in its
circumvent the law. Retail credit card losses individual or company is $1 million or less. arrangements to be fully collateralized on a
arising from non-contractual, third-party Over-the-counter (OTC) derivative contract daily basis; and
initiated fraud (for example, identity theft) means a derivative contract that is not traded (3) The [bank] demonstrates to the
are external fraud operational losses. All on an exchange that requires the daily receipt satisfaction of the [AGENCY] is in sound
other third-party initiated credit losses are to and payment of cash-variation margin. financial condition and is subject to effective
be treated as credit risk losses. Probability of default (PD) means: oversight by a national supervisory authority.
(3) Employment practices and workplace (1) For a wholesale exposure to a non- Qualifying cross-product master netting
safety, which means the operational loss defaulted obligor, the [bank]’s empirically agreement means a qualifying master netting
event type category that comprises based best estimate of the long-run average agreement that provides for termination and
operational losses resulting from an act one-year default rate for the rating grade close-out netting across multiple types of
inconsistent with employment, health, or assigned by the [bank] to the obligor, financial transactions or qualifying master
safety laws or agreements, payment of capturing the average default experience for netting agreements in the event of a
personal injury claims, or payment arising obligors in the rating grade over a mix of
counterparty’s default, provided that:
from diversity- and discrimination-type (1) The underlying financial transactions
economic conditions (including economic
events. are OTC derivative contracts, eligible margin
downturn conditions) sufficient to provide a
(4) Clients, products, and business loans, or repo-style transactions; and
reasonable estimate of the average one-year
practices, which means the operational loss (2) The [bank] obtains a written legal
default rate over the economic cycle for the
event type category that comprises opinion verifying the validity and
rating grade.
operational losses resulting from the nature enforceability of the agreement under
(2) For a segment of non-defaulted retail
or design of a product or from an applicable law of the relevant jurisdictions if
exposures, the [bank]’s empirically based
unintentional or negligent failure to meet a the counterparty fails to perform upon an
best estimate of the long-run average one-year
professional obligation to specific clients event of default, including upon an event of
default rate for the exposures in the segment,
(including fiduciary and suitability bankruptcy, insolvency, or similar
capturing the average default experience for
requirements). proceeding.
(5) Damage to physical assets, which exposures in the segment over a mix of Qualifying master netting agreement means
means the operational loss event type economic conditions (including economic any written, legally enforceable bilateral
category that comprises operational losses downturn conditions) sufficient to provide a agreement, provided that:
resulting from the loss of or damage to reasonable estimate of the average one-year (1) The agreement creates a single legal
physical assets from natural disaster or other default rate over the economic cycle for the obligation for all individual transactions
events. segment and adjusted upward as appropriate covered by the agreement upon an event of
(6) Business disruption and system for segments for which seasoning effects are default, including bankruptcy, insolvency, or
failures, which means the operational loss material. For purposes of this definition, a similar proceeding, of the counterparty;
event type category that comprises segment for which seasoning effects are (2) The agreement provides the [bank] the
operational losses resulting from disruption material is a segment where there is a right to accelerate, terminate, and close-out
of business or system failures. material relationship between the time since on a net basis all transactions under the
(7) Execution, delivery, and process origination of exposures within the segment agreement and to liquidate or set off
management, which means the operational and the [bank]’s best estimate of the long-run collateral promptly upon an event of default,
loss event type category that comprises average one-year default rate for the including upon an event of bankruptcy,
operational losses resulting from failed exposures in the segment. insolvency, or similar proceeding, of the
transaction processing or process (3) For a wholesale exposure to a defaulted counterparty, provided that, in any such
management or losses arising from relations obligor or segment of defaulted retail case, any exercise of rights under the
with trade counterparties and vendors. exposures, 100 percent. agreement will not be stayed or avoided
Operational risk means the risk of loss Protection amount (P) means, with respect under applicable law in the relevant
resulting from inadequate or failed internal to an exposure hedged by an eligible jurisdictions;
processes, people, and systems or from guarantee or eligible credit derivative, the (3) The [bank] has conducted sufficient
external events (including legal risk but effective notional amount of the guarantee or legal review to conclude with a well-founded
excluding strategic and reputational risk). credit derivative, reduced to reflect any basis (and maintains sufficient written
Operational risk exposure means the 99.9th currency mismatch, maturity mismatch, or documentation of that legal review) that:
percentile of the distribution of potential lack of restructuring coverage (as provided in (i) The agreement meets the requirements
aggregate operational losses, as generated by section 33 of this appendix). of paragraph (2) of this definition; and
the [bank]’s operational risk quantification Publicly traded means traded on: (ii) In the event of a legal challenge
system over a one-year horizon (and not (1) Any exchange registered with the SEC (including one resulting from default or from
incorporating eligible operational risk offsets as a national securities exchange under bankruptcy, insolvency, or similar
or qualifying operational risk mitigants). section 6 of the Securities Exchange Act of proceeding) the relevant court and
Originating [bank], with respect to a 1934 (15 U.S.C. 78f); or administrative authorities would find the
securitization, means a [bank] that: (2) Any non-U.S.-based securities exchange agreement to be legal, valid, binding, and
(1) Directly or indirectly originated or that: enforceable under the law of the relevant
securitized the underlying exposures (i) Is registered with, or approved by, a jurisdictions;
included in the securitization; or national securities regulatory authority; and (4) The [bank] establishes and maintains
(2) Serves as an ABCP program sponsor to (ii) Provides a liquid, two-way market for procedures to monitor possible changes in
the securitization. the instrument in question, meaning that relevant law and to ensure that the agreement
Other retail exposure means an exposure there are enough independent bona fide continues to satisfy the requirements of this
(other than a securitization exposure, an offers to buy and sell so that a sales price definition; and
equity exposure, a residential mortgage reasonably related to the last sales price or (5) The agreement does not contain a
exposure, an excluded mortgage exposure, a current bona fide competitive bid and offer walkaway clause (that is, a provision that
qualifying revolving exposure, or the residual quotations can be determined promptly and permits a non-defaulting counterparty to
value portion of a lease exposure) that is a trade can be settled at such a price within make a lower payment than it would make
managed as part of a segment of exposures five business days. otherwise under the agreement, or no
payment at all, to a defaulter or the estate of paragraph (3) of this definition and is legal, facility provider’s right to reimbursement of
a defaulter, even if the defaulter or the estate valid, binding, and enforceable under the drawn amounts is senior to all claims on
of the defaulter is a net creditor under the applicable law in the relevant jurisdictions. the cash flows from the underlying exposures
agreement). Residential mortgage exposure means an except amounts due under interest rate or
Qualifying revolving exposure (QRE) exposure (other than a securitization currency derivative contracts, fees due, or
means an exposure (other than a exposure, equity exposure, or excluded other similar payments.
securitization exposure or equity exposure) mortgage exposure) that is managed as part Servicer cash advance facility means a
to an individual that is managed as part of of a segment of exposures with homogeneous facility under which the servicer of the
a segment of exposures with homogeneous risk characteristics, not on an individual- underlying exposures of a securitization may
risk characteristics, not on an individual- exposure basis, and is: advance cash to ensure an uninterrupted
exposure basis, and: (1) An exposure that is primarily secured flow of payments to investors in the
(1) Is revolving (that is, the amount by a first or subsequent lien on one- to four- securitization, including advances made to
outstanding fluctuates, determined largely by family residential property; or cover foreclosure costs or other expenses to
the borrower’s decision to borrow and repay, (2) An exposure with an original and facilitate the timely collection of the
up to a pre-established maximum amount); outstanding amount of $1 million or less that underlying exposures. See also eligible
(2) Is unsecured and unconditionally is primarily secured by a first or subsequent servicer cash advance facility.
cancelable by the [bank] to the fullest extent lien on residential property that is not one to Sovereign entity means a central
permitted by Federal law; and four family. government (including the U.S. government)
(3) Has a maximum exposure amount Retail exposure means a residential or an agency, department, ministry, or central
(drawn plus undrawn) of up to $100,000. mortgage exposure, a qualifying revolving bank of a central government.
Repo-style transaction means a repurchase exposure, or an other retail exposure. Sovereign exposure means:
or reverse repurchase transaction, or a Retail exposure subcategory means the (1) A direct exposure to a sovereign entity;
securities borrowing or securities lending residential mortgage exposure, qualifying or
transaction, including a transaction in which revolving exposure, or other retail exposure (2) An exposure directly and
the [bank] acts as agent for a customer and subcategory. unconditionally backed by the full faith and
indemnifies the customer against loss, Risk parameter means a variable used in credit of a sovereign entity.
provided that: determining risk-based capital requirements Subsidiary means, with respect to a
(1) The transaction is based solely on for wholesale and retail exposures, company, a company controlled by that
liquid and readily marketable securities, specifically probability of default (PD), loss company.
cash, gold, or conforming residential given default (LGD), exposure at default Synthetic securitization means a
mortgages; (EAD), or effective maturity (M). transaction in which:
(2) The transaction is marked-to-market Scenario analysis means a systematic (1) All or a portion of the credit risk of one
daily and subject to daily margin process of obtaining expert opinions from or more underlying exposures is transferred
maintenance requirements; business managers and risk management to one or more third parties through the use
(3)(i) The transaction is a ‘‘securities experts to derive reasoned assessments of the of one or more credit derivatives or
contract’’ or ‘‘repurchase agreement’’ under likelihood and loss impact of plausible high- guarantees (other than a guarantee that
section 555 or 559, respectively, of the severity operational losses. Scenario analysis transfers only the credit risk of an individual
Bankruptcy Code (11 U.S.C. 555 or 559), a may include the well-reasoned evaluation retail exposure);
qualified financial contract under section and use of external operational loss event (2) The credit risk associated with the
11(e)(8) of the Federal Deposit Insurance Act data, adjusted as appropriate to ensure underlying exposures has been separated into
(12 U.S.C. 1821(e)(8)), or a netting contract relevance to a [bank]’s operational risk at least two tranches reflecting different
between or among financial institutions profile and control structure. levels of seniority;
under sections 401–407 of the Federal SEC means the U.S. Securities and (3) Performance of the securitization
Deposit Insurance Corporation Improvement Exchange Commission. exposures depends upon the performance of
Act of 1991 (12 U.S.C. 4401–4407) or the Securitization means a traditional the underlying exposures; and
Federal Reserve Board’s Regulation EE (12 securitization or a synthetic securitization. (4) All or substantially all of the underlying
CFR part 231); or Securitization exposure means an on- exposures are financial exposures (such as
(ii) If the transaction does not meet the balance sheet or off-balance sheet credit loans, commitments, credit derivatives,
criteria set forth in paragraph (3)(i) of this exposure that arises from a traditional or guarantees, receivables, asset-backed
definition, then either: synthetic securitization (including credit- securities, mortgage-backed securities, other
(A) The transaction is executed under an enhancing representations and warranties). debt securities, or equity securities).
agreement that provides the [bank] the right Securitization special purpose entity Tier 1 capital is defined in [the general
to accelerate, terminate, and close-out the (securitization SPE) means a corporation, risk-based capital rules], as modified in part
transaction on a net basis and to liquidate or trust, or other entity organized for the II of this appendix.
set off collateral promptly upon an event of specific purpose of holding underlying Tier 2 capital is defined in [the general
default (including upon an event of exposures of a securitization, the activities of risk-based capital rules], as modified in part
bankruptcy, insolvency, or similar which are limited to those appropriate to II of this appendix.
proceeding) of the counterparty, provided accomplish this purpose, and the structure of Total qualifying capital means the sum of
that, in any such case, any exercise of rights which is intended to isolate the underlying tier 1 capital and tier 2 capital, after all
under the agreement will not be stayed or exposures held by the entity from the credit deductions required in this appendix.
avoided under applicable law in the relevant risk of the seller of the underlying exposures Total risk-weighted assets means:
jurisdictions; or to the entity. (1) The sum of:
(B) The transaction is: Senior securitization exposure means a (i) Credit risk-weighted assets; and
(1) Either overnight or unconditionally securitization exposure that has a first (ii) Risk-weighted assets for operational
cancelable at any time by the [bank]; and priority claim on the cash flows from the risk; minus
(2) Executed under an agreement that underlying exposures. When determining (2) Excess eligible credit reserves not
provides the [bank] the right to accelerate, whether a securitization exposure has a first included in tier 2 capital.
terminate, and close-out the transaction on a priority claim on the cash flows from the Total wholesale and retail risk-weighted
net basis and to liquidate or set off collateral underlying exposures, a [bank] is not assets means the sum of risk-weighted assets
promptly upon an event of counterparty required to consider amounts due under for wholesale exposures to non-defaulted
default; and interest rate or currency derivative contracts, obligors and segments of non-defaulted retail
(4) The [bank] has conducted sufficient fees due, or other similar payments. Both the exposures; risk-weighted assets for wholesale
legal review to conclude with a well-founded most senior commercial paper issued by an exposures to defaulted obligors and segments
basis (and maintains sufficient written ABCP program and a liquidity facility that of defaulted retail exposures; risk-weighted
documentation of that legal review) that the supports the ABCP program may be senior assets for assets not defined by an exposure
agreement meets the requirements of securitization exposures if the liquidity category; and risk-weighted assets for non-
material portfolios of exposures (all as fixed holding period within a stated and 50 percent from tier 2 capital. If the
determined in section 31 of this appendix) confidence interval. amount deductible from tier 2 capital
and risk-weighted assets for unsettled Wholesale exposure means a credit exceeds the [bank]’s actual tier 2 capital,
transactions (as determined in section 35 of exposure to a company, natural person, however, the [bank] must deduct the excess
this appendix) minus the amounts deducted sovereign entity, or governmental entity from tier 1 capital.
from capital pursuant to [the general risk- (other than a securitization exposure, retail (1) Credit-enhancing interest-only strips
based capital rules] (excluding those exposure, excluded mortgage exposure, or (CEIOs). In accordance with paragraphs (a)(1)
deductions reversed in section 12 of this equity exposure). Examples of a wholesale and (c) of section 42 of this appendix, any
appendix). exposure include: CEIO that does not constitute gain-on-sale.
Traditional securitization means a (1) A non-tranched guarantee issued by a (2) Non-qualifying securitization
transaction in which: [bank] on behalf of a company; exposures. In accordance with paragraphs
(1) All or a portion of the credit risk of one (2) A repo-style transaction entered into by (a)(4) and (c) of section 42 of this appendix,
or more underlying exposures is transferred a [bank] with a company and any other any securitization exposure that does not
to one or more third parties other than transaction in which a [bank] posts collateral qualify for the Ratings-Based Approach, the
through the use of credit derivatives or to a company and faces counterparty credit Internal Assessment Approach, or the
guarantees; risk; Supervisory Formula Approach under
(2) The credit risk associated with the (3) An exposure that a [bank] treats as a sections 43, 44, and 45 of this appendix,
underlying exposures has been separated into covered position under [the market risk rule] respectively.
at least two tranches reflecting different for which there is a counterparty credit risk (3) Securitizations of non-IRB exposures. In
levels of seniority; capital requirement; accordance with paragraphs (c) and (g)(4) of
(3) Performance of the securitization (4) A sale of corporate loans by a [bank] to section 42 of this appendix, certain
exposures depends upon the performance of a third party in which the [bank] retains full exposures to a securitization any underlying
the underlying exposures; recourse; exposure of which is not a wholesale
(4) All or substantially all of the underlying (5) An OTC derivative contract entered into exposure, retail exposure, securitization
exposures are financial exposures (such as by a [bank] with a company; exposure, or equity exposure.
loans, commitments, credit derivatives, (6) An exposure to an individual that is not (4) Low-rated securitization exposures. In
guarantees, receivables, asset-backed managed by a [bank] as part of a segment of accordance with section 43 and paragraph (c)
securities, mortgage-backed securities, other exposures with homogeneous risk of section 42 of this appendix, any
debt securities, or equity securities); characteristics; and securitization exposure that qualifies for and
(5) The underlying exposures are not (7) A commercial lease. must be deducted under the Ratings-Based
owned by an operating company; Wholesale exposure subcategory means the Approach.
(6) The underlying exposures are not HVCRE or non-HVCRE wholesale exposure (5) High-risk securitization exposures
owned by a small business investment subcategory. subject to the Supervisory Formula
company described in section 302 of the Section 3. Minimum Risk-Based Capital Approach. In accordance with paragraphs (b)
Small Business Investment Act of 1958 (15 Requirements and (c) of section 45 of this appendix and
U.S.C. 682); and paragraph (c) of section 42 of this appendix,
(7) The underlying exposures are not (a) Except as modified by paragraph (c) of
certain high-risk securitization exposures (or
owned by a firm an investment in which this section or by section 23 of this appendix,
portions thereof) that qualify for the
qualifies as a community development each [bank] must meet a minimum ratio of:
Supervisory Formula Approach.
investment under 12 U.S.C. 24(Eleventh). (1) Total qualifying capital to total risk-
(6) Eligible credit reserves shortfall. In
(8) The [AGENCY] may determine that a weighted assets of 8.0 percent; and
accordance with paragraph (a)(1) of section
transaction in which the underlying (2) Tier 1 capital to total risk-weighted
assets of 4.0 percent. 13 of this appendix, any eligible credit
exposures are owned by an investment firm reserves shortfall.
that exercises substantially unfettered control (b) Each [bank] must hold capital
commensurate with the level and nature of (7) Certain failed capital markets
over the size and composition of its assets, transactions. In accordance with paragraph
liabilities, and off-balance sheet exposures is all risks to which the [bank] is exposed.
(c) When a [bank] subject to [the market (e)(3) of section 35 of this appendix, the
not a traditional securitization based on the [bank]’s exposure on certain failed capital
transaction’s leverage, risk profile, or risk rule] calculates its risk-based capital
requirements under this appendix, the [bank] markets transactions.
economic substance.
(9) The [AGENCY] may deem a transaction must also refer to [the market risk rule] for Section 12. Deductions and Limitations Not
that meets the definition of a traditional supplemental rules to calculate risk-based Required
securitization, notwithstanding paragraph capital requirements adjusted for market risk.
(a) Deduction of CEIOs. A [bank] is not
(5), (6), or (7) of this definition, to be a Part II. Qualifying Capital required to make the deductions from capital
traditional securitization based on the for CEIOs in 12 CFR part 3, Appendix A,
transaction’s leverage, risk profile, or Section 11. Additional Deductions
section 2(c) (for national banks), 12 CFR part
economic substance. (a) General. A [bank] that uses this 208, Appendix A, section II.B.1.e. (for state
Tranche means all securitization exposures appendix must make the same deductions member banks), 12 CFR part 225, Appendix
associated with a securitization that have the from its tier 1 capital and tier 2 capital A, section II.B.1.e. (for bank holding
same seniority level. required in [the general risk-based capital companies), 12 CFR part 325, Appendix A,
Underlying exposures means one or more rules], except that: section II.B.5. (for state nonmember banks),
exposures that have been securitized in a (1) A [bank] is not required to deduct and 12 CFR 567.5(a)(2)(iii) and 567.12(e) (for
securitization transaction. certain equity investments and CEIOs (as savings associations).
Unexpected operational loss (UOL) means provided in section 12 of this appendix); and (b) Deduction of certain equity
the difference between the [bank]’s (2) A [bank] also must make the deductions investments. A [bank] is not required to make
operational risk exposure and the [bank]’s from capital required by paragraphs (b) and the deductions from capital for nonfinancial
expected operational loss. (c) of this section. equity investments in 12 CFR part 3,
Unit of measure means the level (for (b) Deductions from tier 1 capital. A [bank] Appendix A, section 2(c) (for national banks),
example, organizational unit or operational must deduct from tier 1 capital any gain-on- 12 CFR part 208, Appendix A, section II.B.5.
loss event type) at which the [bank]’s sale associated with a securitization exposure (for state member banks), 12 CFR part 225,
operational risk quantification system as provided in paragraph (a) of section 41 Appendix A, section II.B.5. (for bank holding
generates a separate distribution of potential and paragraphs (a)(1), (c), (g)(1), and (h)(1) of companies), and 12 CFR part 325, Appendix
operational losses. section 42 of this appendix. A, section II.B. (for state nonmember banks).
Value-at-Risk (VaR) means the estimate of (c) Deductions from tier 1 and tier 2
the maximum amount that the value of one capital. A [bank] must deduct the exposures Section 13. Eligible Credit Reserves
or more exposures could decline due to specified in paragraphs (c)(1) through (c)(7) (a) Comparison of eligible credit reserves to
market price or rate movements during a in this section 50 percent from tier 1 capital expected credit losses—(1) Shortfall of
eligible credit reserves. If a [bank]’s eligible requirements in section 22 of this appendix (A) The [bank]’s floor-adjusted total risk-
credit reserves are less than the [bank]’s total or to improve the consistency of the [bank]’s based capital ratio; or
expected credit losses, the [bank] must current practices with the [AGENCY]’s (B) The [bank]’s advanced approaches total
deduct the shortfall amount 50 percent from supervisory guidance on the qualification risk-based capital ratio.
tier 1 capital and 50 percent from tier 2 requirements (gap analysis); (2) Floor-adjusted risk-based capital ratios.
capital. If the amount deductible from tier 2 (v) Describe what specific actions the (i) A [bank]’s floor-adjusted tier 1 risk-based
capital exceeds the [bank]’s actual tier 2 [bank] will take to address the areas capital ratio during a transitional floor period
capital, the [bank] must deduct the excess identified in the gap analysis required by is equal to the [bank]’s tier 1 capital as
amount from tier 1 capital. paragraph (b)(1)(iv) of this section; calculated under [the general risk-based
(2) Excess eligible credit reserves. If a (vi) Identify objective, measurable capital rules], divided by the product of:
[bank]’s eligible credit reserves exceed the milestones, including delivery dates and a (A) The [bank]’s total risk-weighted assets
[bank]’s total expected credit losses, the date when the [bank]’s implementation of the as calculated under [the general risk-based
[bank] may include the excess amount in tier methodologies described in this appendix capital rules]; and
2 capital to the extent that the excess amount will be fully operational; (B) The appropriate transitional floor
does not exceed 0.6 percent of the [bank]’s (vii) Describe resources that have been percentage in Table 1.
credit-risk-weighted assets. budgeted and are available to implement the (ii) A [bank]’s floor-adjusted total risk-
(b) Treatment of allowance for loan and plan; and based capital ratio during a transitional floor
lease losses. Regardless of any provision in (viii) Receive approval of the [bank]’s period is equal to the sum of the [bank]’s tier
[the general risk-based capital rules], the board of directors. 1 and tier 2 capital as calculated under [the
ALLL is included in tier 2 capital only to the (2) The [bank] must submit the general risk-based capital rules], divided by
extent provided in paragraph (a)(2) of this implementation plan, together with a copy of the product of:
section and in section 24 of this appendix. the minutes of the board of directors’ (A) The [bank]’s total risk-weighted assets
approval, to the [AGENCY] at least 60 days as calculated under [the general risk-based
Part III. Qualification capital rules]; and
before the [bank] proposes to begin its
Section 21. Qualification Process parallel run, unless the [AGENCY] waives (B) The appropriate transitional floor
prior notice. percentage in Table 1.
(a) Timing. (1) A [bank] that is described
(c) Parallel run. Before determining its risk- (iii) A [bank] that meets the criteria in
in paragraph (b)(1) of section 1 of this
based capital requirements under this paragraph (b)(1) or (b)(2) of section 1 of this
appendix must adopt a written
appendix and following adoption of the appendix as of April 1, 2008, must use [the
implementation plan no later than six
implementation plan, the [bank] must general risk-based capital rules] during the
months after the later of April 1, 2008, or the
conduct a satisfactory parallel run. A parallel run and as the basis for its
date the [bank] meets a criterion in that
satisfactory parallel run is a period of no less transitional floors.
section. The implementation plan must
incorporate an explicit first floor period start than four consecutive calendar quarters
date no later than 36 months after the later during which the [bank] complies with the TABLE 1.—TRANSITIONAL FLOORS
of April 1, 2008, or the date the [bank] meets qualification requirements in section 22 of
at least one criterion under paragraph (b)(1) this appendix to the satisfaction of the Transitional floor pe- Transitional floor per-
of section 1 of this appendix. The [AGENCY] [AGENCY]. During the parallel run, the riod centage
may extend the first floor period start date. [bank] must report to the [AGENCY] on a
(2) A [bank] that elects to be subject to this calendar quarterly basis its risk-based capital First floor period ........ 95 percent.
appendix under paragraph (b)(2) of section 1 ratios using [the general risk-based capital Second floor period ... 90 percent.
of this appendix must adopt a written rules] and the risk-based capital requirements Third floor period ....... 85 percent.
implementation plan. described in this appendix. During this
(b) Implementation plan. (1) The [bank]’s period, the [bank] is subject to [the general (3) Advanced approaches risk-based
implementation plan must address in detail risk-based capital rules]. capital ratios. (i) A [bank]’s advanced
how the [bank] complies, or plans to comply, (d) Approval to calculate risk-based capital approaches tier 1 risk-based capital ratio
with the qualification requirements in requirements under this appendix. The equals the [bank]’s tier 1 risk-based capital
section 22 of this appendix. The [bank] also [AGENCY] will notify the [bank] of the date ratio as calculated under this appendix (other
must maintain a comprehensive and sound that the [bank] may begin its first floor period than this section on transitional floor
planning and governance process to oversee if the [AGENCY] determines that: periods).
the implementation efforts described in the (1) The [bank] fully complies with all the (ii) A [bank]’s advanced approaches total
plan. At a minimum, the plan must: qualification requirements in section 22 of risk-based capital ratio equals the [bank]’s
(i) Comprehensively address the this appendix; total risk-based capital ratio as calculated
qualification requirements in section 22 of (2) The [bank] has conducted a satisfactory under this appendix (other than this section
this appendix for the [bank] and each parallel run under paragraph (c) of this on transitional floor periods).
consolidated subsidiary (U.S. and foreign- section; and (4) Reporting. During the transitional floor
based) of the [bank] with respect to all (3) The [bank] has an adequate process to periods, a [bank] must report to the
portfolios and exposures of the [bank] and ensure ongoing compliance with the [AGENCY] on a calendar quarterly basis both
each of its consolidated subsidiaries; qualification requirements in section 22 of floor-adjusted risk-based capital ratios and
(ii) Justify and support any proposed this appendix. both advanced approaches risk-based capital
temporary or permanent exclusion of (e) Transitional floor periods. Following a ratios.
business lines, portfolios, or exposures from satisfactory parallel run, a [bank] is subject to (5) Exiting a transitional floor period. A
application of the advanced approaches in three transitional floor periods. [bank] may not exit a transitional floor period
this appendix (which business lines, (1) Risk-based capital ratios during the until the [bank] has spent a minimum of four
portfolios, and exposures must be, in the transitional floor periods—(i) Tier 1 risk- consecutive calendar quarters in the period
aggregate, immaterial to the [bank]); based capital ratio. During a [bank]’s and the [AGENCY] has determined that the
(iii) Include the [bank]’s self-assessment of: transitional floor periods, the [bank]’s tier 1 [bank] may exit the floor period. The
(A) The [bank]’s current status in meeting risk-based capital ratio is equal to the lower [AGENCY]’s determination will be based on
the qualification requirements in section 22 of: an assessment of the [bank]’s ongoing
of this appendix; and (A) The [bank]’s floor-adjusted tier 1 risk- compliance with the qualification
(B) The consistency of the [bank]’s current based capital ratio; or requirements in section 22 of this appendix.
practices with the [AGENCY]’s supervisory (B) The [bank]’s advanced approaches tier (6) Interagency study. After the end of the
guidance on the qualification requirements; 1 risk-based capital ratio. second transition year (2010), the Federal
(iv) Based on the [bank]’s self-assessment, (ii) Total risk-based capital ratio. During a banking agencies will publish a study that
identify and describe the areas in which the [bank]’s transitional floor periods, the evaluates the advanced approaches to
[bank] proposes to undertake additional work [bank]’s total risk-based capital ratio is equal determine if there are any material
to comply with the qualification to the lower of: deficiencies. For any primary Federal
supervisor to authorize any institution to exit severity rating grade (reflecting the [bank]’s in dealing with such exposures during
the third transitional floor period, the study estimate of the LGD of the exposure). A economic downturn conditions.
must determine that there are no such [bank] employing loss severity rating grades (6) PD estimates for wholesale obligors and
material deficiencies that cannot be must have a sufficiently granular loss retail segments must be based on at least five
addressed by then-existing tools, or, if such severity grading system to avoid grouping years of default data. LGD estimates for
deficiencies are found, they are first together exposures with widely ranging wholesale exposures must be based on at
remedied by changes to this appendix. LGDs. least seven years of loss severity data, and
Notwithstanding the preceding sentence, a (3) For retail exposures, a [bank] must have LGD estimates for retail segments must be
primary Federal supervisor that disagrees an internal system that groups retail based on at least five years of loss severity
with the finding of material deficiency may exposures into the appropriate retail data. EAD estimates for wholesale exposures
not authorize any institution under its exposure subcategory, groups the retail must be based on at least seven years of
jurisdiction to exit the third transitional floor exposures in each retail exposure exposure amount data, and EAD estimates for
period unless it provides a public report subcategory into separate segments with retail segments must be based on at least five
explaining its reasoning. homogeneous risk characteristics, and years of exposure amount data.
assigns accurate and reliable PD and LGD (7) Default, loss severity, and exposure
Section 22. Qualification Requirements estimates for each segment on a consistent amount data must include periods of
(a) Process and systems requirements. (1) A basis. The [bank]’s system must identify and economic downturn conditions, or the [bank]
[bank] must have a rigorous process for group in separate segments by subcategories must adjust its estimates of risk parameters
assessing its overall capital adequacy in exposures identified in paragraphs (c)(2)(ii) to compensate for the lack of data from
relation to its risk profile and a and (iii) of section 31 of this appendix. periods of economic downturn conditions.
comprehensive strategy for maintaining an (4) The [bank]’s internal risk rating policy (8) The [bank]’s PD, LGD, and EAD
appropriate level of capital. for wholesale exposures must describe the estimates must be based on the definition of
(2) The systems and processes used by a [bank]’s rating philosophy (that is, must default in this appendix.
[bank] for risk-based capital purposes under describe how wholesale obligor rating (9) The [bank] must review and update (as
this appendix must be consistent with the assignments are affected by the [bank]’s appropriate) its risk parameters and its risk
[bank]’s internal risk management processes choice of the range of economic, business, parameter quantification process at least
and management information reporting and industry conditions that are considered annually.
systems. in the obligor rating process). (10) The [bank] must at least annually
(3) Each [bank] must have an appropriate (5) The [bank]’s internal risk rating system conduct a comprehensive review and
infrastructure with risk measurement and for wholesale exposures must provide for the analysis of reference data to determine
management processes that meet the review and update (as appropriate) of each relevance of reference data to the [bank]’s
qualification requirements of this section and obligor rating and (if applicable) each loss exposures, quality of reference data to
are appropriate given the [bank]’s size and severity rating whenever the [bank] receives support PD, LGD, and EAD estimates, and
level of complexity. Regardless of whether new material information, but no less consistency of reference data to the definition
the systems and models that generate the risk frequently than annually. The [bank]’s retail of default contained in this appendix.
parameters necessary for calculating a exposure segmentation system must provide (d) Counterparty credit risk model. A
[bank]’s risk-based capital requirements are for the review and update (as appropriate) of [bank] must obtain the prior written approval
located at any affiliate of the [bank], the assignments of retail exposures to segments of the [AGENCY] under section 32 of this
[bank] itself must ensure that the risk whenever the [bank] receives new material appendix to use the internal models
parameters and reference data used to information, but generally no less frequently methodology for counterparty credit risk.
determine its risk-based capital requirements than quarterly. (e) Double default treatment. A [bank] must
are representative of its own credit risk and (c) Quantification of risk parameters for obtain the prior written approval of the
operational risk exposures. wholesale and retail exposures. (1) The [AGENCY] under section 34 of this appendix
(b) Risk rating and segmentation systems [bank] must have a comprehensive risk to use the double default treatment.
for wholesale and retail exposures. (1) A parameter quantification process that (f) Securitization exposures. A [bank] must
[bank] must have an internal risk rating and produces accurate, timely, and reliable obtain the prior written approval of the
segmentation system that accurately and estimates of the risk parameters for the [AGENCY] under section 44 of this appendix
reliably differentiates among degrees of credit [bank]’s wholesale and retail exposures. to use the Internal Assessment Approach for
risk for the [bank]’s wholesale and retail (2) Data used to estimate the risk securitization exposures to ABCP programs.
exposures. parameters must be relevant to the [bank]’s (g) Equity exposures model. A [bank] must
(2) For wholesale exposures: actual wholesale and retail exposures, and of obtain the prior written approval of the
(i) A [bank] must have an internal risk sufficient quality to support the [AGENCY] under section 53 of this appendix
rating system that accurately and reliably determination of risk-based capital to use the Internal Models Approach for
assigns each obligor to a single rating grade requirements for the exposures. equity exposures.
(reflecting the obligor’s likelihood of default). (3) The [bank]’s risk parameter (h) Operational risk—(1) Operational risk
A [bank] may elect, however, not to assign to quantification process must produce management processes. A [bank] must:
a rating grade an obligor to whom the [bank] appropriately conservative risk parameter (i) Have an operational risk management
extends credit based solely on the financial estimates where the [bank] has limited function that:
strength of a guarantor, provided that all of relevant data, and any adjustments that are (A) Is independent of business line
the [bank]’s exposures to the obligor are fully part of the quantification process must not management; and
covered by eligible guarantees, the [bank] result in a pattern of bias toward lower risk (B) Is responsible for designing,
applies the PD substitution approach in parameter estimates. implementing, and overseeing the [bank]’s
paragraph (c)(1) of section 33 of this (4) The [bank]’s risk parameter estimation operational risk data and assessment systems,
appendix to all exposures to that obligor, and process should not rely on the possibility of operational risk quantification systems, and
the [bank] immediately assigns the obligor to U.S. government financial assistance, except related processes;
a rating grade if a guarantee can no longer be for the financial assistance that the U.S. (ii) Have and document a process (which
recognized under this appendix. The [bank]’s government has a legally binding must capture business environment and
wholesale obligor rating system must have at commitment to provide. internal control factors affecting the [bank]’s
least seven discrete rating grades for non- (5) Where the [bank]’s quantifications of operational risk profile) to identify, measure,
defaulted obligors and at least one rating LGD directly or indirectly incorporate monitor, and control operational risk in
grade for defaulted obligors. estimates of the effectiveness of its credit risk [bank] products, activities, processes, and
(ii) Unless the [bank] has chosen to directly management practices in reducing its systems; and
assign LGD estimates to each wholesale exposure to troubled obligors prior to default, (iii) Report operational risk exposures,
exposure, the [bank] must have an internal the [bank] must support such estimates with operational loss events, and other relevant
risk rating system that accurately and reliably empirical analysis showing that the estimates operational risk information to business unit
assigns each wholesale exposure to a loss are consistent with its historical experience management, senior management, and the
board of directors (or a designated committee (C) Must include a credible, transparent, (3) A [bank] must have an effective system
of the board). systematic, and verifiable approach for of controls and oversight that:
(2) Operational risk data and assessment weighting each of the four elements, (i) Ensures ongoing compliance with the
systems. A [bank] must have operational risk described in paragraph (h)(2)(ii) of this qualification requirements in this section;
data and assessment systems that capture section, that a [bank] is required to (ii) Maintains the integrity, reliability, and
operational risks to which the [bank] is incorporate into its operational risk data and accuracy of the [bank]’s advanced systems;
exposed. The [bank]’s operational risk data assessment systems; and
and assessment systems must: (D) May use internal estimates of (iii) Includes adequate governance and
(i) Be structured in a manner consistent dependence among operational losses across project management processes.
with the [bank]’s current business activities, and within units of measure if the [bank] can (4) The [bank] must validate, on an ongoing
risk profile, technological processes, and risk demonstrate to the satisfaction of the basis, its advanced systems. The [bank]’s
management processes; and [AGENCY] that its process for estimating validation process must be independent of
(ii) Include credible, transparent, dependence is sound, robust to a variety of the advanced systems’ development,
systematic, and verifiable processes that scenarios, and implemented with integrity, implementation, and operation, or the
incorporate the following elements on an and allows for the uncertainty surrounding validation process must be subjected to an
ongoing basis: the estimates. If the [bank] has not made such independent review of its adequacy and
(A) Internal operational loss event data. a demonstration, it must sum operational risk effectiveness. Validation must include:
The [bank] must have a systematic process exposure estimates across units of measure to (i) An evaluation of the conceptual
for capturing and using internal operational calculate its total operational risk exposure; soundness of (including developmental
loss event data in its operational risk data and evidence supporting) the advanced systems;
and assessment systems. (E) Must be reviewed and updated (as (ii) An ongoing monitoring process that
(1) The [bank]’s operational risk data and appropriate) whenever the [bank] becomes includes verification of processes and
assessment systems must include a historical aware of information that may have a benchmarking; and
observation period of at least five years for material effect on the [bank]’s estimate of (iii) An outcomes analysis process that
internal operational loss event data (or such operational risk exposure, but the review and includes back-testing.
shorter period approved by the [AGENCY] to update must occur no less frequently than (5) The [bank] must have an internal audit
address transitional situations, such as annually. function independent of business-line
integrating a new business line). (ii) With the prior written approval of the management that at least annually assesses
(2) The [bank] must be able to map its [AGENCY], a [bank] may generate an estimate the effectiveness of the controls supporting
internal operational loss event data into the of its operational risk exposure using an the [bank]’s advanced systems and reports its
seven operational loss event type categories. alternative approach to that specified in findings to the [bank]’s board of directors (or
paragraph (h)(3)(i) of this section. A [bank] a committee thereof).
(3) The [bank] may refrain from collecting
proposing to use such an alternative (6) The [bank] must periodically stress test
internal operational loss event data for
operational risk quantification system must its advanced systems. The stress testing must
individual operational losses below
submit a proposal to the [AGENCY]. In include a consideration of how economic
established dollar threshold amounts if the
determining whether to approve a [bank]’s cycles, especially downturns, affect risk-
[bank] can demonstrate to the satisfaction of
proposal to use an alternative operational based capital requirements (including
the [AGENCY] that the thresholds are risk quantification system, the [AGENCY] migration across rating grades and segments
reasonable, do not exclude important internal will consider the following principles: and the credit risk mitigation benefits of
operational loss event data, and permit the (A) Use of the alternative operational risk double default treatment).
[bank] to capture substantially all the dollar quantification system will be allowed only (k) Documentation. The [bank] must
value of the [bank]’s operational losses. on an exception basis, considering the size, adequately document all material aspects of
(B) External operational loss event data. complexity, and risk profile of the [bank]; its advanced systems.
The [bank] must have a systematic process (B) The [bank] must demonstrate that its
for determining its methodologies for estimate of its operational risk exposure Section 23. Ongoing Qualification
incorporating external operational loss event generated under the alternative operational (a) Changes to advanced systems. A [bank]
data into its operational risk data and risk quantification system is appropriate and must meet all the qualification requirements
assessment systems. can be supported empirically; and in section 22 of this appendix on an ongoing
(C) Scenario analysis. The [bank] must (C) A [bank] must not use an allocation of basis. A [bank] must notify the [AGENCY]
have a systematic process for determining its operational risk capital requirements that when the [bank] makes any change to an
methodologies for incorporating scenario includes entities other than depository advanced system that would result in a
analysis into its operational risk data and institutions or the benefits of diversification material change in the [bank]’s risk-weighted
assessment systems. across entities. asset amount for an exposure type, or when
(D) Business environment and internal (i) Data management and maintenance. (1) the [bank] makes any significant change to its
control factors. The [bank] must incorporate A [bank] must have data management and modeling assumptions.
business environment and internal control maintenance systems that adequately support (b) Failure to comply with qualification
factors into its operational risk data and all aspects of its advanced systems and the requirements. (1) If the [AGENCY]
assessment systems. The [bank] must also timely and accurate reporting of risk-based determines that a [bank] that uses this
periodically compare the results of its prior capital requirements. appendix and has conducted a satisfactory
business environment and internal control (2) A [bank] must retain data using an parallel run fails to comply with the
factor assessments against its actual electronic format that allows timely retrieval qualification requirements in section 22 of
operational losses incurred in the intervening of data for analysis, validation, reporting, and this appendix, the [AGENCY] will notify the
period. disclosure purposes. [bank] in writing of the [bank]’s failure to
(3) Operational risk quantification systems. (3) A [bank] must retain sufficient data comply.
(i) The [bank]’s operational risk elements related to key risk drivers to permit (2) The [bank] must establish and submit
quantification systems: adequate monitoring, validation, and a plan satisfactory to the [AGENCY] to return
(A) Must generate estimates of the [bank]’s refinement of its advanced systems. to compliance with the qualification
operational risk exposure using its (j) Control, oversight, and validation requirements.
operational risk data and assessment systems; mechanisms. (1) The [bank]’s senior (3) In addition, if the [AGENCY]
(B) Must employ a unit of measure that is management must ensure that all determines that the [bank]’s risk-based
appropriate for the [bank]’s range of business components of the [bank]’s advanced systems capital requirements are not commensurate
activities and the variety of operational loss function effectively and comply with the with the [bank]’s credit, market, operational,
events to which it is exposed, and that does qualification requirements in this section. or other risks, the [AGENCY] may require
not combine business activities or (2) The [bank]’s board of directors (or a such a [bank] to calculate its risk-based
operational loss events with demonstrably designated committee of the board) must at capital requirements:
different risk profiles within the same loss least annually review the effectiveness of, (i) Under [the general risk-based capital
distribution; and approve, the [bank]’s advanced systems. rules]; or
(ii) Under this appendix with any Part IV. Risk-Weighted Assets for General (d) Phase 3—Assignment of risk
modifications provided by the [AGENCY]. Credit Risk parameters to wholesale exposures and
segments of retail exposures—(1)
Section 24. Merger and Acquisition Section 31. Mechanics for Calculating Total Quantification process. Subject to the
Transitional Arrangements Wholesale and Retail Risk-Weighted Assets limitations in this paragraph (d), the [bank]
(a) Mergers and acquisitions of companies (a) Overview. A [bank] must calculate its must:
without advanced systems. If a [bank] merges total wholesale and retail risk-weighted asset (i) Associate a PD with each wholesale
with or acquires a company that does not amount in four distinct phases: obligor rating grade;
calculate its risk-based capital requirements (1) Phase 1—categorization of exposures; (ii) Associate an LGD with each wholesale
using advanced systems, the [bank] may use (2) Phase 2—assignment of wholesale loss severity rating grade or assign an LGD to
[the general risk-based capital rules] to obligors and exposures to rating grades and each wholesale exposure;
determine the risk-weighted asset amounts segmentation of retail exposures; (iii) Assign an EAD and M to each
for, and deductions from capital associated (3) Phase 3—assignment of risk parameters wholesale exposure; and
with, the merged or acquired company’s to wholesale exposures and segments of retail (iv) Assign a PD, LGD, and EAD to each
exposures for up to 24 months after the exposures; and segment of retail exposures.
calendar quarter during which the merger or (4) Phase 4—calculation of risk-weighted (2) Floor on PD assignment. The PD for
acquisition consummates. The [AGENCY] asset amounts. each wholesale obligor or retail segment may
may extend this transition period for up to (b) Phase 1—Categorization. The [bank] not be less than 0.03 percent, except for
an additional 12 months. Within 90 days of must determine which of its exposures are exposures to or directly and unconditionally
consummating the merger or acquisition, the wholesale exposures, retail exposures, guaranteed by a sovereign entity, the Bank for
[bank] must submit to the [AGENCY] an securitization exposures, or equity exposures. International Settlements, the International
implementation plan for using its advanced The [bank] must categorize each retail Monetary Fund, the European Commission,
systems for the acquired company. During exposure as a residential mortgage exposure, the European Central Bank, or a multilateral
the period when [the general risk-based a QRE, or an other retail exposure. The [bank] development bank, to which the [bank]
capital rules] apply to the merged or acquired must identify which wholesale exposures are assigns a rating grade associated with a PD
company, any ALLL, net of allocated transfer HVCRE exposures, sovereign exposures, OTC of less than 0.03 percent.
risk reserves established pursuant to 12 derivative contracts, repo-style transactions, (3) Floor on LGD estimation. The LGD for
U.S.C. 3904, associated with the merged or eligible margin loans, eligible purchased each segment of residential mortgage
acquired company’s exposures may be wholesale exposures, unsettled transactions exposures (other than segments of residential
included in the acquiring [bank]’s tier 2 to which section 35 of this appendix applies,
mortgage exposures for which all or
capital up to 1.25 percent of the acquired and eligible guarantees or eligible credit
substantially all of the principal of each
company’s risk-weighted assets. All general derivatives that are used as credit risk
exposure is directly and unconditionally
allowances of the merged or acquired mitigants. The [bank] must identify any on-
guaranteed by the full faith and credit of a
company must be excluded from the [bank]’s balance sheet asset that does not meet the
sovereign entity) may not be less than 10
eligible credit reserves. In addition, the risk- definition of a wholesale, retail, equity, or
percent.
weighted assets of the merged or acquired securitization exposure, as well as any non-
(4) Eligible purchased wholesale
company are not included in the [bank]’s material portfolio of exposures described in
credit-risk-weighted assets but are included paragraph (e)(4) of this section. exposures. A [bank] must assign a PD, LGD,
in total risk-weighted assets. If a [bank] relies (c) Phase 2—Assignment of wholesale EAD, and M to each segment of eligible
on this paragraph, the [bank] must disclose obligors and exposures to rating grades and purchased wholesale exposures. If the [bank]
publicly the amounts of risk-weighted assets retail exposures to segments—(1) Assignment can estimate ECL (but not PD or LGD) for a
and qualifying capital calculated under this of wholesale obligors and exposures to rating segment of eligible purchased wholesale
appendix for the acquiring [bank] and under grades. exposures, the [bank] must assume that the
[the general risk-based capital rules] for the (i) The [bank] must assign each obligor of LGD of the segment equals 100 percent and
acquired company. a wholesale exposure to a single obligor that the PD of the segment equals ECL
(b) Mergers and acquisitions of companies rating grade and must assign each wholesale divided by EAD. The estimated ECL must be
with advanced systems—(1) If a [bank] exposure to which it does not directly assign calculated for the exposures without regard
merges with or acquires a company that an LGD estimate to a loss severity rating to any assumption of recourse or guarantees
calculates its risk-based capital requirements grade. from the seller or other parties.
using advanced systems, the [bank] may use (ii) The [bank] must identify which of its (5) Credit risk mitigation—credit
the acquired company’s advanced systems to wholesale obligors are in default. derivatives, guarantees, and collateral. (i) A
determine the risk-weighted asset amounts (2) Segmentation of retail exposures. (i) [bank] may take into account the risk
for, and deductions from capital associated The [bank] must group the retail exposures reducing effects of eligible guarantees and
with, the merged or acquired company’s in each retail subcategory into segments that eligible credit derivatives in support of a
exposures for up to 24 months after the have homogeneous risk characteristics. wholesale exposure by applying the PD
calendar quarter during which the (ii) The [bank] must identify which of its substitution or LGD adjustment treatment to
acquisition or merger consummates. The retail exposures are in default. The [bank] the exposure as provided in section 33 of this
[AGENCY] may extend this transition period must segment defaulted retail exposures appendix or, if applicable, applying double
for up to an additional 12 months. Within 90 separately from non-defaulted retail default treatment to the exposure as provided
days of consummating the merger or exposures. in section 34 of this appendix. A [bank] may
acquisition, the [bank] must submit to the (iii) If the [bank] determines the EAD for decide separately for each wholesale
[AGENCY] an implementation plan for using eligible margin loans using the approach in exposure that qualifies for the double default
its advanced systems for the merged or paragraph (b) of section 32 of this appendix, treatment under section 34 of this appendix
acquired company. the [bank] must identify which of its retail whether to apply the double default
(2) If the acquiring [bank] is not subject to exposures are eligible margin loans for which treatment or to use the PD substitution or
the advanced approaches in this appendix at the [bank] uses this EAD approach and must LGD adjustment treatment without
the time of acquisition or merger, during the segment such eligible margin loans recognizing double default effects.
period when [the general risk-based capital separately from other retail exposures. (ii) A [bank] may take into account the risk
rules] apply to the acquiring [bank], the (3) Eligible purchased wholesale reducing effects of guarantees and credit
ALLL associated with the exposures of the exposures. A [bank] may group its eligible derivatives in support of retail exposures in
merged or acquired company may not be purchased wholesale exposures into a segment when quantifying the PD and LGD
directly included in tier 2 capital. Rather, any segments that have homogeneous risk of the segment.
excess eligible credit reserves associated with characteristics. A [bank] must use the (iii) Except as provided in paragraph (d)(6)
the merged or acquired company’s exposures wholesale exposure formula in Table 2 in of this section, a [bank] may take into
may be included in the [bank]’s tier 2 capital this section to determine the risk-based account the risk reducing effects of collateral
up to 0.6 percent of the credit-risk-weighted capital requirement for each segment of in support of a wholesale exposure when
assets associated with those exposures. eligible purchased wholesale exposures. quantifying the LGD of the exposure and may
take into account the risk reducing effects of (B) Derivative contracts and repo-style with the obligor in the event of credit
collateral in support of retail exposures when transactions that are outstanding with a deterioration of the obligor.
quantifying the PD and LGD of the segment. qualifying central counterparty (but not for (e) Phase 4—Calculation of risk-weighted
(6) EAD for OTC derivative contracts, repo- those transactions that a qualifying central assets—(1) Non-defaulted exposures. (i) A
style transactions, and eligible margin loans. counterparty has rejected); and [bank] must calculate the dollar risk-based
(i) A [bank] must calculate its EAD for an (C) Credit risk exposures to a qualifying capital requirement for each of its wholesale
OTC derivative contract as provided in central counterparty in the form of clearing exposures to a non-defaulted obligor (except
paragraphs (c) and (d) of section 32 of this deposits and posted collateral that arise from eligible guarantees and eligible credit
appendix. A [bank] may take into account the transactions described in paragraph derivatives that hedge another wholesale
risk-reducing effects of financial collateral in (d)(6)(ii)(B) of this section.
exposure and exposures to which the [bank]
support of a repo-style transaction or eligible (7) Effective maturity. An exposure’s M
applies the double default treatment in
margin loan and of any collateral in support must be no greater than five years and no less
section 34 of this appendix) and segments of
of a repo-style transaction that is included in than one year, except that an exposure’s M
the [bank]’s VaR-based measure under [the must be no less than one day if the exposure non-defaulted retail exposures by inserting
market risk rule] through an adjustment to has an original maturity of less than one year the assigned risk parameters for the
EAD as provided in paragraphs (b) and (d) of and is not part of a [bank]’s ongoing wholesale obligor and exposure or retail
section 32 of this appendix. A [bank] that financing of the obligor. An exposure is not segment into the appropriate risk-based
takes collateral into account through such an part of a [bank]’s ongoing financing of the capital formula specified in Table 2 and
adjustment to EAD under section 32 of this obligor if the [bank]: multiplying the output of the formula (K) by
appendix may not reflect such collateral in (i) Has a legal and practical ability not to the EAD of the exposure or segment.
LGD. renew or roll over the exposure in the event Alternatively, a [bank] may apply a 300
(ii) A [bank] may attribute an EAD of zero of credit deterioration of the obligor; percent risk weight to the EAD of an eligible
to: (ii) Makes an independent credit decision margin loan if the [bank] is not able to meet
(A) Derivative contracts that are publicly at the inception of the exposure and at every the agencies’’ requirements for estimation of
traded on an exchange that requires the daily renewal or roll over; and PD and LGD for the margin loan.
receipt and payment of cash-variation (iii) Has no substantial commercial BILLING CODE 4810–33–P; 6210–01–P; 6714–01–P;
margin; incentive to continue its credit relationship 6720–01–P
BILLING CODE 4810–33–C; 6210–01–C; 6714–01–C; dollar risk-based capital requirement exposure to a defaulted obligor calculated in
6720–01–C
calculated in paragraph (e)(1)(ii) of this paragraph (e)(2)(i) of this section plus the
(ii) The sum of all the dollar risk-based section multiplied by 12.5. dollar risk-based capital requirements for
capital requirements for each wholesale (2) Wholesale exposures to defaulted each segment of defaulted retail exposures
exposure to a non-defaulted obligor and obligors and segments of defaulted retail calculated in paragraph (e)(2)(ii) of this
segment of non-defaulted retail exposures exposures. (i) The dollar risk-based capital
calculated in paragraph (e)(1)(i) of this section equals the total dollar risk-based
requirement for each wholesale exposure to
section and in paragraph (e) of section 34 of capital requirement for those exposures and
a defaulted obligor equals 0.08 multiplied by
this appendix equals the total dollar risk- the EAD of the exposure. segments.
based capital requirement for those (ii) The dollar risk-based capital (iv) The aggregate risk-weighted asset
exposures and segments. requirement for a segment of defaulted retail amount for wholesale exposures to defaulted
(iii) The aggregate risk-weighted asset exposures equals 0.08 multiplied by the EAD obligors and segments of defaulted retail
amount for wholesale exposures to non- of the segment. exposures equals the total dollar risk-based
defaulted obligors and segments of non- (iii) The sum of all the dollar risk-based capital requirement calculated in paragraph
ER07DE07.005</GPH>
defaulted retail exposures equals the total capital requirements for each wholesale (e)(2)(iii) of this section multiplied by 12.5.
(3) Assets not included in a defined methodology, the simple VaR methodology, (A) SE equals the value of the exposure (the
exposure category. (i) A [bank] may assign a is available for single product netting sets of sum of the current market values of all
risk-weighted asset amount of zero to cash repo-style transactions and eligible margin instruments, gold, and cash the [bank] has
owned and held in all offices of the [bank] loans. lent, sold subject to repurchase, or posted as
or in transit and for gold bullion held in the (2) This section also describes the collateral to the counterparty under the
[bank]’s own vaults, or held in another methodology for calculating EAD for an OTC transaction (or netting set));
[bank]’s vaults on an allocated basis, to the derivative contract or a set of OTC derivative (B) SC equals the value of the collateral
extent the gold bullion assets are offset by contracts subject to a qualifying master (the sum of the current market values of all
gold bullion liabilities. netting agreement. A [bank] also may use the instruments, gold, and cash the [bank] has
(ii) The risk-weighted asset amount for the internal models methodology to estimate borrowed, purchased subject to resale, or
residual value of a retail lease exposure EAD for qualifying cross-product master taken as collateral from the counterparty
equals such residual value. netting agreements. under the transaction (or netting set));
(iii) The risk-weighted asset amount for (3) A [bank] may only use the standard (C) Es equals the absolute value of the net
any other on-balance-sheet asset that does supervisory haircut approach with a position in a given instrument or in gold
not meet the definition of a wholesale, retail, minimum 10-business-day holding period to (where the net position in a given instrument
securitization, or equity exposure equals the recognize in EAD the benefits of conforming or in gold equals the sum of the current
carrying value of the asset. residential mortgage collateral that secures market values of the instrument or gold the
(4) Non-material portfolios of exposures. repo-style transactions (other than repo-style
[bank] has lent, sold subject to repurchase, or
The risk-weighted asset amount of a portfolio transactions included in the [bank]’s VaR-
posted as collateral to the counterparty
of exposures for which the [bank] has based measure under [the market risk rule]),
minus the sum of the current market values
demonstrated to the [AGENCY]’s satisfaction eligible margin loans, and OTC derivative
of that same instrument or gold the [bank]
that the portfolio (when combined with all contracts.
has borrowed, purchased subject to resale, or
other portfolios of exposures that the [bank] (4) A [bank] may use any combination of
seeks to treat under this paragraph) is not the three methodologies for collateral taken as collateral from the counterparty);
material to the [bank] is the sum of the recognition; however, it must use the same (D) Hs equals the market price volatility
carrying values of on-balance sheet exposures methodology for similar exposures. haircut appropriate to the instrument or gold
plus the notional amounts of off-balance (b) EAD for eligible margin loans and repo- referenced in Es;
sheet exposures in the portfolio. For style transactions—(1) General. A [bank] may (E) Efx equals the absolute value of the net
purposes of this paragraph (e)(4), the notional recognize the credit risk mitigation benefits position of instruments and cash in a
amount of an OTC derivative contract that is of financial collateral that secures an eligible currency that is different from the settlement
not a credit derivative is the EAD of the margin loan, repo-style transaction, or single- currency (where the net position in a given
derivative as calculated in section 32 of this product netting set of such transactions by currency equals the sum of the current
appendix. factoring the collateral into its LGD estimates market values of any instruments or cash in
for the exposure. Alternatively, a [bank] may the currency the [bank] has lent, sold subject
Section 32. Counterparty Credit Risk of Repo- estimate an unsecured LGD for the exposure, to repurchase, or posted as collateral to the
Style Transactions, Eligible Margin Loans, as well as for any repo-style transaction that counterparty minus the sum of the current
and OTC Derivative Contracts is included in the [bank]’s VaR-based market values of any instruments or cash in
(a) In General. (1) This section describes measure under [the market risk rule], and the currency the [bank] has borrowed,
two methodologies—a collateral haircut determine the EAD of the exposure using: purchased subject to resale, or taken as
approach and an internal models (i) The collateral haircut approach collateral from the counterparty); and
methodology—that a [bank] may use instead described in paragraph (b)(2) of this section; (F) Hfx equals the haircut appropriate to
of an LGD estimation methodology to (ii) For netting sets only, the simple VaR the mismatch between the currency
recognize the benefits of financial collateral methodology described in paragraph (b)(3) of referenced in Efx and the settlement
in mitigating the counterparty credit risk of this section; or currency.
repo-style transactions, eligible margin loans, (iii) The internal models methodology (ii) Standard supervisory haircuts. (A)
collateralized OTC derivative contracts, and described in paragraph (d) of this section. Under the standard supervisory haircuts
single product netting sets of such (2) Collateral haircut approach—(i) EAD approach:
transactions and to recognize the benefits of equation. A [bank] may determine EAD for (1) A [bank] must use the haircuts for
any collateral in mitigating the counterparty an eligible margin loan, repo-style market price volatility (Hs) in Table 3, as
credit risk of repo-style transactions that are transaction, or netting set by setting EAD adjusted in certain circumstances as
included in a [bank]’s VaR-based measure equal to max {0, [(SE¥SC) + S(Es × Hs) + provided in paragraph (b)(2)(ii)(A)(3) and (4)
under [the market risk rule]. A third S(Efx × Hfx)]}, where: of this section;
TABLE 3.—STANDARD SUPERVISORY MARKET PRICE VOLATILITY HAIRCUTS 1

Issuers exempt
Residual maturity for debt
Applicable external rating grade category for debt securities from the 3 basis Other issuers
securities point floor
Two highest investment-grade rating categories for long-term ratings/high- ≤ 1 year ............................ 0.005 0.01
est investment-grade rating category for short-term ratings. >1 year, ≤ 5 years ............ 0.02 0.04
> 5 years .......................... 0.04 0.08
Two lowest investment-grade rating categories for both short- and long- ≤ 1 year ............................ 0.01 0.02
term ratings. > 1 year, ≤ 5 years ........... 0.03 0.06
> 5 years .......................... 0.06 0.12
One rating category below investment grade .............................................. All ...................................... 0.15 0.25
Main index equities (including convertible bonds) and gold ....................................................................... 0.15
Other publicly traded equities (including convertible bonds), conforming residential mortgages, and 0.25
nonfinancial collateral.
TABLE 3.—STANDARD SUPERVISORY MARKET PRICE VOLATILITY HAIRCUTS 1—Continued

Issuers exempt
Residual maturity for debt
Applicable external rating grade category for debt securities from the 3 basis Other issuers
securities point floor
Mutual funds ................................................................................................................................................ Highest haircut applicable to any

security in which the fund can invest.
Cash on deposit with the [bank] (including a certificate of deposit issued by the [bank]) ......................... 0
1 The market price volatility haircuts in Table 3 are based on a ten-business-day holding period.
(2) For currency mismatches, a [bank] must haircuts for categories of securities. For a of the 99th percentile, one-tailed confidence
use a haircut for foreign exchange rate category of securities, the [bank] must interval for an increase in the value of (SE—
volatility (Hfx) of 8 percent, as adjusted in calculate the haircut on the basis of internal SC) over a five-business-day holding period
certain circumstances as provided in volatility estimates for securities in that for repo-style transactions or over a ten-
paragraph (b)(2)(ii)(A)(3) and (4) of this category that are representative of the business-day holding period for eligible
section. securities in that category that the [bank] has margin loans using a minimum one-year
(3) For repo-style transactions, a [bank] lent, sold subject to repurchase, posted as historical observation period of price
may multiply the supervisory haircuts collateral, borrowed, purchased subject to data representing the instruments that the
provided in paragraphs (b)(2)(ii)(A)(1) and (2) resale, or taken as collateral. In determining [bank] has lent, sold subject to
of this section by the square root of 1⁄2 (which relevant categories, the [bank] must at a repurchase, posted as collateral,
equals 0.707107). minimum take into account: borrowed, purchased subject to resale, or
(4) A [bank] must adjust the supervisory (1) The type of issuer of the security; taken as collateral. The [bank] must
haircuts upward on the basis of a holding (2) The applicable external rating of the validate its VaR model, including by
period longer than ten business days (for security; establishing and maintaining a rigorous and
eligible margin loans) or five business days (3) The maturity of the security; and regular back-testing regime.
(for repo-style transactions) where and as (4) The interest rate sensitivity of the (c) EAD for OTC derivative contracts. (1) A
appropriate to take into account the security. [bank] must determine the EAD for an OTC
illiquidity of an instrument. (C) With respect to debt securities that derivative contract that is not subject to a
(iii) Own internal estimates for haircuts. have an applicable external rating of below qualifying master netting agreement using the
With the prior written approval of the investment grade and equity securities, a current exposure methodology in paragraph
[AGENCY], a [bank] may calculate haircuts [bank] must calculate a separate haircut for (c)(5) of this section or using the internal
(Hs and Hfx) using its own internal estimates each individual security. models methodology described in paragraph
of the volatilities of market prices and foreign (D) Where an exposure or collateral (d) of this section.
exchange rates. (whether in the form of cash or securities) is (2) A [bank] must determine the EAD for
(A) To receive [AGENCY] approval to use denominated in a currency that differs from multiple OTC derivative contracts that are
its own internal estimates, a [bank] must the settlement currency, the [bank] must subject to a qualifying master netting
satisfy the following minimum quantitative calculate a separate currency mismatch agreement using the current exposure
standards: haircut for its net position in each methodology in paragraph (c)(6) of this
(1) A [bank] must use a 99th percentile mismatched currency based on estimated section or using the internal models
one-tailed confidence interval. volatilities of foreign exchange rates between methodology described in paragraph (d) of
(2) The minimum holding period for a the mismatched currency and the settlement this section.
repo-style transaction is five business days currency. (3) Counterparty credit risk for credit
and for an eligible margin loan is ten (E) A [bank]’s own estimates of market derivatives. Notwithstanding the above, (i) A
business days. When a [bank] calculates an price and foreign exchange rate volatilities [bank] that purchases a credit derivative that
own-estimates haircut on a TN-day holding may not take into account the correlations is recognized under section 33 or 34 of this
period, which is different from the minimum among securities and foreign exchange rates appendix as a credit risk mitigant for an
holding period for the transaction type, the on either the exposure or collateral side of a exposure that is not a covered position under
applicable haircut (HM) is calculated using transaction (or netting set) or the correlations [the market risk rule] need not compute a
the following square root of time formula: among securities and foreign exchange rates separate counterparty credit risk capital
between the exposure and collateral sides of requirement under this section so long as the
the transaction (or netting set). [bank] does so consistently for all such credit
TM
HM = HN , where (3) Simple VaR methodology. With the derivatives and either includes all or
TN prior written approval of the [AGENCY], a excludes all such credit derivatives that are
[bank] may estimate EAD for a netting set subject to a master netting agreement from
(i) TM equals 5 for repo-style transactions and using a VaR model that meets the any measure used to determine counterparty
10 for eligible margin loans; requirements in paragraph (b)(3)(iii) of this credit risk exposure to all relevant
(ii) TN equals the holding period used by the section. In such event, the [bank] must set counterparties for risk-based capital
[bank] to derive HN; and EAD equal to max {0, [(SE—SC) + PFE]}, purposes.
(iii) HN equals the haircut based on the where: (ii) A [bank] that is the protection provider
holding period TN. (i) SE equals the value of the exposure (the in a credit derivative must treat the credit
(3) A [bank] must adjust holding periods sum of the current market values of all derivative as a wholesale exposure to the
upwards where and as appropriate to take instruments, gold, and cash the [bank] has reference obligor and need not compute a
into account the illiquidity of an instrument. lent, sold subject to repurchase, or posted as counterparty credit risk capital requirement
(4) The historical observation period must collateral to the counterparty under the for the credit derivative under this section, so
be at least one year. netting set); long as it does so consistently for all such
(5) A [bank] must update its data sets and (ii) SC equals the value of the collateral credit derivatives and either includes all or
recompute haircuts no less frequently than (the sum of the current market values of all excludes all such credit derivatives that are
quarterly and must also reassess data sets and instruments, gold, and cash the [bank] has subject to a master netting agreement from
haircuts whenever market prices change borrowed, purchased subject to resale, or any measure used to determine counterparty
materially. taken as collateral from the counterparty credit risk exposure to all relevant
(B) With respect to debt securities that under the netting set); and counterparties for risk-based capital purposes
have an applicable external rating of (iii) PFE (potential future exposure) equals (unless the [bank] is treating the credit
ER07DE07.014</MATH>
investment grade, a [bank] may calculate the [bank]’s empirically based best estimate derivative as a covered position under [the
market risk rule], in which case the [bank] section, the EAD for a single OTC derivative which the notional principal amount is
must compute a supplemental counterparty contract that is not subject to a qualifying equivalent to the cash flows, notional
credit risk capital requirement under this master netting agreement is equal to the sum principal amount is the net receipts to each
section). of the [bank]’s current credit exposure and party falling due on each value date in each
(4) Counterparty credit risk for equity potential future credit exposure (PFE) on the currency. For any OTC derivative contract
derivatives. A [bank] must treat an equity derivative contract.
derivative contract as an equity exposure and (i) Current credit exposure. The current that does not fall within one of the specified
compute a risk-weighted asset amount for the credit exposure for a single OTC derivative categories in Table 4, the PFE must be
equity derivative contract under part VI contract is the greater of the mark-to-market calculated using the ‘‘other’’ conversion
(unless the [bank] is treating the contract as value of the derivative contract or zero. factors. A [bank] must use an OTC derivative
a covered position under [the market risk (ii) PFE. The PFE for a single OTC contract’s effective notional principal amount
rule]). In addition, if the [bank] is treating the derivative contract, including an OTC (that is, its apparent or stated notional
contract as a covered position under [the derivative contract with a negative mark-to- principal amount multiplied by any
market risk rule] and in certain other cases market value, is calculated by multiplying multiplier in the OTC derivative contract)
described in section 55 of this appendix, the the notional principal amount of the
rather than its apparent or stated notional
[bank] must also calculate a risk-based derivative contract by the appropriate
capital requirement for the counterparty conversion factor in Table 4. For purposes of principal amount in calculating PFE. PFE of
credit risk of an equity derivative contract calculating either the PFE under this the protection provider of a credit derivative
under this part. paragraph or the gross PFE under paragraph is capped at the net present value of the
(5) Single OTC derivative contract. Except (c)(6) of this section for exchange rate amount of unpaid premiums.
as modified by paragraph (c)(7) of this contracts and other similar contracts in
TABLE 4.—CONVERSION FACTOR MATRIX FOR OTC DERIVATIVE CONTRACTS 1

Credit (invest- Credit (non-in-
Foreign ex- Precious met-
ment-grade vestment-
Remaining maturity 2 Interest rate change rate Equity als (except Other
reference obli- grade ref-
and gold gold)
gor)3 erence obligor)
One year or less ...... 0.00 0.01 0.05 0.10 0.06 0.07 0.10
Over one to five
years ..................... 0.005 0.05 0.05 0.10 0.08 0.07 0.12
Over five years ......... 0.015 0.075 0.05 0.10 0.10 0.08 0.15
1 For an OTC derivative contract with multiple exchanges of principal, the conversion factor is multiplied by the number of remaining payments
in the derivative contract.
2 For an OTC derivative contract that is structured such that on specified dates any outstanding exposure is settled and the terms are reset so
that the market value of the contract is zero, the remaining maturity equals the time until the next reset date. For an interest rate derivative con-
tract with a remaining maturity of greater than one year that meets these criteria, the minimum conversion factor is 0.005.
3 A [bank] must use the column labeled ‘‘Credit (investment-grade reference obligor)’’ for a credit derivative whose reference obligor has an
outstanding unsecured long-term debt security without credit enhancement that has a long-term applicable external rating of at least investment
grade. A [bank] must use the column labeled ‘‘Credit (non-investment-grade reference obligor)’’ for all other credit derivatives.
(6) Multiple OTC derivative contracts (7) Collateralized OTC derivative contracts. internal models methodology for a particular
subject to a qualifying master netting A [bank] may recognize the credit risk transaction type (OTC derivative contracts,
agreement. Except as modified by paragraph mitigation benefits of financial collateral that eligible margin loans, or repo-style
(c)(7) of this section, the EAD for multiple secures an OTC derivative contract or single- transactions) must use the internal models
OTC derivative contracts subject to a product netting set of OTC derivatives by methodology for all transactions of that
qualifying master netting agreement is equal factoring the collateral into its LGD estimates transaction type. A [bank] may choose to use
to the sum of the net current credit exposure for the contract or netting set. Alternatively, the internal models methodology for one or
and the adjusted sum of the PFE exposure for a [bank] may recognize the credit risk two of these three types of exposures and not
all OTC derivative contracts subject to the mitigation benefits of financial collateral that the other types. A [bank] may also use the
qualifying master netting agreement. secures such a contract or netting set that is internal models methodology for OTC
(i) Net current credit exposure. The net marked to market on a daily basis and subject derivative contracts, eligible margin loans,
current credit exposure is the greater of: to a daily margin maintenance requirement and repo-style transactions subject to a
(A) The net sum of all positive and by estimating an unsecured LGD for the qualifying cross-product netting agreement if:
negative mark-to-market values of the contract or netting set and adjusting the EAD (i) The [bank] effectively integrates the risk
individual OTC derivative contracts subject calculated under paragraph (c)(5) or (c)(6) of mitigating effects of cross-product netting
to the qualifying master netting agreement; or this section using the collateral haircut into its risk management and other
(B) zero. approach in paragraph (b)(2) of this section. information technology systems; and
(ii) Adjusted sum of the PFE. The adjusted The [bank] must substitute the EAD (ii) The [bank] obtains the prior written
sum of the PFE, Anet, is calculated as Anet calculated under paragraph (c)(5) or (c)(6) of approval of the [AGENCY]. A [bank] that uses
= (0.4×Agross)+(0.6×NGR×Agross), where: this section for SE in the equation in the internal models methodology for a
(A) Agross = the gross PFE (that is, the sum paragraph (b)(2)(i) of this section and must transaction type must receive approval from
of the PFE amounts (as determined under use a ten-business-day minimum holding the [AGENCY] to cease using the
paragraph (c)(5)(ii) of this section) for each period (TM = 10). methodology for that transaction type or to
individual OTC derivative contract subject to (d) Internal models methodology. (1) With make a material change to its internal model.
the qualifying master netting agreement); and prior written approval from the [AGENCY], a (2) Under the internal models
(B) NGR = the net to gross ratio (that is, the [bank] may use the internal models methodology, a [bank] uses an internal model
ratio of the net current credit exposure to the methodology in this paragraph (d) to to estimate the expected exposure (EE) for a
gross current credit exposure). In calculating determine EAD for counterparty credit risk netting set and then calculates EAD based on
the NGR, the gross current credit exposure for OTC derivative contracts (collateralized that EE.
equals the sum of the positive current credit or uncollateralized) and single-product (i) The [bank] must use its internal model’s
exposures (as determined under paragraph netting sets thereof, for eligible margin loans probability distribution for changes in the
(c)(5)(i) of this section) of all individual OTC and single-product netting sets thereof, and market value of a netting set that are
derivative contracts subject to the qualifying for repo-style transactions and single-product attributable to changes in market variables to
master netting agreement. netting sets thereof. A [bank] that uses the determine EE.
(ii) Under the internal models the [bank] may take the reduction in collateral held, where appropriate. The
methodology, EAD = a x effective EPE, or, exposure to the counterparty into account [bank] must estimate expected exposures for
subject to [AGENCY] approval as provided in when estimating EE. If the [bank] recognizes OTC derivative contracts both with and
paragraph (d)(7), a more conservative this reduction in exposure to the without the effect of collateral agreements.
measure of EAD. counterparty in its estimate of EE, it must (vi) The [bank] must have procedures to
also use its internal model to estimate a identify, monitor, and control specific wrong-
n separate EAD for the [bank]’s exposure to the way risk throughout the life of an exposure.
(A) EffectiveEPE t k = ∑ EffectiveEE t k × ∆t k protection provider of the credit derivative. Wrong-way risk in this context is the risk that
k =1 (3) To obtain [AGENCY] approval to future exposure to a counterparty will be
(that is, effective EPE is the time-weighted calculate the distributions of exposures upon high when the counterparty’s probability of
average of effective EE where the weights are which the EAD calculation is based, the default is also high.
the proportion that an individual effective EE [bank] must demonstrate to the satisfaction of (vii) The model must use current market
the [AGENCY] that it has been using for at data to compute current exposures. When
represents in a one-year time interval) where:
least one year an internal model that broadly
(1) Effective EEtk = max (Effective EEtk−1, estimating model parameters based on
meets the following minimum standards,
EEtk) (that is, for a specific datetk, effective EE historical data, at least three years of
with which the [bank] must maintain
is the greater of EE at that date or the compliance: historical data that cover a wide range of
effective EE at the previous date); and (i) The model must have the systems economic conditions must be used and must
(2) tk represents the kth future time period capability to estimate the expected exposure be updated quarterly or more frequently if
in the model and there are n time periods to the counterparty on a daily basis (but is market conditions warrant. The [bank]
represented in the model over the first year; not expected to estimate or report expected should consider using model parameters
and exposure on a daily basis). based on forward-looking measures, where
(B) a = 1.4 except as provided in paragraph (ii) The model must estimate expected appropriate.
(d)(6), or when the [AGENCY] has exposure at enough future dates to reflect (viii) A [bank] must subject its internal
determined that the [bank] must set a higher accurately all the future cash flows of model to an initial validation and annual
based on the [bank]’s specific characteristics contracts in the netting set. model review process. The model review
of counterparty credit risk. (iii) The model must account for the should consider whether the inputs and risk
(iii) A [bank] may include financial possible non-normality of the exposure factors, as well as the model outputs, are
collateral currently posted by the distribution, where appropriate. appropriate.
counterparty as collateral (but may not (iv) The [bank] must measure, monitor, and (4) Maturity. (i) If the remaining maturity
include other forms of collateral) when control current counterparty exposure and of the exposure or the longest-dated contract
calculating EE. the exposure to the counterparty over the in the netting set is greater than one year, the
(iv) If a [bank] hedges some or all of the whole life of all contracts in the netting set. [bank] must set M for the exposure or netting
counterparty credit risk associated with a (v) The [bank] must be able to measure and set equal to the lower of five years or
netting set using an eligible credit derivative, manage current exposures gross and net of M(EPE),3 where:
(B) dfk is the risk-free discount factor for the counterparty under the agreement. This applicable, the period of time required to re-
future time period tk; and security interest must provide the [bank] hedge the resulting market risk, upon the
(C) Dtk = tk¥tk¥1. with a right to close out the financial default of the counterparty. The minimum
(ii) If the remaining maturity of the positions and liquidate the collateral upon an margin period of risk is five business days for
exposure or the longest-dated contract in the event of default of, or failure to perform by, repo-style transactions and ten business days
netting set is one year or less, the [bank] must the counterparty under the collateral for other transactions when liquid financial
set M for the exposure or netting set equal agreement. A contract would not satisfy this collateral is posted under a daily margin
to one year, except as provided in paragraph requirement if the [bank]’s exercise of rights maintenance requirement. This period
(d)(7) of section 31 of this appendix. under the agreement may be stayed or should be extended to cover any additional
(5) Collateral agreements. A [bank] may avoided under applicable law in the relevant time between margin calls; any potential
capture the effect on EAD of a collateral jurisdictions. Two methods are available to closeout difficulties; any delays in selling
agreement that requires receipt of collateral capture the effect of a collateral agreement: collateral, particularly if the collateral is
when exposure to the counterparty increases (i) With prior written approval from the illiquid; and any impediments to prompt re-
but may not capture the effect on EAD of a [AGENCY], a [bank] may include the effect of hedging of any market risk.
collateral agreement that requires receipt of a collateral agreement within its internal (ii) A [bank] that can model EPE without
collateral when counterparty credit quality model used to calculate EAD. The [bank] may collateral agreements but cannot achieve the
deteriorates. For this purpose, a collateral set EAD equal to the expected exposure at the higher level of modeling sophistication to
agreement means a legal contract that end of the margin period of risk. The margin model EPE with collateral agreements can set
specifies the time when, and circumstances period of risk means, with respect to a effective EPE for a collateralized netting set
under which, the counterparty is required to netting set subject to a collateral agreement, equal to the lesser of:
pledge collateral to the [bank] for a single the time period from the most recent (A) The threshold, defined as the exposure
financial contract or for all financial exchange of collateral with a counterparty amount at which the counterparty is required
contracts in a netting set and confers upon until the next required exchange of collateral to post collateral under the collateral
the [bank] a perfected, first priority security plus the period of time required to sell and agreement, if the threshold is positive, plus
ER07DE07.015</GPH>
interest (notwithstanding the prior security realize the proceeds of the least liquid an add-on that reflects the potential increase
interest of any custodial agent), or the legal collateral that can be delivered under the in exposure of the netting set over the margin
equivalent thereof, in the collateral posted by terms of the collateral agreement and, where period of risk. The add-on is computed as the
3 Alternatively, a [bank] that uses an internal adjustment may use the effective credit duration estimated by the model as M(EPE) in place of the
ER07DE07.026</MATH>
model to calculate a one-sided credit valuation formula in paragraph (d)(4).
expected increase in the netting set’s that the current exposure methodology in entity, and legally enforceable cross-default
exposure beginning from current exposure of paragraphs (c)(5) and (c)(6) of this section or cross-acceleration clauses are in place to
zero over the margin period of risk. The meets the conservatism requirement of this assure payments under the credit derivative
margin period of risk must be at least five paragraph. are triggered when the obligor fails to pay
business days for netting sets consisting only under the terms of the hedged exposure.
of repo-style transactions subject to daily re- Section 33. Guarantees and Credit (c) Risk parameters for hedged exposures—
margining and daily marking-to-market, and Derivatives: PD Substitution and LGD (1) PD substitution approach—(i) Full
ten business days for all other netting sets; Adjustment Approaches coverage. If an eligible guarantee or eligible
or (a) Scope. (1) This section applies to credit derivative meets the conditions in
(B) Effective EPE without a collateral wholesale exposures for which: paragraphs (a) and (b) of this section and the
agreement. (i) Credit risk is fully covered by an eligible protection amount (P) of the guarantee or
(6) Own estimate of alpha. With prior guarantee or eligible credit derivative; or credit derivative is greater than or equal to
written approval of the [AGENCY], a [bank] (ii) Credit risk is covered on a pro rata basis the EAD of the hedged exposure, a [bank]
may calculate alpha as the ratio of economic (that is, on a basis in which the [bank] and may recognize the guarantee or credit
capital from a full simulation of counterparty the protection provider share losses derivative in determining the [bank]’s risk-
exposure across counterparties that proportionately) by an eligible guarantee or based capital requirement for the hedged
incorporates a joint simulation of market and eligible credit derivative. exposure by substituting the PD associated
credit risk factors (numerator) and economic (2) Wholesale exposures on which there is with the rating grade of the protection
capital based on EPE (denominator), subject a tranching of credit risk (reflecting at least provider for the PD associated with the rating
to a floor of 1.2. For purposes of this two different levels of seniority) are grade of the obligor in the risk-based capital
calculation, economic capital is the securitization exposures subject to the formula applicable to the guarantee or credit
unexpected losses for all counterparty credit securitization framework in part V. derivative in Table 2 and using the
risks measured at a 99.9 percent confidence (3) A [bank] may elect to recognize the appropriate LGD as described in paragraph
level over a one-year horizon. To receive credit risk mitigation benefits of an eligible (c)(1)(iii) of this section. If the [bank]
approval, the [bank] must meet the following guarantee or eligible credit derivative determines that full substitution of the
minimum standards to the satisfaction of the covering an exposure described in paragraph protection provider’s PD leads to an
[AGENCY]: (a)(1) of this section by using the PD inappropriate degree of risk mitigation, the
(i) The [bank]’s own estimate of alpha must substitution approach or the LGD adjustment [bank] may substitute a higher PD than that
capture in the numerator the effects of: approach in paragraph (c) of this section or, of the protection provider.
(A) The material sources of stochastic if the transaction qualifies, using the double (ii) Partial coverage. If an eligible guarantee
dependency of distributions of market values default treatment in section 34 of this or eligible credit derivative meets the
of transactions or portfolios of transactions appendix. A [bank]’s PD and LGD for the conditions in paragraphs (a) and (b) of this
across counterparties; hedged exposure may not be lower than the section and the protection amount (P) of the
(B) Volatilities and correlations of market PD and LGD floors described in paragraphs guarantee or credit derivative is less than the
risk factors used in the joint simulation, (d)(2) and (d)(3) of section 31 of this EAD of the hedged exposure, the [bank] must
which must be related to the credit risk factor appendix. treat the hedged exposure as two separate
used in the simulation to reflect potential (4) If multiple eligible guarantees or exposures (protected and unprotected) in
increases in volatility or correlation in an eligible credit derivatives cover a single order to recognize the credit risk mitigation
economic downturn, where appropriate; and exposure described in paragraph (a)(1) of this benefit of the guarantee or credit derivative.
(C) The granularity of exposures (that is, section, a [bank] may treat the hedged (A) The [bank] must calculate its risk-based
the effect of a concentration in the proportion exposure as multiple separate exposures each capital requirement for the protected
of each counterparty’s exposure that is driven covered by a single eligible guarantee or exposure under section 31 of this appendix,
by a particular risk factor). eligible credit derivative and may calculate a where PD is the protection provider’s PD,
(ii) The [bank] must assess the potential separate risk-based capital requirement for LGD is determined under paragraph (c)(1)(iii)
model uncertainty in its estimates of alpha. each separate exposure as described in of this section, and EAD is P. If the [bank]
(iii) The [bank] must calculate the paragraph (a)(3) of this section. determines that full substitution leads to an
numerator and denominator of alpha in a (5) If a single eligible guarantee or eligible inappropriate degree of risk mitigation, the
consistent fashion with respect to modeling credit derivative covers multiple hedged [bank] may use a higher PD than that of the
methodology, parameter specifications, and wholesale exposures described in paragraph protection provider.
portfolio composition. (a)(1) of this section, a [bank] must treat each (B) The [bank] must calculate its risk-based
(iv) The [bank] must review and adjust as hedged exposure as covered by a separate capital requirement for the unprotected
appropriate its estimates of the numerator eligible guarantee or eligible credit derivative exposure under section 31 of this appendix,
and denominator of alpha on at least a and must calculate a separate risk-based where PD is the obligor’s PD, LGD is the
quarterly basis and more frequently when the capital requirement for each exposure as hedged exposure’s LGD (not adjusted to
composition of the portfolio varies over time. described in paragraph (a)(3) of this section. reflect the guarantee or credit derivative), and
(7) Other measures of counterparty (6) A [bank] must use the same risk EAD is the EAD of the original hedged
exposure. With prior written approval of the parameters for calculating ECL as it uses for exposure minus P.
[AGENCY], a [bank] may set EAD equal to a calculating the risk-based capital requirement (C) The treatment in this paragraph
measure of counterparty credit risk exposure, for the exposure. (c)(1)(ii) is applicable when the credit risk of
such as peak EAD, that is more conservative (b) Rules of recognition. (1) A [bank] may a wholesale exposure is covered on a partial
than an alpha of 1.4 (or higher under the only recognize the credit risk mitigation pro rata basis or when an adjustment is made
terms of paragraph (d)(2)(ii)(B) of this benefits of eligible guarantees and eligible to the effective notional amount of the
section) times EPE for every counterparty credit derivatives. guarantee or credit derivative under
whose EAD will be measured under the (2) A [bank] may only recognize the credit paragraph (d), (e), or (f) of this section.
alternative measure of counterparty risk mitigation benefits of an eligible credit (iii) LGD of hedged exposures. The LGD of
exposure. The [bank] must demonstrate the derivative to hedge an exposure that is a hedged exposure under the PD substitution
conservatism of the measure of counterparty different from the credit derivative’s approach is equal to:
credit risk exposure used for EAD. For reference exposure used for determining the (A) The lower of the LGD of the hedged
material portfolios of new OTC derivative derivative’s cash settlement value, exposure (not adjusted to reflect the
products, the [bank] may assume that the deliverable obligation, or occurrence of a guarantee or credit derivative) and the LGD
current exposure methodology in paragraphs credit event if: of the guarantee or credit derivative, if the
(c)(5) and (c)(6) of this section meets the (i) The reference exposure ranks pari passu guarantee or credit derivative provides the
conservatism requirement of this paragraph (that is, equally) with or is junior to the [bank] with the option to receive immediate
for a period not to exceed 180 days. For hedged exposure; and payout upon triggering the protection; or
immaterial portfolios of OTC derivative (ii) The reference exposure and the hedged (B) The LGD of the guarantee or credit
contracts, the [bank] generally may assume exposure are exposures to the same legal derivative, if the guarantee or credit
derivative does not provide the [bank] with reduce its term, the [bank] (protection (iii) HFX = haircut appropriate for the
the option to receive immediate payout upon purchaser) must use the shortest possible currency mismatch between the credit risk
triggering the protection. residual maturity for the credit risk mitigant. mitigant and the hedged exposure.
(2) LGD adjustment approach—(i) Full If a call is at the discretion of the protection (2) A [bank] must set HFX equal to 8
coverage. If an eligible guarantee or eligible provider, the residual maturity of the credit percent unless it qualifies for the use of and
credit derivative meets the conditions in risk mitigant is at the first call date. If the call uses its own internal estimates of foreign
paragraphs (a) and (b) of this section and the is at the discretion of the [bank] (protection exchange volatility based on a ten-business-
protection amount (P) of the guarantee or purchaser), but the terms of the arrangement day holding period and daily marking-to-
credit derivative is greater than or equal to at origination of the credit risk mitigant market and remargining. A [bank] qualifies
the EAD of the hedged exposure, the [bank]’s contain a positive incentive for the [bank] to for the use of its own internal estimates of
risk-based capital requirement for the hedged call the transaction before contractual foreign exchange volatility if it qualifies for:
exposure is the greater of: maturity, the remaining time to the first call (i) The own-estimates haircuts in
(A) The risk-based capital requirement for date is the residual maturity of the credit risk paragraph (b)(2)(iii) of section 32 of this
the exposure as calculated under section 31 mitigant. For example, where there is a step- appendix;
of this appendix, with the LGD of the up in cost in conjunction with a call feature (ii) The simple VaR methodology in
exposure adjusted to reflect the guarantee or or where the effective cost of protection paragraph (b)(3) of section 32 of this
credit derivative; or increases over time even if credit quality appendix; or
(B) The risk-based capital requirement for remains the same or improves, the residual (iii) The internal models methodology in
a direct exposure to the protection provider maturity of the credit risk mitigant will be paragraph (d) of section 32 of this appendix.
as calculated under section 31 of this the remaining time to the first call. (3) A [bank] must adjust HFX calculated in
appendix, using the PD for the protection (4) A credit risk mitigant with a maturity paragraph (f)(2) of this section upward if the
provider, the LGD for the guarantee or credit mismatch may be recognized only if its [bank] revalues the guarantee or credit
derivative, and an EAD equal to the EAD of original maturity is greater than or equal to derivative less frequently than once every ten
the hedged exposure. one year and its residual maturity is greater business days using the square root of time
(ii) Partial coverage. If an eligible guarantee than three months. formula provided in paragraph
or eligible credit derivative meets the (5) When a maturity mismatch exists, the (b)(2)(iii)(A)(2) of section 32 of this appendix.
conditions in paragraphs (a) and (b) of this [bank] must apply the following adjustment Section 34. Guarantees and Credit
section and the protection amount (P) of the to the effective notional amount of the credit Derivatives: Double Default Treatment
guarantee or credit derivative is less than the risk mitigant: Pm = E × (t – 0.25)/(T – 0.25),
(a) Eligibility and operational criteria for
EAD of the hedged exposure, the [bank] must where:
double default treatment. A [bank] may
treat the hedged exposure as two separate (i) Pm = effective notional amount of the
recognize the credit risk mitigation benefits
exposures (protected and unprotected) in credit risk mitigant, adjusted for maturity
of a guarantee or credit derivative covering
order to recognize the credit risk mitigation mismatch;
an exposure described in paragraph (a)(1) of
benefit of the guarantee or credit derivative. (ii) E = effective notional amount of the
section 33 of this appendix by applying the
(A) The [bank]’s risk-based capital credit risk mitigant;
double default treatment in this section if all
requirement for the protected exposure (iii) t = the lesser of T or the residual the following criteria are satisfied.
would be the greater of: maturity of the credit risk mitigant, expressed (1) The hedged exposure is fully covered
(1) The risk-based capital requirement for in years; and or covered on a pro rata basis by:
the protected exposure as calculated under (iv) T = the lesser of five or the residual (i) An eligible guarantee issued by an
section 31 of this appendix, with the LGD of maturity of the hedged exposure, expressed eligible double default guarantor; or
the exposure adjusted to reflect the guarantee in years. (ii) An eligible credit derivative that meets
or credit derivative and EAD set equal to P; (e) Credit derivatives without restructuring the requirements of paragraph (b)(2) of
or as a credit event. If a [bank] recognizes an section 33 of this appendix and is issued by
(2) The risk-based capital requirement for eligible credit derivative that does not an eligible double default guarantor.
a direct exposure to the guarantor as include as a credit event a restructuring of (2) The guarantee or credit derivative is:
calculated under section 31 of this appendix, the hedged exposure involving forgiveness or (i) An uncollateralized guarantee or
using the PD for the protection provider, the postponement of principal, interest, or fees uncollateralized credit derivative (for
LGD for the guarantee or credit derivative, that results in a credit loss event (that is, a example, a credit default swap) that provides
and an EAD set equal to P. charge-off, specific provision, or other similar protection with respect to a single reference
(B) The [bank] must calculate its risk-based debit to the profit and loss account), the obligor; or
capital requirement for the unprotected [bank] must apply the following adjustment (ii) An nth-to-default credit derivative
exposure under section 31 of this appendix, to the effective notional amount of the credit (subject to the requirements of paragraph (m)
where PD is the obligor’s PD, LGD is the derivative: Pr = Pm × 0.60, where: of section 42 of this appendix).
hedged exposure’s LGD (not adjusted to (1) Pr = effective notional amount of the (3) The hedged exposure is a wholesale
reflect the guarantee or credit derivative), and credit risk mitigant, adjusted for lack of exposure (other than a sovereign exposure).
EAD is the EAD of the original hedged restructuring event (and maturity mismatch, (4) The obligor of the hedged exposure is
exposure minus P. if applicable); and not:
(3) M of hedged exposures. The M of the (2) Pm = effective notional amount of the (i) An eligible double default guarantor or
hedged exposure is the same as the M of the credit risk mitigant adjusted for maturity an affiliate of an eligible double default
exposure if it were unhedged. mismatch (if applicable). guarantor; or
(d) Maturity mismatch. (1) A [bank] that (f) Currency mismatch. (1) If a [bank] (ii) An affiliate of the guarantor.
recognizes an eligible guarantee or eligible recognizes an eligible guarantee or eligible (5) The [bank] does not recognize any
credit derivative in determining its risk-based credit derivative that is denominated in a credit risk mitigation benefits of the
capital requirement for a hedged exposure currency different from that in which the guarantee or credit derivative for the hedged
must adjust the effective notional amount of hedged exposure is denominated, the [bank] exposure other than through application of
the credit risk mitigant to reflect any maturity must apply the following formula to the the double default treatment as provided in
mismatch between the hedged exposure and effective notional amount of the guarantee or this section.
the credit risk mitigant. credit derivative: Pc = Pr × (1 – HFX), where: (6) The [bank] has implemented a process
(2) A maturity mismatch occurs when the (i) Pc = effective notional amount of the (which has received the prior, written
residual maturity of a credit risk mitigant is credit risk mitigant, adjusted for currency approval of the [AGENCY]) to detect
less than that of the hedged exposure(s). mismatch (and maturity mismatch and lack excessive correlation between the
(3) The residual maturity of a hedged of restructuring event, if applicable); creditworthiness of the obligor of the hedged
exposure is the longest possible remaining (ii) Pr = effective notional amount of the exposure and the protection provider. If
time before the obligor is scheduled to fulfill credit risk mitigant (adjusted for maturity excessive correlation is present, the [bank]
its obligation on the exposure. If a credit risk mismatch and lack of restructuring event, if may not use the double default treatment for
mitigant has embedded options that may applicable); and the hedged exposure.
(b) Full coverage. If the transaction meets order to recognize double default treatment required in paragraphs (d), (e), and (f) of
the criteria in paragraph (a) of this section on the protected portion of the exposure. section 33 of this appendix.
and the protection amount (P) of the (1) For the protected exposure, the [bank] (e) The double default dollar risk-based
guarantee or credit derivative is at least equal must set EAD equal to P and calculate its capital requirement. The dollar risk-based
to the EAD of the hedged exposure, the risk-weighted asset amount as provided in capital requirement for a hedged exposure to
[bank] may determine its risk-weighted asset paragraph (e) of this section.
amount for the hedged exposure under (2) For the unprotected exposure, the which a [bank] has applied double default
paragraph (e) of this section. [bank] must set EAD equal to the EAD of the treatment is KDD multiplied by the EAD of
(c) Partial coverage. If the transaction original exposure minus P and then calculate the exposure. KDD is calculated according to
meets the criteria in paragraph (a) of this its risk-weighted asset amount as provided in the following formula: KDD = Ko × (0.15 + 160
section and the protection amount (P) of the section 31 of this appendix. × PDg),
guarantee or credit derivative is less than the (d) Mismatches. For any hedged exposure
EAD of the hedged exposure, the [bank] must to which a [bank] applies double default Where:
treat the hedged exposure as two separate treatment, the [bank] must make applicable (1)
exposures (protected and unprotected) in adjustments to the protection amount as
(2) PDg = PD of the protection provider. transaction is equal to or less than the market TABLE 5.—RISK WEIGHTS FOR UNSET-
(3) PDo = PD of the obligor of the hedged standard for the instrument underlying the TLED DVP AND PVP TRANSACTIONS
exposure. transaction and equal to or less than five
(4) LGDg = (i) The lower of the LGD of the business days.
hedged exposure (not adjusted to reflect Risk weight to be
(4) Positive current exposure. The positive Number of business
the guarantee or credit derivative) and applied to positive
current exposure of a [bank] for a transaction days after contractual current exposure
the LGD of the guarantee or credit settlement date
is the difference between the transaction (percent)
derivative, if the guarantee or credit
value at the agreed settlement price and the
derivative provides the [bank] with the From 5 to 15 ................. 100
option to receive immediate payout on current market price of the transaction, if the
difference results in a credit exposure of the From 16 to 30 ............... 625
triggering the protection; or
[bank] to the counterparty. From 31 to 45 ............... 937.5
(ii) The LGD of the guarantee or credit
(b) Scope. This section applies to all 46 or more .................... 1,250
derivative, if the guarantee or credit
derivative does not provide the [bank] transactions involving securities, foreign
with the option to receive immediate exchange instruments, and commodities that (e) Non-DvP/non-PvP (non-delivery-versus-
payout on triggering the protection. have a risk of delayed settlement or delivery. payment/non-payment-versus-payment)
(5) rOS (asset value correlation of the obligor) This section does not apply to: transactions. (1) A [bank] must hold risk-
is calculated according to the (1) Transactions accepted by a qualifying based capital against any non-DvP/non-PvP
appropriate formula for (R) provided in central counterparty that are subject to daily transaction with a normal settlement period
Table 2 in section 31 of this appendix, marking-to-market and daily receipt and if the [bank] has delivered cash, securities,
with PD equal to PDo. payment of variation margin; commodities, or currencies to its
(6) b (maturity adjustment coefficient) is (2) Repo-style transactions, including counterparty but has not received its
calculated according to the formula for b unsettled repo-style transactions (which are corresponding deliverables by the end of the
provided in Table 2 in section 31 of this same business day. The [bank] must continue
addressed in sections 31 and 32 of this
appendix, with PD equal to the lesser of to hold risk-based capital against the
PDo and PDg. appendix);
transaction until the [bank] has received its
(7) M (maturity) is the effective maturity of (3) One-way cash payments on OTC
corresponding deliverables.
the guarantee or credit derivative, which derivative contracts (which are addressed in
(2) From the business day after the [bank]
may not be less than one year or greater sections 31 and 32 of this appendix); or
has made its delivery until five business days
than five years. (4) Transactions with a contractual
after the counterparty delivery is due, the
settlement period that is longer than the [bank] must calculate its risk-based capital
Section 35. Risk-Based Capital Requirement normal settlement period (which are treated
for Unsettled Transactions requirement for the transaction by treating
as OTC derivative contracts and addressed in the current market value of the deliverables
(a) Definitions. For purposes of this sections 31 and 32 of this appendix). owed to the [bank] as a wholesale exposure.
section: (c) System-wide failures. In the case of a (i) A [bank] may assign an obligor rating to
(1) Delivery-versus-payment (DvP) system-wide failure of a settlement or
transaction means a securities or a counterparty for which it is not otherwise
clearing system, the [AGENCY] may waive required under this appendix to assign an
commodities transaction in which the buyer risk-based capital requirements for unsettled
is obligated to make payment only if the obligor rating on the basis of the applicable
and failed transactions until the situation is external rating of any outstanding unsecured
seller has made delivery of the securities or
rectified. long-term debt security without credit
commodities and the seller is obligated to
(d) Delivery-versus-payment (DvP) and enhancement issued by the counterparty.
deliver the securities or commodities only if
the buyer has made payment. payment-versus-payment (PvP) transactions. (ii) A [bank] may use a 45 percent LGD for
(2) Payment-versus-payment (PvP) A [bank] must hold risk-based capital against the transaction rather than estimating LGD
transaction means a foreign exchange any DvP or PvP transaction with a normal for the transaction provided the [bank] uses
transaction in which each counterparty is settlement period if the [bank]’s counterparty the 45 percent LGD for all transactions
obligated to make a final transfer of one or has not made delivery or payment within five described in paragraphs (e)(1) and (e)(2) of
more currencies only if the other business days after the settlement date. The this section.
counterparty has made a final transfer of one [bank] must determine its risk-weighted asset (iii) A [bank] may use a 100 percent risk
or more currencies. amount for such a transaction by multiplying weight for the transaction provided the
(3) Normal settlement period. A transaction the positive current exposure of the [bank] uses this risk weight for all
has a normal settlement period if the transaction for the [bank] by the appropriate transactions described in paragraphs (e)(1)
ER07DE07.016</GPH>
contractual settlement period for the risk weight in Table 5. and (e)(2) of this section.
(3) If the [bank] has not received its deterioration in the credit quality of the (c) Deductions. (1) If a [bank] must deduct
deliverables by the fifth business day after underlying exposures; or a securitization exposure from total capital,
the counterparty delivery was due, the [bank] (v) Provide for increases in a retained first the [bank] must take the deduction 50
must deduct the current market value of the loss position or credit enhancement provided percent from tier 1 capital and 50 percent
deliverables owed to the [bank] 50 percent by the [bank] after the inception of the from tier 2 capital. If the amount deductible
from tier 1 capital and 50 percent from tier securitization; from tier 2 capital exceeds the [bank]’s tier
2 capital. (3) The [bank] obtains a well-reasoned 2 capital, the [bank] must deduct the excess
(f) Total risk-weighted assets for unsettled opinion from legal counsel that confirms the from tier 1 capital.
transactions. Total risk-weighted assets for enforceability of the credit risk mitigant in all (2) A [bank] may calculate any deduction
unsettled transactions is the sum of the risk- relevant jurisdictions; and from tier 1 capital and tier 2 capital for a
weighted asset amounts of all DvP, PvP, and (4) Any clean-up calls relating to the securitization exposure net of any deferred
non-DvP/non-PvP transactions. securitization are eligible clean-up calls. tax liabilities associated with the
securitization exposure.
Part V. Risk-Weighted Assets for Section 42. Risk-Based Capital Requirement (d) Maximum risk-based capital
Securitization Exposures for Securitization Exposures requirement. Regardless of any other
(a) Hierarchy of approaches. Except as provisions of this part, unless one or more
Section 41. Operational Criteria for
provided elsewhere in this section: underlying exposures does not meet the
Recognizing the Transfer of Risk
(1) A [bank] must deduct from tier 1 capital definition of a wholesale, retail,
(a) Operational criteria for traditional any after-tax gain-on-sale resulting from a securitization, or equity exposure, the total
securitizations. A [bank] that transfers securitization and must deduct from total risk-based capital requirement for all
exposures it has originated or purchased to capital in accordance with paragraph (c) of securitization exposures held by a single
a securitization SPE or other third party in this section the portion of any CEIO that does [bank] associated with a single securitization
connection with a traditional securitization not constitute gain-on-sale. (including any risk-based capital
may exclude the exposures from the (2) If a securitization exposure does not requirements that relate to an early
calculation of its risk-weighted assets only if require deduction under paragraph (a)(1) of amortization provision of the securitization
each of the conditions in this paragraph (a) this section and qualifies for the Ratings- but excluding any risk-based capital
is satisfied. A [bank] that meets these Based Approach in section 43 of this requirements that relate to the [bank]’s gain-
conditions must hold risk-based capital appendix, a [bank] must apply the Ratings- on-sale or CEIOs associated with the
against any securitization exposures it retains Based Approach to the exposure. securitization) may not exceed the sum of:
in connection with the securitization. A (3) If a securitization exposure does not (1) The [bank]’s total risk-based capital
[bank] that fails to meet these conditions require deduction under paragraph (a)(1) of requirement for the underlying exposures as
must hold risk-based capital against the this section and does not qualify for the if the [bank] directly held the underlying
transferred exposures as if they had not been Ratings-Based Approach, the [bank] may exposures; and
securitized and must deduct from tier 1 either apply the Internal Assessment (2) The total ECL of the underlying
capital any after-tax gain-on-sale resulting Approach in section 44 of this appendix to exposures.
from the transaction. The conditions are: the exposure (if the [bank], the exposure, and (e) Amount of a securitization exposure. (1)
(1) The transfer is considered a sale under the relevant ABCP program qualify for the The amount of an on-balance sheet
GAAP; Internal Assessment Approach) or the securitization exposure that is not a repo-
(2) The [bank] has transferred to third Supervisory Formula Approach in section 45 style transaction, eligible margin loan, or
parties credit risk associated with the of this appendix to the exposure (if the [bank] OTC derivative contract (other than a credit
underlying exposures; and and the exposure qualify for the Supervisory derivative) is:
(3) Any clean-up calls relating to the Formula Approach). (i) The [bank]’s carrying value minus any
securitization are eligible clean-up calls. (4) If a securitization exposure does not unrealized gains and plus any unrealized
(b) Operational criteria for synthetic require deduction under paragraph (a)(1) of losses on the exposure, if the exposure is a
securitizations. For synthetic securitizations, this section and does not qualify for the security classified as available-for-sale; or
a [bank] may recognize for risk-based capital Ratings-Based Approach, the Internal (ii) The [bank]’s carrying value, if the
purposes the use of a credit risk mitigant to Assessment Approach, or the Supervisory exposure is not a security classified as
hedge underlying exposures only if each of Formula Approach, the [bank] must deduct available-for-sale.
the conditions in this paragraph (b) is the exposure from total capital in accordance (2) The amount of an off-balance sheet
satisfied. A [bank] that fails to meet these with paragraph (c) of this section. securitization exposure that is not an OTC
conditions must hold risk-based capital (5) If a securitization exposure is an OTC derivative contract (other than a credit
against the underlying exposures as if they derivative contract (other than a credit derivative) is the notional amount of the
had not been synthetically securitized. The derivative) that has a first priority claim on exposure. For an off-balance-sheet
conditions are: the cash flows from the underlying exposures securitization exposure to an ABCP program,
(1) The credit risk mitigant is financial (notwithstanding amounts due under interest such as a liquidity facility, the notional
collateral, an eligible credit derivative from rate or currency derivative contracts, fees amount may be reduced to the maximum
an eligible securitization guarantor or an due, or other similar payments), with potential amount that the [bank] could be
eligible guarantee from an eligible approval of the [AGENCY], a [bank] may required to fund given the ABCP program’s
securitization guarantor; choose to set the risk-weighted asset amount current underlying assets (calculated without
(2) The [bank] transfers credit risk of the exposure equal to the amount of the regard to the current credit quality of those
associated with the underlying exposures to exposure as determined in paragraph (e) of assets).
third parties, and the terms and conditions in this section rather than apply the hierarchy (3) The amount of a securitization exposure
the credit risk mitigants employed do not of approaches described in paragraphs (a) (1) that is a repo-style transaction, eligible
include provisions that: through (4) of this section. margin loan, or OTC derivative contract
(i) Allow for the termination of the credit (b) Total risk-weighted assets for (other than a credit derivative) is the EAD of
protection due to deterioration in the credit securitization exposures. A [bank]’s total the exposure as calculated in section 32 of
quality of the underlying exposures; risk-weighted assets for securitization this appendix.
(ii) Require the [bank] to alter or replace exposures is equal to the sum of its risk- (f) Overlapping exposures. If a [bank] has
the underlying exposures to improve the weighted assets calculated using the Ratings- multiple securitization exposures that
credit quality of the pool of underlying Based Approach in section 43 of this provide duplicative coverage of the
exposures; appendix, the Internal Assessment Approach underlying exposures of a securitization

(iii) Increase the [bank]’s cost of credit in section 44 of this appendix, and the (such as when a [bank] provides a program-
protection in response to deterioration in the Supervisory Formula Approach in section 45 wide credit enhancement and multiple pool-
credit quality of the underlying exposures; of this appendix, and its risk-weighted assets specific liquidity facilities to an ABCP
(iv) Increase the yield payable to parties amount for early amortization provisions program), the [bank] is not required to hold
other than the [bank] in response to a calculated in section 47 of this appendix. duplicative risk-based capital against the
overlapping position. Instead, the [bank] may (iii) The loans and leases are to businesses capital requirement for the underlying
apply to the overlapping position the that meet the criteria for a small-business exposures as if the [bank] synthetically
applicable risk-based capital treatment that concern established by the Small Business securitized the underlying exposure with the
results in the highest risk-based capital Administration under section 3(a) of the lowest risk-based capital requirement and
requirement. Small Business Act (15 U.S.C. 632). had obtained no credit risk mitigant on the
(g) Securitizations of non-IRB exposures. If (iv) The [bank] is well capitalized, as other underlying exposures.
a [bank] has a securitization exposure where defined in the [AGENCY]’s prompt corrective (ii) Protection provider. A [bank] that
any underlying exposure is not a wholesale action regulation—12 CFR part 6 (for national provides credit protection on a group of
exposure, retail exposure, securitization banks), 12 CFR part 208, subpart D (for state underlying exposures through a first-to-
exposure, or equity exposure, the [bank] member banks or bank holding companies), default credit derivative must determine its
must: 12 CFR part 325, subpart B (for state risk-weighted asset amount for the derivative
(1) If the [bank] is an originating [bank], nonmember banks), and 12 CFR part 565 (for by applying the RBA in section 43 of this
deduct from tier 1 capital any after-tax gain- savings associations). For purposes of appendix (if the derivative qualifies for the
on-sale resulting from the securitization and determining whether a [bank] is well RBA) or, if the derivative does not qualify for
deduct from total capital in accordance with capitalized for purposes of this paragraph, the RBA, by setting its risk-weighted asset
paragraph (c) of this section the portion of the [bank]’s capital ratios must be calculated amount for the derivative equal to the
any CEIO that does not constitute gain-on- without regard to the capital treatment for product of:
sale; transfers of small-business obligations with (A) The protection amount of the
(2) If the securitization exposure does not recourse specified in paragraph (k)(1) of this derivative;
require deduction under paragraph (g)(1), section. (B) 12.5; and
apply the RBA in section 43 of this appendix (2) The total outstanding amount of (C) The sum of the risk-based capital
to the securitization exposure if the exposure recourse retained by a [bank] on transfers of requirements of the individual underlying
qualifies for the RBA; small-business obligations receiving the exposures, up to a maximum of 100 percent.
(3) If the securitization exposure does not capital treatment specified in paragraph (2) Second-or-subsequent-to-default credit
require deduction under paragraph (g)(1) and (k)(1) of this section cannot exceed 15 derivatives—(i) Protection purchaser. (A) A
does not qualify for the RBA, apply the IAA percent of the [bank]’s total qualifying [bank] that obtains credit protection on a
in section 44 of this appendix to the exposure capital. group of underlying exposures through a nth-
(if the [bank], the exposure, and the relevant (3) If a [bank] ceases to be well capitalized to-default credit derivative (other than a first-
ABCP program qualify for the IAA); and or exceeds the 15 percent capital limitation, to-default credit derivative) may recognize
(4) If the securitization exposure does not the preferential capital treatment specified in the credit risk mitigation benefits of the
require deduction under paragraph (g)(1) and paragraph (k)(1) of this section will continue derivative only if:
does not qualify for the RBA or the IAA, to apply to any transfers of small-business (1) The [bank] also has obtained credit
deduct the exposure from total capital in obligations with recourse that occurred protection on the same underlying exposures
accordance with paragraph (c) of this section. during the time that the [bank] was well in the form of first-through-(n-1)-to-default
(h) Implicit support. If a [bank] provides capitalized and did not exceed the capital credit derivatives; or
(2) If n-1 of the underlying exposures have
support to a securitization in excess of the limit.
already defaulted.
[bank]’s contractual obligation to provide (4) The risk-based capital ratios of the
(B) If a [bank] satisfies the requirements of
credit support to the securitization (implicit [bank] must be calculated without regard to
paragraph (m)(2)(i)(A) of this section, the
support): the capital treatment for transfers of small-
[bank] must determine its risk-based capital
(1) The [bank] must hold regulatory capital business obligations with recourse specified
requirement for the underlying exposures as
against all of the underlying exposures in paragraph (k)(1) of this section as provided
if the [bank] had only synthetically
associated with the securitization as if the in 12 CFR part 3, Appendix A (for national
securitized the underlying exposure with the
exposures had not been securitized and must banks), 12 CFR part 208, Appendix A (for
nth lowest risk-based capital requirement and
deduct from tier 1 capital any after-tax gain- state member banks), 12 CFR part 225,
had obtained no credit risk mitigant on the
on-sale resulting from the securitization; and Appendix A (for bank holding companies), other underlying exposures.
(2) The [bank] must disclose publicly: 12 CFR part 325, Appendix A (for state (ii) Protection provider. A [bank] that
(i) That it has provided implicit support to nonmember banks), and 12 CFR provides credit protection on a group of
the securitization; and 567.6(b)(5)(v) (for savings associations). underlying exposures through a nth-to-default
(ii) The regulatory capital impact to the (l) Consolidated ABCP programs. (1) A credit derivative (other than a first-to-default
[bank] of providing such implicit support. [bank] that qualifies as a primary beneficiary credit derivative) must determine its risk-
(i) Eligible servicer cash advance facilities. and must consolidate an ABCP program as a weighted asset amount for the derivative by
Regardless of any other provisions of this variable interest entity under GAAP may applying the RBA in section 43 of this
part, a [bank] is not required to hold risk- exclude the consolidated ABCP program appendix (if the derivative qualifies for the
based capital against the undrawn portion of assets from risk-weighted assets if the [bank] RBA) or, if the derivative does not qualify for
an eligible servicer cash advance facility. is the sponsor of the ABCP program. If a the RBA, by setting its risk-weighted asset
(j) Interest-only mortgage-backed [bank] excludes such consolidated ABCP amount for the derivative equal to the
securities. Regardless of any other provisions program assets from risk-weighted assets, the product of:
of this part, the risk weight for a non-credit- [bank] must hold risk-based capital against (A) The protection amount of the
enhancing interest-only mortgage-backed any securitization exposures of the [bank] to derivative;
security may not be less than 100 percent. the ABCP program in accordance with this (B) 12.5; and
(k) Small-business loans and leases on part. (C) The sum of the risk-based capital
personal property transferred with recourse. (2) If a [bank] either is not permitted, or requirements of the individual underlying
(1) Regardless of any other provisions of this elects not, to exclude consolidated ABCP exposures (excluding the n-1 underlying
appendix, a [bank] that has transferred small- program assets from its risk-weighted assets, exposures with the lowest risk-based capital
business loans and leases on personal the [bank] must hold risk-based capital requirements), up to a maximum of 100
property (small-business obligations) with against the consolidated ABCP program percent.
recourse must include in risk-weighted assets assets in accordance with this appendix but
only the contractual amount of retained is not required to hold risk-based capital Section 43. Ratings-Based Approach (RBA)
recourse if all the following conditions are against any securitization exposures of the (a) Eligibility requirements for use of the
met: [bank] to the ABCP program. RBA—(1) Originating [bank]. An originating
(i) The transaction is a sale under GAAP. (m) N th-to-default credit derivatives—(1) [bank] must use the RBA to calculate its risk-
(ii) The [bank] establishes and maintains, First-to-default credit derivatives—(i) based capital requirement for a securitization
pursuant to GAAP, a non-capital reserve Protection purchaser. A [bank] that obtains exposure if the exposure has two or more
sufficient to meet the [bank]’s reasonably credit protection on a group of underlying external ratings or inferred ratings (and may
estimated liability under the recourse exposures through a first-to-default credit not use the RBA if the exposure has fewer
arrangement. derivative must determine its risk-based than two external ratings or inferred ratings).
(2) Investing [bank]. An investing [bank] (2) A [bank] must apply the risk weights in 25 or more or if all of the underlying
must use the RBA to calculate its risk-based Table 6 when the securitization exposure’s exposures are retail exposures, a [bank] may
capital requirement for a securitization applicable external or applicable inferred assume that N is six or more unless the
exposure if the exposure has one or more rating represents a long-term credit rating, [bank] knows or has reason to know that N
external or inferred ratings (and may not use and must apply the risk weights in Table 7 is less than six); and
the RBA if the exposure has no external or when the securitization exposure’s (B) The securitization exposure is a senior
applicable external or applicable inferred securitization exposure.
inferred rating).
rating represents a short-term credit rating. (ii) A [bank] must apply the risk weights
(b) Ratings-based approach. (1) A [bank]
(i) A [bank] must apply the risk weights in in column 3 of Table 6 or Table 7 to the
must determine the risk-weighted asset column 1 of Table 6 or Table 7 to the securitization exposure if N is less than six,
amount for a securitization exposure by securitization exposure if: regardless of the seniority of the
multiplying the amount of the exposure (as (A) N (as calculated under paragraph (e)(6) securitization exposure.
defined in paragraph (e) of section 42 of this of section 45 of this appendix) is six or more (iii) Otherwise, a [bank] must apply the
appendix) by the appropriate risk weight (for purposes of this section only, if the risk weights in column 2 of Table 6 or Table
provided in Table 6 and Table 7. notional number of underlying exposures is 7.
TABLE 6.—LONG-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA
Risk weights
Risk weights Risk weights for
Applicable external or inferred rating for senior for non-senior securitization
(Illustrative rating example) securitization securitization exposures
exposures exposures backed by
backed by backed by non-granular
granular pools granular pools pools
Highest investment grade (for example, AAA) ............................................................................ 7% 12% 20%

Second highest investment grade (for example, AA) ................................................................. 8% 15% 25%
Third-highest investment grade—positive designation (for example, A+) .................................. 10% 18% 35%
Third-highest investment grade (for example, A) ........................................................................ 12% 20%
Third-highest investment grade—negative designation (for example, A¥) ............................... 20% 35%
Lowest investment grade—positive designation (for example, BBB+) ....................................... 35% 50%
Lowest investment grade (for example, BBB) ............................................................................. 60% 75%
Lowest investment grade—negative designation (for example, BBB¥) .................................... 100%

One category below investment grade—positive designation (for example, BB+) ..................... 250%
One category below investment grade (for example, BB) .......................................................... 425%
One category below investment grade—negative designation (for example, BB¥) .................. 650%
More than one category below investment grade ....................................................................... Deduction from tier 1 and tier 2 capital.
TABLE 7.—SHORT-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA
Risk weights
Risk weights Risk weights for
Applicable external or inferred rating for senior for non-senior securitization
(Illustrative rating example) securitization securitization exposures
exposures exposures backed by
backed by backed by non-granular
granular pools granular pools pools
Highest investment grade (for example, A1) ............................................................................... 7% 12% 20%

Second highest investment grade (for example, A2) .................................................................. 12% 20% 35%
Third highest investment grade (for example, A3) ...................................................................... 60% 75% 75%
All other ratings ............................................................................................................................ Deduction from tier 1 and tier 2 capital.
Section 44. Internal Assessment Approach assessment process meets the following identify gradations of risk. Each of the
(IAA) criteria: [bank]’s internal credit assessment categories
(a) Eligibility requirements. A [bank] may (i) The [bank]’s internal credit assessments must correspond to an external rating of an
apply the IAA to calculate the risk-weighted of securitization exposures must be based on NRSRO.
asset amount for a securitization exposure publicly available rating criteria used by an (iv) The [bank]’s internal credit assessment
that the [bank] has to an ABCP program (such NRSRO. process, particularly the stress test factors for
as a liquidity facility or credit enhancement) (ii) The [bank]’s internal credit assessments determining credit enhancement
if the [bank], the ABCP program, and the of securitization exposures used for risk- requirements, must be at least as conservative
exposure qualify for use of the IAA. based capital purposes must be consistent as the most conservative of the publicly
(1) [Bank] qualification criteria. A [bank] with those used in the [bank]’s internal risk available rating criteria of the NRSROs that
qualifies for use of the IAA if the [bank] has management process, management have provided external ratings to the
received the prior written approval of the information reporting systems, and capital commercial paper issued by the ABCP
[AGENCY]. To receive such approval, the adequacy assessment process. program.
[bank] must demonstrate to the [AGENCY]’s (iii) The [bank]’s internal credit assessment (A) Where the commercial paper issued by
satisfaction that the [bank]’s internal process must have sufficient granularity to an ABCP program has an external rating from
two or more NRSROs and the different underwriting standards) for the exposures multiplying the amount of the exposure (as
NRSROs’’ benchmark stress factors require underlying the securitization exposure. defined in paragraph (e) of section 42 of this
different levels of credit enhancement to (iii) The ABCP program performs a detailed appendix) by the appropriate risk weight in
achieve the same external rating equivalent, credit analysis of the sellers of the exposures Table 6 and Table 7 in paragraph (b) of
the [bank] must apply the NRSRO stress underlying the securitization exposure. section 43 of this appendix.
factor that requires the highest level of credit (iv) The ABCP program’s underwriting
enhancement. policy for the exposures underlying the Section 45. Supervisory Formula Approach
(B) If any NRSRO that provides an external securitization exposure establishes minimum (SFA)
rating to the ABCP program’s commercial asset eligibility criteria that include the (a) Eligibility requirements. A [bank] may
paper changes its methodology (including prohibition of the purchase of assets that are use the SFA to determine its risk-based
stress factors), the [bank] must evaluate significantly past due or of assets that are capital requirement for a securitization
whether to revise its internal assessment defaulted (that is, assets that have been exposure only if the [bank] can calculate on
process. charged off or written down by the seller an ongoing basis each of the SFA parameters
(v) The [bank] must have an effective prior to being placed into the ABCP program in paragraph (e) of this section.
system of controls and oversight that ensures or assets that would be charged off or written (b) Mechanics. Under the SFA, a
compliance with these operational down under the program’s governing securitization exposure incurs a deduction
requirements and maintains the integrity and contracts), as well as limitations on from total capital (as described in paragraph
accuracy of the internal credit assessments. concentration to individual obligors or (c) of section 42 of this appendix) and/or an
The [bank] must have an internal audit geographic areas and the tenor of the assets
SFA risk-based capital requirement, as
function independent from the ABCP to be purchased.
determined in paragraph (c) of this section.
program business line and internal credit (v) The aggregate estimate of loss on the
The risk-weighted asset amount for the
assessment process that assesses at least exposures underlying the securitization
annually whether the controls over the exposure considers all sources of potential securitization exposure equals the SFA risk-
internal credit assessment process function risk, such as credit and dilution risk. based capital requirement for the exposure
as intended. (vi) Where relevant, the ABCP program multiplied by 12.5.
(vi) The [bank] must review and update incorporates structural features into each (c) The SFA risk-based capital
each internal credit assessment whenever purchase of exposures underlying the requirement. (1) If KIRB is greater than or
new material information is available, but no securitization exposure to mitigate potential equal to L + T, the entire exposure must be
less frequently than annually. credit deterioration of the underlying deducted from total capital.
(vii) The [bank] must validate its internal exposures. Such features may include wind- (2) If KIRB is less than or equal to L, the
credit assessment process on an ongoing down triggers specific to a pool of underlying exposure’s SFA risk-based capital
basis and at least annually. exposures. requirement is UE multiplied by TP
(2) ABCP-program qualification criteria. (b) Mechanics. A [bank] that elects to use multiplied by the greater of:
An ABCP program qualifies for use of the the IAA to calculate the risk-based capital (i) 0.0056 * T; or
IAA if all commercial paper issued by the requirement for any securitization exposure (ii) S[L + T] ¥ S[L].
ABCP program has an external rating. must use the IAA to calculate the risk-based (3) If KIRB is greater than L and less than
(3) Exposure qualification criteria. A capital requirements for all securitization L + T, the [bank] must deduct from total
securitization exposure qualifies for use of exposures that qualify for the IAA approach. capital an amount equal to UE*TP*(KIRB ¥
the IAA if the exposure meets the following Under the IAA, a [bank] must map its L), and the exposure’s SFA risk-based capital
criteria: internal assessment of such a securitization requirement is UE multiplied by TP
(i) The [bank] initially rated the exposure exposure to an equivalent external rating multiplied by the greater of:
at least the equivalent of investment grade. from an NRSRO. Under the IAA, a [bank] (i) 0.0056 * (T ¥ (KIRB ¥ L)); or
(ii) The ABCP program has robust credit must determine the risk-weighted asset (ii) S[L + T] ¥ S[KIRB].
and investment guidelines (that is, amount for such a securitization exposure by (d) The supervisory formula:
(11) In these expressions, b[Y; a, b] refers (A) The sum of the risk-based capital (ii) A [bank] must determine L before
to the cumulative beta distribution with requirements for the underlying exposures considering the effects of any tranche-
parameters a and b evaluated at Y. In the case plus the expected credit losses of the specific credit enhancements.
where N = 1 and EWALGD = 100 percent, underlying exposures (as determined under (iii) Any gain-on-sale or CEIO associated
S[Y] in formula (1) must be calculated with this appendix as if the underlying exposures with the securitization may not be included
K[Y] set equal to the product of KIRB and Y, in L.
were directly held by the [bank]); to
and d set equal to 1 ¥ KIRB. (iv) Any reserve account funded by
(B) UE.
(e) SFA parameters—(1) Amount of the accumulated cash flows from the underlying
underlying exposures (UE). UE is the EAD of (ii) The calculation of KIRB must reflect the
effects of any credit risk mitigant applied to exposures that is subordinated to the tranche
any underlying exposures that are wholesale that contains the [bank]’s securitization
and retail exposures (including the amount of the underlying exposures (either to an
exposure may be included in the numerator
any funded spread accounts, cash collateral individual underlying exposure, to a group of
and denominator of L to the extent cash has
accounts, and other similar funded credit underlying exposures, or to the entire pool of
enhancements) plus the amount of any accumulated in the account. Unfunded
underlying exposures).
underlying exposures that are securitization reserve accounts (that is, reserve accounts
(iii) All assets related to the securitization
exposures (as defined in paragraph (e) of that are to be funded from future cash flows
are treated as underlying exposures, from the underlying exposures) may not be
section 42 of this appendix) plus the adjusted including assets in a reserve account (such as
carrying value of any underlying exposures included in the calculation of L.
a cash collateral account). (v) In some cases, the purchase price of
that are equity exposures (as defined in
(4) Credit enhancement level (L). (i) L is the receivables will reflect a discount that
paragraph (b) of section 51 of this appendix).
(2) Tranche percentage (TP). TP is the ratio ratio of: provides credit enhancement (for example,
of the amount of the [bank]’s securitization (A) The amount of all securitization first loss protection) for all or certain
exposure to the amount of the tranche that exposures subordinated to the tranche that tranches of the securitization. When this
contains the securitization exposure. contains the [bank]’s securitization exposure; arises, L should be calculated inclusive of
(3) Capital requirement on underlying to this discount if the discount provides credit
ER07DE07.017</GPH>
exposures (KIRB). (i) KIRB is the ratio of: (B) UE. enhancement for the securitization exposure.
(5) Thickness of tranche (T). T is the ratio (iii) In the case of a re-securitization (that underlying exposures that are themselves
of: is, a securitization in which some or all of securitization exposures.
(i) The amount of the tranche that contains the underlying exposures are themselves (f) Simplified method for computing N and
the [bank]’s securitization exposure; to securitization exposures), the [bank] must EWALGD. (1) If all underlying exposures of
treat each underlying exposure as a single a securitization are retail exposures, a [bank]
(ii) UE.
underlying exposure and must not look may apply the SFA using the following
(6) Effective number of exposures (N). (i) through to the originally securitized
Unless the [bank] elects to use the formula simplifications:
underlying exposures.
provided in paragraph (f) of this section, (7) Exposure-weighted average loss given (i) h = 0; and
default (EWALGD). EWALGD is calculated (ii) v = 0.
as: (2) Under the conditions in paragraphs
(f)(3) and (f)(4) of this section, a [bank] may
employ a simplified method for calculating N
and EWALGD.
(3) If C1 is no more than 0.03, a [bank] may
where EADi represents the EAD associated set EWALGD = 0.50 if none of the underlying
with the ith instrument in the pool of exposures is a securitization exposure or
underlying exposures. where LGDi represents the average LGD EWALGD = 1 if one or more of the
(ii) Multiple exposures to one obligor must associated with all exposures to the ith underlying exposures is a securitization
obligor. In the case of a re-securitization, an exposure, and may set N equal to the
be treated as a single underlying exposure.
LGD of 100 percent must be assumed for the following amount:
where: (other than a repo-style transaction, an the collateral are denominated in different
(i) Cm is the ratio of the sum of the amounts eligible margin loan, or an OTC derivative currencies;
of the ‘m’ largest underlying exposures to UE; contract for which the [bank] has reflected (iii) A [bank] must multiply the
and collateral in its determination of exposure supervisory haircuts obtained in paragraphs
(ii) The level of m is to be selected by the amount under section 32 of this appendix) as (b)(3)(i) and (ii) by the square root of 6.5
[bank]. follows. The [bank]’s risk-based capital (which equals 2.549510); and
requirement for the collateralized (iv) A [bank] must adjust the supervisory
(4) Alternatively, if only C1 is available and
securitization exposure is equal to the risk- haircuts upward on the basis of a holding
C1 is no more than 0.03, the [bank] may set
based capital requirement for the period longer than 65 business days where
EWALGD = 0.50 if none of the underlying
securitization exposure as calculated under and as appropriate to take into account the
exposures is a securitization exposure or illiquidity of the collateral.
the RBA in section 43 of this appendix or
EWALGD = 1 if one or more of the (4) Own estimates for haircuts. With the
under the SFA in section 45 of this appendix
underlying exposures is a securitization prior written approval of the [AGENCY], a
multiplied by the ratio of adjusted exposure
exposure and may set N = 1/C1. [bank] may calculate haircuts using its own
amount (SE*) to original exposure amount
Section 46. Recognition of Credit Risk (SE), where: internal estimates of market price volatility
Mitigants for Securitization Exposures (i) SE* = max {0, [SE—C x (1¥Hs¥Hfx)]}; and foreign exchange volatility, subject to
(ii) SE = the amount of the securitization paragraph (b)(2)(iii) of section 32 of this
(a) General. An originating [bank] that has appendix. The minimum holding period
obtained a credit risk mitigant to hedge its exposure calculated under paragraph (e) of
section 42 of this appendix; (TM) for securitization exposures is 65
securitization exposure to a synthetic or business days.
traditional securitization that satisfies the (iii) C = the current market value of the
collateral; (c) Guarantees and credit derivatives—(1)
operational criteria in section 41 of this Limitations on recognition. A [bank] may
(iv) Hs = the haircut appropriate to the
appendix may recognize the credit risk only recognize an eligible guarantee or
collateral type; and
mitigant, but only as provided in this section. eligible credit derivative provided by an
(v) Hfx = the haircut appropriate for any
An investing [bank] that has obtained a credit eligible securitization guarantor in
currency mismatch between the collateral
risk mitigant to hedge a securitization determining the [bank]’s risk-based capital
and the exposure.
exposure may recognize the credit risk requirement for a securitization exposure.
(2) Mixed collateral. Where the collateral is
mitigant, but only as provided in this section. (2) ECL for securitization exposures. When
a basket of different asset types or a basket
A [bank] that has used the RBA in section 43 a [bank] recognizes an eligible guarantee or
of assets denominated in different currencies,
of this appendix or the IAA in section 44 of eligible credit derivative provided by an ER07DE07.023</GPH>
the haircut on the basket will be
this appendix to calculate its risk-based eligible securitization guarantor in
capital requirement for a securitization
H = ∑ a i Hi ,
determining the [bank]’s risk-based capital
exposure whose external or inferred rating requirement for a securitization exposure, the
(or equivalent internal rating under the IAA) i [bank] must also:
reflects the benefits of a credit risk mitigant where ai is the current market value of the (i) Calculate ECL for the protected portion
ER07DE07.020</GPH>
provided to the associated securitization or asset in the basket divided by the current of the exposure using the same risk
that supports some or all of the underlying market value of all assets in the basket and parameters that it uses for calculating the
exposures may not use the credit risk Hi is the haircut applicable to that asset. risk-weighted asset amount of the exposure
mitigation rules in this section to further (3) Standard supervisory haircuts. Unless a as described in paragraph (c)(3) of this
reduce its risk-based capital requirement for [bank] qualifies for use of and uses own- section; and
ER07DE07.019</GPH>
the exposure to reflect that credit risk estimates haircuts in paragraph (b)(4) of this (ii) Add the exposure’s ECL to the [bank]’s
mitigant. section: total ECL.
(b) Collateral—(1) Rules of recognition. A (i) A [bank] must use the collateral type (3) Rules of recognition. A [bank] may
[bank] may recognize financial collateral in haircuts (Hs) in Table 3; recognize an eligible guarantee or eligible
determining the [bank]’s risk-based capital (ii) A [bank] must use a currency mismatch credit derivative provided by an eligible
ER07DE07.018</GPH>
requirement for a securitization exposure haircut (Hfx) of 8 percent if the exposure and securitization guarantor in determining the
[bank]’s risk-based capital requirement for (4) Mismatches. The [bank] must make (3) KIRB (as defined in paragraph (e)(3) of
the securitization exposure as follows: applicable adjustments to the protection section 45 of this appendix);
(i) Full coverage. If the protection amount amount as required in paragraphs (d), (e), and (4) 12.5; and
of the eligible guarantee or eligible credit (f) of section 33 of this appendix for any (5) The proportion of the underlying
derivative equals or exceeds the amount of hedged securitization exposure and any more exposures in which the borrower is permitted
the securitization exposure, the [bank] may senior securitization exposure that benefits to vary the drawn amount within an agreed
set the risk-weighted asset amount for the from the hedge. In the context of a synthetic limit under a line of credit.
securitization exposure equal to the risk- securitization, when an eligible guarantee or (c) Conversion factor. (1) (i) Except as
weighted asset amount for a direct exposure eligible credit derivative covers multiple provided in paragraph (c)(2) of this section,
to the eligible securitization guarantor (as hedged exposures that have different residual
to calculate the appropriate conversion
determined in the wholesale risk weight maturities, the [bank] must use the longest
function described in section 31 of this residual maturity of any of the hedged factor, a [bank] must use Table 8 for a
appendix), using the [bank]’s PD for the exposures as the residual maturity of all the securitization that contains a controlled early
guarantor, the [bank]’s LGD for the guarantee hedged exposures. amortization provision and must use Table 9
or credit derivative, and an EAD equal to the for a securitization that contains a non-
amount of the securitization exposure (as Section 47. Risk-Based Capital Requirement controlled early amortization provision. In
determined in paragraph (e) of section 42 of for Early Amortization Provisions circumstances where a securitization
this appendix). (a) General. (1) An originating [bank] must contains a mix of retail and nonretail
(ii) Partial coverage. If the protection hold risk-based capital against the sum of the exposures or a mix of committed and
amount of the eligible guarantee or eligible originating [bank]’s interest and the uncommitted exposures, a [bank] may take a
credit derivative is less than the amount of investors’ interest in a securitization that: pro rata approach to determining the
the securitization exposure, the [bank] may (i) Includes one or more underlying conversion factor for the securitization’s
set the risk-weighted asset amount for the exposures in which the borrower is permitted early amortization provision. If a pro rata
securitization exposure equal to the sum of: to vary the drawn amount within an agreed approach is not feasible, a [bank] must treat
(A) Covered portion. The risk-weighted limit under a line of credit; and the mixed securitization as a securitization of
asset amount for a direct exposure to the (ii) Contains an early amortization nonretail exposures if a single underlying
eligible securitization guarantor (as provision. exposure is a nonretail exposure and must
determined in the wholesale risk weight (2) For securitizations described in treat the mixed securitization as a
function described in section 31 of this paragraph (a)(1) of this section, an originating securitization of committed exposures if a
appendix), using the [bank]’s PD for the [bank] must calculate the risk-based capital
single underlying exposure is a committed
guarantor, the [bank]’s LGD for the guarantee requirement for the originating [bank]’s
exposure.
or credit derivative, and an EAD equal to the interest under sections 42–45 of this
protection amount of the credit risk mitigant; (ii) To find the appropriate conversion
appendix, and the risk-based capital
and requirement for the investors’ interest under factor in the tables, a [bank] must divide the
(B) Uncovered portion. (1) 1.0 minus the paragraph (b) of this section. three-month average annualized excess
ratio of the protection amount of the eligible (b) Risk-weighted asset amount for spread of the securitization by the excess
guarantee or eligible credit derivative to the investors’ interest. The originating [bank]’s spread trapping point in the securitization
amount of the securitization exposure); risk-weighted asset amount for the investors’ structure. In securitizations that do not
multiplied by interest in the securitization is equal to the require excess spread to be trapped, or that
(2) The risk-weighted asset amount for the product of the following 5 quantities: specify trapping points based primarily on
securitization exposure without the credit (1) The investors’ interest EAD; performance measures other than the three-
risk mitigant (as determined in sections 42– (2) The appropriate conversion factor in month average annualized excess spread, the
45 of this appendix). paragraph (c) of this section; excess spread trapping point is 4.5 percent.
TABLE 8.—CONTROLLED EARLY AMORTIZATION PROVISIONS

Retail Credit Lines ....................................... Three-month average annualized excess spread Conversion Factor (CF) .................... 90% CF
Non-retail Credit Lines ................................ 90% CF ............................................................................................................................ 90% CF
TABLE 9.—NON-CONTROLLED EARLY AMORTIZATION PROVISIONS

Retail Credit Lines ....................................... Three-month average annualized excess spread Conversion Factor (CF) .................... 100% CF
Non-retail Credit Lines ................................ 100% CF .......................................................................................................................... 100% CF
(2) For a securitization for which all or may use a conversion factor of 10 percent. If substantially all of the underlying exposures
substantially all of the underlying exposures the [bank] chooses to use a conversion factor are residential mortgage exposures.
are residential mortgage exposures, a [bank] of 10 percent, it must use that conversion
may calculate the appropriate conversion factor for all securitizations for which all or
factor using paragraph (c)(1) of this section or
Part VI. Risk-Weighted Assets for Equity defined in paragraph (c) of this section) by unconsolidated small business investment
Exposures the lowest applicable risk weight in this companies or held through consolidated
paragraph (b). small business investment companies
Section 51. Introduction and Exposure (1) 0 percent risk weight equity exposures. described in section 302 of the Small
Measurement An equity exposure to an entity whose credit Business Investment Act of 1958 (15 U.S.C.
(a) General. To calculate its risk-weighted exposures are exempt from the 0.03 percent 682), then must include publicly traded
asset amounts for equity exposures that are PD floor in paragraph (d)(2) of section 31 of equity exposures (including those held
not equity exposures to investment funds, a this appendix is assigned a 0 percent risk indirectly through investment funds), and
[bank] may apply either the Simple Risk weight. then must include non-publicly traded equity
Weight Approach (SRWA) in section 52 of (2) 20 percent risk weight equity exposures. exposures (including those held indirectly
this appendix or, if it qualifies to do so, the An equity exposure to a Federal Home Loan through investment funds).
Internal Models Approach (IMA) in section Bank or Farmer Mac is assigned a 20 percent (4) 300 percent risk weight equity
53 of this appendix. A [bank] must use the risk weight. exposures. A publicly traded equity exposure
look-through approaches in section 54 of this (3) 100 percent risk weight equity (other than an equity exposure described in
appendix to calculate its risk-weighted asset exposures. The following equity exposures
amounts for equity exposures to investment paragraph (b)(6) of this section and including
are assigned a 100 percent risk weight:
funds. the ineffective portion of a hedge pair) is
(i) Community development equity
(b) Adjusted carrying value. For purposes assigned a 300 percent risk weight.
exposures. An equity exposure that qualifies
of this part, the adjusted carrying value of an as a community development investment (5) 400 percent risk weight equity
equity exposure is: under 12 U.S.C. 24 (Eleventh), excluding exposures. An equity exposure (other than an
(1) For the on-balance sheet component of equity exposures to an unconsolidated small equity exposure described in paragraph (b)(6)
an equity exposure, the [bank]’s carrying business investment company and equity of this section) that is not publicly traded is
value of the exposure reduced by any exposures held through a consolidated small assigned a 400 percent risk weight.
unrealized gains on the exposure that are business investment company described in (6) 600 percent risk weight equity
reflected in such carrying value but excluded section 302 of the Small Business Investment exposures. An equity exposure to an
from the [bank]’s tier 1 and tier 2 capital; and Act of 1958 (15 U.S.C. 682). investment firm that:
(2) For the off-balance sheet component of (ii) Effective portion of hedge pairs. The (i) Would meet the definition of a
an equity exposure, the effective notional effective portion of a hedge pair. traditional securitization were it not for the
principal amount of the exposure, the size of (iii) Non-significant equity exposures. [AGENCY]’s application of paragraph (8) of
which is equivalent to a hypothetical on- Equity exposures, excluding exposures to an that definition; and
balance sheet position in the underlying investment firm that would meet the (ii) Has greater than immaterial leverage is
equity instrument that would evidence the definition of a traditional securitization were assigned a 600 percent risk weight.
same change in fair value (measured in it not for the [AGENCY]’s application of (c) Hedge transactions—(1) Hedge pair. A
dollars) for a given small change in the price paragraph (8) of that definition and has hedge pair is two equity exposures that form
of the underlying equity instrument, minus greater than immaterial leverage, to the an effective hedge so long as each equity
the adjusted carrying value of the on-balance extent that the aggregate adjusted carrying exposure is publicly traded or has a return
sheet component of the exposure as value of the exposures does not exceed 10 that is primarily based on a publicly traded
calculated in paragraph (b)(1) of this section. percent of the [bank]’s tier 1 capital plus tier equity exposure.
For unfunded equity commitments that are 2 capital. (2) Effective hedge. Two equity exposures
unconditional, the effective notional (A) To compute the aggregate adjusted form an effective hedge if the exposures
principal amount is the notional amount of carrying value of a [bank]’s equity exposures either have the same remaining maturity or
the commitment. For unfunded equity for purposes of this paragraph (b)(3)(iii), the each has a remaining maturity of at least
commitments that are conditional, the [bank] may exclude equity exposures three months; the hedge relationship is
effective notional principal amount is the described in paragraphs (b)(1), (b)(2), (b)(3)(i), formally documented in a prospective
[bank]’s best estimate of the amount that and (b)(3)(ii) of this section, the equity
manner (that is, before the [bank] acquires at
would be funded under economic downturn exposure in a hedge pair with the smaller
conditions. least one of the equity exposures); the
adjusted carrying value, and a proportion of
documentation specifies the measure of
each equity exposure to an investment fund
Section 52. Simple Risk Weight Approach effectiveness (E) the [bank] will use for the
equal to the proportion of the assets of the
(SRWA) hedge relationship throughout the life of the
investment fund that are not equity
(a) General. Under the SRWA, a [bank]’s exposures or that meet the criterion of transaction; and the hedge relationship has
aggregate risk-weighted asset amount for its paragraph (b)(3)(i) of this section. If a [bank] an E greater than or equal to 0.8. A [bank]
equity exposures is equal to the sum of the does not know the actual holdings of the must measure E at least quarterly and must
risk-weighted asset amounts for each of the investment fund, the [bank] may calculate use one of three alternative measures of E:
[bank]’s individual equity exposures (other the proportion of the assets of the fund that (i) Under the dollar-offset method of
than equity exposures to an investment fund) are not equity exposures based on the terms measuring effectiveness, the [bank] must
as determined in this section and the risk- of the prospectus, partnership agreement, or determine the ratio of value change (RVC).
weighted asset amounts for each of the similar contract that defines the fund’s The RVC is the ratio of the cumulative sum
[bank]’s individual equity exposures to an permissible investments. If the sum of the of the periodic changes in value of one equity
investment fund as determined in section 54 investment limits for all exposure classes exposure to the cumulative sum of the
of this appendix. within the fund exceeds 100 percent, the periodic changes in the value of the other
(b) SRWA computation for individual [bank] must assume for purposes of this equity exposure. If RVC is positive, the hedge
equity exposures. A [bank] must determine paragraph (b)(3)(iii) that the investment fund is not effective and E equals 0. If RVC is
the risk-weighted asset amount for an invests to the maximum extent possible in negative and greater than or equal to ¥1 (that
individual equity exposure (other than an equity exposures. is, between zero and ¥1), then E equals the
equity exposure to an investment fund) by (B) When determining which of a [bank]’s absolute value of RVC. If RVC is negative and
multiplying the adjusted carrying value of equity exposures qualify for a 100 percent less than ¥1, then E equals 2 plus RVC.
the equity exposure or the effective portion risk weight under this paragraph, a [bank] (ii) Under the variability-reduction method
and ineffective portion of a hedge pair (as first must include equity exposures to of measuring effectiveness:
(A) Xt = At ¥ Bt; (4) The [bank]’s model and benchmarking (C) 300 percent multiplied by the aggregate
(B) At = the value at time t of one exposure process must incorporate data that are adjusted carrying value of the [bank]’s equity
in a hedge pair; and relevant in representing the risk profile of the exposures that are not publicly traded, do not
(C) Bt = the value at time t of the other [bank]’s modeled equity exposures, and must qualify for a 0 percent, 20 percent, or 100
exposure in a hedge pair. include data from at least one equity market percent risk weight under paragraphs (b)(1)
(iii) Under the regression method of cycle containing adverse market movements through (b)(3)(i) of section 52 of this
measuring effectiveness, E equals the relevant to the risk profile of the [bank]’s appendix, and are not equity exposures to an
coefficient of determination of a regression in modeled equity exposures. In addition, the investment fund.
which the change in value of one exposure [bank]’s benchmarking exercise must be (d) Risk-weighted assets calculation for a
in a hedge pair is the dependent variable and based on daily market prices for the [bank] using the IMA only for publicly traded
the change in value of the other exposure in benchmark portfolio. If the [bank]’s model equity exposures. If a [bank] models only
a hedge pair is the independent variable. uses a scenario methodology, the [bank] must publicly traded equity exposures, the [bank]’s
However, if the estimated regression demonstrate that the model produces a aggregate risk-weighted asset amount for its
coefficient is positive, then the value of E is conservative estimate of potential losses on equity exposures is equal to the sum of:
zero. the [bank]’s modeled equity exposures over (1) The risk-weighted asset amount of each
(3) The effective portion of a hedge pair is a relevant long-term market cycle. If the equity exposure that qualifies for a 0 percent,
E multiplied by the greater of the adjusted [bank] employs risk factor models, the [bank] 20 percent, or 100 percent risk weight under
carrying values of the equity exposures must demonstrate through empirical analysis paragraphs (b)(1) through (b)(3)(i) of section
forming a hedge pair. the appropriateness of the risk factors used. 52 (as determined under section 52 of this
(4) The ineffective portion of a hedge pair (5) The [bank] must be able to demonstrate, appendix), each equity exposure that
is (1–E) multiplied by the greater of the using theoretical arguments and empirical qualifies for a 400 percent risk weight under
adjusted carrying values of the equity evidence, that any proxies used in the paragraph (b)(5) of section 52 or a 600
exposures forming a hedge pair. modeling process are comparable to the percent risk weight under paragraph (b)(6) of
[bank]’s modeled equity exposures and that section 52 (as determined under section 52
Section 53. Internal Models Approach (IMA) the [bank] has made appropriate adjustments of this appendix), and each equity exposure
(a) General. A [bank] may calculate its risk- for differences. The [bank] must derive any to an investment fund (as determined under
weighted asset amount for equity exposures proxies for its modeled equity exposures and section 54 of this appendix); and
using the IMA by modeling publicly traded benchmark portfolio using historical market (2) The greater of:
and non-publicly traded equity exposures (in data that are relevant to the [bank]’s modeled (i) The estimate of potential losses on the
accordance with paragraph (c) of this section) equity exposures and benchmark portfolio [bank]’s equity exposures (other than equity
or by modeling only publicly traded equity (or, where not, must use appropriately
exposures referenced in paragraph (d)(1) of
exposures (in accordance with paragraph (d) adjusted data), and such proxies must be
this section) generated by the [bank]’s
of this section). robust estimates of the risk of the [bank]’s
internal equity exposure model multiplied by
(b) Qualifying criteria. To qualify to use the modeled equity exposures.
12.5; or
IMA to calculate risk-based capital (c) Risk-weighted assets calculation for a
[bank] modeling publicly traded and non- (ii) The sum of:
requirements for equity exposures, a [bank] (A) 200 percent multiplied by the aggregate
publicly traded equity exposures. If a [bank]
must receive prior written approval from the adjusted carrying value of the [bank]’s
models publicly traded and non-publicly
[AGENCY]. To receive such approval, the publicly traded equity exposures that do not
traded equity exposures, the [bank]’s
[bank] must demonstrate to the [AGENCY]’s belong to a hedge pair, do not qualify for a
aggregate risk-weighted asset amount for its
satisfaction that the [bank] meets the 0 percent, 20 percent, or 100 percent risk
equity exposures is equal to the sum of:
following criteria: (1) The risk-weighted asset amount of each weight under paragraphs (b)(1) through
(1) The [bank] must have one or more equity exposure that qualifies for a 0 percent, (b)(3)(i) of section 52 of this appendix, and
models that: 20 percent, or 100 percent risk weight under are not equity exposures to an investment
(i) Assess the potential decline in value of paragraphs (b)(1) through (b)(3)(i) of section fund; and
its modeled equity exposures; 52 (as determined under section 52 of this (B) 200 percent multiplied by the aggregate
(ii) Are commensurate with the size, appendix) and each equity exposure to an ineffective portion of all hedge pairs.
complexity, and composition of the [bank]’s investment fund (as determined under
modeled equity exposures; and Section 54. Equity Exposures to Investment
section 54 of this appendix); and Funds
(iii) Adequately capture both general (2) The greater of:
market risk and idiosyncratic risk. (i) The estimate of potential losses on the (a) Available approaches. (1) Unless the
(2) The [bank]’s model must produce an [bank]’s equity exposures (other than equity exposure meets the requirements for a
estimate of potential losses for its modeled exposures referenced in paragraph (c)(1) of community development equity exposure in
equity exposures that is no less than the this section) generated by the [bank]’s paragraph (b)(3)(i) of section 52 of this
estimate of potential losses produced by a internal equity exposure model multiplied by appendix, a [bank] must determine the risk-
VaR methodology employing a 99.0 percent, 12.5; or weighted asset amount of an equity exposure
one-tailed confidence interval of the (ii) The sum of: to an investment fund under the Full Look-
distribution of quarterly returns for a (A) 200 percent multiplied by the aggregate Through Approach in paragraph (b) of this
benchmark portfolio of equity exposures adjusted carrying value of the [bank]’s section, the Simple Modified Look-Through
comparable to the [bank]’s modeled equity publicly traded equity exposures that do not Approach in paragraph (c) of this section, the
exposures using a long-term sample period. belong to a hedge pair, do not qualify for a Alternative Modified Look-Through
(3) The number of risk factors and 0 percent, 20 percent, or 100 percent risk Approach in paragraph (d) of this section, or,
exposures in the sample and the data period weight under paragraphs (b)(1) through if the investment fund qualifies for the
used for quantification in the [bank]’s model (b)(3)(i) of section 52 of this appendix, and Money Market Fund Approach, the Money
and benchmarking exercise must be are not equity exposures to an investment Market Fund Approach in paragraph (e) of
sufficient to provide confidence in the fund; this section.
accuracy and robustness of the [bank]’s (B) 200 percent multiplied by the aggregate (2) The risk-weighted asset amount of an
ER07DE07.021</GPH>
estimates. ineffective portion of all hedge pairs; and equity exposure to an investment fund that
meets the requirements for a community of each exposure held by the investment fund (c) Simple Modified Look-Through
development equity exposure in paragraph (as calculated under this appendix as if the Approach. Under this approach, the risk-
(b)(3)(i) of section 52 of this appendix is its proportional ownership share of each weighted asset amount for a [bank]’s equity
adjusted carrying value. exposure were held directly by the [bank]) exposure to an investment fund equals the
(3) If an equity exposure to an investment may either: adjusted carrying value of the equity
fund is part of a hedge pair and the [bank] (1) Set the risk-weighted asset amount of
does not use the Full Look-Through exposure multiplied by the highest risk
the [bank]’s exposure to the fund equal to the weight in Table 10 that applies to any
Approach, the [bank] may use the ineffective
product of: exposure the fund is permitted to hold under
portion of the hedge pair as determined
(i) The aggregate risk-weighted asset its prospectus, partnership agreement, or
under paragraph (c) of section 52 of this
appendix as the adjusted carrying value for amounts of the exposures held by the fund similar contract that defines the fund’s
the equity exposure to the investment fund. as if they were held directly by the [bank];
permissible investments (excluding
The risk-weighted asset amount of the and
derivative contracts that are used for hedging
effective portion of the hedge pair is equal to (ii) The [bank]’s proportional ownership
rather than speculative purposes and that do
its adjusted carrying value. share of the fund; or
(2) Include the [bank]’s proportional not constitute a material portion of the fund’s
(b) Full Look-Through Approach. A [bank]
that is able to calculate a risk-weighted asset ownership share of each exposure held by exposures).
amount for its proportional ownership share the fund in the [bank]’s IMA.
TABLE 10.—MODIFIED LOOK-THROUGH APPROACHES FOR EQUITY EXPOSURES TO INVESTMENT FUNDS

Risk weight Exposure class
0 percent ........................... Sovereign exposures with a long-term applicable external rating in the highest investment-grade rating category and
sovereign exposures of the United States.
20 percent ......................... Non-sovereign exposures with a long-term applicable external rating in the highest or second-highest investment-
grade rating category; exposures with a short-term applicable external rating in the highest investment-grade rat-
ing category; and exposures to, or guaranteed by, depository institutions, foreign banks (as defined in 12 CFR
211.2), or securities firms subject to consolidated supervision and regulation comparable to that imposed on U.S.
securities broker-dealers that are repo-style transactions or bankers’ acceptances.
50 percent ......................... Exposures with a long-term applicable external rating in the third-highest investment-grade rating category or a
short-term applicable external rating in the second-highest investment-grade rating category.
100 percent ....................... Exposures with a long-term or short-term applicable external rating in the lowest investment-grade rating category.
200 percent ....................... Exposures with a long-term applicable external rating one rating category below investment grade.
300 percent ....................... Publicly traded equity exposures.
400 percent ....................... Non-publicly traded equity exposures; exposures with a long-term applicable external rating two rating categories or
more below investment grade; and exposures without an external rating (excluding publicly traded equity expo-
sures).
1,250 percent .................... OTC derivative contracts and exposures that must be deducted from regulatory capital or receive a risk weight
greater than 400 percent under this appendix.
(d) Alternative Modified Look-Through equity exposure to an investment fund that operational risk exposure to reflect qualifying
Approach. Under this approach, a [bank] is a money market fund subject to 17 CFR operational risk mitigants if:
may assign the adjusted carrying value of an 270.2a–7 and that has an applicable external (1) The [bank]’s operational risk
equity exposure to an investment fund on a rating in the highest investment-grade rating quantification system is able to generate an
pro rata basis to different risk weight category equals the adjusted carrying value of estimate of the [bank]’s operational risk
categories in Table 10 based on the the equity exposure multiplied by 7 percent. exposure (which does not incorporate
investment limits in the fund’s prospectus, qualifying operational risk mitigants) and an
partnership agreement, or similar contract Section 55. Equity Derivative Contracts
estimate of the [bank]’s operational risk
that defines the fund’s permissible Under the IMA, in addition to holding risk- exposure adjusted to incorporate qualifying
investments. The risk-weighted asset amount based capital against an equity derivative operational risk mitigants; and
for the [bank]’s equity exposure to the contract under this part, a [bank] must hold (2) The [bank]’s methodology for
investment fund equals the sum of each risk-based capital against the counterparty incorporating the effects of insurance, if the
portion of the adjusted carrying value credit risk in the equity derivative contract [bank] uses insurance as an operational risk
assigned to an exposure class multiplied by by also treating the equity derivative contract mitigant, captures through appropriate
the applicable risk weight. If the sum of the as a wholesale exposure and computing a discounts to the amount of risk mitigation:
investment limits for exposure classes within supplemental risk-weighted asset amount for
the fund exceeds 100 percent, the [bank] (i) The residual term of the policy, where
the contract under part IV. Under the SRWA, less than one year;
must assume that the fund invests to the a [bank] may choose not to hold risk-based
maximum extent permitted under its (ii) The cancellation terms of the policy,
capital against the counterparty credit risk of where less than one year;
investment limits in the exposure class with equity derivative contracts, as long as it does
the highest risk weight under Table 10, and (iii) The policy’s timeliness of payment;
so for all such contracts. Where the equity (iv) The uncertainty of payment by the
continues to make investments in order of derivative contracts are subject to a qualified
the exposure class with the next highest risk provider of the policy; and
master netting agreement, a [bank] using the (v) Mismatches in coverage between the
weight under Table 10 until the maximum SRWA must either include all or exclude all
total investment level is reached. If more policy and the hedged operational loss event.
of the contracts from any measure used to (b) Qualifying operational risk mitigants.
than one exposure class applies to an
determine counterparty credit risk exposure. Qualifying operational risk mitigants are:
exposure, the [bank] must use the highest
applicable risk weight. A [bank] may exclude Part VII. Risk-Weighted Assets for (1) Insurance that:
derivative contracts held by the fund that are Operational Risk (i) Is provided by an unaffiliated company
used for hedging rather than for speculative that has a claims payment ability that is rated
purposes and do not constitute a material Section 61. Qualification Requirements for in one of the three highest rating categories
portion of the fund’s exposures. Incorporation of Operational Risk Mitigants by a NRSRO;
(e) Money Market Fund Approach. The (a) Qualification to use operational risk (ii) Has an initial term of at least one year
risk-weighted asset amount for a [bank]’s mitigants. A [bank] may adjust its estimate of and a residual term of more than 90 days;
(iii) Has a minimum notice period for 12 CFR Part 225 ■ 3. Appendix C to part 3 is amended
cancellation by the provider of 90 days; as set forth below:
(iv) Has no exclusions or limitations based Administrative practice and
■ a. Remove ‘‘[AGENCY]’’ and add
upon regulatory action or for the receiver or procedure, Banks, banking, Federal
‘‘OCC’’ in its place wherever it appears.
liquidator of a failed depository institution; Reserve System, Holding companies, ■ b. Remove ‘‘[bank]’’ and add ‘‘bank’’
and Reporting and recordkeeping
(v) Is explicitly mapped to a potential in its place wherever it appears, remove
requirements, Securities. ‘‘[banks]’’ and add ‘‘banks’’ in its place
operational loss event; and
(2) Operational risk mitigants other than 12 CFR Part 325 wherever it appears, remove ‘‘[Banks]’’
insurance for which the [AGENCY] has given and add ‘‘Banks’’ in its place wherever
prior written approval. In evaluating an Administrative practice and it appears, and remove ‘‘[Bank]’’ and
operational risk mitigant other than procedure, Banks, banking, Capital add ‘‘Bank’’ in its place wherever it
insurance, the [AGENCY] will consider Adequacy, Reporting and recordkeeping appears.
whether the operational risk mitigant covers requirements, Savings associations, ■ c. Remove ‘‘[Appendixl to Part l]’’
potential operational losses in a manner State nonmember banks.
equivalent to holding regulatory capital. and add ‘‘Appendix C to Part 3’’ in its
12 CFR Part 559 place wherever it appears.
Section 62. Mechanics of Risk-Weighted ■ d. Remove ‘‘[the general risk-based
Asset Calculation Reporting and recordkeeping capital rules]’’ and add ‘‘12 CFR part 3,
(a) If a [bank] does not qualify to use or requirements, Savings associations, Appendix A’’ in its place wherever it
does not have qualifying operational risk Subsidiaries. appears.
mitigants, the [bank]’s dollar risk-based ■ e. Remove ‘‘[the market risk rule]’’ and
capital requirement for operational risk is its 12 CFR Part 560
operational risk exposure minus eligible
add ‘‘12 CFR part 3, Appendix B’’ in its
Consumer protection, Investments, place wherever it appears.
operational risk offsets (if any).
Manufactured homes, Mortgages, ■ f. In section 1, revise paragraph
(b) If a [bank] qualifies to use operational
risk mitigants and has qualifying operational Reporting and recordkeeping (b)(1)(i), the last sentence in paragraph
risk mitigants, the [bank]’s dollar risk-based requirements, Savings associations, (b)(3), and the last sentence in
capital requirement for operational risk is the Securities. paragraph (c)(1) to read as follows:
greater of:
(1) The [bank]’s operational risk exposure 12 CFR Part 563 Section 1. Purpose, Applicability,
adjusted for qualifying operational risk Accounting, Administrative practice Reservation of Authority, and Principle
mitigants minus eligible operational risk and procedure, Advertising, Conflict of of Conservatism
offsets (if any); or
(2) 0.8 multiplied by the difference
interest, Crime, Currency, Holding * * * * *
between: companies, Investments, Mortgages, (b) Applicability. (1) * * *
(i) The [bank]’s operational risk exposure; Reporting and recordkeeping (i) Has consolidated assets, as
and requirements, Savings associations, reported on the most recent year-end
(ii) Eligible operational risk offsets (if any). Securities, Surety bond. Consolidated Report of Condition and
(c) The [bank]’s risk-weighted asset amount Income (Call Report) equal to $250
for operational risk equals the [bank]’s dollar 12 CFR Part 567
billion or more; * * *
risk-based capital requirement for operational (3) * * * In making a determination
Capital, Reporting and recordkeeping
risk determined under paragraph (a) or (b) of
this section multiplied by 12.5. requirements, Savings associations. under this paragraph, the OCC will
apply notice and response procedures in
Part VIII. Disclosure Adoption of Common Appendix
the same manner and to the same extent
Section 71. Disclosure Requirements ■ The adoption of the final common as the notice and response procedures
(a) Each [bank] must publicly disclose each rules by the agencies, as modified by in 12 CFR 3.12.
quarter its total and tier 1 risk-based capital agency-specific text, is set forth below: (c) Reservation of authority—(1)
ratios and their components (that is, tier 1 * * * In making a determination under
capital, tier 2 capital, total qualifying capital, DEPARTMENT OF THE TREASURY this paragraph, the OCC will apply
and total risk-weighted assets).4 Office of the Comptroller of the notice and response procedures in the
[Disclosure paragraph (b)] same manner and to the same extent as
[Disclosure paragraph Currency
the notice and response procedures in
(c)] 12 CFR Chapter I 12 CFR 3.12.
END OF COMMON RULE Authority and Issuance * * * * *
[END OF COMMON TEXT] ■ g. In section 2, revise the definition of
For the reasons stated in the common excluded mortgage exposure, the
List of Subjects preamble, the Office of the Comptroller definition of gain-on-sale, and
of the Currency amends part 3 of paragraph (2)(i) of the definition of high
12 CFR Part 3 chapter I of Title 12, Code of Federal volatility commercial real estate
Administrative practices and Regulations as follows: (HVCRE) exposure to read as follows:
procedure, Capital, National banks,
Reporting and recordkeeping PART 3—MINIMUM CAPITAL RATIOS; Section 2. Definitions
requirements, Risk. ISSUANCE OF DIRECTIVES
* * * * *
12 CFR Part 208 ■ 1. The authority citation for part 3 Excluded mortgage exposure means
continues to read as follows: any one- to four-family residential pre-
Confidential business information,
sold construction loan for a residence
Crime, Currency, Federal Reserve Authority: 12 U.S.C. 93a, 161, 1818,
for which the purchase contract is

System, Mortgages, reporting and 1828(n), 1828 note, 1831n note, 1835, 3907,
recordkeeping requirements, Securities. and 3909. cancelled that would receive a 100
percent risk weight under section
4 Other public disclosure requirements continue ■ 2. New Appendix C to part 3 is added 618(a)(2) of the Resolution Trust
to apply—for example, Federal securities law and as set forth at the end of the common Corporation Refinancing, Restructuring,
regulatory reporting requirements. preamble. and Improvement Act and under and 12
CFR part 3, Appendix A, section ■ k. Remove ‘‘[Disclosure paragraph Consolidated Report of Condition and
3(a)(3)(iii). (c)].’’ Income (Call Report) equal to $250
* * * * * billion or more; * * *
BOARD OF GOVERNORS OF THE
Gain-on-sale means an increase in the (3) * * * In making a determination
FEDERAL RESERVE SYSTEM
equity capital (as reported on Schedule under this paragraph, the Federal
RC of the Call Report) of a bank that 12 CFR Chapter II Reserve will apply notice and response
results from a securitization (other than procedures in the same manner and to
Authority and Issuance
an increase in equity capital that results the same extent as the notice and
from the bank’s receipt of cash in ■ For the reasons stated in the common response procedures in 12 CFR 263.202.
connection with the securitization). preamble, the Board of Governors of the (c) Reservation of authority—(1)
Federal Reserve System amends parts * * * In making a determination under
* * * * *
208 and 225 of chapter II of title 12 of this paragraph, the Federal Reserve will
High volatility commercial real estate
the Code of Federal Regulations as apply notice and response procedures in
(HVCRE) exposure * * *
follows: the same manner and to the same extent
(2) * * *
as the notice and response procedures
(i) The loan-to-value ratio is less than PART 208—MEMBERSHIP OF STATE in 12 CFR 263.202.
or equal to the applicable maximum BANKING INSTITUTIONS IN THE
supervisory loan-to-value ratio in the * * * * *
FEDERAL RESERVE SYSTEM ■ g. In section 2, revise the definition of
OCC’s real estate lending standards at (REGULATION H)
12 CFR part 34, Subpart D; excluded mortgage exposure, the
■ 1. The authority citation for part 208 definition of gain-on-sale, and
* * * * * paragraph (2)(i) of the definition of high
continues to read as follows:
■ h. Revise section 12 to read as follows:
Authority: 12 U.S.C. 24, 36, 92a, 93a, volatility commercial real estate
Section 12. Deductions and Limitations 248(a), 248(c), 321–338a, 371d, 461, 481–486, (HVCRE) exposure to read as follows:
Not Required 601, 611, 1814, 1816, 1818, 1820(d)(9), Section 2. Definitions
1823(j), 1828(o), 1831, 1831o, 1831p–1,
(a) Deduction of CEIOs. A bank is not 1831r–1, 1835a, 1882, 2901–2907, 3105, * * * * *
required to make the deductions from 3310, 3331–3351, and 3906–3909; 15 U.S.C. Excluded mortgage exposure means
capital for CEIOs in 12 CFR part 3, 78b, 78l(b), 78l(g), 78l(i), 78o–4(c)(5), 78q, any one- to four-family residential pre-
Appendix A, section 2(c). 78q–1, and 78w, 6801, and 6805; 31 U.S.C. sold construction loan for a residence
(b) Deduction of certain equity 5318; 42 U.S.C. 4012a, 4104a, 4104b, 4106,
and 4128.
for which the purchase contract is
investments. A bank is not required to cancelled that would receive a 100
make the deductions from capital for ■ 2. New Appendix F to part 208 is percent risk weight under section
nonfinancial equity investments in 12 added as set forth at the end of the 618(a)(2) of the Resolution Trust
CFR part 3, Appendix A, section 2(c). common preamble. Corporation Refinancing, Restructuring,
* * * * * ■ 3. Appendix F to part 208 is amended and Improvement Act and under and 12
■ i. Revise the first sentence of as set forth below: CFR part 208, Appendix A, section
paragraph (k)(1)(iv) and paragraph (k)(4) ■ a. Remove ‘‘[AGENCY]’’ and add III.C.3.
of section 42 to read as follows: ‘‘Federal Reserve’’ in its place wherever * * * * *
it appears. Gain-on-sale means an increase in the
Section 42. Risk-Based Capital
■ b. Remove ‘‘[bank]’’ and add ‘‘bank’’ equity capital (as reported on Schedule
Requirement for Securitization
in its place wherever it appears, remove RC of the Call Report) of a bank that
Exposures
‘‘[banks]’’ and add ‘‘banks’’ in its place results from a securitization (other than
* * * * * wherever it appears, remove ‘‘[Banks]’’ an increase in equity capital that results
(k) * * * and add ‘‘Banks’’ in its place wherever from the bank’s receipt of cash in
(1) * * * it appears, and remove ‘‘[Bank]’’ and connection with the securitization).
(iv) The bank is well capitalized, as add ‘‘Bank’’ in its place wherever it
* * * * *
defined in the OCC’s prompt corrective appears. High volatility commercial real estate
action regulation at 12 CFR part 6. ■ c. Remove ‘‘[Appendix l to Part l]’’
(HVCRE) exposure * * *
* * * and add ‘‘Appendix F to part 208’’ in its
(2) * * *
* * * * * place wherever it appears. (i) The loan-to-value ratio is less than
(4) The risk-based capital ratios of the ■ d. Remove ‘‘[the general risk-based
or equal to the applicable maximum
bank must be calculated without regard capital rules]’’ and add ‘‘12 CFR part
supervisory loan-to-value ratio in the
to the capital treatment for transfers of 208, Appendix A’’ in its place wherever
Federal Reserve’s real estate lending
small-business obligations with recourse it appears.
■ e. Remove ‘‘[the market risk rule]’’ and
standards at 12 CFR part 208, Appendix
specified in paragraph (k)(1) of this C;
section as provided in 12 CFR part 3, add ‘‘12 CFR part 208, Appendix E’’ in
its place wherever it appears. * * * * *
Appendix A. ■ h. Revise section 12 to read as follows:
■ f. In section 1, revise paragraph
* * * * * (b)(1)(i), the last sentence in paragraph
■ j. Remove ‘‘[Disclosure paragraph Section 12. Deductions and Limitations
(b)(3), and the last sentence in Not Required
(b)]’’ and add in its place ‘‘(b) A bank paragraph (c)(1) to read as follows:
must comply with paragraph (b) of (a) Deduction of CEIOs. A bank is not
section 71 of appendix G to the Federal Section 1. Purpose, Applicability, required to make the deductions from
Reservation of Authority, and Principle
Reserve Board’s Regulation Y (12 CFR capital for CEIOs in 12 CFR part 208,
part 225, appendix G) unless it is a of Conservatism Appendix A, section II.B.1.e.
consolidated subsidiary of a bank * * * * * (b) Deduction of certain equity
holding company or depository (b) Applicability. (1) * * * investments. A bank is not required to
institution that is subject to these (i) Has consolidated assets, as make the deductions from capital for
requirements.’’ reported on the most recent year-end nonfinancial equity investments in 12
CFR part 208, Appendix A, section ■ c. Remove ‘‘[Appendixlto Partl]’’ as the notice and response procedures
II.B.5. and add ‘‘Appendix G to Part 225’’ in its in 12 CFR 263.202.
* * * * * place wherever it appears. * * * * *
■ i. Revise the first sentence of ■ d. Remove ‘‘[the general risk-based
■ g. In section 2, revise the definition of
paragraph (k)(1)(iv) and paragraph (k)(4) capital rules]’’ and add ‘‘12 CFR part
excluded mortgage exposure, the
of section 42 to read as follows: 225, Appendix A’’ in its place wherever
definition of gain-on-sale, and
it appears.
Section 42. Risk-Based Capital ■ e. Remove ‘‘[the market risk rule]’’ and
paragraph (2)(i) of the definition of high
Requirement for Securitization add ‘‘12 CFR part 225, Appendix E’’ in volatility commercial real estate
Exposures its place wherever it appears. (HVCRE) exposure to read as follows:
■ f. In section 1, revise paragraph (b)(1), Section 2. Definitions
* * * * *
(k) * * * the last sentence in paragraph (b)(3),
and the last sentence in paragraph (c)(1) * * * * *
(1) * * * Excluded mortgage exposure means
to read as follows:
(iv) The bank is well capitalized, as any one- to four-family residential pre-
defined in the Federal Reserve’s prompt Section 1. Purpose, Applicability, sold construction loan for a residence
corrective action regulation at 12 CFR Reservation of Authority, and Principle for which the purchase contract is
part 208, Subpart D.* * * of Conservatism cancelled that would receive a 100
* * * * * * * * * * percent risk weight under section
(4) The risk-based capital ratios of the (b) * * * 618(a)(2) of the Resolution Trust
bank must be calculated without regard (1) This appendix applies to a bank Corporation Refinancing, Restructuring,
to the capital treatment for transfers of holding company that: and Improvement Act and under 12 CFR
small-business obligations with recourse (i) Is not a consolidated subsidiary of part 225, Appendix A, section III.C.3.
specified in paragraph (k)(1) of this another bank holding company that uses * * * * *
section as provided in 12 CFR part 208, this appendix to calculate its risk-based
Appendix A. capital requirements; and Gain-on-sale means an increase in the
(ii) That: equity capital (as reported on Schedule
* * * * * HC of the FR Y–9C Report) of a bank
■ j. Remove ‘‘[Disclosure paragraph
(A) Is a U.S.-based bank holding
company that has total consolidated holding company that results from a
(b)]’’ and add in its place ‘‘(b) A bank securitization (other than an increase in
must comply with paragraph (b) of assets (excluding assets held by an
insurance underwriting subsidiary), as equity capital that results from the bank
section 71 of appendix G to the Federal holding company’s receipt of cash in
Reserve Board’s Regulation (12 CFR part reported on the most recent year-end FR
Y–9C Report, equal to $250 billion or connection with the securitization).
225, appendix G) unless it is a
more; * * * * *
consolidated subsidiary of a bank
(B) Has consolidated total on-balance High volatility commercial real estate
holding company or depository
sheet foreign exposure at the most (HVCRE) exposure * * *
institution that is subject to these
recent year-end equal to $10 billion or
requirements.’’ (2) * * *
more (where total on-balance sheet
■ k. Remove ‘‘[Disclosure paragraph (i) The loan-to-value ratio is less than
foreign exposure equals total cross-
(c)].’’ or equal to the applicable maximum
border claims less claims with head
office or guarantor located in another supervisory loan-to-value ratio in the
PART 225—BANK HOLDING relevant agency’s real estate lending
COMPANIES AND CHANGE IN BANK country plus redistributed guaranteed
amounts to the country of head office or standards at 12 CFR part 34, Subpart D
CONTROL (REGULATION Y) (OCC), 12 CFR part 208, Appendix C
guarantor plus local country claims on
■ 1. The authority citation for part 225 local residents plus revaluation gains on (Federal Reserve); 12 CFR part 365,
continues to read as follows: foreign exchange and derivative Subpart D (FDIC); and 12 CFR 560.100–
products, calculated in accordance with 560.101 (OTS).
Authority: 12 U.S.C. 1817(j)(13), 1818,
1828(o), 1831i, 1831p–1, 1843(c)(8), 1844(b), the Federal Financial Institutions * * * * *
1972(1), 3106, 3108, 3310, 3331–3351, 3907, Examination Council (FFIEC) 009 ■ h. Add a new paragraph (c)(8) to
and 3909; 15 U.S.C. 6801 and 6805. Country Exposure Report); or section 11 to read as follows:
(C) Has a subsidiary depository
■ 2. New Appendix G to part 225 is institution that is required, or has Section 11. Additional Deductions.
added as set forth at the end of the elected, to use 12 CFR part 3, Appendix * * * * *
common preamble. C, 12 CFR part 208, Appendix F, 12 CFR (c) * * *
■ 3. Appendix G to part 225 is amended part 325, Appendix F, or 12 CFR part
as set forth below: 567, Appendix C to calculate its risk- (8) A bank holding company must
■ a. Remove ‘‘[AGENCY]’’ and add based capital requirements. also deduct an amount equal to the
‘‘Federal Reserve’’ in its place wherever minimum regulatory capital
* * * * * requirement established by the regulator
it appears. (3) * * * In making a determination
■ b. Remove ‘‘[bank]’’ and add in its
of any insurance underwriting
under this paragraph, the Federal
place ‘‘bank holding company’’ subsidiary of the holding company. For
Reserve will apply notice and response
wherever it appears, remove ‘‘[banks]’’ U.S.-based insurance underwriting
procedures in the same manner and to
and add ‘‘bank holding companies’’ in subsidiaries, this amount generally
the same extent as the notice and
would be 200 percent of the subsidiary’s
its place wherever it appears, remove response procedures in 12 CFR 263.202.

‘‘[Banks]’’ and add ‘‘Bank holding (c) Reservation of authority—(1) Authorized Control Level as established
companies’’ in its place wherever it * * * In making a determination under by the appropriate state regulator of the
appears, and remove ‘‘[Bank]’’ and add this paragraph, the Federal Reserve will insurance company.
‘‘Bank holding company’’ in its place apply notice and response procedures in * * * * *
wherever it appears. the same manner and to the same extent ■ i. Revise section 12 to read as follows:
Section 12. Deductions and Limitations (k) * * * objectives and policies, reporting
Not Required. (1) * * * system, and definitions) may be
(iv) The bank holding company is disclosed annually, provided any
(a) Deduction of CEIOs. A bank
well capitalized, as defined in the significant changes to these are
holding company is not required to
Federal Reserve’s prompt corrective disclosed in the interim. Management is
make the deductions from capital for
action regulation at 12 CFR part 208, encouraged to provide all of the
CEIOs in 12 CFR part 225, Appendix A,
Subpart D.* * * disclosures required by this appendix in
section II.B.1.e.
(b) Deduction for certain equity * * * * * one place on the bank holding
investments. A bank holding company (4) The risk-based capital ratios of the company’s public Web site.5 The bank
is not required to make the deductions bank holding company must be holding company must make these
from capital for nonfinancial equity calculated without regard to the capital disclosures publicly available for each
investments in 12 CFR part 225, treatment for transfers of small-business of the last three years (that is, twelve
Appendix A, section II.B.5. obligations with recourse specified in quarters) or such shorter period since it
paragraph (k)(1) of this section as began its first floor period.
* * * * * provided in 12 CFR part 225, Appendix
■ j. Remove and reserve section (2) Each bank holding company is
A. required to have a formal disclosure
22(h)(3)(ii).
■ k. In section 31(e)(3)(i), remove ‘‘A
* * * * * policy approved by the board of
■ m. In section 71, remove ‘‘[Disclosure directors that addresses its approach for
[bank] may assign a risk-weighted asset
paragraph (b)].’’ determining the disclosures it makes.
amount of zero to cash owned and held ■ n. In section 71, remove ‘‘[Disclosure
in all offices of the [bank] or in transit The policy must address the associated
paragraph (c)].’’ internal controls and disclosure controls
and to gold bullion held in the [bank]’s ■ o. In section 71, add new paragraph
own vaults, or held in another [bank]’s and procedures. The board of directors
(b) and Tables 11.1 through 11.11 to
vaults on an allocated basis, to the and senior management are responsible
read as follows:
extent the gold bullion assets are offset for establishing and maintaining an
by gold bullion liabilities’’ and add in Section 71. Disclosure Requirements effective internal control structure over
its place ‘‘A bank holding company may * * * * * financial reporting, including the
assign a risk-weighted asset amount of (b)(1) Each consolidated bank holding disclosures required by this appendix,
zero to cash owned and held in all company that is not a subsidiary of a and must ensure that appropriate review
offices of subsidiary depository non-U.S. banking organization that is of the disclosures takes place. One or
institutions or in transit and for gold subject to comparable public disclosure more senior officers of the bank holding
bullion held in either a subsidiary requirements in its home jurisdiction company must attest that the
depository institution’s own vaults, or and has successfully completed its disclosures meet the requirements of
held in another depository institution’s parallel run must provide timely public this appendix.
vaults on an allocated basis, to the disclosures each calendar quarter of the (3) If a bank holding company
extent the gold bullion assets are offset information in tables 11.1–11.11 below. believes that disclosure of specific
by gold bullion liabilities.’’ If a significant change occurs, such that commercial or financial information
* * * * * the most recent reported amounts are no would prejudice seriously its position
■ l. Revise the first sentence of longer reflective of the bank holding by making public information that is
paragraph (k)(1)(iv) and revise company’s capital adequacy and risk either proprietary or confidential in
paragraph (k)(4) of section 42 to read as profile, then a brief discussion of this nature, the bank holding company need
follows: change and its likely impact must be not disclose those specific items, but
provided as soon as practicable must disclose more general information
Section 42. Risk-Based Capital thereafter. Qualitative disclosures that about the subject matter of the
Requirement for Securitization typically do not change each quarter (for requirement, together with the fact that,
Exposures example, a general summary of the bank and the reason why, the specific items
* * * * * holding company’s risk management of information have not been disclosed.
TABLE 11.1.—SCOPE OF APPLICATION

Qualitative Disclosures ................... (a) The name of the top corporate entity in the group to which the appendix applies.
(b) An outline of differences in the basis of consolidation for accounting and regulatory purposes, with a
brief description of the entities 6 within the group that are fully consolidated; that are deconsolidated and
deducted; for which the regulatory capital requirement is deducted; and that are neither consolidated nor
deducted (for example, where the investment is risk-weighted).
(c) Any restrictions, or other major impediments, on transfer of funds or regulatory capital within the group.
Quantitative Disclosures ................. (d) The aggregate amount of surplus capital of insurance subsidiaries (whether deducted or subjected to
an alternative method) included in the regulatory capital of the consolidated group.
(e) The aggregate amount by which actual regulatory capital is less than the minimum regulatory capital
requirement in all subsidiaries with regulatory capital requirements and the name(s) of the subsidiaries
with such deficiencies.
5 Alternatively, a bank holding company may regulatory reports. The bank holding company must 6 Entities include securities, insurance and other
provide the disclosures in more than one place, as provide a summary table on its public Web site that financial subsidiaries, commercial subsidiaries
some of them may be included in public financial specifically indicates where all the disclosures may (where permitted), and significant minority equity
reports (for example, in Management’s Discussion be found (for example, regulatory report schedules, investments in insurance, financial and commercial
and Analysis included in SEC filings) or other page numbers in annual reports). entities.
TABLE 11.2.—CAPITAL STRUCTURE

Qualitative Disclosures ................... (a) Summary information on the terms and conditions of the main features of all capital instruments, espe-
cially in the case of innovative, complex or hybrid capital instruments.
Quantitative Disclosures ................. (b) The amount of tier 1 capital, with separate disclosure of:
• Common stock/surplus;
• Retained earnings;
• Minority interests in the equity of subsidiaries;
• Restricted core capital elements as defined in 12 CFR part 225, Appendix A;
• Regulatory calculation differences deducted from tier 1 capital; 7 and
• Other amounts deducted from tier 1 capital, including goodwill and certain intangibles.
(c) The total amount of tier 2 capital.
(d) Other deductions from capital. 8
(e) Total eligible capital.
TABLE 11.3.—CAPITAL ADEQUACY

Qualitative disclosures .................... (a) A summary discussion of the bank holding company’s approach to assessing the adequacy of its cap-
ital to support current and future activities.
Quantitative disclosures .................. (b) Risk-weighted assets for credit risk from:
• Wholesale exposures;
• Residential mortgage exposures;
• Qualifying revolving exposures;
• Other retail exposures;
• Securitization exposures;
• Equity exposures
• Equity exposures subject to the simple risk weight approach; and
• Equity exposures subject to the internal models approach.
(c) Risk-weighted assets for market risk as calculated under [the market risk rule]: 9
• Standardized approach for specific risk; and
• Internal models approach for specific risk.
(d) Risk-weighted assets for operational risk.
(e) Total and tier 1 risk-based capital ratios: 10
• For the top consolidated group; and
• For each DI subsidiary.
General Qualitative Disclosure management objectives and policies, • The scope and nature of risk
Requirement including: reporting and/or measurement systems;
• Strategies and processes; • Policies for hedging and/or
For each separate risk area described mitigating risk and strategies and
in tables 11.4 through 11.11, the bank • The structure and organization of processes for monitoring the continuing
holding company must describe its risk the relevant risk management function; effectiveness of hedges/mitigants.
TABLE 11.4.11—CREDIT RISK: GENERAL DISCLOSURES
Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to credit risk (excluding counterparty credit
risk disclosed in accordance with Table 11.6), including:
• Definitions of past due and impaired (for accounting purposes);
• Description of approaches followed for allowances, including statistical methods used where applica-
ble; and
• Discussion of the bank holding company’s credit risk management policy.
Quantitative Disclosures ................. (b) Total credit risk exposures and average credit risk exposures, after accounting offsets in accordance
with GAAP,12 and without taking into account the effects of credit risk mitigation techniques (for exam-
ple, collateral and netting), over the period broken down by major types of credit exposure.13
(c) Geographic 14 distribution of exposures, broken down in significant areas by major types of credit expo-
sure.
(d) Industry or counterparty type distribution of exposures, broken down by major types of credit exposure.
(e) Remaining contractual maturity breakdown (for example, one year or less) of the whole portfolio, bro-
ken down by major types of credit exposure.
(f) By major industry or counterparty type:
• Amount of impaired loans;
• Amount of past due loans; 15
• Allowances; and
7 Representing 50 percent of the amount, if any, 8 Including 50 percent of the amount, if any, by 9 Risk-weighted assets determined under [the
by which total expected credit losses as calculated which total expected credit losses as calculated market risk rule] are to be disclosed only for the
within the IRB approach exceed eligible credit within the IRB approach exceed eligible credit approaches used.
reserves, which must be deducted from tier 1 reserves, which must be deducted from tier 2 10 Total risk-weighted assets should also be
capital. capital. disclosed.
TABLE 11.4.11—CREDIT RISK: GENERAL DISCLOSURES—Continued

• Charge-offs during the period.
(g) Amount of impaired loans and, if available, the amount of past due loans broken down by significant
geographic areas including, if practical, the amounts of allowances related to each geographical area.16
(h) Reconciliation of changes in the allowance for loan and lease losses.17
TABLE 11.5.—CREDIT RISK: DISCLOSURES FOR PORTFOLIOS SUBJECT TO IRB RISK-BASED CAPITAL FORMULAS
Qualitative disclosures .................... (a) Explanation and review of the:
• Structure of internal rating systems and relation between internal and external ratings;
• Use of risk parameter estimates other than for regulatory capital purposes;
• Process for managing and recognizing credit risk mitigation (see table 11.7); and
• Control mechanisms for the rating system, including discussion of independence, accountability, and
rating systems review.
(b) Description of the internal ratings process, provided separately for the following:
• Wholesale category;
• Retail subcategories;
• Qualifying revolving exposures; and
• Other retail exposures.
For each category and subcategory the description should include:
• The types of exposure included in the category/subcategories; and
• The definitions, methods and data for estimation and validation of PD, LGD, and EAD, including as-
sumptions employed in the derivation of these variables.18
Quantitative disclosures: Risk as- (c) For wholesale exposures, present the following information across a sufficient number of PD grades
sessment. (including default) to allow for a meaningful differentiation of credit risk: 19
• Total EAD; 20
• Exposure-weighted average LGD (percentage);
• Exposure-weighted average risk weight; and
• Amount of undrawn commitments and exposure-weighted average EAD for wholesale exposures.
For each retail subcategory, present the disclosures outlined above across a sufficient number of seg-
ments to allow for a meaningful differentiation of credit risk.
Quantitative disclosures: Historical (d) Actual losses in the preceding period for each category and subcategory and how this differs from past
results. experience. A discussion of the factors that impacted the loss experience in the preceding period—for
example, has the bank holding company experienced higher than average default rates, loss rates or
EADs.
(e) Bank holding company’s estimates compared against actual outcomes over a longer period.21 At a
minimum, this should include information on estimates of losses against actual losses in the wholesale
category and each retail subcategory over a period sufficient to allow for a meaningful assessment of
the performance of the internal rating processes for each category/subcategory.22 Where appropriate,
the bank holding company should further decompose this to provide analysis of PD, LGD, and EAD out-
comes against estimates provided in the quantitative risk assessment disclosures above.23
11 Table 4 does not include equity exposures. losses during the period; any other adjustments (for PD grades for the purposes of disclosure, this
12 For example, FASB Interpretations 39 and 41. example, exchange rate differences, business should be a representative breakdown of the
13 For example, bank holding companies could combinations, acquisitions and disposals of distribution of PD grades used for regulatory capital
apply a breakdown similar to that used for subsidiaries), including transfers between purposes.
accounting purposes. Such a breakdown might, for allowances; and the closing balance of the 20 Outstanding loans and EAD on undrawn
instance, be (a) loans, off-balance sheet allowance. Charge-offs and recoveries that have commitments can be presented on a combined basis
commitments, and other non-derivative off-balance been recorded directly to the income statement for these disclosures.
sheet exposures, (b) debt securities, and (c) OTC should be disclosed separately. 21 These disclosures are a way of further
derivatives. 18 This disclosure does not require a detailed
14 Geographical areas may comprise individual
informing the reader about the reliability of the
description of the model in full—it should provide
information provided in the ‘‘quantitative
countries, groups of countries, or regions within the reader with a broad overview of the model
disclosures: risk assessment’’ over the long run. The
countries. A bank holding company might choose approach, describing definitions of the variables
to define the geographical areas based on the way disclosures are requirements from year-end 2010; in
and methods for estimating and validating those
the company’s portfolio is geographically managed. the meantime, early adoption is encouraged. The
variables set out in the quantitative risk disclosures
The criteria used to allocate the loans to below. This should be done for each of the four phased implementation is to allow a bank holding
geographical areas must be specified. category/subcategories. The bank holding company company sufficient time to build up a longer run
15 A bank holding company is encouraged also to should disclose any significant differences in of data that will make these disclosures meaningful.
22 This regulation is not prescriptive about the
provide an analysis of the aging of past-due loans. approach to estimating these variables within each
16 The portion of general allowance that is not category/subcategories. period used for this assessment. Upon
allocated to a geographical area should be disclosed 19 The PD, LGD and EAD disclosures in Table implementation, it might be expected that a bank
separately. 11.5(c) should reflect the effects of collateral, holding company would provide these disclosures
17 The reconciliation should include the qualifying master netting agreements, eligible for as long run of data as possible—for example, if
following: A description of the allowance; the guarantees and eligible credit derivatives as defined a bank holding company has 10 years of data, it
opening balance of the allowance; charge-offs taken in part I. Disclosure of each PD grade should might choose to disclose the average default rates
against the allowance during the period; amounts include the exposure-weighted average PD for each for each PD grade over that 10-year period. Annual
provided (or reversed) for estimated probable loan grade. Where a bank holding company aggregates amounts need not be disclosed.
TABLE 11.6.—GENERAL DISCLOSURE FOR COUNTERPARTY CREDIT RISK OF OTC DERIVATIVE CONTRACTS, REPO-STYLE
TRANSACTIONS, AND ELIGIBLE MARGIN LOANS
Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to OTC derivatives, eligible margin loans,
and repo-style transactions, including:
• Discussion of methodology used to assign economic capital and credit limits for counterparty credit
exposures;
• Discussion of policies for securing collateral, valuing and managing collateral, and establishing credit
reserves;
• Discussion of the primary types of collateral taken;
• Discussion of policies with respect to wrong-way risk exposures; and
• Discussion of the impact of the amount of collateral the bank holding company would have to provide
if the bank holding company were to receive a credit rating downgrade.
Quantitative Disclosures ................. (b) Gross positive fair value of contracts, netting benefits, netted current credit exposure, collateral held (in-
cluding type, for example, cash, government securities), and net unsecured credit exposure.24 Also re-
port measures for EAD used for regulatory capital for these transactions, the notional value of credit de-
rivative hedges purchased for counterparty credit risk protection, and, for bank holding companies not
using the internal models methodology in section 32(d) of this appendix, the distribution of current credit
exposure by types of credit exposure.25
(c) Notional amount of purchased and sold credit derivatives, segregated between use for the bank holding
company’s own credit portfolio and for its intermediation activities, including the distribution of the credit
derivative products used, broken down further by protection bought and sold within each product group.
(d) The estimate of alpha if the bank holding company has received supervisory approval to estimate
alpha.
TABLE 11.7.—CREDIT RISK MITIGATION 26 27 28

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to credit risk mitigation including:
• Policies and processes for, and an indication of the extent to which the bank holding company uses,
on- and off-balance sheet netting;
• Policies and processes for collateral valuation and management;
• A description of the main types of collateral taken by the bank holding company;
• The main types of guarantors/credit derivative counterparties and their creditworthiness; and
• Information about (market or credit) risk concentrations within the mitigation taken.
Quantitative Disclosures ................. (b) For each separately disclosed portfolio, the total exposure (after, where applicable, on-or off-balance
sheet netting) that is covered by guarantees/credit derivatives.
TABLE 11.8.—SECURITIZATION
Qualitative disclosures .................... (a) The general qualitative disclosure requirement with respect to securitization (including synthetics), in-
cluding a discussion of:
• The bank holding company’s objectives relating to securitization activity, including the extent to which
these activities transfer credit risk of the underlying exposures away from the bank holding company
to other entities;
• The roles played by the bank holding company in the securitization process 29 and an indication of the
extent of the bank holding company’s involvement in each of them; and
• The regulatory capital approaches (for example, RBA, IAA and SFA) that the bank holding company
follows for its securitization activities.
(b) Summary of the bank holding company’s accounting policies for securitization activities, including:
• Whether the transactions are treated as sales or financings;
• Recognition of gain-on-sale;
• Key assumptions for valuing retained interests, including any significant changes since the last report-
ing period and the impact of such changes; and
• Treatment of synthetic securitizations.
23 A bank holding company should provide this arrangements, without taking into account haircuts companies are encouraged to give further
further decomposition where it will allow users for price volatility, liquidity, etc. information about mitigants that have not been
greater insight into the reliability of the estimates 25 This may include interest rate derivative recognized for that purpose.
provided in the ‘‘quantitative disclosures: risk contracts, foreign exchange derivative contracts, 27 Credit derivatives that are treated, for the
assessment.’’ In particular, it should provide this
equity derivative contracts, credit derivatives, purposes of this appendix, as synthetic
information where there are material differences
between its estimates of PD, LGD or EAD compared commodity or other derivative contracts, repo-style securitization exposures should be excluded from
to actual outcomes over the long run. The bank transactions, and eligible margin loans. the credit risk mitigation disclosures and included
holding company should also provide explanations 26 At a minimum, a bank holding company must within those relating to securitization.
for such differences. provide the disclosures in Table 11.7 in relation to 28 Counterparty credit risk-related exposures
24 Net unsecured credit exposure is the credit credit risk mitigation that has been recognized for disclosed pursuant to Table 11.6 should be
exposure after considering the benefits from legally the purposes of reducing capital requirements excluded from the credit risk mitigation disclosures
enforceable netting agreements and collateral under this appendix. Where relevant, bank holding in Table 11.7.
TABLE 11.8.—SECURITIZATION—Continued
(c) Names of NRSROs used for securitizations and the types of securitization exposure for which each
agency is used.
Quantitative disclosures .................. (d) The total outstanding exposures securitized by the bank holding company in securitizations that meet
the operational criteria in section 41 of this appendix (broken down into traditional/synthetic), by under-
lying exposure type.30 31 32
(e) For exposures securitized by the bank holding company in securitizations that meet the operational cri-
teria in Section 41 of this appendix:
• Amount of securitized assets that are impaired/past due; and
• Losses recognized by the bank holding company during the current period 33 broken down by expo-
sure type.
(f) Aggregate amount of securitization exposures broken down by underlying exposure type.
(g) Aggregate amount of securitization exposures and the associated IRB capital requirements for these
exposures broken down into a meaningful number of risk weight bands. Exposures that have been de-
ducted from capital should be disclosed separately by type of underlying asset.
(h) For securitizations subject to the early amortization treatment, the following items by underlying asset
type for securitized facilities:
• The aggregate drawn exposures attributed to the seller’s and investors’ interests; and
• The aggregate IRB capital charges incurred by the bank holding company against the investors’
shares of drawn balances and undrawn lines.
(i) Summary of current year’s securitization activity, including the amount of exposures securitized (by ex-
posure type), and recognized gain or loss on sale by asset type.
TABLE 11.9.—OPERATIONAL RISK

Qualitative disclosures .................... (a) The general qualitative disclosure requirement for operational risk.
(b) Description of the AMA, including a discussion of relevant internal and external factors considered in
the bank holding company’s measurement approach.
(c) A description of the use of insurance for the purpose of mitigating operational risk.
TABLE 11.10.—EQUITIES NOT SUBJECT TO MARKET RISK RULE

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to equity risk, including:
• Differentiation between holdings on which capital gains are expected and those held for other objec-
tives, including for relationship and strategic reasons; and
• Discussion of important policies covering the valuation of and accounting for equity holdings in the
banking book. This includes the accounting techniques and valuation methodologies used, including
key assumptions and practices affecting valuation as well as significant changes in these practices.
Quantitative Disclosures ................. (b) Value disclosed in the balance sheet of investments, as well as the fair value of those investments; for
quoted securities, a comparison to publicly-quoted share values where the share price is materially dif-
ferent from fair value.
(c) The types and nature of investments, including the amount that is:
• Publicly traded; and
• Non-publicly traded.
(d) The cumulative realized gains (losses) arising from sales and liquidations in the reporting period.
(e) • Total unrealized gains (losses) 34
• Total latent revaluation gains (losses) 35
• Any amounts of the above included in tier 1 and/or tier 2 capital.
(f) Capital requirements broken down by appropriate equity groupings, consistent with the bank holding
company’s methodology, as well as the aggregate amounts and the type of equity investments subject
to any supervisory transition regarding regulatory capital requirements.36
29 For example: originator, investor, servicer, any securitization exposure should be shown balance sheet) or write-downs of I/O strips and
provider of credit enhancement, sponsor of asset separately but need only be reported for the year other residual interests.
backed commercial paper facility, liquidity of inception. 34 Unrealized gains (losses) recognized in the
provider, or swap provider. 32 Where relevant, a bank holding company is balance sheet but not through earnings.
30 Underlying exposure types may include, for encouraged to differentiate between exposures 35 Unrealized gains (losses) not recognized either
example, one- to four-family residential loans, resulting from activities in which they act only as in the balance sheet or through earnings.
home equity lines, credit card receivables, and auto sponsors, and exposures that result from all other 36 This disclosure should include a breakdown of
loans. bank holding company securitization activities. equities that are subject to the 0 percent, 20 percent,
31 Securitization transactions in which the 33 For example, charge-offs/allowances (if the 100 percent, 300 percent, 400 percent, and 600
originating bank holding company does not retain assets remain on the bank holding company’s percent risk weights, as applicable.
TABLE 11.11.—INTEREST RATE RISK FOR NON-TRADING ACTIVITIES

Qualitative disclosures .................... (a) The general qualitative disclosure requirement, including the nature of interest rate risk for non-trading
activities and key assumptions, including assumptions regarding loan prepayments and behavior of non-
maturity deposits, and frequency of measurement of interest rate risk for non-trading activities.
Quantitative disclosures .................. (b) The increase (decline) in earnings or economic value (or relevant measure used by management) for
upward and downward rate shocks according to management’s method for measuring interest rate risk
for non-trading activities, broken down by currency (as appropriate).
* * * * * (b) Applicability. (1) * * * ■ h. Revise section 12 to read as follows:

(i) Has consolidated assets, as
FEDERAL DEPOSIT INSURANCE reported on the most recent year-end Section 12. Deductions and Limitations
CORPORATION Consolidated Report of Condition and Not Required
12 CFR Chapter III Income (Call Report) equal to $250 (a) Deduction of CEIOs. A bank is not
billion or more; required to make the deductions from
Authority and Issuance
* * * * * capital for CEIOs in 12 CFR part 325,
■ For the reasons stated in the common (3) * * * In making a determination Appendix A, section II.B.5.
preamble, the Federal Deposit Insurance under this paragraph, the FDIC will (b) Deduction for certain equity
Corporation amends part 325 of chapter apply notice and response procedures in investments. A bank is not required to
III of title 12 of the Code of Federal the same manner and to the same extent make the deductions from capital for
Regulations as follows: as the notice and response procedures nonfinancial equity investments in 12
in 12 CFR 325.6(c). CFR part 325, Appendix A, section II.B.
PART 325—CAPITAL MAINTENANCE (c) Reservation of authority—(1)
* * * In making a determination under * * * * *
■ 1. The authority citation for part 325 ■ i. Revise the first sentence of
continues to read as follows: this paragraph, the FDIC will apply
notice and response procedures in the paragraph (k)(1)(iv) and paragraph (k)(4)
Authority: 12 U.S.C. 1815(a), 1815(b), same manner and to the same extent as of section 42 to read as follows:
1816, 1818(a), 1818(b), 1818(c), 1818(t), the notice and response procedures in
1819(Tenth), 1828(c), 1828(d), 1828(i), Section 42. Risk-Based Capital
1828(n), 1828(o), 1831o, 1835, 3907, 3909,
12 CFR 325.6(c). Requirement for Securitization
4808; Pub. L. 102–233, 105 Stat. 1761, 1789, * * * * * Exposures
1790 (12 U.S.C. 1831n note); Pub. L. 102– ■ g. In section 2, revise the definition of
* * * * *
242, 105 Stat. 2236, 2355, 2386 (12 U.S.C. excluded mortgage exposure, the
1828 note). definition of gain-on-sale, and (k) * * *
paragraph (2)(i) of the definition of high (1) * * *
■ 2. New Appendix D to part 325 is
added as set forth at the end of the volatility commercial real estate (iv) The bank is well capitalized, as
common preamble. (HVCRE) exposure to read as follows: defined in the FDIC ’s prompt corrective
■ 3. Appendix D to part 325 is amended Section 2. Definitions action regulation at 12 CFR part 325,
as set forth below: Subpart B. For purposes of determining
* * * * * whether a bank is well capitalized for
■ a. Remove ‘‘[AGENCY]’’ and add Excluded mortgage exposure means
‘‘FDIC’’ in its place wherever it appears. purposes of this paragraph, the bank’s
any one- to four-family residential pre- capital ratios must be calculated
■ b. Remove ‘‘[bank]’’ and add ‘‘bank’’
sold construction loan for a residence without regard to the capital treatment
in its place wherever it appears, remove for which the purchase contract is
‘‘[banks]’’ and add ‘‘banks’’ in its place for transfers of small-business
cancelled that would receive a 100 obligations with recourse specified in
wherever it appears, remove ‘‘[Banks]’’ percent risk weight under section
and add ‘‘Banks’’ in its place wherever paragraph (k)(1) of this section. * * *
618(a)(2) of the Resolution Trust
it appears, and remove ‘‘[Bank]’’ and * * * * *
Corporation Refinancing, Restructuring,
add ‘‘Bank’’ in its place wherever it and Improvement Act and under 12 CFR (4) The risk-based capital ratios of the
appears. part 325, Appendix A, section II.C. bank must be calculated without regard
■ c. Remove ‘‘[Appendix l to Part l]’’ to the capital treatment for transfers of
and add ‘‘Appendix D to Part 325’’ in its * * * * *
Gain-on-sale means an increase in the small-business obligations with recourse
place wherever it appears. specified in paragraph (k)(1) of this
■ d. Remove ‘‘[the general risk-based
equity capital (as reported on Schedule
RC of the Call Report) of a bank that section as provided in 12 CFR part 325,
capital rules]’’ and add ‘‘12 CFR part Appendix A.
325, Appendix A’’ in its place wherever results from a securitization (other than
an increase in equity capital that results * * * * *
it appears.
■ e. Remove ‘‘[the market risk rule]’’ and
from the bank’s receipt of cash in ■ j. Remove ‘‘[Disclosure paragraph
add ‘‘12 CFR part 325, Appendix C’’ in connection with the securitization). (b)]’’ and add in its place ‘‘(b) A bank
its place wherever it appears. * * * * * must comply with paragraph (b) of
■ f. In section 1, revise paragraph High volatility commercial real estate section 71 of appendix G to the Federal
(b)(1)(i), the last sentence in paragraph (HVCRE) exposure * * * Reserve Board’s Regulation Y (12 CFR
(b)(3), and the last sentence in (2) * * * part 225, appendix G) unless it is a
(i) The loan-to-value ratio is less than consolidated subsidiary of a bank
paragraph (c)(1) to read as follows:

or equal to the applicable maximum holding company or depository
Section 1. Purpose, Applicability, supervisory loan-to-value ratio in the institution that is subject to these
Reservation of Authority, and Principle FDIC’s real estate lending standards at requirements.’’
of Conservatism 12 CFR part 365, Appendix A. ■ k. Remove ‘‘[Disclosure paragraph
* * * * * * * * * * (c)].’’
DEPARTMENT OF THE TREASURY the phrase ‘‘regulatory capital (2) Subpart B of this part does not
requirements under part 567 of this apply to the computation of risk-based
Office of Thrift Supervision
chapter’’ in its place. capital requirements by a savings
12 CFR Chapter V ■ b. In paragraph (i)(2)(v) remove the association that uses Appendix C of this
Authority and Issuance phrase ‘‘regulatory capital requirement part. However, these savings
under § 567.2 of this chapter’’ and add associations:
■ For the reasons set out in the the phrase ‘‘regulatory capital (i) Must compute the components of
preamble, the Office of Thrift requirements under part 567 of this capital under § 567.5, subject to the
Supervision amends Chapter V of title chapter’’ in its place. modifications in sections 11 and 12 of
12 of the Code of Federal Regulations to Appendix C of this part.
read as follows: § 563.81 [Amended] (ii) Must meet the leverage ratio
■ 7. Amend § 563.81 as follows: requirement at §§ 567.2(a)(2) and 567.8
PART 559—SUBORDINATE ■ a. In paragraph (a), remove the phrase with tier 1 capital, as computed under
ORGANIZATIONS ‘‘in supplementary capital under 12 CFR sections 11 and 12 of Appendix C of this
■ 1. The authority citation for part 559 567.5(b)’’ and add the phrase ‘‘in part.
continues to read as follows: supplementary capital (tier 2 capital) (iii) Must meet the tangible capital
under part 567 of this chapter’’ in its requirement described at §§ 567.2(a)(3)
Authority: 12 U.S.C. 1462, 1462a, 1463, and 567.9.
1464, 1467a, 1828. place.
■ b. In paragraph (d)(2)(ii), remove the (iv) Are subject to §§ 567.3 (individual
■ 2. Revise § 559.5(b)(1) to read as minimum capital requirement), 567.4
phrase ‘‘regulatory capital requirements
follows: (capital directives); and 567.10
at § 567.2 of this chapter’’ and add the
§ 559.5 How much may a savings phrase ‘‘regulatory capital requirements (consequences of failure to meet capital
association invest in service corporations at part 567 of this chapter’’ in its place. requirements).
or lower tier entities? (v) Are subject to the reservations of
* * * * *
§ 563.141 [Amended] authority at § 567.11, which supplement
(b) * * * ■ 8. In § 563.141(b), remove the phrase the reservations of authority at section
(1) You and your GAAP-consolidated ‘‘in your total capital under § 567.5 of 1 of Appendix C of this part.
subsidiaries may, in the aggregate, make this chapter’’ and add the phrase ‘‘in ■ 12. Designate §§ 567.1 through 567.6
loans of up to 15% of your total capital, your total capital under part 567 of this and §§ 567.8 through 567.12 as subpart
as described in part 567 of this chapter chapter’’ in its place. B and add a heading for subpart B to
to each subordinate organization that read as follows:
does not qualify as a GAAP- § 563.142 [Amended]
consolidated subsidiary. All loans made ■ 9. In § 563.142, amend the definition Subpart B—Regulatory Capital
under this paragraph (b)(1) may not, in of ‘‘capital’’ by removing the phrase Requirements
the aggregate, exceed 50% of your total ‘‘total capital, as described under ■ 13. Revise the introductory sentence
capital, as described in part 567 of this § 567.5(c) of this chapter’’ and adding to § 567.1 to read as follows:
chapter. the phrase ‘‘total capital, as computed
* * * * * under part 567 of this chapter’’ in its § 567.1 Definitions.
place. For the purposes of this subpart:
PART 560—LENDING AND * * * * *
INVESTMENT PART 567—CAPITAL
■ 14. In § 567.3, revise paragraphs (a),
■ 3. The authority citation for part 560 ■ 10. The authority citation for part 567 (b) introductory text, and (d)(1) to read
continues to read as follows: continues to read as follows: as follows:
Authority: 12 U.S.C. 1462, 1462a, 1463, Authority: 12 U.S.C. 1462, 1462a, 1463, § 567.3 Individual minimum capital
1464, 1467a, 1701j–3, 1828, 3803, 3806, 42 1464, 1467a, 1828(note). requirements.
U.S.C. 4106.
■ 11. Add a new subpart A to read as (a) Purpose and scope. The rules and
§ 560.101 [Amended] follows: procedures specified in this section
apply to the establishment of an
■ 4. In footnote 2 to the appendix to
Subpart A—Scope individual minimum capital
§ 560.101, remove the phrase ‘‘as
requirement for a savings association
defined at 12 CFR 567.5(c)’’ and add the § 567.0 Scope. that varies from the risk-based capital
phrase ‘‘as described in part 567 of this (a) This part prescribes the minimum requirement, the leverage ratio
chapter’’ in its place. regulatory capital requirements for requirement or the tangible capital
PART 563—SAVINGS savings associations. Subpart B of this requirement that would otherwise apply
ASSOCIATIONS—OPERATIONS part applies to all savings associations, to the savings association under this
except as described in paragraph (b) of part.
■ 5. The authority citation for part 563 this section. (b) Appropriate considerations for
continues to read as follows: (b)(1) A savings association that uses establishing individual minimum
Authority: 12 U.S.C. 375b, 1462, 1462a, Appendix C of this part must comply capital requirements. Minimum capital
1463, 1464, 1467a, 1468, 1817, 1820, 1828, with the minimum qualifying criteria levels higher than the risk-based capital
1831o, 3806; 31 U.S.C. 5318; 42 U.S.C. 4106. for internal risk measurement and requirement, the leverage ratio
management processes for calculating requirement or the tangible capital

§ 563.74 [Amended] risk-based capital requirements, utilize requirement required under this part
■ 6. Amend § 563.74 as follows: the methodologies for calculating risk- may be appropriate for individual
■ a. In paragraph (i)(2)(iv), remove the based capital requirements, and make savings associations. Increased
phrase ‘‘regulatory capital requirement the required disclosures described in individual minimum capital
under § 567.2 of this chapter’’ and add that appendix. requirements may be established upon a
determination that the savings ■ 18. Appendix C is added to part 567 (HVCRE) exposure, and paragraph (7) of
association’s capital is or may become as set forth at the end of the common the definition of traditional
inadequate in view of its circumstances. preamble. securitization, to read as follows:
For example, higher capital levels may ■ 19. Amend Appendix C of part 567 as Section 2 Definitions
be appropriate for: follows:
* * * * * ■ a. Revise the heading of Appendix C * * * * *
(d) Procedures—(1) Notification. to read as follows: Eligible credit reserves means all
When the OTS determines that a general allowances that have been
minimum capital requirement is Risk-Based Capital Requirements— established through a charge against
necessary or appropriate for a particular Internal-Ratings-Based and Advanced earnings to absorb credit losses
savings association, it shall notify the Measurement Approaches associated with on- or off-balance sheet
savings association in writing of its ■ b. Remove [AGENCY] and add ‘‘OTS’’ wholesale and retail exposures,
proposed individual minimum capital in its place wherever it appears. including the allowance for loan and
requirement; the schedule for ■ c. Remove ‘‘[bank]’’ and add ‘‘savings lease losses (ALLL) associated with such
compliance with the new requirement; association’’ in its place wherever it exposures but excluding specific
and the specific causes for determining appears, remove ‘‘[banks]’’ and add reserves created against recognized
that the higher individual minimum ‘‘savings associations’’ in its place losses.
capital requirement is necessary or wherever it appears, remove ‘‘[Banks]’’ * * * * *
appropriate for the savings association. and add ‘‘Savings associations’’ in its Excluded mortgage exposure means
The OTS shall forward the notifying place wherever it appears, and remove any one- to four-family residential pre-
letter to the appropriate state supervisor ‘‘[Bank]’’ and add ‘‘Savings association’’ sold construction loan for a residence
if a state-chartered savings association in its place wherever it appears. for which the purchase contract is
would be subject to an individual ■ d. Remove ‘‘[Appendixlto Partl]’’ cancelled that would receive a 100
minimum capital requirement. and add ‘‘Appendix C to Part 567’’ in its percent risk weight under section
* * * * * place wherever it appears. 618(a)(2) of the Resolution Trust
■ e. Remove ‘‘[the general risk-based Corporation Refinancing, Restructuring,
■ 15. Revise paragraph (a)(1)
introductory text of § 567.4 to read as capital rules]’’ and add ‘‘subpart B of and Improvement Act and under 12 CFR
follows: part 567’’ in its place wherever it 567.1 (definition of ‘‘qualifying
appears. residential construction loan’’) and 12
§ 567.4 Capital directives. ■ f. Remove ‘‘[the market risk rule]’’ and CFR 567.6(a)(1)(iv).
(a) Issuance of a Capital Directive—(1) add ‘‘any applicable market risk rule’’ in * * * * *
Purpose. In addition to any other action its place wherever it appears. Exposure at default (EAD). (1) For the
authorized by law, the Office, may issue ■ g. In section 1, revise paragraph on-balance sheet component of a
a capital directive to a savings (b)(1)(i), the last sentence in paragraph wholesale exposure or segment of retail
association that does not have an (b)(3), and the last sentence in exposures (other than an OTC derivative
amount of capital satisfying its paragraph (c)(1) to read as follows: contract, or a repo-style transaction, or
minimum capital requirement. Issuance Section 1 Purpose, Applicability, eligible margin loan for which the
of such a capital directive may be based Reservation of Authority, and Principle savings association determines EAD
on a savings association’s of Conservatism under section 32 of this appendix), EAD
noncompliance with the risk-based means:
capital requirement, the leverage ratio * * * * * (i) If the exposure or segment is a
requirement, the tangible capital (b) Applicability. (1) * * * security classified as available-for-sale,
requirement, or individual minimum (i) Has consolidated assets, as the savings associations carrying value
capital requirement established under reported on the most recent year-end (including net accrued but unpaid
this part, by a written agreement under Thrift Financial Report (TFR) equal to interest and fees) for the exposure or
12 U.S.C. 1464(s), or as a condition for $250 billion or more; segment less any unrealized gains on
approval of an application. A capital * * * * * the exposure or segment and plus any
directive may order a savings (3) * * * In making a determination unrealized losses on the exposure or
association to: under this paragraph, the OTS will segment; or
* * * * * apply notice and response procedures in (ii) If the exposure or segment is not
the same manner and to the same extent a security classified as available-for-sale,
■ 16. Revise paragraph (e) introductory
as the notice and response procedures the savings association’s carrying value
text of § 567.10 to read as follows:
in § 567.3(d). (including net accrued but unpaid
§ 567.10 Consequences of failure to meet (c) Reservation of authority—(1) interest and fees) for the exposure or
capital requirements. * * * In making a determination under segment.
* * * * * this paragraph, the OTS will apply * * * * *
(e) If a savings association fails to notice and response procedures in the Gain-on-sale means an increase in the
meet the risk-based capital requirement, same manner and to the same extent as equity capital (as reported on Schedule
the leverage ratio requirement, or the the notice and response procedures in SC of the Thrift Financial Report) of a
tangible capital requirement established § 567.3(d). savings association that results from a
under this part, the Director may, * * * * * securitization (other than an increase in
through enforcement proceedings or ■ h. In section 2, revise the definition of equity capital that results from the
otherwise, require such savings savings association’s receipt of cash in
eligible credit reserves, the definition of

association to take one or more of the excluded mortgage exposure, paragraph connection with the securitization).
following corrective actions: (1) of the definition of exposure at * * * * *
* * * * * default (EAD), the definition of gain-on- High volatility commercial real estate
■ 17. Appendices A and B are added to sale, paragraph (2)(i) of the definition of (HVCRE) exposure * * *
part 567, and are reserved. high volatility commercial real estate (2) * * *
(i) The loan-to-value ratio is less than prompt corrective action regulation at profile, then a brief discussion of this
or equal to the applicable maximum 12 CFR part 565. * * * change and its likely impact must be
supervisory loan-to-value ratio in the * * * * * provided as soon as practicable
OTS’s real estate lending standards at 12 (4) The risk-based capital ratios of the thereafter. Qualitative disclosures that
CFR 560.100–560.101; savings association must be calculated typically do not change each quarter (for
* * * * * without regard to the capital treatment example, a general summary of the
Traditional securitization * * * for transfers of small-business savings association’s risk management
(7) The underlying exposures are not obligations with recourse specified in objectives and policies, reporting
owned by a firm an investment in which paragraph (k)(1) of this section as system, and definitions) may be
is designed primarily to promote provided in 12 CFR 567.6(b)(5)(v). disclosed annually, provided any
community welfare, including the * * * * * significant changes to these are
welfare of low- and moderate-income ■ l. Revise paragraph (b)(3)(i) of section disclosed in the interim. Management is
communities or families, such as by 52 to read as follows: encouraged to provide all of the
providing services or jobs. disclosures required by this appendix in
Section 52 Simple Risk Weight one place on the savings association’s
* * * * * Approach (SRWA) public Web site.5 The savings
■ i. Revise section 12 to read as follows: * * * * * association must make these disclosures
Section 12 Deductions and limitations (b) * * * publicly available for each of the last
not required (3) * * * three years (twelve quarters) or such
(i) An equity exposure that is shorter period since it began its first
(a) Deduction of CEIOs. A savings designed primarily to promote floor period.
association is not required to make the community welfare, including the
(2) Each savings association is
deduction from capital for CEIOs in 12 welfare of low- and moderate-income
required to have a formal disclosure
CFR 567.5(a)(2)(iii) and 567.12(e). communities or families, such as by
policy approved by the board of
(b) Deduction for certain equity providing services or jobs, excluding
directors that addresses its approach for
investments. A savings association is equity exposures to an unconsolidated
determining the disclosures it makes.
not required to deduct equity securities small business investment company and
The policy must address the associated
from capital under 12 CFR equity exposures held through a
internal controls and disclosure controls
567.5(c)(2)(ii). However, it must consolidated small business investment
and procedures. The board of directors
continue to deduct equity investments company described in section 302 of the
and senior management are responsible
in real estate under that section. See 12 Small Business Investment Act of 1958
for establishing and maintaining an
CFR 567.1, which defines equity (15 U.S.C. 682).
effective internal control structure over
investments, including equity securities * * * * * financial reporting, including the
and equity investments in real estate. ■ m. Remove ‘‘[Disclosure paragraph disclosures required by this appendix,
■ j. Revise the fourth sentence of section (b)]’’ and add in its place ‘‘(b) A savings and must ensure that appropriate review
24(a) to read as follows: association must comply with paragraph of the disclosures takes place. One or
Section 24 Merger and Acquisition (c) of section 71 of this appendix unless more senior officers of the savings
Transition Arrangements it is a consolidated subsidiary of a association must attest that the
depository institution or bank holding disclosures required by this appendix
(a) Mergers and acquisitions of company that is subject to these meet the requirements of this appendix.
companies without advanced systems. requirements.’’
* * * During the period when subpart ■ n. Remove ‘‘[Disclosure paragraph
(3) If a savings association believes
A of this part applies to the merged or (c)].’’ that disclosure of specific commercial or
acquired company, any ALLL associated ■ o. In section 71, add new paragraph financial information would prejudice
with the merged or acquired company’s (c) and Tables 11.1 through 11.11 to seriously its position by making public
exposures may be included in the read as follows: information that is either proprietary or
savings association’s tier 2 capital up to confidential in nature, the savings
Section 71 Disclosure Requirements association need not disclose those
1.25 percent of the acquired company’s
risk-weighted assets. * * * * * * * * specific items, but must disclose more
(c)(1) Each consolidated savings general information about the subject
* * * * * matter of the requirement, together with
association described in paragraph (b) of
■ k. Revise the first sentence of this section that is not a subsidiary of a the fact that, and the reason why, the
paragraph (k)(1)(iv) and paragraph (k)(4) non-U.S. banking organization that is specific items of information have not
of section 42 to read as follows: subject to comparable public disclosure been disclosed.
Section 42 Risk-Based Capital requirements in its home jurisdiction
5 Alternatively, a savings association may provide
Requirement for Securitization and has successfully completed its
parallel run must provide timely public the disclosures in more than one place, as some of
Exposures them may be included in public financial reports
disclosures each calendar quarter of the (for example, in Management’s Discussion and
* * * * * information in tables 11.1–11.11 below. Analysis included in SEC filings) or other
(k) * * * If a significant change occurs, such that regulatory reports. The savings association must
(1) * * * the most recent reported amounts are no provide a summary table on its public Web site that
(iv) The savings association is well longer reflective of the savings specifically indicates where all the disclosures may
capitalized, as defined in the OTS’s association’s capital adequacy and risk be found (for example, regulatory report schedules,
page numbers in annual reports).
TABLE 11.1.—SCOPE OF APPLICATION

Qualitative Disclosures ................... (a) The name of the top corporate entity in the group to which the appendix applies.
(b) An outline of differences in the basis of consolidation for accounting and regulatory purposes, with a
brief description of the entities6 within the group that are fully consolidated; that are deconsolidated and
deducted; for which the regulatory capital requirement is deducted; and that are neither consolidated nor
deducted (for example, where the investment is risk-weighted).
(c) Any restrictions, or other major impediments, on transfer of funds or regulatory capital within the group.
Quantitative Disclosures ................. (d) The aggregate amount of surplus capital of insurance subsidiaries (whether deducted or subjected to
an alternative method) included in the regulatory capital of the consolidated group.
(e) The aggregate amount by which actual regulatory capital is less than the minimum regulatory capital
requirement in all subsidiaries with regulatory capital requirements and the name(s) of the subsidiaries
with such deficiencies.
TABLE 11.2.—CAPITAL STRUCTURE

Qualitative Disclosures ................... (a) Summary information on the terms and conditions of the main features of all capital instruments, espe-
cially in the case of innovative, complex or hybrid capital instruments.
Quantitative Disclosures ................. (b) The amount of tier 1 capital, with separate disclosure of:
• Common stock/surplus;
• Retained earnings;
• Minority interests in the equity of subsidiaries;
• Regulatory calculation differences deducted from tier 1 capital;7 and
• Other amounts deducted from tier 1 capital, including goodwill and certain intangibles.
(c) The total amount of tier 2 capital.
(d) Other deductions from capital.8
(e) Total eligible capital.
TABLE 11.3.—CAPITAL ADEQUACY

Qualitative disclosures .................... (a) A summary discussion of the savings association’s approach to assessing the adequacy of its capital to
support current and future activities.
Quantitative disclosures .................. (b) Risk-weighted assets for credit risk from:
• Wholesale exposures;
• Qualifying revolving exposures;
• Other retail exposures;
• Securitization exposures;
• Equity exposures
• Equity exposures subject to the simple risk weight approach; and
• Equity exposures subject to the internal models approach.
(c) Risk-weighted assets for market risk as calculated under [the market risk rule]:9
• Standardized approach for specific risk; and
• Internal models approach for specific risk.
(d) Risk-weighted assets for operational risk.
(e) Total and tier 1 risk-based capital ratios:10
• For the top consolidated group; and
• For each DI subsidiary.
association must describe its risk • the scope and nature of risk
management objectives and policies, reporting and/or measurement systems;
General qualitative disclosure
including: • policies for hedging and/or
requirement
• strategies and processes; mitigating risk and strategies and
For each separate risk area described • the structure and organization of processes for monitoring the continuing
in tables 11.4 through 11.11, the savings the relevant risk management function; effectiveness of hedges/mitigants.
6 Entities include securities, insurance and other within the IRB approach exceed eligible credit reserves, which must be deducted from tier 2
financial subsidiaries, commercial subsidiaries reserves, which must be deducted from tier 1 capital.
(where permitted), and significant minority equity capital. 9 Risk-weighted assets determined under [the
investments in insurance, financial and commercial 8 Including 50 percent of the amount, if any, by market risk rule] are to be disclosed only for the
entities. which total expected credit losses as calculated approaches used.
7 Representing 50 percent of the amount, if any, 10 Total risk-weighted assets should also be
within the IRB approach exceed eligible credit
by which total expected credit losses as calculated disclosed.
TABLE 11.4.11—CREDIT RISK: GENERAL DISCLOSURES

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to credit risk (excluding counterparty credit
risk disclosed in accordance with Table 11.6), including:
• Definitions of past due and impaired (for accounting purposes);
• Description of approaches followed for allowances, including statistical methods used where applica-
ble; and
• Discussion of the savings association’s credit risk management policy.
Quantitative Disclosures ................. (b) Total credit risk exposures and average credit risk exposures, after accounting offsets in accordance
with GAAP,12 and without taking into account the effects of credit risk mitigation techniques (for exam-
ple, collateral and netting), over the period broken down by major types of credit exposure.13
(c) Geographic14 distribution of exposures, broken down in significant areas by major types of credit expo-
sure.
(d) Industry or counterparty type distribution of exposures, broken down by major types of credit exposure.
(e) Remaining contractual maturity breakdown (for example, one year or less) of the whole portfolio, bro-
ken down by major types of credit exposure.
(f) By major industry or counterparty type:
• Amount of impaired loans;
• Amount of past due loans; 15
• Allowances; and
• Charge-offs during the period.
(g) Amount of impaired loans and, if available, the amount of past due loans broken down by significant
geographic areas including, if practical, the amounts of allowances related to each geographical area.16
(h) Reconciliation of changes in the allowance for loan and lease losses.17
TABLE 11.5.—CREDIT RISK: DISCLOSURES FOR PORTFOLIOS SUBJECT TO IRB RISK-BASED CAPITAL FORMULAS
Qualitative disclosures .................... (a) Explanation and review of the:

• Structure of internal rating systems and relation between internal and external ratings;
• Use of risk parameter estimates other than for regulatory capital purposes;
• Process for managing and recognizing credit risk mitigation (see table 11.7); and
• Control mechanisms for the rating system, including discussion of independence, accountability, and
rating systems review.
(b) Description of the internal ratings process, provided separately for the following:
• Wholesale category;
• Retail subcategories;
• Qualifying revolving exposures; and
• Other retail exposures.
For each category and subcategory the description should include:
• The types of exposure included in the category/subcategories; and
• The definitions, methods and data for estimation and validation of PD, LGD, and EAD, including as-
sumptions employed in the derivation of these variables.18
Quantitative disclosures: risk as- (c) For wholesale exposures, present the following information across a sufficient number of PD grades
sessment. (including default) to allow for a meaningful differentiation of credit risk:19
• Total EAD; 20
• Exposure-weighted average LGD (percentage);
• Exposure-weighted average risk weight; and
• Amount of undrawn commitments and exposure-weighted average EAD for wholesale exposures.
For each retail subcategory, present the disclosures outlined above across a sufficient number of seg-
ments to allow for a meaningful differentiation of credit risk.
Quantitative disclosures: historical (d) Actual losses in the preceding period for each category and subcategory and how this differs from past
results. experience. A discussion of the factors that impacted the loss experience in the preceding period—for
example, has the savings association experienced higher than average default rates, loss rates or
EADs.
11 Table 4 does not include equity exposures. A savings association might choose to define the opening balance of the allowance; charge-offs taken
12 For example, FASB Interpretations 39 and 41. geographical areas based on the way the company’s against the allowance during the period; amounts
13 For example, savings associations could apply portfolio is geographically managed. The criteria provided (or reversed) for estimated probable loan
a breakdown similar to that used for accounting used to allocate the loans to geographical areas losses during the period; any other adjustments (for
purposes. must be specified.
example, exchange rate differences, business
15 A savings association is encouraged also to

Such a breakdown might, for instance, be (a) combinations, acquisitions and disposals of
loans, off-balance sheet commitments, and other provide an analysis of the aging of past-due loans.
16 The portion of general allowance that is not
subsidiaries), including transfers between
non-derivative off-balance sheet exposures, (b) debt
allowances; and the closing balance of the
securities, and (c) OTC derivatives. allocated to a geographical area should be disclosed
14 Geographical areas may comprise individual separately. allowance. Charge-offs and recoveries that have
countries, groups of countries, or regions within 17 The reconciliation should include the been recorded directly to the income statement
countries. following: a description of the allowance; the should be disclosed separately.
TABLE 11.5.—CREDIT RISK: DISCLOSURES FOR PORTFOLIOS SUBJECT TO IRB RISK-BASED CAPITAL FORMULAS—
Continued
(e) Savings association’s estimates compared against actual outcomes over a longer period.21 At a min-
imum, this should include information on estimates of losses against actual losses in the wholesale cat-
egory and each retail subcategory over a period sufficient to allow for a meaningful assessment of the
performance of the internal rating processes for each category/subcategory.22 Where appropriate, the
savings association should further decompose this to provide analysis of PD, LGD, and EAD outcomes
against estimates provided in the quantitative risk assessment disclosures above.23
TABLE 11.6.—GENERAL DISCLOSURE FOR COUNTERPARTY CREDIT RISK OF OTC DERIVATIVE CONTRACTS, REPO-STYLE
TRANSACTIONS, AND ELIGIBLE MARGIN LOANS
Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to OTC derivatives, eligible margin loans,
and repo-style transactions, including:
• Discussion of methodology used to assign economic capital and credit limits for counterparty credit
exposures;
• Discussion of policies for securing collateral, valuing and managing collateral, and establishing credit
reserves;
• Discussion of the primary types of collateral taken;
• Discussion of policies with respect to wrong-way risk exposures; and
• Discussion of the impact of the amount of collateral the savings association would have to provide if
the savings association were to receive a credit rating downgrade.
Quantitative Disclosures ................. (b) Gross positive fair value of contracts, netting benefits, netted current credit exposure, collateral held (in-
cluding type, for example, cash, government securities), and net unsecured credit exposure.24 Also re-
port measures for EAD used for regulatory capital for these transactions, the notional value of credit de-
rivative hedges purchased for counterparty credit risk protection, and, for savings associations not using
the internal models methodology in section 32(d) of this appendix, the distribution of current credit expo-
sure by types of credit exposure.25
(c) Notional amount of purchased and sold credit derivatives, segregated between use for the savings as-
sociation’s own credit portfolio and for its intermediation activities, including the distribution of the credit
derivative products used, broken down further by protection bought and sold within each product group.
(d) The estimate of alpha if the savings association has received supervisory approval to estimate alpha.
TABLE 11.7.—CREDIT RISK MITIGATION 26 27 28
Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to credit risk mitigation including:
• Policies and processes for, and an indication of the extent to which the savings association uses, on-
and off-balance sheet netting;
• Policies and processes for collateral valuation and management;
• A description of the main types of collateral taken by the savings association;
• The main types of guarantors/credit derivative counterparties and their creditworthiness; and
• Information about (market or credit) risk concentrations within the mitigation taken.
Quantitative Disclosures ................. (b) For each separately disclosed portfolio, the total exposure (after, where applicable, on-or off-balance
sheet netting) that is covered by guarantees/credit derivatives.
18 This disclosure does not require a detailed 20 Outstanding loans and EAD on undrawn 23 A savings association should provide this
description of the model in full—it should provide commitments can be presented on a combined basis further decomposition where it will allow users
the reader with a broad overview of the model for these disclosures. greater insight into the reliability of the estimates
approach, describing definitions of the variables 21 These disclosures are a way of further
provided in the ‘‘quantitative disclosures: risk
and methods for estimating and validating those informing the reader about the reliability of the assessment.’’ In particular, it should provide this
variables set out in the quantitative risk disclosures information provided in the ‘‘quantitative information where there are material differences
below. This should be done for each of the four disclosures: risk assessment’’ over the long run. The between its estimates of PD, LGD or EAD compared
category/subcategories. The savings association disclosures are requirements from year-end 2010; in to actual outcomes over the long run. The savings
should disclose any significant differences in the meantime, early adoption is encouraged. The association should also provide explanations for
approach to estimating these variables within each phased implementation is to allow a savings such differences.
category/subcategories. association sufficient time to build up a longer run 24 Net unsecured credit exposure is the credit
19 The PD, LGD and EAD disclosures in Table of data that will make these disclosures meaningful.
exposure after considering the benefits from legally
11.5(c) should reflect the effects of collateral, 22 This regulation is not prescriptive about the
enforceable netting agreements and collateral
qualifying master netting agreements, eligible period used for this assessment. Upon
guarantees and eligible credit derivatives as defined implementation, it might be expected that a savings arrangements, without taking into account haircuts
in part I. Disclosure of each PD grade should association would provide these disclosures for as for price volatility, liquidity, etc.
25 This may include interest rate derivative
include the exposure-weighted average PD for each long a run of data as possible—for example, if a
grade. Where a savings association aggregates PD savings association has 10 years of data, it might contracts, foreign exchange derivative contracts,
grades for the purposes of disclosure, this should choose to disclose the average default rates for each equity derivative contracts, credit derivatives,
be a representative breakdown of the distribution of PD grade over that 10-year period. Annual amounts commodity or other derivative contracts, repo-style
PD grades used for regulatory capital purposes. need not be disclosed. transactions, and eligible margin loans.
TABLE 11.8.—SECURITIZATION
Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to securitization (including synthetics), in-
cluding a discussion of:
• The savings association’s objectives relating to securitization activity, including the extent to which
these activities transfer credit risk of the underlying exposures away from the savings association to
other entities;
• The roles played by the savings association in the securitization process 29 and an indication of the
extent of the savings association’s involvement in each of them; and
• The regulatory capital approaches (for example, RBA, IAA and SFA) that the savings association fol-
lows for its securitization activities.
(b) Summary of the savings association’s accounting policies for securitization activities, including:
• Whether the transactions are treated as sales or financings;
• Recognition of gain-on-sale;
• Key assumptions for valuing retained interests, including any significant changes since the last report-
ing period and the impact of such changes; and
• Treatment of synthetic securitizations.
(c) Names of NRSROs used for securitizations and the types of securitization exposure for which each
agency is used.
Quantitative Disclosures ................. (d) The total outstanding exposures securitized by the savings association in securitizations that meet the
operational criteria in section 41 of this appendix (broken down into traditional/synthetic), by underlying
exposure type.30 31 32
(e) For exposures securitized by the savings association in securitizations that meet the operational criteria
in Section 41 of this appendix:
• Amount of securitized assets that are impaired/past due; and
• Losses recognized by the savings association during the current period 33 broken down by exposure
type.
(f) Aggregate amount of securitization exposures broken down by underlying exposure type.
(g) Aggregate amount of securitization exposures and the associated IRB capital requirements for these
exposures broken down into a meaningful number of risk weight bands. Exposures that have been de-
ducted from capital should be disclosed separately by type of underlying asset.
(h) For securitizations subject to the early amortization treatment, the following items by underlying asset
type for securitized facilities:
• The aggregate drawn exposures attributed to the seller’s and investors’ interests; and
• The aggregate IRB capital charges incurred by the savings association against the investors’ shares
of drawn balances and undrawn lines.
(i) Summary of current year’s securitization activity, including the amount of exposures securitized (by ex-
posure type), and recognized gain or loss on sale by asset type.
TABLE 11.9.—OPERATIONAL RISK
Qualitative Disclosures ................... (a) The general qualitative disclosure requirement for operational risk.
(b) Description of the AMA, including a discussion of relevant internal and external factors considered in
the savings association’s measurement approach.
(c) A description of the use of insurance for the purpose of mitigating operational risk.
TABLE 11.10.—EQUITIES NOT SUBJECT TO MARKET RISK RULE
Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to equity risk, including:
• Differentiation between holdings on which capital gains are expected and those held for other objec-
tives, including for relationship and strategic reasons; and
• Discussion of important policies covering the valuation of and accounting for equity holdings in the
banking book. This includes the accounting techniques and valuation methodologies used, including
key assumptions and practices affecting valuation as well as significant changes in these practices.
26 At a minimum, a savings associagtion must 28 Counterparty credit risk-related exposures 31 Securitization transactions in which the
provide the disclosures in Table 11.7 in relation to disclosed pursuant to Table 11.6 should be originating savings association does not retain any
credit risk mitigation that has been recognized for excluded from the credit risk mitigation disclosures securitization exposure should be shown separately
the purposes of reducing capital requirements in Table 11.7. but need only be reported for the year of inception.
under this appendix. Where relevant, savings 29 For example: originator, investor, servicer,
32 Where relevant, a savings association is
associations are encouraged to give further encouraged to differentiate between exposures

provider of credit enhancement, sponsor of asset
information about mitigants that have not been resulting from activities in which they act only as
recognized for that purpose. backed commercial paper facility, liquidity
sponsors, and exposures that result from all other
27 Credit derivatives that are treated, for the provider, or swap provider. savings association securitization activities.
30 Underlying exposure types may include, for
purposes of this appendix, as synthetic 33 For example, charge-offs/allowances (if the
securitization exposures should be excluded from example, one- to four-family residential loans, assets remain on the savings association’s balance
the credit risk mitigation disclosures and included home equity lines, credit card receivables, and auto sheet) or write-downs of I/O strips and other
within those relating to securitization. loans. residual interests.
TABLE 11.10.—EQUITIES NOT SUBJECT TO MARKET RISK RULE—Continued

Quantitative Disclosures ................. (b) Value disclosed in the balance sheet of investments, as well as the fair value of those investments; for
quoted securities, a comparison to publicly-quoted share values where the share price is materially dif-
ferent from fair value.
(c) The types and nature of investments, including the amount that is:
• Publicly traded; and
• Non-publicly traded.
(d) The cumulative realized gains (losses) arising from sales and liquidations in the reporting period.
(e) • Total unrealized gains (losses)34
• Total latent revaluation gains (losses)35
• Any amounts of the above included in tier 1 and/or tier 2 capital.
(f) Capital requirements broken down by appropriate equity groupings, consistent with the savings associa-
tion’s methodology, as well as the aggregate amounts and the type of equity investments subject to any
supervisory transition regarding regulatory capital requirements.36
TABLE 11.11.—INTEREST RATE RISK FOR NON-TRADING ACTIVITIES

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement, including the nature of interest rate risk for non-trading
activities and key assumptions, including assumptions regarding loan prepayments and behavior of non-
maturity deposits, and frequency of measurement of interest rate risk for non-trading activities.
Quantitative Disclosures ................. (b) The increase (decline) in earnings or economic value (or relevant measure used by management) for
upward and downward rate shocks according to management’s method for measuring interest rate risk
for non-trading activities, broken down by currency (as appropriate).
* * * * * By Order of the Board of Directors. Federal By the Office of Thrift Supervision.

Deposit Insurance Corporation. John M. Reich,
Dated: November 8, 2007.
John C. Dugan, Valerie J. Best, Director.
Comptroller of the Currency. Assistant Executive Secretary. [FR Doc. 07–5729 Filed 12–6–07; 8:45 am]
By order of the Board of Governors of the Dated: October 29, 2007. BILLING CODE 4810–33–P, 6210–01–P, 6714–01–P,
Federal Reserve System, November 13, 2007. 6720–01–P
Robert deV. Frierson,

Deputy Secretary of the Board.
Dated at Washington, DC, this 5th day of
November, 2007.
34 Unrealized gains (losses) recognized in the 35 Unrealized gains (losses) not recognized either 36 This disclosure should include a breakdown of
balance sheet but not through earnings. in the balance sheet or through earnings. equities that are subject to the 0 percent, 20 percent,
100 percent, 300 percent, 400 percent, and 600
percent risk weights, as applicable.

Rule: Risk-Based Capital: Advnced Capital Adequacy Framework Basel II

Hochgeladen von

Dokumentinformationen

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Rule: Risk-Based Capital: Advnced Capital Adequacy Framework Basel II

Hochgeladen von

Copyright:

Verfügbare Formate

Friday,

Department of the Treasury

Federal Reserve System

Federal Deposit Insurance

Department of the Treasury

Risk-Based Capital Standards: Advanced

should consider employing lower AVCs

commenters objected to the proposed there are no such material deficiencies

established an Accord Implementation approaches to calculating the credit risk

Adequacy Guidelines to Bank Holding Companies

advised of a limit smaller than the

replaced the 5 percent credit-related of assignments of retail exposures to rating grade.

an LGD estimate of 80 percent that is estimates’’ treatment to trade-related

result in lower estimates of risk This process must capture business

quantification system, subject to prior

this aspect of the proposal and urged the

loans, repo-style transactions, OTC rating grades (for purposes of assigning

a PD to each wholesale obligor risk counterparties in one or more financial

PD of less than 0.03 percent. compute expected contractual interest

exposure immediately before the became defaulted), multiplied by the

OTC derivative ................................................................................................. X ........................ ........................ X

11(e)(8) of the Federal Deposit Insurance Act (12

protection amount of the credit derivative is

requested comment on all aspects of the internal estimates of alpha. These

84 Under the final rule, if an eligible guarantee mismatch;

capitalized DI that transfers small business loans general securitization collateral

guiding principles for use in of the principal amount of the reference

Risk weights for Risk weights for Risk weights for

Highest investment grade (for example, AAA) .............................................. 7 12 20

Second highest investment grade (for example, AA) ................................... 8 15 25

Third-highest investment grade—positive designation (for example, A+) .... 10 18 35

Third-highest investment grade (for example, A) .......................................... 12 20

Third-highest investment grade—negative designation (for example, A¥) 20 35

Lowest investment grade—positive designation (for example, BBB+) ......... 35 50

Lowest investment grade (for example, BBB) ............................................... 60 75

Lowest investment grade—negative designation (for example, BBB¥) ...... 100

One category below investment grade—positive designation (for example,

One category below investment grade—negative designation (for example,

Risk weights for Risk weights for Risk weights for

Risk weights for Risk weights for Risk weights for

Highest investment grade (for example, A1) ................................................. 7 12 20

Second highest investment grade (for example, A2) .................................... 12 20 35

Third highest investment grade (for example, A3) ........................................ 60 75 75

deducting such exposures from European Union’s Capital Requirements

adequate flexibility to determine an necessary. denominated in different currencies. To

TABLE H.—CONTROLLED EARLY AMORTIZATION PROVISIONS

TABLE I.—NON-CONTROLLED EARLY AMORTIZATION PROVISIONS

Xt = At ¥ Bt of this regression, which is the multiplying the adjusted carrying value

TABLE L.—MODIFIED LOOK-THROUGH APPROACHES FOR EQUITY EXPOSURES TO INVESTMENT FUNDS

disclosures. Several commenters meaningful and could generate

Table 11.11 disclosures (Interest Rate specific comments on the reporting

advance notices of proposed rulemaking, and

and training. To date, Basel II competitive advantage of Basel II http://www.occ.treas.gov/law/basel.htm

2005. conjunction with the Executive Order

2 This requirement is met where all transactions

TABLE 3.—STANDARD SUPERVISORY MARKET PRICE VOLATILITY HAIRCUTS 1

TABLE 3.—STANDARD SUPERVISORY MARKET PRICE VOLATILITY HAIRCUTS 1—Continued

Mutual funds ................................................................................................................................................ Highest haircut applicable to any

TABLE 4.—CONVERSION FACTOR MATRIX FOR OTC DERIVATIVE CONTRACTS 1

model to calculate a one-sided credit valuation formula in paragraph (d)(4).

exposures; appendix, the Internal Assessment Approach underlying exposures of a securitization

Highest investment grade (for example, AAA) ............................................................................ 7% 12% 20%

Lowest investment grade—negative designation (for example, BBB¥) .................................... 100%