Monday, September 25, 2006

Part II

Department of the Treasury Office of the Comptroller of the Currency Office of Thrift Supervision 12 CFR Part 3 and 566 Federal Reserve System 12 CFR Parts 208 and 225 Federal Deposit Insurance Corporation 12 CFR Part 325

Risk-Based Capital Standards: Advanced Capital Adequacy Framework and Market ; Proposed Rules and Notices

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00001 Fmt 4717 Sfmt 4717 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55830 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

DEPARTMENT OF THE TREASURY requirements for that operate All public comments are available under the framework. from the Board’s Web site at Office of the Comptroller of the DATES: Comments must be received on www.federalreserve.gov/generalinfo/ Currency or before January 23, 2007. foia/ProposedRegs.cfm as submitted, ADDRESSES: Comments should be unless modified for technical reasons. 12 CFR Part 3 directed to: Accordingly, your comments will not be [Docket No. 06–09] OCC: You should include OCC and edited to remove any identifying or contact information. Public comments RIN 1557–AC91 Docket Number 06–09 in your comment. You may submit comments by any of may also be viewed electronically or in paper in Room MP–500 of the Board’s FEDERAL RESERVE SYSTEM the following methods: • Federal eRulemaking Portal: http:// Martin Building (20th and C Streets, NW.) between 9 a.m. and 5 p.m. on 12 CFR Parts 208 and 225 www.regulations.gov. Follow the instructions for submitting comments. weekdays. [Regulations H and Y; Docket No. R–1261] • OCC Web Site: http:// FDIC: You may submit comments, www.occ.treas.gov. Click on ‘‘Contact identified by RIN number, by any of the FEDERAL DEPOSIT INSURANCE the OCC,’’ scroll down and click on following methods: CORPORATION • ‘‘Comments on Proposed Regulations.’’ Federal eRulemaking Portal: http:// • E-mail address: www.regulations.gov. Follow the 12 CFR Part 325 [email protected]. instructions for submitting comments. • Agency Web Site: http:// RIN 3064–AC73 • Fax: (202) 874–4448. www.fdic.gov/regulations/laws/federal/ • Mail: Office of the Comptroller of propose.html. DEPARTMENT OF THE TREASURY the Currency, 250 E Street, SW., Mail • Mail: Robert E. Feldman, Executive Stop 1–5, Washington, DC 20219. Secretary, Attention: Comments, Federal Office of Thrift Supervision • Hand Delivery/Courier: 250 E Deposit Insurance Corporation, 550 17th Street, SW., Attn: Public Information 12 CFR Part 566 Street, NW., Washington, DC 20429. Room, Mail Stop 1–5, Washington, DC • Hand Delivery/Courier: Guard RIN 1550–AB56 20219. station at rear of the 550 17th Street Instructions: All submissions received Building (located on F Street) on Risk-Based Capital Standards: must include the agency name (OCC) business days between 7 a.m. and 5 p.m. Advanced Capital Adequacy and docket number or Regulatory • E-mail: [email protected]. Framework Information Number (RIN) for this • Public Inspection: Comments may notice of proposed rulemaking. In AGENCIES: be inspected at the FDIC Public Office of the Comptroller of general, OCC will enter all comments the Currency, Treasury; Board of Information Center, Room E–1002, 3502 received into the docket without Fairfax Drive, Arlington, VA 22226, Governors of the Federal Reserve change, including any business or System; Federal Deposit Insurance between 9 a.m. and 5 p.m. on business personal information that you provide. days. Corporation; and Office of Thrift You may review comments and other Supervision, Treasury. Instructions: Submissions received related materials by any of the following must include the agency name and RIN ACTION: Joint notice of proposed methods: for this rulemaking. Comments received rulemaking. • Viewing Comments Personally: You will be posted without change to http:// SUMMARY: The Office of the Comptroller may personally inspect and photocopy www.fdic.gov/regulations/laws/federal/ of the Currency (OCC), the Board of comments at the OCC’s Public propose.html including any personal Governors of the Federal Reserve Information Room, 250 E Street, SW., information provided. System (Board), the Federal Deposit Washington, DC. You can make an OTS: You may submit comments, Insurance Corporation (FDIC), and the appointment to inspect comments by identified by No. 2006–33, by any of the Office of Thrift Supervision (OTS) calling (202) 874–5043. following methods: (collectively, the agencies) are Board: You may submit comments, • Federal eRulemaking Portal: http:// proposing a new risk-based capital identified by Docket No. R–1261, by any www.regulations.gov. Follow the adequacy framework that would require of the following methods: instructions for submitting comments. • • some and permit other qualifying Agency Web Site: http:// E-mail address: banks 1 to use an internal ratings-based www.federalreserve.gov. Follow the [email protected]. Please approach to calculate regulatory credit instructions for submitting comments at include No. 2006–33 in the subject line risk capital requirements and advanced http://www.federalreserve.gov/ of the message and include your name measurement approaches to calculate generalinfo/foia/ProposedRegs.cfm. and telephone number in the message. • Federal eRulemaking Portal: http:// • Fax: (202) 906–6518. regulatory capital • requirements. The proposed rule www.regulations.gov. Follow the Mail: Regulation Comments, Chief instructions for submitting comments. Counsel’s Office, Office of Thrift describes the qualifying criteria for • banks required or seeking to operate E-mail: Supervision, 1700 G Street, NW., under the proposed framework and the [email protected]. Washington, DC 20552, Attention: No. applicable risk-based capital Include docket number in the subject 2006–33. line of the message. • Hand Delivery/Courier: Guard’s • 1 For simplicity, and unless otherwise indicated, FAX: 202/452–3819 or 202/452– Desk, East Lobby Entrance, 1700 G this notice of proposed rulemaking (NPR) uses the 3102. Street, NW., from 9 a.m. to 4 p.m. on term ‘‘’’ to include banks, savings associations, • Mail: Jennifer J. Johnson, Secretary, business days, Attention: Regulation and bank holding companies (BHCs). The terms Board of Governors of the Federal Comments, Chief Counsel’s Office, ‘‘bank holding company’’ and ‘‘BHS’’ refer only to bank holding companies regulated by the board and Reserve System, 20th Street and Attention: No. 2006–33. do not include savings and loan holding companies Constitution Avenue, NW., Washington, Instructions: All submissions received regulated by the OTS. DC 20551. must include the agency name and

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00002 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55831

docket number or Regulatory Regulations and Legislation Division Category, and Immaterial Credit Information Number (RIN) for this (202) 906–6639, Office of Thrift Exposures) rulemaking. All comments received will Supervision, 1700 G Street, NW., 1. Phase 1—Categorization of Exposures be posted without change to the OTS Washington, DC 20552. 2. Phase 2—Assignment of Wholesale Obligors and Exposures to Rating Grades Internet Site at http://www.ots.treas.gov/ SUPPLEMENTARY INFORMATION: and Retail Exposures to Segments pagehtml.cfm?catNumber=67&an=1, Purchased wholesale receivables Table of Contents including any personal information Wholesale lease residuals provided. I. Introduction 3. Phase 3—Assignment of Risk Parameters Docket: For access to the docket to A. Background to Wholesale Obligors and Exposures read background documents or B. Conceptual Overview and Retail Segments comments received, go to http:// 1. The IRB Framework for 4. Phase 4—Calculation of Risk-Weighted 2. The AMA for Operational Risk www.ots.treas.gov/ Assets C. Overview of Proposed Rule 5. Statutory Provisions on the Regulatory pagehtml.cfm?catNumber=67&an=1. D. Structure of Proposed Rule Capital Treatment of Certain Mortgage In addition, you may inspect E. Quantitative Impact Study 4 and Overall Loans comments at the Public Reading Room, Capital Objectives C. Credit Risk Mitigation Techniques 1700 G Street, NW., by appointment. To 1. Quantitative Impact Study 4 1. Collateral make an appointment for access, call 2. Overall Capital Objectives 2. EAD for Counterparty Credit Risk (202) 906–5922, send an e-mail to F. Competitive Considerations EAD for repo-style transactions and eligible [email protected], or send a II. Scope margin loans facsimile transmission to (202) 906– A. Core and Opt-In Banks Collateral haircut approach B. U.S. Depository Institution Subsidiaries Standard supervisory haircuts 7755. (Prior notice identifying the of Foreign Banks Own estimates of haircuts materials you will be requesting will C. Reservation of Authority Simple VaR methodology assist us in serving you.) We schedule III. Qualification 3. EAD for OTC Derivative Contracts appointments on business days between A. The Qualification Process Current exposure methodology 10 a.m. and 4 p.m. In most cases, 1. In General 4. Internal Models Methodology appointments will be available the next 2. Parallel Run and Transitional Floor Maturity under the internal models business day following the date we Periods methodology receive a request. B. Qualification Requirements Collateral agreements under the internal 1. Process and Systems Requirements models methodology FOR FURTHER INFORMATION CONTACT: 2. Risk Rating and Segmentation Systems Internal estimate of alpha OCC: Roger Tufts, Senior Economic for Wholesale and Retail Exposures Alternative models Advisor, Capital Policy (202–874–4925) Wholesale exposures 5. Guarantees and Credit Derivatives That or Ron Shimabukuro, Special Counsel, Retail exposures Cover Wholesale Exposures Legislative and Regulatory Activities Definition of default Eligible guarantees and eligible credit Division (202–874–5090). Office of the Rating philosophy derivatives Comptroller of the Currency, 250 E Rating and segmentation reviews and PD substitution approach Street, SW., Washington, DC 20219. updates LGD adjustment approach 3. Quantification of Risk Parameters for Maturity mismatch haircut Board: Barbara Bouchard, Deputy Wholesale and Retail Exposures Restructuring haircut Associate Director (202–452–3072 or (PD) Currency mismatch haircut [email protected]) or Anna Lee (LGD) and expected loss Example Hewko, Senior Supervisory Financial given default (ELGD) Multiple credit risk mitigants Analyst (202–530–6260 or (EAD) Double default treatment [email protected]), Division of General quantification principles 6. Guarantees and Credit Derivatives That Banking Supervision and Regulation; or 4. Optional Approaches That Require Prior Cover Retail Exposures Mark E. Van Der Weide, Senior Counsel Supervisory Approval D. Unsettled Securities, Foreign Exchange, (202–452–2263 or 5. Operational Risk and Commodity Transactions Operational risk data and assessment E. Securitization Exposures [email protected]), Legal system 1. Hierarchy of Approaches Division. For users of Operational risk quantification system Exceptions to the general hierarchy of Telecommunications Device for the Deaf 6. Data Management and Maintenance approaches (‘‘TDD’’) only, contact 202–263–4869. 7. Control and Oversight Mechanisms Servicer cash advances FDIC: Jason C. Cave, Associate Validation Amount of a securitization exposure Director, Capital Markets Branch, (202) Internal audit Implicit support 898–3548, Bobby R. Bean, Senior Stress testing Operational requirements for traditional Quantitative Risk Analyst, Capital 8. Documentation securitizations Markets Branch, (202) 898–3575, C. Ongoing Qualification Clean-up calls IV. Calculation of and Total 2. Ratings-Based Approach (RBA) Kenton Fox, Senior Capital Markets Qualifying Capital 3. Internal Assessment Approach (IAA) Specialist, Capital Markets Branch, V. Calculation of Risk-Weighted Assets 4. Supervisory Formula Approach (SFA) (202) 898–7119, Division of Supervision A. Categorization of Exposures General requirements and Consumer Protection; or Michael B. 1. Wholesale Exposures Inputs to the SFA formula Phillips, Counsel, (202) 898–3581, 2. Retail Exposures 5. Eligible Disruption Liquidity Facilities Supervision and Legislation Branch, 3. Securitization Exposures 6. Credit Risk Mitigation for Securitization Legal Division, Federal Deposit 4. Equity Exposures Exposures Insurance Corporation, 550 17th Street, 5. Boundary Between Operational Risk and 7. Synthetic Securitizations NW., Washington, DC 20429. Other Background 6. Boundary Between the Proposed Rule Operational requirements for synthetic OTS: Michael D. Solomon, Director, and the Amendment securitizations Capital Policy, Supervision Policy (202) B. Risk-Weighted Assets for General Credit First-loss tranches 906–5654; David W. Riley, Senior Risk (Wholesale Exposures, Retail Mezzanine tranches Analyst, Capital Policy (202) 906–6669; Exposures, On-Balance Sheet Assets Super-senior tranches or Karen Osterloh, Special Counsel, That Are Not Defined by Exposure 8. Nth-to-Default Credit Derivatives

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00003 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55832 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

9. Early Amortization Provisions internal ratings-based (IRB) approach for produce risk-based capital requirements Background credit risk and the advanced that are more risk-sensitive than the Controlled early amortization measurement approaches (AMA) for existing risk-based capital rules of the Noncontrolled early amortization operational risk (together, the advanced agencies (general risk-based capital F. Equity Exposures approaches). The IRB framework uses 1. Introduction and Exposure Measurement rules). The proposed framework seeks to Hedge transactions risk parameters determined by a bank’s build on improvements to risk Measures of hedge effectiveness internal systems in the calculation of assessment approaches that a number of 2. Simple Risk-Weight Approach (SRWA) the bank’s credit risk capital large banks have adopted over the last Non-significant equity exposures requirements. The AMA relies on a decade. In particular, the proposed 3. Internal Models Approach (IMA) bank’s internal estimates of its framework requires banks to assign risk IMA qualification operational risks to generate an parameters to exposures and provides Risk-weighted assets under the IMA operational risk for 4. Equity Exposures to Investment Funds the bank. The ANPR included a number specific risk-based capital formulas that Full look-through approach of questions highlighting various issues would be used to transform these risk Simple modified look-through approach for the industry’s consideration. The parameters into risk-based capital Alternative modified look-through requirements. approach agencies received approximately 100 VI. Operational Risk public comments on the ANPR from The proposed framework is based on VII. Disclosure banks, trade associations, supervisory the ‘‘value-at-risk’’ (VaR) approach to 1. Overview authorities, and other interested parties. measuring credit risk and operational Comments on ANPR These comments addressed the risk. VaR modeling techniques for 2. General Requirements agencies’ specific questions as well as a measuring risk have been the subject of Frequency/timeliness range of other issues. Commenters economic research and are used by large Location of disclosures and audit/ generally encouraged further certification requirements banks. The proposed framework has development of the framework, and benefited significantly from comments Proprietary and confidential information most supported the overall direction of 3. Summary of Specific Public Disclosure on the ANPR, as well as consultations the ANPR. Commenters did, however, Requirements organized in conjunction with the 4. Regulatory Reporting raise a number of conceptual and technical issues that they believed BCBS’s development of the New I. Introduction required additional consideration. Accord. Because bank risk measurement practices are both continually evolving A. Background Since the issuance of the ANPR, the agencies have worked domestically and and subject to model and other errors, On August 4, 2003, the agencies with other BCBS member countries to the proposed framework should be issued an advance notice of proposed modify the methodologies in the viewed less as an effort to produce a rulemaking (ANPR) (68 FR 45900) that Proposed New Accord to reflect statistically precise measurement of sought public comment on a new risk- comments received during the risk, and more as an effort to improve based regulatory capital framework international consultation process and the risk sensitivity of the risk-based based on the Basel Committee on the U.S. ANPR comment process. In capital requirements for banks. Banking Supervision (BCBS)2 April June 2004, the BCBS issued a document The proposed framework’s conceptual 2003 consultative paper entitled ‘‘ New entitled ‘‘International Convergence of foundation is based on the view that Basel Capital Accord’’ (Proposed New Capital Measurement and Capital risk can be quantified through the Accord). The Proposed New Accord set Standards: A Revised Framework’’ (New forth a ‘‘three pillar’’ framework Accord or Basel II). The New Accord assessment of specific characteristics of encompassing risk-based capital recognizes developments in financial the probability distribution of potential requirements for credit risk, market risk, products, incorporates advances in risk losses over a given time horizon. This and operational risk (Pillar 1); measurement and management approach assumes that a suitable supervisory review of capital adequacy practices, and assesses capital estimate of that probability distribution, (Pillar 2); and market discipline through requirements that are generally more or at least of the specific characteristics enhanced public disclosures (Pillar 3). sensitive to risk. It is intended for use to be measured, can be produced. Figure The Proposed New Accord incorporated by individual countries as the basis for 1 illustrates some of the key concepts several methodologies for determining a national consultation and associated with the proposed bank’s risk-based capital requirements implementation. Accordingly, the framework. The figure shows a for credit, market, and operational risk.3 agencies are issuing this proposed rule probability distribution of potential The ANPR sought comment on to implement the New Accord for banks losses associated with some time selected regulatory capital approaches in the United States. horizon (for example, one year). It could contained in the Proposed New Accord B. Conceptual Overview reflect, for example, credit losses, that the agencies believe are appropriate operational losses, or other types of for large, internationally active U.S. The framework outlined in this losses. banks. These approaches include the proposal (IRB framework) is intended to

2 The BCBS is a committee of banking supervisory 3 The BCBS developed the Proposed New Accord Settlements Web site at http://www.bis.org. The authorities, which was established by the central to modernize its first capital Accord, which was agencies’ implementing regulations are available at bank governors of the G–10 countries in 1975. It endorsed by the G–10 governors in 1988 and 12 CFR part 3, Appendices A and B (national consists of senior representatives of bank implemented by the agencies in the United States banks); 12 CFR part 208, Appendices A and E (state supervisory authorities and central banks from in 1989. The BCBS’s 1988 Accord is described in member banks); 12 CFR part 225, Appendixes A Belgium, Canada, France, Germany, Italy, Japan, a document entitled ‘‘International Convergence of Luxembourg, the Netherlands, Spain, Sweden, Capital Measurement and Capital Standards.’’ This and E (bank holding companies); 12 CFR part 325, Switzerland, the United Kingdom, and the United document and other documents issued by the BCBS Appendices A and C (state nonmember banks); and States. are available through the Bank for International 12 CFR part 567 (savings associations).

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00004 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55833

The area under the curve to the right Assessing risk and assigning assessing credit risk capital of a particular loss amount is the regulatory capital requirements by requirements is based on a 99.9 percent probability of experiencing losses reference to a specific percentile of a nominal confidence level, a one-year exceeding this amount within a given probability distribution of potential horizon, and a supervisory model of time horizon. The figure also shows the losses is commonly referred to as a VaR credit losses embodying particular statistical mean of the loss distribution, approach. Such an approach was assumptions about the underlying which is equivalent to the amount of adopted by the FDIC, Board, and OCC drivers of portfolio credit risk, including loss that is ‘‘expected’’ over the time for assessing a bank’s risk-based capital loss correlations among different asset horizon. The concept of ‘‘expected loss’’ requirements for market risk in 1996 types.4 (EL) is distinguished from that of (market risk amendment or MRA). The IRB framework is broadly similar ‘‘unexpected loss’’ (UL), which Under the MRA, a bank’s own internal to the credit VaR approaches used by represents potential losses over and models are used to estimate the 99th many banks as the basis for their percentile of the bank’s market risk loss above the expected loss amount. A internal assessment of the economic distribution over a ten-business-day given level of unexpected loss can be capital necessary to cover credit risk. It horizon. The bank’s market risk capital is common for a bank’s internal credit defined by reference to a particular requirement is based on this VaR percentile threshold of the probability risk models to consider a one-year loss estimate, generally multiplied by a horizon, and to focus on a high loss distribution. In the figure, for example, factor of three. The agencies threshold confidence level. As with the the 99.9th percentile is shown. implemented this multiplication factor internal credit VaR models used by Unexpected losses, measured at the to provide a prudential buffer for market banks, the output of the risk-based 99.9th percentile level, are equal to the volatility and modeling error. capital formulas in the IRB framework is value of the loss distribution 1. The IRB Framework for Credit Risk an estimate of the amount of credit corresponding to the 99.9th percentile, losses above expected credit losses less the amount of expected losses. This The conceptual foundation of this (ECL) over a one-year horizon that is shown graphically at the bottom of proposal’s approach to credit risk would only be exceeded a small the figure. capital requirements is similar to the percentage of the time. The agencies MRA’s approach to market risk capital The particular percentile level chosen believe that a one-year horizon is requirements, in the sense that each is for the measurement of unexpected VaR-oriented. That is, the proposed 4 The theoretical underpinnings for the losses is referred to as the ‘‘confidence framework bases minimum credit risk level’’ or the ‘‘soundness standard’’ supervisory model of credit risk underlying this capital requirements largely on proposal are provided in Michael Gordy, ‘‘A Risk- associated with the measurement. If estimated statistical measures of credit Factor Model Foundation for Ratings-Based Bank capital is available to cover losses up to risk. Nevertheless, there are important Capital Rules,’’ Journal of Financial Intermediation, and including this percentile level, then July 2003. The IRB formulas are derived as an differences between this proposal and application of these results to a single-factor the bank will remain solvent in the face the MRA. The MRA approach for CreditMetrics-style model. For mathematical details of actual losses of that magnitude. assessing market risk capital on this model, see Michael Gordy, ‘‘A Comparative Typically, the choice of confidence level requirements currently employs a Anatomy of Credit Risk Models,’’ Journal of or soundness standard reflects a very Banking and Finance, January 2000, or H.U. nominal confidence level of 99.0 Koyluogu and A. Hickman, ‘‘Reconcilable high percentile level, so that there is a percent and a ten-business-day horizon, Differences,’’ Risk, October 1998. For a less very low estimated probability that but otherwise provides banks with technical overview of the IRB formulas, see the actual losses would exceed the substantial modeling flexibility in BCBS’s ‘‘An Explanatory Note on the Basel II Risk unexpected loss amount associated with Weight Functions,’’ July 2005 (Explanatory Note). determining their market risk loss The document can be found on the Bank for that confidence level or soundness distribution and capital requirements. In International Settlements Web site at http:// standard. contrast, the IRB framework for www.bis.org.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00005 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.075 55834 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

appropriate because it balances the fact applicable to a range of banks and to mortgage exposures would result in a that banking book positions likely could obtain tractable information for lower risk-based capital requirement not be easily or rapidly exited with the calculating risk-based capital than a 20 percent AVC and a higher possibility that in many cases a bank requirements. Chief among the risk-based capital requirement than a 10 can cover credit losses by raising assumptions embodied in the IRB percent AVC. additional capital should the underlying framework are: (i) Assumptions that a The AVCs that appear in the IRB risk- credit problems manifest themselves bank’s credit portfolio is infinitely based capital formulas for wholesale gradually. The nominal confidence level granular; (ii) assumptions that loan exposures decline with increasing PD; of the IRB risk-based capital formulas defaults at a bank are driven by a single, that is, the IRB risk-based capital (99.9 percent) means that if all the systematic risk factor; (iii) assumptions formulas generally imply that a group of assumptions in the IRB supervisory that systematic and non-systematic risk low-PD wholesale exposures are more model for credit risk were correct for a factors are log-normal random variables; correlated than a group of high-PD bank, there would be less than a 0.1 and (iv) assumptions regarding wholesale exposures. Thus, under the percent probability that credit losses at correlations among credit losses on proposed rule, a low-PD wholesale the bank in any year would exceed the various types of assets. exposure would have a higher relative IRB risk-based capital requirement.5 The specific risk-based capital risk-based capital requirement than that As noted above, the supervisory formulas in this proposed rule require implied by its PD were the AVC in the model of credit risk underlying the IRB the bank to estimate certain risk IRB risk-based capital formulas for framework embodies specific parameters for its wholesale and retail wholesale exposures fixed rather than a assumptions about the economic drivers exposures, which the bank may do function of PD. This inverse of portfolio credit risk at banks. As with using a variety of techniques. These risk relationship between PD and AVC for any modeling approach, these parameters are probability of default wholesale exposures is broadly assumptions represent simplifications of (PD), expected loss given default consistent with empirical research very complex real-world phenomena (ELGD), loss given default (LGD), undertaken by G10 supervisors and and, at best, are only an approximation exposure at default (EAD), and, for moderates the sensitivity of IRB risk- of the actual credit risks at any bank. To wholesale exposures, effective based capital requirements for the extent these assumptions (described remaining maturity (M). The risk-based wholesale exposures to the economic in greater detail below) do not capital formulas into which the cycle. Question 1: The agencies seek characterize a given bank precisely, the estimated risk parameters are inserted comment on and empirical analysis of actual confidence level implied by the are simpler than the the appropriateness of the proposed IRB risk-based capital formulas may methodologies typically employed by rule’s AVCs for wholesale exposures in exceed or fall short of the framework’s banks (which often require complex general and for various types of nominal 99.9 percent confidence level. computer simulations). In particular, an wholesale exposures (for example, In combination with other important property of the IRB risk-based commercial real estate exposures). supervisory assumptions and capital formulas is portfolio invariance. The AVCs included in the IRB risk- parameters underlying this proposal, the That is, the risk-based capital based capital formulas for retail IRB framework’s 99.9 percent nominal requirement for a particular exposure exposures also reflect a combination of confidence level reflects a judgmental generally does not depend on the other supervisory judgment and empirical pooling of available information, exposures held by the bank. Like the evidence.7 However, the historical data including supervisory experience. The general risk-based capital rules, the total available for estimating these framework underlying this proposal credit risk capital requirement for a correlations was more limited than was reflects a desire on the part of the bank’s wholesale and retail exposures is the case with wholesale exposures, agencies to achieve (i) relative risk- the sum of the credit risk capital particularly for non-mortgage retail based capital requirements across requirements on individual wholesale exposures. As a result, supervisory different assets that are broadly exposures and retail exposures. judgment played a greater role. consistent with maintaining at least an The IRB risk-based capital formulas Moreover, the flat 15 percent AVC for investment grade rating (for example, at contain supervisory asset value residential mortgage exposures is based least BBB) on the liabilities funding correlation (AVC) factors, which have a largely on empirical analysis of those assets, even in periods of significant impact on the capital traditional long-term, fixed-rate economic adversity; and (ii) for the U.S. requirements generated by the formulas. mortgages. Question 2: The agencies banking system as a whole, aggregate The AVC assigned to a given portfolio seek comment on and empirical minimum regulatory capital of exposures is an estimate of the degree analysis of the appropriateness and risk requirements that are not a material to which any unanticipated changes in sensitivity of the proposed rule’s AVC reduction from the aggregate minimum the financial conditions of the for residential mortgage exposures—not regulatory capital requirements under underlying obligors of the exposures are only for long-term, fixed-rate mortgages, the general risk-based capital rules. correlated (that is, would likely move but also for adjustable-rate mortgages, A number of important explicit up and down together). High correlation home equity lines of credit, and other generalizing assumptions and specific of exposures in a period of economic mortgage products—and for other retail parameters are built into the IRB downturn conditions is an area of portfolios. framework to make the framework supervisory concern. For a portfolio of Another important conceptual exposures having the same risk element of the IRB framework concerns 5 Banks’ internal economic capital models parameters, a larger AVC implies less the treatment of EL. The ANPR typically focus on measures of equity capital, diversification within the portfolio, generally would have required banks to whereas the total regulatory capital measure underlying this proposal includes not only equity greater overall systematic risk, and, hold capital against the measured capital, but also certain debt and hybrid hence, a higher risk-based capital amount of UL plus EL over a one-year instruments, such as subordinated debt. Thus, the requirement.6 For example, a 15 percent horizon, except in the limited instance 99.9 percent nominal confidence level embodied in the IRB framework is not directly comparable to the AVC for a portfolio of residential of credit card exposures where future nominal solvency standards underpinning banks’ economic capital models. 6 See Explanatory Note. 7 See Explanatory Note, section 5.3.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00006 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55835

margin income (FMI) was allowed to should receive risk-based capital calibration issues identified during the offset EL. The ANPR treatment also benefits only for the most highly reliable parallel run and transitional floor would have maintained the existing ECL offsets. periods (described below) and make definition of regulatory capital, which The combined impact of these changes to the rule as necessary. While includes the allowance for loan and changes in the treatment of ECL and a scaling factor is one way to ensure that lease losses (ALLL) in up reserves will depend on the reserving regulatory capital is maintained at a to a limit equal to 1.25 percent of risk- practices of individual banks. certain level, particularly in the short- to weighted assets. The ANPR requested Nevertheless, if other factors are equal, medium-term, the agencies also may comment on the proposed treatment of the removal of ECL from the calculation address calibration issues through EL. Many commenters on the ANPR of risk-weighted assets will result in a modifications to the underlying IRB objected to this treatment on conceptual lower amount of risk-weighted assets risk-based capital formulas. grounds, arguing that capital is not the than the proposals in the ANPR. appropriate mechanism for covering EL. However, the impact on risk-based 2. The AMA for Operational Risk In response to this feedback, the capital ratios should be partially offset The proposed rule also includes the agencies sought and obtained changes to by related changes to the numerators of the BCBS’s proposals in this area. the risk-based capital ratios— AMA for determining risk-based capital The agencies supported the BCBS’s specifically, (i) the ALLL will be requirements for operational risk. Under proposal, announced in October 2003, allowed in tier 2 capital up to certain the proposed rule, operational risk is to remove ECL (as defined below) from limits only to the extent that it and defined as the risk of loss resulting from the risk-weighted assets calculation. certain other reserves exceed ECL, and inadequate or failed internal processes, This NPR, consistent with the New (ii) if ECL exceeds reserves, the reserve people, and systems or from external Accord, removes ECL from the risk- shortfall must be deducted 50 percent events. This definition of operational weighted assets calculation but requires from tier 1 capital and 50 percent from risk includes —which is the a bank to compare its ECL to its eligible tier 2 capital. risk of loss (including litigation costs, credit reserves (as defined below). If a Using data from QIS–3, the BCBS settlements, and regulatory fines) bank’s ECL exceeds its eligible credit conducted an analysis of the risk-based resulting from the failure of the bank to reserves, the bank must deduct the capital requirements that would be comply with laws, regulations, prudent excess ECL amount 50 percent from tier generated under the New Accord, taking ethical standards, and contractual 1 capital and 50 percent from tier 2 into account the aggregate effect of ECL- obligations in any aspect of the bank’s capital. If a bank’s eligible credit related changes to both the numerator business—but excludes strategic and reserves exceed its ECL, the bank would and the denominator of the risk-based reputational risks. be able to include the excess eligible capital ratios. The BCBS concluded that Under the AMA, a bank would use its credit reserves amount in tier 2 capital, to offset these changes relative to the internal operational up to 0.6 percent of the bank’s credit credit risk-based capital requirements of systems and processes to assess its risk-weighted assets. This treatment is the Proposed New Accord, it might be exposure to operational risk. Given the intended to maintain a capital incentive necessary under the New Accord to complexities involved in measuring to reserve prudently and seeks to ensure apply a ‘‘scaling factor’’ (multiplier) to operational risk, the AMA provides that ECL over a one-year horizon is credit risk-weighted assets. The BCBS, banks with substantial flexibility and, covered either by reserves or capital. in the New Accord, indicated that the therefore, does not require a bank to use This treatment also recognizes that best estimate of the scaling factor using specific methodologies or distributional prudent reserving that considers QIS–3 data adjusted for the EL–UL assumptions. Nevertheless, a bank using probable losses over the life of a loan decisions was 1.06. The BCBS noted the AMA must demonstrate to the may result in a bank holding reserves in that a final determination of any scaling satisfaction of its primary Federal excess of ECL measured with a one-year factor would be reconsidered prior to supervisor that its systems for managing horizon. The BCBS calibrated the full implementation of the new and measuring operational risk meet proposed 0.6 percent limit on inclusion framework. The agencies are proposing established standards, including of excess reserves in tier 2 capital to be a multiplier of 1.06 at this time, producing an estimate of operational approximately as restrictive as the consistent with the New Accord. risk exposure that meets a 1-year, 99.9th existing cap on the inclusion of ALLL The agencies note that a 1.06 percentile soundness standard. A bank’s under the general risk-based capital multiplier should be viewed as a estimate of operational risk exposure rules, based on data obtained in the placeholder. The BCBS is expected to includes both expected operational loss BCBS’s Third Quantitative Impact Study revisit the determination of a scaling (EOL) and unexpected operational loss 8 (QIS–3). Question 3: The agencies seek factor based on the results of the latest (UOL) and forms the basis of the bank’s comment and supporting data on the international QIS (QIS–5, which was not risk-based capital requirement for 9 appropriateness of this limit. conducted in the United States). The operational risk. The agencies are aware that certain agencies will consider the BCBS’s banks believe that FMI should be determination, as well as other factors The AMA allows a bank to base its eligible to cover ECL for the purposes of including the most recent QIS risk-based capital requirement for such a calculation, while other banks conducted in the United States (QIS–4, operational risk on UOL alone if the have asserted that, for certain business which is described below),10 in bank can demonstrate to the satisfaction lines, prudential reserving practices do determining a multiplier for the final of its primary Federal supervisor that not involve setting reserves at levels rule. As the agencies gain more the bank has eligible operational risk consistent with ECL over a horizon as experience with the proposed advanced offsets, such as certain operational risk long as one year. The agencies approaches, the agencies will revisit the reserves, that equal or exceed the bank’s nevertheless believe that the proposed scaling factor along with other EOL. To the extent that eligible approach is appropriate because banks operational risk offsets are less than 9 See http://www.bis.org/bcbs/qis/qis5.htm. EOL, the bank’s risk-based capital 8 BCBS, ‘‘QIS 3: Third Quantitative Impact 10 See ‘‘Summary Findings of the Fourth requirement for operational risk must Study,’’ May 2003. Quantitative Impact Study,’’ February 24, 2006. incorporate the shortfall.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00007 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55836 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

C. Overview of Proposed Rule stated as a percentage and is an estimate (CEIOs)11 and securitization exposures The proposed rule maintains the of the economic loss rate if a default that do not qualify for the RBA, the IAA, general risk-based capital rules’ occurs during economic downturn or the SFA would be deducted from minimum tier 1 risk-based capital ratio conditions); EAD (which is measured in regulatory capital. Banks would be able to use an of 4.0 percent and total risk-based dollars and is an estimate of the amount internal models approach (IMA) for capital ratio of 8.0 percent. The that would be owed to the bank at the determining risk-based capital components of tier 1 and total capital time of default); and M (which is requirements for equity exposures, are also generally the same, with a few measured in years and reflects the subject to certain qualifying criteria and adjustments described in more detail effective remaining maturity of the floors. If a bank does not have a below. The primary difference between exposure). Banks would be able to factor qualifying internal model for equity the general risk-based capital rules and into their risk parameter estimates the exposures, or chooses not to use such a the proposed rule is the methodologies risk mitigating impact of collateral, model, the bank must apply a simple used for calculating risk-weighted credit derivatives, and guarantees that risk weight approach (SRWA) in which assets. Banks applying the proposed meet certain criteria. Banks would input publicly traded equity exposures would rule generally would use their internal the risk parameters for each wholesale have a 300 percent risk weight and non- risk measurement systems to calculate exposure into an IRB risk-based capital publicly traded equity exposures would the inputs for determining the risk- formula to determine the risk-based have a 400 percent risk weight. Under weighted asset amounts for (i) general capital requirement for the exposure. both the IMA and the SRWA, equity credit risk (including wholesale and Retail exposures under the proposed exposures to certain entities or made retail exposures); (ii) securitization rule include most credit exposures to pursuant to certain statutory authorities exposures; (iii) equity exposures; and individuals and small businesses that would be subject to a 0 to 100 percent (iv) operational risk. In certain cases, are managed as part of a segment of risk weight. however, external ratings or supervisory exposures with similar risk Banks would have to develop risk weights would be used to determine characteristics, not on an individual- qualifying AMA systems to determine risk-weighted asset amounts. Each of exposure basis. A bank would classify risk-based capital requirements for these areas is discussed below. operational risk. Under the AMA, a Banks using the proposed rule also each of its retail exposures into one of three retail subcategories—residential bank would use its own methodology to would be subject to supervisory review identify operational loss events, of their capital adequacy (Pillar 2) and mortgage exposures, qualifying revolving exposures (QREs) (for measure its exposure to operational risk, certain public disclosure requirements and assess a risk-based capital to foster transparency and market example, credit cards and overdraft lines), and other retail exposures. requirement for operational risk. discipline (Pillar 3). In addition, each Under the proposed rule, a bank bank using the advanced approaches Within these three subcategories, the would calculate its risk-based capital would continue to be subject to the tier bank would group exposures into ratios by first converting any dollar risk- 1 leverage ratio requirement, and each segments with similar risk based capital requirements for depository institution (DI) (as defined in characteristics. The bank would then exposures produced by the IRB risk- section 3 of the Federal Deposit assign the risk parameters PD, ELGD, based capital formulas into risk- Insurance Act (12 U.S.C. 1813)) using LGD, and EAD to each retail segment. weighted asset amounts by multiplying the advanced approaches would The bank would be able to take into the capital requirements by 12.5 (the continue to be subject to the prompt account the risk mitigating impact of inverse of the overall 8.0 percent risk- corrective action (PCA) thresholds. collateral and guarantees in the based capital requirement). After Those banks subject to the MRA also segmentation process and in the determining the risk-weighted asset would continue to be subject to the assignment of risk parameters to retail amounts for credit risk and operational MRA. segments. Like wholesale exposures, the risk, a bank would sum these amounts Under the proposed rule, a bank must risk parameters for each retail segment and then subtract any allocated transfer identify whether each of its on- and off- would be used as inputs into an IRB risk reserves and excess eligible credit balance sheet exposures is a wholesale, risk-based capital formula to determine reserves not included in tier 2 capital retail, securitization, or equity exposure. the risk-based capital requirement for (defined below) to determine total risk- Assets that are not defined by any the segment. Question 4: The agencies weighted assets. The bank would then exposure category (and certain seek comment on the use of a segment- calculate its risk-based capital ratios by immaterial portfolios of exposures) based approach rather than an dividing its tier 1 capital and total generally would be assigned risk- exposure-by-exposure approach for qualifying capital by the total risk- weighted asset amounts equal to their retail exposures. weighted assets amount. carrying value (for on-balance sheet The proposed rule contains specific For securitization exposures, the bank exposures) or notional amount (for off- public disclosure requirements to would apply one of three general balance sheet exposures). provide important information to Wholesale exposures under the approaches, subject to various market participants on the capital proposed rule include most credit conditions and qualifying criteria: the structure, risk exposures, risk exposures to companies and Ratings-Based Approach (RBA), which assessment processes, and, hence, the governmental entities. For each uses external ratings to risk-weight wholesale exposure, a bank would exposures; an Internal Assessment 11 A CEIO is an on-balance-sheet asset that (i) assign five quantitative risk parameters: Approach (IAA), which uses internal represents the contractual right to receive some or ratings to risk-weight exposures to asset- all of the interest and no more than a minimal PD (which is stated as a percentage and amount of principal due on the underlying measures the likelihood that an obligor backed commercial paper programs exposures of a securitization and (ii) exposes the will default over a 1-year horizon); (ABCP programs); or the Supervisory holder to credit risk directly or indirectly associated ELGD (which is stated as a percentage Formula Approach (SFA). Securitization with the underlying exposures that exceeds its pro exposures in the form of gain-on-sale or rata claim on the underlying exposures whether and is an estimate of the economic loss through subordination provisions or other credit- rate if a default occurs); LGD (which is credit-enhancing interest-only strips enhancement techniques.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00008 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55837

capital adequacy of a bank. The public rules by cross-reference and are proposed regulatory text. Definitions, disclosure requirements would apply proposing modifications to the market however, are discussed in the portions only to the DI or bank holding company risk rules in a separate NPR issued of the preamble where they are most representing the top consolidated level concurrently.12 The OTS is proposing relevant. of the banking group that is subject to its own market risk rule, including the E. Quantitative Impact Study 4 and the advanced approaches. In addition, proposed modifications, as a part of that Overall Capital Objectives the agencies are also publishing today separate NPR. In addition, the agencies proposals to require certain disclosures may need to make additional 1. Quantitative Impact Study 4 from subsidiary DIs in the banking conforming amendments to certain of After the BCBS published the New group through the supervisory reporting their regulations that use tier 1 or total Accord, the agencies conducted the process. The agencies believe that the qualifying capital or the risk-based additional quantitative impact study reporting of key risk parameter capital ratios for various purposes. referenced above, QIS–4, in the fall and estimates for each DI applying the The proposed rule is structured in winter of 2004–2005, to better advanced approaches will provide the eight broad parts. Part I identifies understand the potential impact of the primary Federal supervisor of the DI criteria for determining which banks are proposed framework on the risk-based and other relevant supervisors with subject to the rule, provides key capital requirements for individual U.S. important data for assessing the definitions, and sets forth the minimum banks and U.S. banks as a whole. The reasonableness and accuracy of the risk-based capital ratios. Part II results showed a substantial dollar- institution’s calculation of its risk-based describes the adjustments to the weighted average decline and variation capital requirements under this numerator of the risk-based capital in risk-based capital requirements proposal and the adequacy of the ratios for banks using the advanced across the 26 participating U.S. banks institution’s capital in relation to its approaches. Part III describes the and their portfolios.13 In an April 2005 risks. Some of the proposed supervisory qualification process and provides press release,14 the agencies expressed reports would be publicly available (for qualification requirements for obtaining their concern about the magnitude of example, on the Call Report or Thrift supervisory approval for use of the the drop in QIS–4 risk-based capital Financial Report), and others would be advanced approaches. This part requirements and the dispersion of confidential disclosures to the agencies incorporates critical elements of those requirements and decided to to augment the supervisory process. supervisory oversight of capital undertake further analysis. adequacy (Pillar 2). D. Structure of Proposed Rule The QIS–4 analysis indicated a dollar- Parts IV through VII address the weighted average reduction of 15.5 The agencies are considering calculation of risk-weighted assets. Part percent in risk-based capital implementing a comprehensive IV provides the risk-weighted assets requirements at participating banks regulatory framework for the advanced calculation methodologies for wholesale when moving from the current - approaches in which each agency would and retail exposures; on-balance-sheet based framework to a Basel II-based have an advanced approaches regulation assets that do not meet the regulatory framework.15 Table A provides a or appendix that sets forth (i) the definition of a wholesale, retail, numerical summary of the QIS–4 elements of tier 1 and tier 2 capital and securitization, or equity exposure; and results, in total and by portfolio, associated adjustments to the risk-based certain immaterial portfolios of credit aggregated across all QIS–4 capital ratio numerator, (ii) the exposures. This part also describes the participants.16 The first column shows qualification requirements for using the risk-based capital treatment for over-the- advanced approaches, and (iii) the counter (OTC) derivative contracts, 13 Since neither an NPR and associated details of the advanced approaches. For repo-style transactions, and eligible supervisory guidance nor final regulations proposal purposes, the agencies are margin loans. In addition, this part implementing a Basel II-based framework had been issuing a single proposed regulatory text issued in the United States at the time of data describes the methodology for reflecting collection, all QIS–4 results relating to the U.S. for comment. Unless otherwise eligible credit risk mitigation techniques implementation of Basel II are based on the indicated, the term ‘‘bank’’ in the in risk-weighted assets for wholesale description of the framework contained in the QIS– regulatory text includes banks, savings and retail exposures. Furthermore, this 4 instructions. These instructions differed from the associations, and bank holding framework issued by the BCBS in June 2004 in part sets forth the risk-based capital several respects. For example, the QIS–4 companies (BHCs). The term requirements for failed and unsettled articulation of the Basel II framework does not ‘‘[AGENCY]’’ in the regulatory text securities, commodities, and foreign include the 1.06 scaling factor. The QIS–4 refers to the primary Federal supervisor exchange transactions. instructions are available at http://www.ffiec.gov/ of the bank applying the rule. Areas Part V identifies operating criteria for qis4. where the regulatory text would differ 14 See ‘‘Banking Agencies to Perform Additional recognizing risk transference in the Analysis Before Issuing Notice of Proposed by agency—for example, provisions that securitization context and outlines the Rulemaking Related to Basel II,’’ Apr. 29, 2005. would only apply to savings approaches for calculating risk-weighted 15 The Basel II framework on which QIS–4 is associations or to BHCs—are generally assets for securitization exposures. Part based uses a UL-only approach (even though EL indicated in appropriate places. VI describes the approaches for requirements were included in QIS–4). But the In this proposed rule, the agencies are current Basel I risk-based capital requirements use calculating risk-weighted assets for a UL+EL approach. Therefore, in order to compare not restating the elements of tier 1 and equity exposures. Part VII describes the the Basel II results from QIS–4 with the current tier 2 capital, which would generally calculation of risk-weighted assets for Basel I requirements, the EL requirements from remain the same as under the general operational risk. Finally, Part VIII QIS–4 had to be added to the UL capital risk-based capital rules. Adjustments to requirements from QIS–4. provides public disclosure requirements 16 In the table, ‘‘Minimum required capital’’ the risk-based capital ratio numerators for banks employing the advanced (MRC) refers to the total risk-based capital specific to banks applying the advanced approaches (Pillar 3). requirement before incorporating the impact of approaches are in part II of the proposed The structure of the preamble reserves. ‘‘Effective MRC’’ is equal to MRC adjusted rule and explained in greater detail in for the impact of reserves. As noted above, under generally follows the structure of the the Basel II framework, a shortfall in reserves section IV of this preamble. The OCC, generally increases the total risk-based capital Board, and FDIC also are proposing to 12 See elsewhere in today’s issue of the Federal requirement and a surplus in reserves generally incorporate their existing market risk Register. Continued

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00009 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55838 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

changes in dollar-weighted average both the increase/decrease and relative with the exception of credit cards. It minimum required capital (MRC) both size of each portfolio. The table also should be noted that column 3 gives by portfolio and overall, as well as in shows (column 3) that risk-based capital every participating bank equal weight. dollar-weighted average overall effective requirements declined by more than 26 Column 4 shows the analogous MRC. Column 2 shows the relative percent in half the banks in the study. weighted median change, using total contribution of each portfolio to the Most portfolios showed double-digit exposures as weights. overall dollar-weighted average decline declines in risk-based capital of 12.5 percent in MRC, representing requirements for over half the banks,

QIS–4 results (not shown in Table A) 22 percent in the aggregate. The Basel II-based risk-based capital regime, also suggested that tier 1 risk-based unweighted median indicates that half the existing tier 1 leverage ratio capital requirements under a Basel II- of the participating banks reported requirement could be a more important based framework would be lower for reductions in tier 1 risk-based capital constraint than it is currently. many banks than they are under the requirements of over 31 percent. The Evidence from some of the follow-up general risk-based capital rules, in part MRC calculations do not take into analysis also illustrated that similar loan reflecting the move to a UL-only risk- account the impact of the tier 1 leverage products at different banks may have based capital requirement. Tier 1 risk- ratio requirement. Were such results resulted in very different risk-based based capital requirements declined by produced under a fully implemented capital requirements. Analysis

reduces the total risk-based capital requirement, though not with equal impact.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00010 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.076 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55839

determined that this dispersion in any formal supervisory review of their The agencies also noted above that capital requirements not only reflected progress toward meeting the Basel II tier 1 capital requirements reported in differences in actual risk or portfolio qualification requirements. In addition, QIS–4 declined substantially more than composition, but also reflected the risk measurement and management did total capital requirements. The differences in the banks’ estimated risk systems of the QIS–4 participants, as agencies have long placed special parameters for similar exposures. indicated by the QIS–4 exercise, did not emphasis on the importance of tier 1 Although concerns with dispersion yet meet the Basel II qualification capital in maintaining bank safety and might be remedied to some degree with requirements outlined in this proposed soundness because of its ability to refinements to internal bank risk rule. absorb losses on a going concern basis. measurement and management systems As banks work with their supervisors The agencies will continue to monitor and through the rulemaking process, the to refine their risk measurement and the trend in tier 1 capital requirements agencies also note that some of the management systems, it will become during the parallel run and transitional dispersion encountered in the QIS–4 easier to determine the actual floor periods and will take appropriate exercise is a reflection of the flexibility quantitative impact of the advanced action if reductions in tier 1 capital in methods to quantify the risk approaches. The agencies have decided, requirements are inconsistent with the parameters that may be allowed under therefore, not to recalibrate the agencies’ overall capital goals. implementation of the proposed framework at the present time based on Similar to the attention the agencies framework. QIS–4 results, but to await further will give to overall risk-based capital The agencies intend to conduct other experience with more fully developed requirements for the U.S. banking analyses of the impact of the Basel II bank risk measurement and system, the agencies will carefully framework during both the parallel run management systems. consider during the transitional floor and transitional floor periods. These If there is a material reduction in periods whether dispersion in risk- analyses will look at both the impact of aggregate minimum regulatory capital based capital results across banks and the Basel II framework and the requirements upon implementation of portfolios appropriately reflects preparedness of banks to compute risk- differences in risk. A conclusion by the Basel II-based rules, the agencies will based capital requirements in a manner agencies that dispersion in risk-based propose regulatory changes or consistent with the Basel II framework. capital requirements does not adjustments during the transitional floor appropriately reflect differences in risk 2. Overall Capital Objectives periods. In this context, materiality will could be another possible basis for depend on a number of factors, The ANPR stated: ‘‘The Agencies do proposing regulatory adjustments or including the size, source, and nature of not expect the implementation of the refinements during the transitional floor any reduction; the risk profiles of banks New Accord to result in a significant periods. decrease in aggregate capital authorized to use Basel II-based rules; It should also be noted that given the requirements for the U.S. banking and other considerations relevant to the bifurcated regulatory capital framework system. Individual banking maintenance of a safe and sound that would result from the adoption of organizations may, however, face banking system. In any event, the this rule, issues related to overall capital increases or decreases in their minimum agencies will view a 10 percent or may be inextricably linked to the risk-based capital requirements because greater decline in aggregate minimum competitive issues discussed elsewhere the New Accord is more risk sensitive required risk-based capital (without in this document. The agencies than the 1988 Accord and the Agencies’ reference to the effects of the indicated in the ANPR that if the existing risk-based capital rules (general transitional floors described in a later competitive effects of differential capital risk-based capital rules).’’ 17 The ANPR section of this preamble), compared to requirements were deemed significant, was in this respect consistent with minimum required risk-based capital as ‘‘the Agencies would need to consider statements made by the BCBS in its determined under the existing rules, as potential ways to address those effects series of Basel II consultative papers and a material reduction warranting while continuing to seek the objectives its final text of the New Accord, in modifications to the supervisory risk of the current proposal. Alternatives which the BCBS stated as an objective functions or other aspects of this could potentially include modifications broad maintenance of the overall level framework. to the proposed approaches, as well as of risk-based capital requirements while The agencies are, in short, identifying fundamentally different approaches.’’ 18 allowing some incentives for banks to a numerical benchmark for evaluating In this regard, the agencies view the adopt the advanced approaches. and responding to capital outcomes parallel run and transitional floor The agencies remain committed to during the parallel run and transitional periods as a trial of the new framework these objectives. Were the QIS–4 results floor periods that do not comport with under controlled conditions. While the just described produced under an up- the overall capital objectives outlined in agencies hope and expect that and-running risk-based capital regime, the ANPR. At the end of the transitional regulatory changes proposed during the risk-based capital requirements floor periods, the agencies would re- those years would be in the nature of generated under the framework would evaluate the consistency of the adjustments made within the framework not meet the objectives described in the framework, as (possibly) revised during described in this proposed rule, more ANPR, and thus would be considered the transitional floor periods, with the fundamental changes cannot be ruled unacceptable. capital goals outlined in the ANPR and out if warranted based on future When considering QIS–4 results and with the maintenance of broad experience or comments received on their implications, it is important to competitive parity between banks this proposal. recognize that banking organizations adopting the framework and other The agencies reiterate that, especially participated in QIS–4 on a best-efforts banks, and would be prepared to make in light of the QIS–4 results, retention basis. The agencies had not qualified further changes to the framework if of the tier 1 leverage ratio and other any of the participants to use the Basel warranted. Question 5: The agencies existing prudential safeguards (for II framework and had not conducted seek comment on this approach to example, PCA) is critical for the ensuring that overall capital objectives 17 68 FR 45900, 45902 (Aug. 4, 2003). are achieved. 18 68 FR 45900, 45905 (August 4, 2003).

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00011 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55840 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

preservation of a safe and sound requirements under the Proposed New constructive dialogue about regulatory capital framework. In Accord would create a competitive implementation processes, and particular, the leverage ratio is a disadvantage for banks operating under harmonize approaches as much as straightforward and tangible measure of the general risk-based capital rules, possible within the range of national solvency and serves as a needed which in turn may adversely affect their discretion embedded in the New complement to the risk-sensitive Basel II asset quality and cost of capital. Other Accord. framework based on internal bank commenters suggested that if the While supervisory judgment will play inputs. advanced approaches in the Proposed a critical role in the evaluation of risk New Accord are implemented, the measurement and management practices F. Competitive Considerations agencies should consider revising their at individual banks, supervisors are A fundamental objective of the New general risk-based capital rules to committed to developing protocols and Accord is to strengthen the soundness enhance risk sensitivity and to mitigate information-sharing arrangements that and stability of the international potential competitive inequities should minimize burdens on banks banking system while maintaining associated with the bifurcated system. operating in multiple countries and sufficient consistency in capital The agencies recognize that the ensure that supervisory authorities are adequacy regulation to ensure that the industry has concerns with the potential implementing the New Accord as New Accord will not be a significant competitive inequities associated with a consistently as possible. The New source of competitive inequity among bifurcated risk-based capital framework. Accord identifies numerous areas where internationally active banks. The The agencies reaffirm their intention, national discretion is encouraged. This agencies support this objective and expressed in the ANPR, to address design was intended to enable national believe that it is crucial to promote competitive issues while continuing to supervisors to implement the continual advancement of the risk pursue the objectives of the current methodology, or combination of measurement and management practices proposal. In addition to the QIS–4 methodologies, most appropriate for of large and internationally active analysis discussed above, the agencies banks in their jurisdictions. Disparate banks. For this reason, the agencies have also researched discrete topics to implementation decisions are expected, propose to implement only the further understand where competitive particularly during the transition years. advanced approaches of the New pressures might arise. As part of their Over time, the agencies expect that Accord because these approaches utilize effort to develop a bifurcated risk-based industry and supervisory practices the most sophisticated and risk- capital framework that minimizes likely will converge in many areas, thus sensitive risk measurement and competitive inequities and is not mitigating differences across countries. management techniques. disruptive to the banking sector, the Competitive considerations, both While all banks should work to agencies issued an Advance Notice of internationally and domestically, will enhance their risk management Proposed Rulemaking (Basel IA ANPR) be monitored and discussed by the practices, the advanced approaches and considering various modifications to the agencies on an ongoing basis. With the systems required to support their general risk-based capital rules to regard to implementation timing use may not be appropriate for many improve risk sensitivity and to reduce concerns, the agencies believe that the banks from a cost-benefit point of view. potential competitive disparities transitional arrangements described in For these banks, the agencies believe between Basel II banks and non-Basel II section III.A. of this preamble below that, with some modifications, the banks.19 The comment period for the provide a prudent and reasonable general risk-based capital rules are a Basel IA ANPR ended on January 18, framework for moving to the advanced reasonable alternative. As discussed in 2006, and the agencies intend to approaches. Where international section E.2. above, this proposal’s consider all comments and issue for implementation differences affect an bifurcated approach to risk-based public comment a more fully developed individual bank, the agencies expect to capital requirements raises difficult risk-based capital proposal for non- work with the bank and appropriate issues and inextricably links Basel II banks. The comment period for national supervisory authorities for the competitive considerations with overall the non-Basel II proposal is expected to bank to ensure that implementation capital issues. One such issue relates to overlap that of this proposal, allowing proceeds as smoothly as possible. concerns about competitive inequities commenters to analyze the effects of the Question 6: The agencies seek comment between U.S. banks operating under two proposals concurrently. on all potential competitive aspects of different regulatory capital regimes. The In addition, some commenters this proposal and on any specific ANPR cited this concern, and a number expressed concern about competitive aspects of the proposal that might raise of commenters expressed their belief inequities arising from differences in competitive concerns for any bank or that in some portfolios competitive implementation and application of the group of banks. inequities would be worsened under the New Accord by supervisory authorities proposed bifurcated framework. These in different countries. In particular, II. Scope commenters expressed the concern that some commenters expressed concern The agencies have identified three the Proposed New Accord might place about the different implementation groups of banks: (i) Large or community banks operating under the timetables of various jurisdictions, and internationally active banks that would general risk-based capital rules at a differences in the scope of application be required to adopt the advanced competitive disadvantage to banks in various jurisdictions or in the range approaches in the proposed rule (core applying the advanced approaches of approaches that different banks); (ii) banks that voluntarily decide because the IRB framework would likely jurisdictions will allow. The BCBS has to adopt the advanced approaches (opt- result in lower risk-based capital established an Accord Implementation in banks); and (iii) banks that do not requirements on some types of Group, comprised of supervisors from adopt the advanced approaches (general exposures, such as residential mortgage member countries, whose primary banks). Each core and opt-in bank exposures, other retail exposures, and objectives are to work through would be required to meet certain small business loans. implementation issues, maintain a qualification requirements to the Some commenters asserted that the satisfaction of its primary Federal application of lower risk-based capital 19 See 70 FR 61068 (Oct. 20, 2005). supervisor, in consultation with other

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00012 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55841

relevant supervisors, before the bank recent year-end regulatory reports; or (ii) rule unless its primary Federal may use the advanced approaches for consolidated total on-balance sheet supervisor determines in writing that risk-based capital purposes. foreign exposure of $10 billion or more application of the rule is not appropriate Pillar I of the New Accord requires all at the most recent year-end. To in light of the bank’s asset size, level of banks subject to the New Accord to determine total on-balance sheet foreign complexity, risk profile, or scope of calculate capital requirements for exposure, a bank would sum its operations. Question 8B: The agencies exposure to both credit risk and adjusted cross-border claims, local seek comment on the proposed scope of operational risk. The New Accord country claims, and cross-border application. In particular, the agencies provides a bank three approaches to revaluation gains (calculated in seek comment on the regulatory burden calculate its credit risk capital accordance with the Federal Financial of a framework that requires the requirement and three approaches to Institutions Examination Council advanced approaches to be calculate its operational risk capital (FFIEC) Country Exposure Report implemented by each subsidiary DI of a requirement. Outside the United States, (FFIEC 009)). Adjusted cross-border BHC or bank that uses the advanced countries that are replacing Basel I with claims would equal total cross-border approaches. the New Accord generally have required claims less claims with the head office/ B. U.S. DI Subsidiaries of Foreign all banks to comply with the New guarantor located in another country, Banks Accord, but have provided banks the plus redistributed guaranteed amounts option of choosing among the New to the country of head office/guarantor. Any U.S.-chartered DI that is a Accord’s various approaches for A DI also is a core bank if it is a subsidiary of a foreign banking calculating credit risk and operational subsidiary of another DI or BHC that organization is subject to the U.S. risk capital requirements.20 For banks in uses the advanced approaches. regulatory capital requirements applied the United States, the NPR, like the Under the proposed rule, a U.S.- to domestically-owned U.S. DIs. Thus, if ANPR, takes a different approach. It chartered BHC 21 is a core bank if the the U.S. DI subsidiary of a foreign would not subject all U.S. banks to the BHC has: (i) Consolidated total assets banking organization meets any of the New Accord, but instead focuses on (excluding assets held by an insurance threshold criteria, it would be a core only the largest and most internationally underwriting subsidiary) of $250 billion bank and would be subject to the active banks. Due to the size and or more, as reported on the most recent advanced approaches. If it does not complexity of these banks, the NPR year-end regulatory reports; (ii) meet any of the criteria, the U.S. DI may would require core banks to comply consolidated total on-balance sheet remain a general bank or may opt-in to with the most advanced approaches for foreign exposure of $10 billion or more the advanced approaches, subject to the calculating credit and operational risk at the most recent year-end; or (iii) a same qualification process and capital requirements ‘‘ that is, the IRB subsidiary DI that is a core bank or opt- requirements as a domestically-owned and the AMA. In addition, the NPR in bank. Currently 11 top-tier banking U.S. DI. A top-tier U.S. BHC, and its would allow other U.S. banks to ‘‘opt organizations meet these criteria. The subsidiary DIs, that is owned by a in’’ to Basel II-based rules, but, as with agencies note that, using this approach foreign banking organization also would core banks, the only Basel II-based rules to define whether a BHC is a core bank, be subject to the same threshold levels available to U.S. ‘‘opt-in’’ banks would it is possible that no single DI under a for core bank determination as would a be the New Accord’s most advanced BHC would meet the threshold criteria, top-tier BHC that is not owned by a approaches. but that all of the BHC’s subsidiary DIs foreign banking organization. A U.S. Question 7: The agencies request would be core banks. BHC that meets the conditions in comment on whether U.S. banks subject The proposed BHC consolidated asset Federal Reserve SR letter 01–0122 and is to the advanced approaches in the threshold is different from the threshold a core bank would not be required to proposed rule (that is, core banks and in the ANPR, which applied to the total meet the minimum capital ratios in the opt-in banks) should be permitted to use consolidated DI assets of a BHC. The Board’s capital adequacy guidelines, other credit and operational risk proposed shift to total consolidated although it would be required to adopt approaches similar to those provided assets (excluding assets held by an the advanced approaches, compute and under the New Accord. With respect to insurance underwriting subsidiary) report its capital ratios in accordance the credit risk capital requirement, the recognizes that BHCs can hold similar with the advanced approaches, and agencies request comment on whether assets within and outside of DIs and make the required public and regulatory banks should be provided the option of reduces potential incentives to structure disclosures. using a U.S. version of the so-called BHC assets and activities to arbitrage A DI subsidiary of such a U.S. BHC ‘‘standardized approach’’ of the New Accord and on the appropriate length of capital regulations. The proposed rule would be a core bank and would be time for such an option. excludes assets held in an insurance required to adopt the advanced underwriting subsidiary of a BHC approaches (unless specifically A. Core and Opt-In Banks because the New Accord was not exempted from the advanced A DI is a core bank if it meets either designed to address insurance company approaches by its primary Federal of two independent threshold criteria: exposures. Question 8A: The Board supervisor) and meet the minimum (i) Consolidated total assets of $250 seeks comment on the proposed BHC capital ratio requirements. In addition, billion or more, as reported on the most consolidated non-insurance assets the Board retains its supervisory threshold relative to the consolidated DI authority to require any BHC, including 20 Despite the options provided in national assets threshold in the ANPR. a U.S. BHC owned or controlled by a legislation and rules, most non-U.S. banks A bank that is subject to the proposed foreign banking organization that is or is comparable in size and complexity to U.S. core rule either as a core bank or as an opt- treated as a financial holding company banks are adopting some form of the advanced approaches. For example, based on currently in bank would be required to apply the (FHC), to maintain capital levels above available information, the vast majority of large, internationally-active banks based outside of the 21 OTS does not currently impose any explicit 22 SR 01–01, ‘‘Application of the Board’s Capital United States plan to employ an internal ratings- capital requirements on savings and loan holding Adequacy Guidelines to Bank Holding Companies based approach in the calculation of credit risk companies and does not propose to apply the Basel Owned by Foreign Banking Organizations,’’ January capital requirements. II proposal to these holding companies. 5, 2001.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00013 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55842 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

the regulatory minimums. Question 9: advanced approaches for risk-based of readiness relative to the qualification The agencies seek comment on the capital purposes, it must develop and requirements in this proposed rule and application of the proposed rule to DI adopt a written implementation plan, related supervisory guidance. This subsidiaries of a U.S. BHC that meets establish and maintain a comprehensive assessment would include a gap the conditions in Federal Reserve SR and sound planning and governance analysis that identifies where additional letter 01–01 and on the principle of process to oversee the implementation work is needed and a remediation or national treatment in this context. efforts described in the plan, action plan that clearly sets forth how the bank intends to fill the gaps it has C. Reservation of Authority demonstrate to its primary Federal supervisor that it meets the qualification identified. The implementation plan The proposed rule would restate the requirements in section 22 of the must comprehensively address the authority of a bank’s primary Federal proposed rule, and complete a qualification requirements for the bank supervisor to require the bank to hold satisfactory ‘‘parallel run’’ (discussed and each of its consolidated subsidiaries an overall amount of capital greater than below). A bank’s primary Federal (U.S. and foreign-based) with respect to would otherwise be required under the supervisor would be responsible, after all portfolios and exposures of the bank rule if the agency determines that the consultation with other relevant and each of its consolidated bank’s risk-based capital requirements supervisors, for evaluating the bank’s subsidiaries. The implementation plan under the rule are not commensurate initial and ongoing compliance with the must justify and support any proposed with the bank’s credit, market, qualification requirements for the temporary or permanent exclusion of a operational, or other risks. In addition, advanced approaches. business line, portfolio, or exposure the agencies anticipate that there may be The agencies will jointly issue from the advanced approaches. The instances when the proposed rule supervisory guidance describing agency business lines, portfolios, and exposures generates a risk-weighted asset amount expectations for wholesale, retail, that the bank proposes to exclude from for specific exposures that is not securitization, and equity exposures, as the advanced approaches must be, in commensurate with the risks posed by well as for operational risk.23 The the aggregate, immaterial to the bank. such exposures. In these cases, under agencies recognize that a consistent and The implementation plan must include the proposed rule, the bank’s primary transparent process to oversee objective, measurable milestones Federal supervisor would retain the implementation of the advanced (including delivery dates and a date authority to require the bank to use a approaches is crucial, and will consult when the bank’s implementation of the different risk-weighted asset amount for with each other on significant issues advanced approaches will be fully the exposures or to use different risk raised during the implementation operational). For core banks, the parameters (for wholesale or retail process. implementation plan must include an exposures) or model assumptions (for Under the proposed rule, a bank explicit first floor period start date that modeled equity or securitization preparing to implement the advanced is no later than 36 months after the later exposures) than those required in the approaches must adopt a written of the effective date of the rule or the proposed rule when calculating the risk- implementation plan, approved by its date the bank meets at least one of the weighted asset amount for those board of directors, describing in detail threshold criteria.24 Further, the exposures. Similarly, the proposed rule how the bank complies, or intends to implementation plan must describe the would provide authority for a bank’s comply, with the qualification resources that the bank has budgeted primary Federal supervisor to require requirements. A core bank must adopt a and are available to implement the plan. the bank to assign a different risk- plan no later than six months after it During implementation of the weighted asset amount for operational meets a threshold criterion in section advanced approaches, a bank would risk, to change elements of its 1(b)(1) of the proposed rule. If a bank work closely with its primary Federal operational risk analytical framework meets a threshold criterion on the supervisor to ensure that its risk (including distributional and effective date of the final rule, the bank measurement and management systems dependence assumptions), or to make would have to adopt a plan within six are fully functional and reliable and are other changes to the bank’s operational months of the effective date. Banks that able to generate risk parameter estimates risk management processes, data and do not meet a threshold criterion, but that can be used to calculate the risk- assessment systems, or quantification are nearing any criterion by direct based capital ratios correctly under the systems if the supervisor finds that the growth or merger, would be expected to advanced approaches. The risk-weighted asset amount for engage in ongoing dialogue with their implementation plan, including the gap operational risk produced by the bank primary Federal supervisor regarding analysis and action plan, will provide a under the rule is not commensurate implementation strategies to ensure basis for ongoing supervisory dialogue with the operational risks of the bank. their readiness to adopt the advanced and review during this period. The Any agency that exercises this approaches when a threshold criterion primary Federal supervisor will assess a reservation of authority would notify is reached. An opt-in bank may adopt an bank’s progress relative to its each of the other agencies of its implementation plan at any time, but implementation plan. To the extent that determination. must adopt an implementation plan and adjustments to target dates are needed, III. Qualification notify its primary Federal supervisor in these adjustments would be made writing at least twelve months before it subject to the ongoing supervisory A. The Qualification Process proposes to begin the first floor period discussion between the bank and its 1. In General (as discussed later in this section of the primary Federal supervisor. Supervisory qualification to use the preamble). 2. Parallel Run and Transitional Floor advanced approaches is a continuous In developing an implementation Periods plan, a bank must assess its current state and iterative process that begins when Once a bank has adopted its a bank’s board of directors adopts an 23 The agencies have issued for public comment implementation plan, it must complete implementation plan and continues as draft supervisory guidance on corporate and retail the bank operates under the advanced exposures and operational risk. See 68 FR 45949 24 The bank’s primary Federal supervisor may approaches. Before a bank may use the (Aug. 4, 2003); 69 FR 62748 (Oct. 27, 2004). extend the bank’s first floor period start date.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00014 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55843

a satisfactory parallel run before it may During the transitional floor periods, applicable supervisory and regulatory use the advanced approaches to a bank would calculate its risk-weighted requirements using the lower of the calculate its risk-based capital assets under the general risk-based respective floor-adjusted risk-based requirements. A satisfactory parallel run capital rules. Next, the bank would capital ratio and the advanced is a period of at least four consecutive multiply this risk-weighted assets approaches risk-based capital ratio. calendar quarters during which the bank amount by the appropriate floor After a bank completes its transitional complies with all of the qualification percentage in the table above. This floor periods and its primary Federal requirements to the satisfaction of its product would be the bank’s ‘‘floor- supervisor determines the bank may primary Federal supervisor. During this adjusted’’ risk-weighted assets. Third, begin using the advanced approaches period, the bank would continue to be the bank would calculate its tier 1 and with no further transitional floor, the subject to the general risk-based capital total risk-based capital ratios using the bank would use its tier 1 and total risk- rules but would simultaneously definitions of tier 1 and tier 2 capital based capital ratios as calculated under calculate its risk-based capital ratios (and associated deductions and the advanced approaches and its tier 1 under the advanced approaches. During adjustments) in the general risk-based leverage ratio calculated using the the parallel run period, a bank would capital rules for the numerator values advanced approaches definition of tier 1 report its risk-based capital ratios under and floor-adjusted risk-weighted assets capital for PCA and all other both the general risk-based capital rules for the denominator values. These ratios supervisory and regulatory purposes. and the advanced approaches to its would be referred to as the ‘‘floor- The transitional floor calculations primary Federal supervisor through the adjusted risk-based capital ratios.’’ described above are linked to the supervisory process on a quarterly basis. The bank also would calculate its tier general risk-based capital rules. As The agencies will share this information 1 and total risk-based capital ratios noted above, the agencies issued the with each other for calibration and other using the definitions and rules in this Basel IA ANPR outlining possible analytical purposes. proposed rule. These ratios would be modifications to those rules and are A bank’s primary Federal supervisor referred to as the ‘‘advanced approaches developing an NPR in this regard. The would notify the bank of the date when risk-based capital ratios.’’ In addition, agencies are still considering the extent it may begin to use the advanced the bank would calculate a tier 1 and nature of these modifications to the approaches for risk-based capital leverage ratio using tier 1 capital as general risk-based capital rules and the purposes. A bank would not be defined in this proposed rule for the scope of application of these permitted to begin using the advanced numerator of the ratio. modifications, including for banks that approaches for risk-based capital During a bank’s transitional floor transition to the advanced approaches. purposes until its primary Federal periods, the bank would report all five The agencies expect banks that meet the supervisor is satisfied that the bank regulatory capital ratios described threshold criteria in section 1(b)(1) of fully complies with the qualification above—two floor-adjusted risk-based the proposed rule (that is, core banks) as requirements, the bank has satisfactorily capital ratios, two advanced approaches of the effective date of the rule, and completed a parallel run, and the bank risk-based capital ratios, and one banks that opt-in pursuant to section has an adequate process to ensure leverage ratio. To determine its 1(b)(2) at the earliest possible date, will ongoing compliance with the applicable capital category for PCA use the general risk-based capital rules qualification requirements. purposes and for all other regulatory in place immediately before the rule To provide for a smooth transition to and supervisory purposes, a bank’s risk- becomes effective both during the the advanced approaches, the proposed based capital ratios during the parallel run and as a basis for the rule would impose temporary limits on transitional floor periods would be set transitional floor calculations. Other the amount by which a bank’s risk- equal to the lower of the respective changes to the general risk-based capital based capital requirements could floor-adjusted risk-based capital ratio rules (outside the scope of the changes decline over a period of at least three and the advanced approaches risk-based outlined in the Basel IA ANPR) may be years (that is, at least four consecutive capital ratio. During the transitional considered by the agencies, as calendar quarters in each of the three floor periods, a bank’s tier 1 capital and appropriate. Question 10: The agencies transitional floor periods). Based on its tier 2 capital for all non-risk-based- seek comment on this approach, assessment of the bank’s ongoing capital supervisory and regulatory including the transitional floor compliance with the qualification purposes (for example, lending limits thresholds and transition period, and on requirements, a bank’s primary Federal and Regulation W quantitative limits) how and to what extent future supervisor would determine when the would be the bank’s tier 1 capital and modifications to the general risk-based bank is ready to move from one tier 2 capital as calculated under the capital rules should be incorporated transitional floor period to the next advanced approaches. into the transitional floor calculations period and, after the full transition has Thus, for example, in order to be well for advanced approaches banks. been completed, to move to stand-alone capitalized under PCA, a bank would Banks’ computation of risk-based use of the advanced approaches. Table have to have a floor-adjusted tier 1 risk- capital requirements under both the B sets forth the proposed transitional based capital ratio and an advanced general risk-based capital rules and the approaches tier 1 risk-based capital ratio advanced approaches will help the floor periods for banks moving to the of 6 percent or greater, a floor-adjusted agencies assess the impact of the advanced approaches: total risk-based capital ratio and an advanced approaches on overall capital advanced approaches total risk-based requirements, including whether the TABLE B.—TRANSITIONAL FLOORS capital ratio of 10 percent or greater, and change in capital requirements relative Transitional a tier 1 leverage ratio of 5 percent or to the general risk-based capital rules is Transitional floor period floor percent- greater (with tier 1 capital calculated consistent with the agencies’ overall age under the advanced approaches). capital objectives. Question 11: The Although the PCA rules do not apply to agencies seek comment on what other First floor period ...... 95 BHCs, a BHC would be required to information should be considered in Second floor period ...... 90 Third floor period ...... 85 report all five of these regulatory capital deciding whether those overall capital ratios and would have to meet goals have been achieved.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00015 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55844 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

The agencies are proposing to make 1. Process and Systems Requirements banks operating under the advanced 2008 the first possible year for a bank One of the objectives of the proposed approaches would address specific to conduct its parallel run and 2009– framework is to provide appropriate assumptions embedded in the advanced 2011 the first possible years for the three incentives for banks to develop and use approaches (such as diversification in transitional floor periods. Question 12: better techniques for measuring and credit portfolios), and would evaluate The agencies seek comment on this managing their risks. The proposed rule these banks, in part, on their ability to proposed timetable for implementing specifically requires a bank to have a account for deviations from the the advanced approaches in the United rigorous process for assessing its overall underlying assumptions in their own States. capital adequacy in relation to its total portfolios. As noted, each core or opt-in bank risk profile and a comprehensive B. Qualification Requirements would apply the advanced approaches strategy for maintaining appropriate Because the Basel II framework uses for risk-based capital purposes at the capital levels. Consistent with Pillar 2 of banks’ estimates of certain key risk consolidated top-tier legal entity level the New Accord, a bank’s primary parameters to determine risk-based (that is, either the top-tier BHC or top- Federal supervisor will evaluate how capital requirements, the advanced tier DI that is a core or opt-in bank) and approaches would introduce greater well the bank is assessing its capital at the level of each DI that is a complexity to the regulatory capital needs relative to its risks and, if subsidiary of such a top-tier legal entity. framework and would require banks deficiencies are identified, will take any Thus, each bank that applies the using the advanced approaches to necessary action to ensure that advanced approaches must have an possess a high level of sophistication in appropriate and prudent levels of appropriate infrastructure with risk risk measurement and risk management capital are maintained. measurement and management A bank should address all of its systems. As a result, the agencies processes that meet the proposed rule’s propose to require each core or opt-in material risks in its overall capital qualification requirements and that are bank to meet the qualification assessment process. Although not every appropriate given the bank’s size and requirements described in section 22 of risk can be measured precisely, the level of complexity. Regardless of the proposed rule to the satisfaction of following risks, at a minimum, should whether the systems and models that its primary Federal supervisor for a be factored into a bank’s capital generate the risk parameters necessary period of at least four consecutive assessment process: credit risk, market for calculating a bank’s risk-based calendar quarters before using the risk, operational risk, interest rate risk capital requirements are located at any advanced approaches to calculate its in the banking book, , affiliate of the bank, each legal entity minimum risk-based capital concentration risk, reputational risk, that applies the advanced approaches requirements (subject to the transitional and strategic risk. With regard to must ensure that the risk parameters floors for at least an additional three interest rate risk in the banking book, (that is, PD, ELGD, LGD, EAD, and M) years). The qualification requirements the agencies note that for some assets— and reference data used to determine its are written broadly to accommodate the for example, a long-term mortgage risk-based capital requirements are many ways a bank may design and loan—interest rate risk may be as great representative of its own credit and implement a robust internal credit and as, or greater than, the credit risk of the operational risk exposures. operational risk measurement and asset. The agencies will continue to The proposed rule also requires that management system and to permit focus attention on exposures where the systems and processes that an industry practice to evolve. interest rate risk may be significant and advanced approaches bank uses for risk- Many of the qualification will foster sound interest rate risk based capital purposes must be requirements relate to a bank’s measurement and management practices sufficiently consistent with the bank’s advanced IRB systems. A bank’s across banks. Additionally, because internal risk management processes and advanced IRB systems must incorporate credit risk concentrations can pose management information reporting five interdependent components in a substantial risk to a bank that might be systems such that data from the latter framework for evaluating credit risk and managing individual credits in a processes and systems can be used to measuring regulatory capital: satisfactory manner, a bank also should verify the reasonableness of the inputs (i) A risk rating and segmentation give proper attention to such the bank uses for risk-based capital system that assigns ratings to individual concentrations. purposes. Banks already are required to hold wholesale obligors and exposures and 2. Risk Rating and Segmentation assigns individual retail exposures to capital sufficient to meet their risk profiles, and existing rules allow Systems for Wholesale and Retail segments; Exposures (ii) A quantification process that Federal supervisors to require a bank to translates the risk characteristics of increase its capital if its current capital To implement the IRB framework, a wholesale obligors and exposures and levels are deficient or some element of bank must have internal risk rating and segments of retail exposures into its business practices suggests the need segmentation systems that accurately numerical risk parameters that are used for more capital. Existing supervisory and reliably differentiate between as inputs to the IRB risk-based capital guidance directs banks to meaningfully degrees of credit risk for wholesale and formulas; tie the identification, monitoring, and retail exposures. As described below, (iii) An ongoing process that validates evaluation of risk to the determination wholesale exposures include most the accuracy of the rating assignments, of the bank’s capital needs. Banks are credit exposures to companies, segmentations, and risk parameters; expected to implement and continually sovereigns, and governmental entities, (iv) A data management and update the fundamental elements of a as well as some exposures to maintenance system that supports the sound internal capital adequacy individuals. Retail exposures include advanced IRB systems; and analysis—identifying and measuring all most credit exposures to individuals (v) Oversight and control mechanisms material risks, setting capital adequacy and small businesses that are managed that ensure the advanced IRB systems goals that relate to risk, and assessing as part of a segment of exposures with are functioning effectively and conformity to the bank’s stated homogeneous risk characteristics. producing accurate results. objectives. The agencies expect that all Together, wholesale and retail

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00016 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55845

exposures cover most credit exposures triggers the proposed rule’s definition of estimate. Banks employing loss severity of banks. default, all of the bank’s wholesale grades must have a sufficiently granular To differentiate among degrees of exposures to that obligor are in default loss severity grading system to avoid credit risk, a bank must be able to make for risk-based capital purposes. In grouping together exposures with meaningful and consistent distinctions addition, a bank may not consider the widely ranging ELGDs or LGDs. among credit exposures along two value of collateral pledged to support a Retail exposures. To implement the dimensions—default risk and loss particular wholesale exposure (or any advanced approach for retail exposures, severity in the event of a default. In other exposure-specific characteristics) a bank must have an internal system addition, a bank must be able to assign when assigning a rating to the obligor of that segments its retail exposures to wholesale obligors to rating grades that the exposure, even in the context of differentiate accurately and reliably approximately reflect likelihood of nonrecourse loans and other loans among degrees of credit risk. The most default and must be able to assign underwritten primarily based on the significant difference between the wholesale exposures to rating grades (or operating income or cash flows from proposed rule’s treatment of wholesale ELGD and LGD estimates) that real estate collateral. A bank may, of and retail exposures is that the risk approximately reflect the loss severity course, consider all available financial parameters for retail exposures are not expected in the event of default. As information about the obligor— assigned at the individual exposure discussed below, the proposed rule including, where applicable, the total level. Banks typically manage retail requires banks to treat wholesale operating income or cash flows from all exposures on a segment basis, where exposures differently from retail of the obligor’s projects or businesses— each segment contains exposures with exposures when differentiating among when assigning an obligor rating. similar risk characteristics. Therefore, a degrees of credit risk. Question 13: The agencies seek key characteristic of the proposed rule’s Wholesale exposures. For wholesale comment on this aspect of the proposed retail framework is that the risk exposures, a bank must have an internal rule and on any circumstances under parameters for retail exposures would risk rating system that indicates the which it would be appropriate to assign be assigned to segments of exposures likelihood of default of each individual different obligor ratings to different rather than to individual exposures. obligor and may use an internal risk exposures to the same obligor (for Under the retail framework, a bank rating system that indicates the example, income-producing property would group its retail exposures into economic loss rate upon default of each lending or exposures involving transfer segments with homogeneous risk individual exposure.25 A bank would risk). characteristics and then estimate PD, assign an internal risk rating to each A bank’s rating system must have at ELGD, and LGD for each segment. wholesale obligor, which should reflect least seven discrete (non-overlapping) A bank must first group its retail the obligor’s PD—that is, its long-run obligor grades for non-defaulted obligors exposures into three separate average one-year default rate over a and at least one obligor grade for subcategories: (i) Residential mortgage reasonable mix of economic conditions. defaulted obligors. The agencies believe exposures; (ii) QREs; and (iii) other PD is defined in more detail below. that because the risk-based capital retail exposures. The bank would then In determining an obligor rating, a requirement of a wholesale exposure is classify the retail exposures in each bank should consider key obligor directly linked to its obligor rating subcategory into segments to produce a attributes, including both quantitative grade, a bank must have at least seven meaningful differentiation of risk. The and qualitative factors that could affect non-overlapping obligor grades to proposed rule requires banks to segment the obligor’s default risk. From a sufficiently differentiate the separately (i) defaulted retail exposures quantitative perspective, this could creditworthiness of non-defaulted from non-defaulted retail exposures and include an assessment of the obligor’s wholesale obligors. (ii) retail eligible margin loans for which historic and projected financial A bank would capture the estimated the bank adjusts EAD rather than ELGD performance, trends in key financial loss severity upon default for a and LGD to reflect the risk mitigating performance ratios, financial wholesale exposure either by directly effects of financial collateral from other contingencies, industry risk, and the assigning an ELGD and LGD estimate to retail eligible margin loans. Otherwise, obligor’s position in the industry. On the exposure or by grouping the the agencies are not proposing to require the qualitative side, this could include exposure with other wholesale that banks consider any particular risk an assessment of the quality of the exposures into loss severity rating drivers or employ any minimum obligor’s financial reporting, non- grades (reflecting the bank’s estimate of number of segments in any of the three financial contingencies (for example, the ELGD or LGD of the exposure). The retail subcategories. labor problems and environmental LGD of an exposure is an estimate of the In determining how to segment retail issues), and the quality of the obligor’s economic loss rate on the exposure, exposures within each subcategory for management based on an evaluation of taking into account related material the purpose of assigning risk management’s ability to make realistic costs and recoveries, in the event of the parameters, a bank should use a projections, management’s track record obligor’s default during a period of segmentation approach that is in meeting projections, and economic downturn conditions. LGD is consistent with its approach for internal management’s ability to effectively deal described in more detail below. risk assessment purposes and that with changes in the economy and the Whether a bank chooses to assign ELGD classifies exposures according to competitive environment. and LGD values directly or, predominant risk characteristics or A bank must assign each legal entity alternatively, to assign exposures to drivers. Examples of risk drivers could wholesale obligor to a single rating rating grades and then quantify the include loan-to-value (LTV) ratios, grade. Accordingly, if a single wholesale ELGD or LGD, as appropriate, for the credit scores, loan terms and structure exposure of the bank to an obligor rating grades, the key requirement is (for example, interest only or payment that the bank must identify exposure option adjustable rate mortgages), 25 As explained below, a bank that chooses not to characteristics that influence ELGD and origination channel, geographical use an internal risk rating system for ELGD and LGD. Each of the loss severity rating location of the borrower, and collateral LGD for a wholesale exposure must directly assign an ELGD and LGD estimate to the wholesale grades would be associated with an type. A bank must be able to exposure. empirically supported ELGD or LGD demonstrate to its primary Federal

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00017 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55846 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

supervisor that its system assigns sale prices of the individual exposures default on one retail exposure would accurate and reliable PD, ELGD, and contained in the set and evaluate not require a bank to treat all other LGD estimates for each retail segment whether a credit loss of 5 percent or obligations of the same obligor to the on a consistent basis. more of the exposure’s initial carrying bank as defaulted. This difference Definition of default. In the ANPR, the value has occurred on any given reflects the fact that banks generally agencies proposed to define default for exposure. Write-downs of securities that manage retail credit risk based on a wholesale exposure as either or both are not credit-related (for example, a segments of similar exposures rather of the following events: (i) The bank write-down that is due to a change in than through the assignment of ratings determines that the borrower is unlikely market interest rates) would not be a to particular obligors. In addition, it is to pay its obligations to the bank in full, default event. quite common for retail borrowers that without recourse to actions by the bank Question 14: The agencies seek default on some of their obligations to such as the realization of collateral; or comment on this proposed definition of continue payment on others. (ii) the borrower is more than 90 days default and on how well it captures Second, the retail definition of past due on principal or interest on any substantially all of the circumstances default, unlike the wholesale definition material obligation to the bank. under which a bank could experience a of default, does not include exposures A number of commenters encouraged material credit-related economic loss on placed on non-accrual status. The the agencies to use a definition of a wholesale exposure. In particular, the agencies recognize that retail non- default that conforms more closely to agencies seek comment on the accrual practices vary considerably that used by bank risk managers. Many appropriateness of the 5 percent credit among banks. Accordingly, the agencies of these commenters recommended that loss threshold for exposures sold or have determined that removing non- the agencies define default as the entry transferred between reporting accrual from the retail definition of into non-accrual status for wholesale categories. The agencies also seek default would promote greater exposures and the number of days past commenters’ views on specific issues consistency among banks in the due for retail exposures, or as the entry raised by applying different definitions treatment of retail exposures. into charge-off status for wholesale and of default in multiple national In addition, the retail definition of retail exposures. The agencies have jurisdictions and on ways to minimize default, unlike the wholesale definition amended the ANPR definitions of potential regulatory burden, including of default, does not explicitly state that default to respond to these concerns and use of the definition of default in the an exposure is in default if a bank recognize that the definition of default New Accord, keeping in mind that incurs credit-related losses of 5 percent in this proposed rule is different from national bank supervisory authorities or more in connection with the sale of the definitions that are being must adopt default definitions that are the exposure. Because of the large implemented in other jurisdictions. appropriate in light of national banking number of diverse retail exposures that Under the proposed rule’s definition practices and conditions. banks usually sell in a single of default, a bank’s wholesale obligor In response to comments on the transaction, banks typically do not would be in default if, for any credit ANPR, the agencies propose to define allocate the sales price of a pool of retail exposure of the bank to the obligor, the default for retail exposures according to exposures in such a way as to enable the bank has (i) placed the exposure on non- the timeframes for loss classification bank to calculate the premium or accrual status consistent with the Call that banks generally use for internal discount on individual retail exposures. Report Instructions or the Thrift purposes and that are embodied in the Although the proposed rule’s definition Financial Report and the Thrift FFIEC’s Uniform Retail Credit of retail default does not explicitly Financial Report Instruction Manual; (ii) Classification and Account Management include credit-related losses in taken a full or partial charge-off or Policy.26 Specifically, revolving retail connection with loan sales, the agencies write-down on the exposure due to the exposures and residential mortgages would expect banks to assess carefully distressed financial condition of the would be in default at 180 days past the impact of retail exposure sales in obligor; or (iii) incurred a credit-related due; other retail exposures would be in quantifying the risk parameters loss of 5 percent or more of the default at 120 days past due. In calculated by the bank for its retained exposure’s initial carrying value in addition, a retail exposure would be in retail exposures. connection with the sale of the exposure default if the bank has taken a full or Rating philosophy. A bank must or the transfer of the exposure to the partial charge-off or write-down of explain to its primary Federal held-for-sale, available-for-sale, trading principal on the exposure for credit- supervisor its rating philosophy—that account, or other reporting category. related reasons. Such an exposure is, how the bank’s wholesale obligor rating assignments are affected by the Under the proposed definition, a would remain in default until the bank bank’s choice of the range of economic, wholesale exposure to an obligor has reasonable assurance of repayment business, and industry conditions that remains in default until the bank has and performance for all contractual are considered in the obligor rating reasonable assurance of repayment and principal and interest payments on the process. The philosophical basis of a performance for all contractual exposure. principal and interest payments on all The proposed definition of default for bank’s ratings system is important exposures of the bank to the obligor retail exposures differs from the because, when combined with the credit (other than exposures that have been proposed definition for the wholesale quality of individual obligors, it will determine the frequency of obligor fully written-down or charged-off). The portfolio in several important respects. rating changes in a changing economic agencies would expect a bank to employ First, the proposed retail default environment. Rating systems that rate standards for determining whether it definition applies on an exposure-by- obligors based on their ability to has a reasonable assurance of repayment exposure basis (rather than, as is the perform over a wide range of economic, and performance that are similar to case for wholesale exposures, on an business, and industry conditions, those for determining whether to restore obligor-by-obligor basis). In other words, a loan from non-accrual to accrual sometimes described as ‘‘through-the- status. 26 FFIEC, ‘‘Uniform Retail Credit Classification cycle’’ systems, would tend to have When a bank sells a set of wholesale and Account Management Policy,’’ 65 FR 36903 ratings that migrate more slowly as exposures, the bank must examine the (June 12, 2000). conditions change. Banks that rate

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00018 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55847

obligors based on a more narrow range one-year default rates for the rating Because of the one-year IRB horizon, of likely expected conditions (primarily grade assigned by the bank to the the agencies are proposing a different on recent conditions), sometimes called obligor, capturing the average default PD definition for retail segments with ‘‘point-in-time’’ systems, would tend to experience for obligors in the rating material seasoning effects. Under the have ratings that migrate more grade over a mix of economic conditions proposed rule, PD for a segment of non- frequently. Many banks will rate (including economic downturn defaulted retail exposures for which obligors using an approach that conditions) sufficient to provide a seasoning effects are material would be considers a combination of the current reasonable estimate of the average one- the bank’s empirically based best conditions and a wider range of other year default rate over the economic estimate of the annualized cumulative likely conditions. In any case, the bank cycle for the rating grade. This estimate default rate over the expected remaining would need to specify the rating of the long-run average PD is converted life of exposures in the segment, philosophy used and establish a policy into an estimate of PD under economic capturing the average default experience for the migration of obligors from one downturn conditions as part of the IRB for exposures in the segment over a mix rating grade to another in response to risk-based capital formulas. of economic conditions (including economic cycles. A bank should In addition, under the proposed rule, economic downturn conditions) to understand the effects of ratings a bank must assign a PD to each segment provide a reasonable estimate of the migration on its risk-based capital of retail exposures. The proposed rule average performance over the economic requirements and ensure that sufficient provides two different definitions of the cycle for the segment. A bank’s PD capital is maintained during all phases PD of a segment of non-defaulted retail estimates for these retail segments with of the economic cycle. exposures based on the materiality of material seasoning effects also should Rating and segmentation reviews and seasoning effects for the segment or for reflect potential changes in the expected updates. A bank must have a policy that the segment’s retail exposure remaining life of exposures in the ensures that each wholesale obligor subcategory. Some types of retail segment over the economic cycle. rating and (if applicable) wholesale exposures display a distinct seasoning For wholesale exposures to defaulted exposure loss severity rating reflects pattern—that is, the exposures have obligors and for segments of defaulted current information. A bank’s internal relatively low default rates in their first retail exposures, PD would be 100 risk rating system for wholesale year, rising default rates in the next few percent. exposures must provide for the review years, and declining default rates for the Loss given default (LGD) and expected and update (as appropriate) of each remainder of their terms. A bank must loss given default (ELGD). Under the obligor rating and (if applicable) loss use a separate definition of PD that proposed rule, a bank must directly severity rating whenever the bank addresses seasoning effects for a estimate an ELGD and LGD risk receives new material information, but segment of non-defaulted retail parameter for each wholesale exposure no less frequently than annually. A exposures unless the bank has or must assign each wholesale exposure bank’s retail exposure segmentation determined that seasoning effects are to an expected loss severity grade and system must provide for the review and not material for the segment or for the update (as appropriate) of assignments a downturn loss severity grade, estimate segment’s entire retail exposure of retail exposures to segments an ELGD risk parameter for each subcategory. whenever the bank receives new expected loss severity grade, and material information, but no less The proposed rule provides a estimate an LGD risk parameter for each frequently than quarterly. definition of PD for segments of non- loss severity grade. In addition, a bank defaulted retail exposures where must estimate an ELGD and LGD risk 3. Quantification of Risk Parameters for seasoning is not a material parameter for each segment of retail Wholesale and Retail Exposures consideration that tracks closely the exposures. The same ELGD and LGD A bank must have a comprehensive wholesale PD definition. Specifically, may be appropriate for more than one risk parameter quantification process PD for a segment of non-defaulted retail retail segment. that produces accurate, timely, and exposures for which seasoning effects LGD is an estimate of the economic reliable estimates of the risk are not material, or for a segment of non- loss that would be incurred on an parameters—PD, ELGD, LGD, EAD, and defaulted retail exposures in a retail exposure, relative to the exposure’s (for wholesale exposures) M—for its exposure subcategory for which EAD, if the exposure were to default wholesale obligors and exposures and seasoning effects are not material, within a one-year horizon during retail exposures. Statistical methods and would be the bank’s empirically based economic downturn conditions. The models used to develop risk parameter best estimate of the long-run average of economic loss amount must capture all estimates, as well as any adjustments to one-year default rates for the exposures material credit-related losses on the the estimates or empirical default data, in the segment, capturing the average exposure (including accrued but unpaid should be transparent, well supported, default experience for exposures in the interest or fees, losses on the sale of and documented. The following segment over a mix of economic repossessed collateral, direct workout sections of the preamble discuss the conditions (including economic costs, and an appropriate allocation of proposed rule’s definitions of the risk downturn conditions) sufficient to indirect workout costs). Where positive parameters for wholesale and retail provide a reasonable estimate of the or negative cash flows on a wholesale exposures. average one-year default rate over the exposure to a defaulted obligor or on a Probability of default (PD). As noted economic cycle for the segment. Banks defaulted retail exposure (including above, under the proposed rule, a bank that use this PD formulation for a proceeds from the sale of collateral, must assign each of its wholesale segment of retail exposures should be workout costs, and draw-downs of obligors to an internal rating grade and able to demonstrate to their primary unused credit lines) occur after the date then must associate a PD with each Federal supervisor, using empirical of default, the economic loss amount rating grade. PD for a wholesale data, why seasoning effects are not must reflect the net present value of exposure to a non-defaulted obligor material for the segment or the retail cash flows as of the default date using would be the bank’s empirically based exposure subcategory in which the a discount rate appropriate to the risk of best estimate of the long-run average of segment resides. the exposure.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00019 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55848 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

The LGD of some exposures may be national jurisdictions or in particular conditions (including economic substantially higher during economic industrial sectors may result in downturn conditions). For example, downturn conditions than during other significantly increased loss rates in given appropriate data, the ELGD could periods, while for other types of material subdivisions of a bank’s be estimated by calculating the default- exposures it may not. Accordingly, the exposures in an exposure subcategory. weighted average economic loss per proposed rule requires banks to use an Question 15: In light of the possibility of dollar of EAD given default for LGD estimate that reflects economic significantly increased loss rates at the exposures in a particular loss severity downturn conditions for purposes of subdivision level due to downturn grade or segment observed over a calculating the risk-based capital conditions in the subdivision, the complete credit cycle. requirements for wholesale exposures agencies seek comment on whether to As an alternative to internal estimates and retail segments; however, the LGD require banks to determine economic of LGD, the proposed rule provides a of an exposure may never be less than downturn conditions at a more granular supervisory mapping function for the exposure’s ELGD. More specifically, level than an entire wholesale or retail converting ELGD into LGD for risk- banks must produce for each wholesale exposure subcategory in a national based capital purposes. Although the exposure (or downturn loss severity jurisdiction. agencies encourage banks to develop rating grade) and retail segment an The proposed rule provides banks two internal LGD estimates, the agencies are estimate of the economic loss per dollar methods of generating LGD estimates for aware that it may be difficult at this of EAD that the bank would expect to wholesale and retail exposures. First, a time and in the near future for banks to incur if default were to occur within a bank may use its own estimates of LGD produce internal estimates of LGD that one-year horizon during economic for a subcategory of exposures if the are sufficient for risk-based capital downturn conditions. The estimate of bank has prior written approval from its purposes because LGD data for LGD can be thought of as the ELGD plus primary Federal supervisor to use important portfolios may be sparse, and an increase if appropriate to reflect the internal estimates for that subcategory of there is very limited industry impact of economic downturn exposures. In approving a bank’s use of experience with incorporating conditions. internal estimates of LGD, a bank’s downturn conditions into LGD For the purpose of defining economic primary Federal supervisor will estimates. Accordingly, under the downturn conditions, the proposed rule consider whether the bank’s internal proposed rule, a bank that does not identifies two wholesale exposure estimates of LGD are reliable and qualify for use of its own estimates of subcategories—high-volatility sufficiently reflective of economic LGD for a subcategory of exposures commercial real estate (HVCRE) downturn conditions. The supervisor must instead compute LGD by applying wholesale exposures and non-HVCRE will also consider whether the bank has a supervisory mapping function to its wholesale exposures (that is, all rigorous and well-documented policies internal estimates of ELGD for such wholesale exposures that are not and procedures for identifying exposures. The bank would adjust its HVCRE exposures)—and three retail economic downturn conditions for the ELGDs upward to LGDs using the linear exposure subcategories—residential exposure subcategory, identifying supervisory mapping function: LGD = mortgage exposures, QREs, and other material adverse correlations between 0.08 + 0.92 x ELGD. Under this mapping retail exposures. The proposed rule the relevant drivers of default rates and function, for example, an ELGD of 0 defines economic downturn conditions loss rates given default, and percent is converted to an LGD of 8 with respect to an exposure as those incorporating identified correlations percent, an ELGD of 20 percent is conditions in which the aggregate into internal LGD estimates. If a bank converted to an LGD of 26.4 percent, default rates for the exposure’s entire has supervisory approval to use its own and an ELGD of 50 percent is converted wholesale or retail subcategory held by estimates of LGD for an exposure to an LGD of 54 percent. A bank would the bank (or subdivision of such subcategory, it must use its own not have to apply the supervisory subcategory selected by the bank) in the estimates of LGD for all exposures mapping function to repo-style exposure’s national jurisdiction (or within that subcategory. transactions, eligible margin loans, and subdivision of such jurisdiction selected As noted above, the LGD of an OTC derivative contracts (defined below by the bank) are significantly higher exposure or segment may never be less in section V.C. of the preamble). For than average. than the ELGD of that exposure or these exposures, the agencies believe Under this approach, a bank with a segment. The proposed rule defines the that the difference between a bank’s geographical or industry sector ELGD of a wholesale exposure as the estimate of LGD and its estimate of concentration in a subcategory of bank’s empirically-based best estimate ELGD is likely to be small. Instead a exposures may find that information of the default-weighted average bank would set LGD equal to ELGD for relating to a downturn in that economic loss per dollar of EAD the these exposures. geographical region or industry sector bank expects to incur in the event that As noted, the proposed rule would may be more relevant for the bank than the obligor of the exposure (or a typical permit a bank to use the supervisory a general downturn affecting many obligor in the loss severity grade mapping function to translate ELGDs to regions or industries. At this time, assigned by the bank to the exposure) LGDs and would only permit a bank to however, the proposed rule does not defaults within a one-year horizon.27 use its own estimates of LGD for an require a bank with a geographical, For a segment of retail exposures, ELGD exposure subcategory if the bank has industry sector, or other concentration is the bank’s empirically-based best received prior written approval from its to subdivide exposure subcategories or estimate of the default-weighted average primary Federal supervisor. The national jurisdictions to reflect such economic loss per dollar of EAD the agencies also are considering whether to concentrations; rather, the proposed bank expects to incur on exposures in require every bank, as a condition to rule allows banks to subdivide exposure the segment that default within a one- qualifying for use of the advanced subcategories or national jurisdictions year horizon. ELGD estimates must approaches, to be able to produce as they deem appropriate given the incorporate a mix of economic credible and reliable internal estimates exposures held by the bank. The of LGD for all its wholesale and retail agencies understand that downturns in 27 Under the proposal, ELGD is not the statistical exposures. Under this stricter approach, particular geographical subdivisions of expected value of LGD. a bank that is unable to demonstrate to

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00020 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55849

its primary Federal supervisor that it important component of a bank’s overall seek comment on whether, for wholesale could produce credible and reliable credit risk management, and that such exposures, allowing ELGD and LGD to internal estimates of LGD would not be actions should be reflected in ELGD and reflect anticipated future contractual permitted to use the advanced LGD when banks can quantify their paydowns prior to default may be approaches. effectiveness in a reliable manner. In the inconsistent with the proposed rule’s Question 16: The agencies seek proposed rule, this is achieved by imposition of a one-year floor on M (for comment on and supporting empirical measuring ELGD and LGD relative to the certain types of exposures) or may lead analysis of (i) the proposed rule’s exposure’s EAD (defined in the next to some double-counting of the risk- definitions of LGD and ELGD; (ii) the section) as opposed to the amount mitigating benefits of shorter maturities proposed rule’s overall approach to LGD actually owed at default.28 for exposures not subject to this floor. estimation; (iii) the appropriateness of In practice, the agencies would expect Exposure at default (EAD). Except as requiring a bank to produce credible methods for estimating ELGD and LGD, noted below, EAD for the on-balance- and reliable internal estimates of LGD and the way those methods reflect sheet component of a wholesale or retail for all its wholesale and retail exposures changes in exposure during the period exposure means (i) the bank’s carrying as a precondition for using the prior to default, to be consistent with value for the exposure (including net advanced approaches; (iv) the other aspects of the proposed rule. For accrued but unpaid interest and fees) 29 appropriateness of requiring all banks to example, a default horizon that is longer less any allocated transfer risk reserve use a supervisory mapping function, than one year could result in lower for the exposure, if the exposure is held- rather than internal estimates, for estimates of economic loss due to to-maturity or for trading; or (ii) the estimating LGDs, due to limited data greater contractual amortization prior to bank’s carrying value for the exposure availability and lack of industry default, or a greater likelihood that (including net accrued but unpaid experience with incorporating economic covenants would enable a bank to interest and fees) less any allocated downturn conditions in LGD estimates; accelerate paydowns of principal as the transfer risk reserve for the exposure (v) the appropriateness of the proposed condition of an obligor deteriorates, but and any unrealized gains on the supervisory mapping function for such long horizons could be exposure, plus any unrealized losses on translating ELGD into LGD for all inconsistent with the one-year default the exposure, if the exposure is portfolios of exposures and possible horizon incorporated in other aspects of available for sale. For the off-balance- alternative supervisory mapping this proposed rule, such as the sheet component of a wholesale or retail functions; (vi) exposures for which no quantification of PD. exposure (other than an OTC derivative mapping function would be appropriate; The agencies intend to limit contract, repo-style transaction, or and (vii) exposures for which a more recognition of the impact on ELGD and eligible margin loan) in the form of a lenient (that is, producing a lower LGD LGD of pre-default paydowns to certain loan commitment or line of credit, EAD for a given ELGD) or more strict (that is, types of exposures where the pattern is means the bank’s best estimate of net producing a higher LGD for a given common, measurable, and especially additions to the outstanding amount ELGD) mapping function may be significant, as with various types of owed the bank, including estimated appropriate (for example, residential asset-based lending. In addition, not all future additional draws of principal and mortgage exposures and HVCRE paydowns during the period prior to accrued but unpaid interest and fees, exposures). default warrant recognition as part of that are likely to occur over the The agencies are concerned that some the recovery process. For example, a remaining life of the exposure assuming approaches to ELGD or LGD pre-default reduction in the outstanding the exposure were to go into default. quantification could produce estimates amount on one exposure may simply This estimate of net additions must that are pro-cyclical, particularly if reflect a refinancing by the obligor with reflect what would be expected during these estimates are based on economic the bank, with no reduction in the a period of economic downturn indicators, such as frequently updated bank’s total exposure to the obligor. conditions. For the off-balance-sheet loan-to-value (LTV) ratios, that are Question 18: The agencies seek component of a wholesale or retail highly sensitive to current economic comment on the feasibility of exposure other than an OTC derivative conditions. Question 17: The agencies recognizing such pre-default changes in contract, repo-style transaction, eligible seek comment on the extent to which exposure in a way that is consistent with margin loan, loan commitment, or line ELGD or LGD estimates under the the safety and soundness objectives of of credit issued by a bank, EAD means proposed rule would be pro-cyclical, this proposed rule. The agencies also the notional amount of the exposure. particularly for longer-term secured seek comment on appropriate For a segment of retail exposures, exposures. The agencies also seek restrictions to place on any such EAD is the sum of the EADs for each comment on alternative approaches to recognition to ensure that the results are individual exposure in the segment. For measuring ELGDs or LGDs that would not counter to the objectives of this wholesale or retail exposures in which address concerns regarding potential proposal to ensure adequate capital only the drawn balance has been pro-cyclicality without imposing undue within a more risk-sensitive capital securitized, the bank must reflect its burden on banks. framework. In addition, the agencies share of the exposures’ undrawn This proposed rule incorporates balances in EAD. The undrawn balances comments on the ANPR suggesting a 28 To illustrate, suppose that for a particular asset- of exposures for which the drawn need to better accommodate certain based lending exposure, the EAD equaled $100 and balances have been securitized must be credit products, most prominently asset- that for every $1 owed by the obligor at the time of default, the bank’s recovery would be $0.40. allocated between the seller’s and based lending programs, whose investors’ interests on a pro rata basis, structures typically result in a bank Furthermore, suppose that in the event of default, within a one-year horizon, pre-default paydowns of based on the proportions of the seller’s recovering substantial amounts of the $20 would reduce the exposure amount to $80 at and investors’ shares of the securitized exposure prior to the default date—for the time of default. In this case, the bank’s drawn balances. For example, if the example, through paydowns of economic loss rate measured relative to the amount owed at default (60%) would exceed the economic outstanding principal. The agencies loss rate measured relative to EAD (48% = 60% × 29 ‘‘Net accrued but unpaid interest and fees’’ are believe that actions taken prior to ($100 ¥ $20)/$100), because the former does not accrued but unpaid interest and fees net of any default to mitigate losses are an reflect fully the impact of the pre-default paydowns. amount expensed by the bank as uncollectable.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00021 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55850 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

EAD of a group of securitized exposures’ longer sample period usually captures inherent in the process. In practice, a undrawn balances is $100, and the varying economic conditions better than reasonable estimation approach likely bank’s share (seller’s interest) in the a shorter sample period; in addition, a would result in a range of defensible securitized exposures is 25 percent, the longer sample period will include more risk parameter estimates. The choices of bank must reflect $25 in EAD for the default observations for ELGD, LGD, and the particular assumptions and undrawn balances. EAD estimation. Banks should consider adjustments that determine the final The proposed rule contains a special using a longer-than-minimum sample estimate, within the defensible range, treatment of EAD for OTC derivative period when possible. However, the should reflect the uncertainty in the contracts, repo-style transactions, and potential increase in precision afforded quantification process. That is, more eligible margin loans, which is in by a larger sample should be weighed uncertainty in the process should be section 32 of the proposed rule and against the potential for diminished reflected in the assignment of final risk discussed in more detail in section V.C. comparability of older data to the parameter estimates that result in higher of the preamble. existing portfolio; striking the correct risk-based capital requirements relative General quantification principles. The balance is an important aspect of to a quantification process with less proposed rule requires data used by a quantitative modeling. uncertainty. The degree of conservatism bank to estimate risk parameters to be Both internal and external reference applied to adjust for uncertainty should relevant to the bank’s actual wholesale data should not differ systematically be related to factors such as the and retail exposures and of sufficient from a bank’s existing portfolio in ways relevance of the reference data to a quality to support the determination of that seem likely to be related to default bank’s existing exposures, the risk-based capital requirements for the risk, loss severity, or exposure at robustness of the models, the precision exposures. For wholesale exposures, default. Otherwise, the derived PD, of the statistical estimates, and the estimation of the risk parameters must ELGD, LGD, or EAD estimates may not amount of judgment used throughout be based on a minimum of 5 years of be applicable to the bank’s existing the process. Margins of conservatism default data to estimate PD, 7 years of portfolio. Accordingly, the bank must need not be added at each step; indeed, loss severity data to estimate ELGD and conduct a comprehensive review and that could produce an excessively LGD, and 7 years of exposure amount analysis of reference data at least conservative result. Instead, the overall data to estimate EAD. For segments of annually to determine the relevance of margin of conservatism should retail exposures, estimation of risk reference data to the bank’s exposures, adequately account for all uncertainties parameters must be based on a the quality of reference data to support and weaknesses in the quantification minimum of 5 years of default data to PD, ELGD, LGD, and EAD estimates, and process. Improvements in the estimate PD, 5 years of loss severity data the consistency of reference data to the quantification process (including use of to estimate ELGD and LGD, and 5 years definition of default contained in the more complete data and better of exposure amount data to estimate proposed rule. Furthermore, a bank estimation techniques) may reduce the EAD. Default, loss severity, and must have adequate data to estimate risk appropriate degree of conservatism over exposure amount data must include parameters for all its wholesale and time. periods of economic downturn retail exposures as if they were held to Judgment will inevitably play a role conditions or the bank must adjust its maturity, even if some loans are likely in the quantification process and may estimates of risk parameters to to be sold or securitized before their materially affect the estimates of risk compensate for the lack of data from long-term credit performance can be parameters. Judgmental adjustments to such periods. Banks must base their observed. estimates are often necessary because of estimates of PD, ELGD, LGD, and EAD As noted above, periods of economic some limitations on available reference on the proposed rule’s definition of downturn conditions must be included data or because of inherent differences default, and must review at least in the data sample (or adjustments to between the reference data and the annually and update (as appropriate) risk parameters must be made). If the bank’s existing exposures. The bank their risk parameters and risk parameter reference data include data from beyond must ensure that adjustments are not quantification process. the minimum number of years (to biased toward optimistically low risk In all cases, banks would be expected capture a period of economic downturn parameter estimates. This standard does to use the best available data for conditions or for other valid reasons), not prohibit individual adjustments that quantifying the risk parameters. A bank the reference data need not cover all of result in lower estimates of risk could meet the minimum data the intervening years. However, a bank parameters, as both upward and requirement by using internal data, should justify the exclusion of available downward adjustments are expected. external data, or pooled data combining data and, in particular, any temporal Individual adjustments are less internal data with external data. Internal discontinuities in data used. Including important than broad patterns; data refers to any data on exposures periods of economic downturn consistent signs of judgmental decisions held in a bank’s existing or historical conditions increases the size and that lower risk parameter estimates portfolios, including data elements or potentially the breadth of the reference materially may be evidence of information provided by third parties. data set. According to some empirical systematic bias, which would not be External data refers to information on studies, the average loss rate is higher permitted. exposures held outside of the bank’s during periods of economic downturn In estimating relevant risk parameters, portfolio or aggregate information across conditions, such that exclusion of such banks should not rely on the possibility an industry. periods would bias ELGD, LGD, or EAD of U.S. government financial assistance, For example, for new lines of business estimates downward and unjustifiably except for the financial assistance that where a bank lacks sufficient internal lower risk-based capital requirements. the government has legally committed data, it must use external data to Risk parameter estimates should take to provide. supplement its internal data. The into account the robustness of the agencies recognize that the minimum quantification process. The assumptions 4. Optional Approaches That Require sample period for reference data and adjustments embedded in the Prior Supervisory Approval provided in the proposed rule may not quantification process should reflect the A bank that intends to apply the provide the best available results. A degree of uncertainty or potential error internal models methodology to

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00022 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55851

counterparty credit risk, the double the scope and complexity of its business substantially the same whether viewed default treatment for credit risk lines, as well as its corporate from the perspective of its effect on the mitigation, the internal assessment organizational structure. Each bank’s bank’s regulatory capital or an approach (IAA) for securitization operational risk profile is unique and alternative approach that more directly exposures to ABCP programs, or the requires a tailored risk management incorporates economic capital concepts. internal models approach (IMA) to approach appropriate for the scale and In the case of operational loss events equity exposures must receive prior materiality of the operational risks associated with premises and other written approval from its primary present in the bank. fixed assets, however, potential loss Federal supervisor. The criteria on Operational risk data and assessment amounts used in a bank’s estimate of its which approval would be based are system. A bank must have an operational risk exposure could be described in the respective sections operational risk data and assessment considerably different under the two below. system that incorporates on an ongoing approaches. The agencies recognize basis the following four elements: that, for purposes of economic capital 5. Operational Risk internal operational loss event data, analysis, banks often use replacement A bank must have operational risk external operational loss event data, cost or market value, and not carrying management processes, data and results of scenario analysis, and value, to determine the amount of an assessment systems, and quantification assessments of the bank’s business operational loss with respect to fixed systems that meet the qualification environment and internal controls. assets. The use of carrying value would requirements in section 22(h) of the These four operational risk elements be consistent with a definition of proposed rule. A bank must have an should aid the bank in identifying the operational loss that covers a loss operational risk management function level and trend of operational risk, event’s effect on a bank’s regulatory independent from business line determining the effectiveness of capital, but may not reflect the full management. The operational risk operational risk management and economic impact of a loss event in the management function is responsible for control efforts, highlighting case of assets that have a carrying value the design, implementation, and opportunities to better mitigate that is different from their market value. oversight of the bank’s operational risk operational risk, and assessing Further, the agencies recognize that data and assessment systems, operational risk on a forward-looking there is a potential to double-count all operational risk quantification systems, basis. A bank’s operational risk data and or a portion of the risk-based capital and related processes. The roles and assessment system must be structured in requirement associated with fixed responsibilities of the operational risk a manner consistent with the bank’s assets. Under section 31(e)(3) of the management function may vary between current business activities, risk profile, proposed rule, which addresses banks, but must be clearly documented. technological processes, and risk calculation of risk-weighted asset The operational risk management management processes. amounts for assets that are not included function should have organizational The proposed rule defines operational in an exposure category, the risk- stature commensurate with the bank’s loss as a loss (excluding insurance or tax weighted asset amount for a bank’s operational risk profile. At a minimum, effects) resulting from an operational premises will equal the carrying value the bank’s operational risk management loss event. Operational losses include of the premises on the financial function should ensure the development all expenses associated with an statements of the bank, determined in of policies and procedures for the operational loss event except for accordance with generally accepted explicit management of operational risk opportunity costs, forgone revenue, and accounting principles (GAAP). A bank’s as a distinct risk to the bank’s safety and costs related to risk management and operational risk exposure estimate soundness. control enhancements implemented to addressing bank premises generally will A bank also must establish and prevent future operational losses. The be different than the risk-based capital document a process to identify, definition of operational loss is an requirement generated under section measure, monitor, and control important issue, as it is a critical 31(e)(3) of the proposed rule and, at operational risk in bank products, building block in a bank’s calculation of least in part, will address the same risk activities, processes, and systems. This its operational risk capital requirement exposure. process should provide for the under the AMA. More specifically, Question 19: The agencies solicit consistent and comprehensive under the proposed rule, the bank’s comment on all aspects of the proposed collection of the data needed to estimate estimate of operational risk exposure— treatment of operational loss and, in the bank’s exposure to operational risk. the basis for determining a bank’s risk- particular, on (i) the appropriateness of The process must also ensure reporting weighted asset amount for operational the proposed definition of operational of operational risk exposures, risk—is an estimate of aggregate loss; (ii) whether the agencies should operational loss events, and other operational losses generated by the define operational loss in terms of the relevant operational risk information to bank’s AMA process. effect an operational loss event has on business unit management, senior The agencies are considering whether the bank’s regulatory capital or should management, and to the board of to define operational loss based solely consider a broader definition based on directors (or a designated committee of on the effect of an operational loss event economic capital concepts; and (iii) how the board). The proposed rule defines on a bank’s regulatory capital or to use the agencies should address the operational loss events as events that a definition of operational loss that potential double-counting issue for result in loss and are associated with incorporates, to a greater extent, premises and other fixed assets. internal fraud; external fraud; economic capital concepts. In either A bank must have a systematic employment practices and workplace case, operational losses would continue process for capturing and using internal safety; clients, products, and business to be determined exclusive of insurance operational loss event data in its practices; damage to physical assets; and tax effects. operational risk data and assessment business disruption and system failures; With respect to most operational loss systems. Consistent with the ANPR, the or execution, delivery, and process events, the agencies believe that the proposed rule defines internal management. A bank’s operational risk operational loss amount incorporated operational loss event data for a bank as management processes should reflect into a bank’s AMA process would be gross operational loss amounts, dates,

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00023 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55852 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

recoveries, and relevant causal identify and assess the level and trends year horizon (and not incorporating information for operational loss events in operational risk and related control eligible operational risk offsets or occurring at the bank. A bank’s structures at the bank. These qualifying operational risk mitigants). operational risk data and assessment assessments should be current, should The mean of such a total loss system must include a minimum be comprehensive across the bank, and distribution is the bank’s EOL. The historical observation period of five should identify the operational risks proposed rule defines EOL as the years of internal operational losses. facing the bank. The framework expected value of the distribution of With approval of its primary Federal established by a bank to maintain these potential aggregate operational losses, as supervisor, however, a bank may use a risk assessments should be sufficiently generated by the bank’s operational risk shorter historical observation period to flexible to accommodate increasing quantification system using a one-year address transitional situations such as complexity, new activities, changes in horizon. The bank’s UOL is the integrating a new business line. A bank internal control systems, and an difference between the bank’s may refrain from collecting internal increasing volume of information. A operational risk exposure and the bank’s operational loss event data for bank must also periodically compare the EOL. individual operational losses below results of its prior business environment As part of its estimation of its established dollar threshold amounts if and internal control factor assessments operational risk exposure, a bank must the bank can demonstrate to the against the bank’s actual operational demonstrate that its unit of measure is satisfaction of its primary Federal losses incurred in the intervening appropriate for the bank’s range of supervisor that the thresholds are period. business activities and the variety of reasonable, do not exclude important Similar to business environment and operational loss events to which it is internal operational loss event data, and internal control factor assessments, the exposed. The proposed rule defines a permit the bank to capture substantially results of scenario analysis provide a unit of measure as the level (for all the dollar value of the bank’s means for a bank to incorporate a example, organizational unit or operational losses. forward-looking element in its operational loss event type) at which the A bank also must establish a operational risk data and assessment bank’s operational risk quantification systematic process for determining its systems. Under the proposed rule, system generates a separate distribution methodologies for incorporating scenario analysis is a systematic process of potential operational losses. A bank external operational loss event data into of obtaining expert opinions from must also demonstrate that it has not its operational risk data and assessment business managers and risk management combined business activities or systems. The proposed rule defines experts to derive reasoned assessments operational loss events with different external operational loss event data for of the likelihood and loss impact of risk profiles within the same loss a bank as gross operational loss plausible high-severity operational distribution. amounts, dates, recoveries, and relevant losses that may occur at a bank. A bank The agencies recognize that causal information for operational loss must establish a systematic process for operational losses across operational events occurring at organizations other determining its methodologies for loss event types and business lines may than the bank. External operational loss incorporating scenario analysis into its be related. A bank may use its internal event data may serve a number of operational risk data and assessment estimates of dependence among different purposes in a bank’s systems. As an input to a bank’s operational losses within and across operational risk data and assessment operational risk data and assessment business lines and operational loss systems. For example, external systems, scenario analysis is especially event types if the bank can demonstrate operational loss event data may be a relevant for business lines or loss event to the satisfaction of its primary Federal particularly useful input in determining types where internal data, external data, supervisor that its process for estimating a bank’s level of exposure to operational and assessments of the business dependence is sound, robust to a variety risk when internal operational loss environment and internal control factors of scenarios, and implemented with event data are limited. In addition, do not provide a sufficiently robust integrity, and allows for the uncertainty external operational loss event data estimate of the bank’s exposure to surrounding the estimates. The agencies provide a means for the bank to operational risk. expect that a bank’s assumptions understand industry experience and, in A bank’s operational risk data and regarding dependence will be turn, provide a means for the bank to assessment systems must include conservative given the uncertainties assess the adequacy of its internal credible, transparent, systematic, and surrounding dependence modeling for operational loss event data. verifiable processes that incorporate all operational risk. If a bank does not While internal and external four operational risk elements. The bank satisfy the requirements surrounding operational loss event data provide a should have clear standards for the dependence described above, the bank historical perspective on operational collection and modification of all must sum operational risk exposure risk, it is also important that a bank elements. The bank should combine estimates across units of measure to incorporate forward-looking elements in these four elements in a manner that calculate its operational risk exposure. its operational risk data and assessment most effectively enables it to quantify its A bank’s chosen unit of measure systems. Accordingly, a bank must exposure to operational risk. affects how it should account for incorporate a business environment and Operational risk quantification dependence. Explicit assumptions internal control factor analysis in its system. A bank must have an regarding dependence across units of operational risk data and assessment operational risk quantification system measure are always necessary to systems to fully assess its exposure to that measures its operational risk estimate operational risk exposure at the operational risk. In principle, a bank exposure using its operational risk data bank level. However, explicit with strong internal controls in a stable and assessment systems. The proposed assumptions regarding dependence business environment would have less rule defines operational risk exposure as within units of measure are not exposure to operational risk than a bank the 99.9th percentile of the distribution necessary, and under many with internal control weaknesses that is of potential aggregate operational losses, circumstances models assume statistical growing rapidly or introducing new as generated by the bank’s operational independence within each unit of products. In this regard, a bank should risk quantification system over a one- measure. The use of only a few units of

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00024 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55853

measure heightens the need to ensure Furthermore, the agencies expect a bank methodologies of the risk measurement that dependence within units of using an alternative operational risk and management systems employed by measure is suitably reflected in the quantification system to adhere to the the bank. To meet the significant data operational risk exposure estimate. qualification requirements outlined in management challenges presented by In addition, the bank’s process for the proposed rule, including the quantification, validation, and estimating dependence should provide establishment and use of operational control and oversight requirements of for ongoing monitoring, recognizing that risk management processes and data the advanced approaches, a bank must dependence estimates can change. The and assessment systems. store its data in an electronic format that agencies expect that a bank’s approach A bank proposing an alternative allows timely retrieval for analysis, for developing explicit and objective approach to operational risk based on an reporting, and disclosure purposes. dependence determinations will allocation methodology should be aware improve over time. As such, the bank of certain limitations associated with 7. Control and Oversight Mechanisms should develop a process for assessing use of such an approach. Specifically, The consequences of an inaccurate or incremental improvements to the the agencies will not accept an unreliable advanced system can be approach (for example, through out-of- allocation of operational risk capital significant, particularly on the sample testing). requirements that includes non-DI calculation of risk-based capital A bank must review and update (as entities or the benefits of diversification requirements. Accordingly, bank senior appropriate) its operational risk across entities. The exclusion of management would be responsible for quantification system whenever the allocations that include non-DIs is in ensuring that all advanced system bank becomes aware of information that recognition that, unlike the cross- components function effectively and are may have a material effect on the bank’s guarantee provision of the Federal in compliance with the qualification estimate of operational risk exposure, Deposit Insurance Act, which provides requirements of the advanced but no less frequently than annually. that a DI is liable for any losses incurred approaches. Moreover, the bank’s board As described above, the agencies by the FDIC in connection with the of directors (or a designated committee expect a bank using the AMA to failure of a commonly controlled DI, of the board) must evaluate at least demonstrate that its systems for there are no statutory provisions annually the effectiveness of, and managing and measuring operational requiring cross-guarantees between a DI approve, the bank’s advanced systems. risk meet established standards, and its non-DI affiliates.30 Furthermore, To support senior management’s and including producing an estimate of depositors and creditors of a DI the board of directors’ oversight operational risk exposure at the 99.9 generally have no legal recourse to responsibilities, a bank must have an percent confidence level. However, the capital funds that are not held by the DI effective system of controls and agencies recognize that, in limited or its affiliate DIs. oversight that ensures ongoing circumstances, there may not be compliance with the qualification sufficient data available for a bank to 6. Data Management and Maintenance requirements and maintains the generate a credible estimate of its own A bank must have data management integrity, reliability, and accuracy of the operational risk exposure at the 99.9 and maintenance systems that bank’s advanced systems. Banks would percent confidence level. In these adequately support all aspects of the have flexibility in how they achieve limited circumstances, a bank may bank’s advanced IRB systems, integrity in their risk management propose use of an alternative operational risk management processes, systems. They would, however, be operational risk quantification system to operational risk data and assessment expected to follow standard control that specified in section 22(h)(3)(i) of systems, operational risk quantification principles in their systems such as the proposed rule, subject to approval systems, and, to the extent the bank uses checks and balances, separation of by the bank’s primary Federal the following systems, the internal duties, appropriateness of incentives, supervisor. The alternative approach is models methodology to counterparty and data integrity assurance, including not available at the BHC level. credit risk, double default excessive that of information purchased from The agencies are not prescribing correlation detection process, IMA to third parties. Moreover, the oversight specific estimation methodologies under equity exposures, and IAA to process should be sufficiently this approach and expect use of an securitization exposures to ABCP independent of the advanced systems’ alternative approach to occur on a very programs (collectively, advanced development, implementation, and limited basis. A bank proposing to use systems). The bank’s data management operation to ensure the integrity of the an alternative operational risk and maintenance systems must ensure component systems. The objective of quantification system must submit a the timely and accurate reporting of risk management system oversight is to proposal to its primary Federal risk-based capital requirements. ensure that the various systems used in supervisor. In evaluating a bank’s Specifically, a bank must retain determining risk-based capital proposal, the bank’s primary Federal sufficient data elements to permit requirements are operating as intended. supervisor will review the bank’s monitoring, validation, and refinement The oversight process should draw justification for requesting use of an of the bank’s advanced systems. A conclusions on the soundness of the alternative approach in light of the bank’s data management and components of the risk management bank’s size, complexity, and risk profile. maintenance systems should generally system, identify errors and flaws, and The bank’s primary Federal supervisor support the proposed rule’s recommend corrective action as will also consider whether the proposed qualification requirements relating to appropriate. approach results in capital levels that quantification, validation, and control Validation. A bank must validate its are commensurate with the bank’s and oversight mechanisms, as well as advanced systems on an ongoing basis. operational risk profile, is sensitive to the bank’s broader risk management and Validation is the set of activities changes in the bank’s risk profile, can be reporting needs. The precise data designed to give the greatest possible supported empirically, and allows the elements to be collected would be assurances of accuracy of the advanced bank’s board of directors to fulfill its dictated by the features and systems. Validation includes three fiduciary responsibilities to ensure that broad components: (i) Evaluation of the the bank is adequately capitalized. 30 12 U.S.C. 1815(e). conceptual soundness of the advanced

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00025 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55854 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

systems, taking into account industry Validation should ensure that these investigate the source of the differences developments; (ii) ongoing monitoring judgments are well informed and and whether the extent of the that includes process verification and considered, and generally include a differences is appropriate. comparison of the bank’s internal body of expert opinion. A bank should The third component of the validation estimates with relevant internal and review developmental evidence process is outcomes analysis, which is external data sources or results using whenever the bank makes material the comparison of the bank’s forecasts of other estimation techniques changes in its advanced systems. risk parameters and other model outputs (benchmarking); and (iii) outcomes The second component of the with actual outcomes. A bank’s analysis that includes comparisons of validation process for a bank’s advanced outcomes analysis must include actual outcomes to the bank’s internal systems is ongoing monitoring to backtesting, which is the comparison of estimates by backtesting and other confirm that the systems were the bank’s forecasts generated by its methods. implemented appropriately and internal models with actual outcomes Each of these three components of continue to perform as intended. Such during a sample period not used in validation must be applied to the bank’s monitoring involves process verification model development. In this context, risk rating and segmentation systems, and benchmarking. Process verification backtesting is one form of out-of-sample risk parameter quantification processes, includes verifying that internal and testing. The agencies note that in other and internal models that are part of the external data are accurate and complete contexts backtesting may refer to in- bank’s advanced systems. A sound and ensuring that internal risk rating sample fit, but in-sample fit analysis is validation process should take business and segmentation systems are being not what the proposed rule requires a cycles into account, and any used, monitored, and updated as bank to do as part of the advanced adjustments for stages of the economic designed and that ratings are assigned to approaches validation process. cycle should be clearly specified in wholesale obligors and exposures as Actual outcomes would be compared advance and fully documented as part intended, and that appropriate with expected ranges around the of the validation policy. Senior remediation is undertaken if estimated values of the risk parameters management of the bank should be deficiencies exist. and model results. Random chance and notified of the validation results and Benchmarking is the set of activities many other factors will make should take corrective action, where that uses alternative data sources or risk discrepancies between realized appropriate. assessment approaches to draw outcomes and the estimated risk A bank’s validation process must be inferences about the correctness of parameters inevitable. Therefore the independent of the advanced systems’ internal risk ratings, segmentations, risk expected ranges should take into development, implementation, and parameter estimates, or model outputs account relevant elements of a bank’s operation, or be subject to independent before outcomes are actually known. For internal risk rating or segmentation assessment of its adequacy and credit risk ratings, examples of processes. For example, depending on effectiveness. A bank should ensure that alternative data sources include the bank’s rating philosophy, year-by- individuals who perform the review are independent internal raters (such as year realized default rates may be independent—that is, are not biased in loan review), external rating agencies, expected to differ significantly from the their assessment due to their wholesale and retail credit risk models long-run one-year average. Also, involvement in the development, developed independently, or retail changes in economic conditions implementation, or operation of the credit bureau models. Because it will between the historical data and current processes or products. For example, take considerable time before outcomes period can lead to differences between reviews of the internal risk rating and will be available and backtesting is realizations and estimates. segmentation systems should be possible, benchmarking will be a very Internal audit. A bank must have an performed by individuals who were not important validation device. internal audit function independent of part of the development, Benchmarking would be applied to all business-line management that assesses implementation, or maintenance of quantification processes and internal at least annually the effectiveness of the those systems. In addition, individuals risk rating and segmentation activities. controls supporting the bank’s advanced performing the reviews should possess Benchmarking allows a bank to systems. At least annually, internal the requisite technical skills and compare its estimates with those of audit should review the validation expertise to fulfill their mandate. other estimation techniques and data process, including validation The first component of validation is sources. Results of benchmarking procedures, responsibilities, results, evaluating conceptual soundness, which exercises can be a valuable diagnostic timeliness, and responsiveness to involves assessing the quality of the tool in identifying potential weaknesses findings. Further, internal audit should design and construction of a risk in a bank’s risk quantification system. evaluate the depth, scope, and quality of measurement or management system. While benchmarking activities allow for the risk management system review This evaluation of conceptual inferences about the appropriateness of process and conduct appropriate testing soundness should include the quantification processes and to ensure that the conclusions of these documentation and empirical evidence internal risk rating and segmentation reviews are well founded. Internal audit supporting the methods used and the systems, they are not the same as must report its findings at least annually variables selected in the design and backtesting. When differences are to the bank’s board of directors (or a quantification of the bank’s advanced observed between the bank’s risk committee thereof). systems. The documentation should estimates and the benchmark, this Stress testing. A bank must also include evidence of an should not necessarily indicate that the periodically stress test its advanced understanding of the limitations of the internal risk ratings, segmentation systems. Stress testing analysis is a systems. The development of internal decisions, or risk parameter estimates means of understanding how economic risk rating and segmentation systems are in error. The benchmark itself is an cycles, especially downturns as and their quantification processes alternative prediction, and the described by stress scenarios, affect risk- requires banks to adopt methods, choose difference may be due to different data based capital requirements, including characteristics, and make adjustments; or methods. As part of the migration across rating grades or each of these actions requires judgment. benchmarking exercise, the bank should segments and the credit risk mitigation

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00026 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55855

benefits of double default treatment. systems, risk parameter quantification acquisition would not be included in Under the proposed rule, changes in processes, model design, assumptions, the acquiring bank’s regulatory capital. borrower credit quality will lead to and validation results. The guiding An acquiring bank using the general changes in risk-based capital principle governing documentation is risk-based capital rules for acquired requirements. Because credit quality that it should support the requirements exposures would be required to disclose changes typically reflect changing for the quantification, validation, and publicly the amounts of risk-weighted economic conditions, risk-based capital control and oversight mechanisms as assets and qualifying capital calculated requirements may also vary with the well as the bank’s broader risk under the general risk-based capital economic cycle. During an economic management and reporting needs. rules with respect to the acquired downturn, risk-based capital Documentation is also critical to the company and under the proposed rule requirements would increase if supervisory oversight process. for the acquiring bank. wholesale obligors or retail exposures The bank should document the Similarly, due to the substantial migrate toward lower credit quality rationale for all material assumptions infrastructure requirements of the ratings or segments. underpinning its chosen analytical proposed rule, a core or opt-in bank that Supervisors expect that banks will frameworks, including the choice of merges with or acquires another core or manage their regulatory capital position inputs, distributional assumptions, and opt-in bank might not be able to apply so that they remain at least adequately weighting of quantitative and qualitative its own version of the advanced capitalized during all phases of the elements. The bank also should approaches immediately to the acquired economic cycle. A bank that is able to document and justify any subsequent bank’s exposures. Accordingly, the credibly estimate regulatory capital changes to these assumptions. proposed rule permits a core or opt-in levels during a downturn can be more bank that merges with or acquires C. Ongoing Qualification confident of appropriately managing another core or opt-in bank to use the regulatory capital. Stress testing analysis An advanced approaches bank must acquired bank’s advanced approaches to consists of identifying a stress scenario meet the qualification requirements on determine the risk-weighted asset and then translating the scenario into its an ongoing basis. Banks are expected to amounts for, and deductions from effect on the levels of key performance improve their advanced systems as they capital associated with, the acquired measures, including regulatory capital improve data gathering capabilities and bank’s exposures for up to 24 months ratios. as industry practice evolves. To following the calendar quarter during Banks should use a range of plausible facilitate the supervisory oversight of which the merger or acquisition but severe scenarios and methods when such systems changes, a bank must consummates. stress testing to manage regulatory notify its primary Federal supervisor In all mergers and acquisitions capital. Scenarios could be historical, when it makes a change to its advanced involving a core or opt-in bank, the hypothetical, or model-based. Key systems that results in a material change acquiring bank must submit an variables specified in a scenario could in the bank’s risk-weighted asset implementation plan for using advanced include, for example, interest rates, amount for an exposure type, or when approaches for the merged or acquired transition matrices (ratings and score- the bank makes any significant change company to its primary Federal band segments), asset values, credit to its modeling assumptions. supervisor within 30 days of spreads, market liquidity, economic Due to the advanced approaches’ consummating the merger or growth rates, inflation rates, exchange rigorous systems requirements, a core or acquisition. A bank’s primary Federal rates, or unemployment rates. A bank opt-in bank that merges with or acquires supervisor may extend the transition may choose to have scenarios apply to another company that does not calculate period for mergers or acquisitions for up an entire portfolio, or it may identify risk-based capital requirements using to an additional 12 months. The primary scenarios specific to various sub- the advanced approaches might not be Federal supervisor of the bank will portfolios. The severity of the stress able to use the advanced approaches monitor the merger or acquisition to scenarios should be consistent with the immediately for the merged or acquired determine whether the application of periodic economic downturns company’s exposures. Therefore, the the general risk-based capital rules by experienced in the bank’s market areas. proposed rule would permit a core or the acquired company produces Such scenarios may be less severe than opt-in bank to use the general risk-based appropriate risk weights for the assets of those used for other purposes, such as capital rules to compute the risk- the acquired company in light of the testing a bank’s solvency. weighted assets and associated capital overall risk profile of the combined The scope of stress testing analysis for the merged or acquired company’s bank. should be broad and include all material exposures for up to 24 months following Question 20: The agencies seek portfolios. The time horizon of the the calendar quarter during which the comment on the appropriateness of the analysis should be consistent with the merger or acquisition consummates. 24-month and 30-day time frames for specifics of the scenario and should be Any ALLL associated with the addressing the merger and acquisition long enough to measure the material acquired company’s exposures may be transition situations advanced effects of the scenario on key included in the acquiring bank’s tier 2 approaches banks may face. performance measures. For example, if capital up to 1.25 percent of the If a bank that uses the advanced a scenario such as a historical recession acquired company’s risk-weighted approaches to calculate its risk-based has material income and segment or assets. Such ALLL would be excluded capital requirements falls out of ratings migration effects over two years, from the acquiring bank’s eligible credit compliance with the qualification the appropriate time horizon is at least reserves. The risk-weighted assets of the requirements, the bank must establish a two years. acquired company would not be plan satisfactory to its primary Federal included in the acquiring bank’s credit- supervisor to return to compliance with 8. Documentation risk-weighted assets but would be the qualification requirements. Such a A bank must document adequately all included in the acquiring bank’s total bank also must disclose to the public its material aspects of its advanced risk-weighted assets. Any amount of the failure to comply with the qualification systems, including but not limited to the acquired company’s ALLL that was requirements promptly after receiving internal risk rating and segmentation eliminated in accounting for the notice of non-compliance from its

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00027 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55856 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

primary Federal supervisor. If the bank’s After identifying the elements of tier Under the general risk-based capital primary Federal supervisor determines 1 and tier 2 capital, a bank would make rules, a bank is allowed to include in that the bank’s risk-based capital certain adjustments to determine its tier tier 2 capital its ALLL up to 1.25 percent requirements are not commensurate 1 capital and total qualifying capital of risk-weighted assets (net of certain with the bank’s credit, market, (that is, the numerator of the total risk- deductions). Amounts of ALLL in operational, or other risks, it may based capital ratio). Some of these excess of this limit, as well as allocated require the bank to calculate its risk- adjustments would be made only to the transfer risk reserves, may be deducted based capital requirements using the tier 1 portion of the capital base. Other from the gross amount of risk-weighted general risk-based capital rules or a adjustments would be made 50 percent assets. modified form of the advanced from tier 1 capital and 50 percent from Under the proposed framework, as approaches (for example, with fixed tier 2 capital.32 Under the proposed noted above, the ALLL is treated supervisory risk parameters). rule, a bank must still have at least 50 differently. The proposed rule includes percent of its total qualifying capital in IV. Calculation of Tier 1 Capital and a methodology for adjusting risk-based the form of tier 1 capital. Total Qualifying Capital capital requirements based on a The bank would continue to deduct comparison of the bank’s eligible credit The proposed rule maintains the from tier 1 capital goodwill, other reserves to its ECL. The proposed rule minimum risk-based capital ratio intangible assets, and deferred tax assets defines eligible credit reserves as all requirements of 4.0 percent tier 1 capital to the same extent that those assets are general allowances, including the ALLL, to total risk-weighted assets and 8.0 currently required to be deducted from that have been established through a percent total qualifying capital to total tier 1 capital under the general risk- charge against earnings to absorb credit risk-weighted assets. Under the based capital rules. Thus, all goodwill losses associated with on- or off-balance proposed rule, a bank’s total qualifying would be deducted from tier 1 capital. sheet wholesale and retail exposures. capital is the sum of its tier 1 (core) Qualifying intangible assets—including Eligible credit reserves would not capital elements and tier 2 mortgage servicing assets, non-mortgage include allocated transfer risk reserves (supplemental) capital elements, subject servicing assets, and purchased credit established pursuant to 12 U.S.C. 390435 to various limits and restrictions, minus card relationships—that meet the and other specific reserves created certain deductions (adjustments). The conditions and limits in the general against recognized losses. agencies are not restating the elements risk-based capital rules would not have The proposed rule defines a bank’s of tier 1 and tier 2 capital in this to be deducted from tier 1 capital. total ECL as the sum of ECL for all proposed rule. Those capital elements Likewise, deferred tax assets that are wholesale and retail exposures other generally remain as they are currently in dependent upon future taxable income than exposures to which the bank has the general risk-based capital rules.31 and that meet the valuation applied the double default treatment The agencies have provided proposed requirements and limits in the general (described below). The bank’s ECL for a regulatory text for, and the following risk-based capital rules would not have wholesale exposure to a non-defaulted discussion of, proposed adjustments to to be deducted from tier 1 capital.33 obligor or a non-defaulted retail segment the capital elements for purposes of the Under the general risk-based capital is the product of PD, ELGD, and EAD for advanced approaches. rules, a bank also must deduct from its the exposure or segment. The bank’s The agencies are considering restating tier 1 capital certain percentages of the ECL for a wholesale exposure to a the elements of tier 1 and tier 2 capital, adjusted carrying value of its defaulted obligor or a defaulted retail with any necessary conforming and nonfinancial equity investments. An segment is equal to the bank’s technical amendments, in any final advanced approaches bank would no impairment estimate for ALLL purposes rules that are issued regarding this longer be required to make this for the exposure or segment. proposed framework so that a bank deduction. Instead, the bank’s equity The proposed method of measuring using the advanced approaches would exposures would be subject to the ECL for non-defaulted exposures is have a single, comprehensive regulatory equity treatment in part VI of the different than the proposed method of text that describes both the numerator proposed rule and described in section measuring ECL for defaulted exposures. 34 and denominator of the bank’s V.F. of this preamble. For non-defaulted exposures, ECL minimum risk-based capital ratios. The depends directly on ELGD and hence agencies decided not to set forth the 32 If the amount deductible from tier 2 capital exceeds the bank’s actual tier 2 capital, however, would reflect economic losses, capital elements in this proposed rule so the bank must deduct the shortfall amount from tier including the cost of carry and direct that commenters would be able to focus 1 capital. and indirect workout expenses. In attention on the parts of the risk-based 33 See 12 CFR part 3, § 2 (national banks); 12 CFR contrast, for defaulted exposures, ECL is capital framework that the agencies part 208, Appendix A, § 2L3II (state member banks); based on accounting measures of credit 12 CFR part 225, Appendix A, § II (bank holding propose to amend. Question 21: companies); 12 CFR part 325, Appendix A, § II Commenters are encouraged to provide (state nonmember banks). OTS existing rules are than investments in subsidiaries, equity views on the proposed adjustments to formulated differently, but include similar investments that are permissible for national banks, the components of the risk-based capital deductions. Under OTS rules, for example, indirect ownership interests in certain pools of goodwill is included within the definition of assets (for example, mutual funds), Federal Home numerator as described below. ‘‘intangible assets’’ and is deducted from tier 1 Loan Bank stock and Federal Reserve Bank stock); Commenters also may provide views on (core) capital along with other intangible assets. See and (ii) investments in certain real property. 12 CFR numerator-related issues that they 12 CFR 567.1 and 567.5(a)(2)(i). Similarly, 567.1. Savings associations applying the proposed believe would be useful to the agencies’ purchased credit card relationships and mortgage rule would not be required to deduct investments and non-mortgage servicing assets are included in in equity securities. Instead, such investments consideration of the proposed rule. capital to the same extent as the other agencies’ would be subject to the equity treatment in part VI rules. See 12 CFR 567.5(a)(2)(ii) and 567.12. The of the proposed rule. Equity investments in real 31 See 12 CFR part 3, Appendix A, § 2 (national deduction of deferred tax assets is discussed in estate would continue to be deducted to the same banks); 12 CFR part 208, Appendix A, § II (state Thrift Bulletin 56. extent as under the current rules. member banks); 12 CFR part 225, Appendix A, § II 34 By contrast, OTS rules require the deduction of 35 12 U.S.C. 3904 does not apply to savings (bank holding companies); 12 CFR part 325, equity investments from total capital. 12 CFR associations regulated by the OTS. As a result, the Appendix A (state nonmember banks); and 12 CFR 567.5(c)(2)(ii). ‘‘Equity investments’’ are defined to OTS rule will not refer to allocated transfer risk 567.5 (savings associations). include (i) investments in equity securities (other reserves.

VerDate Aug<31>2005 00:22 Sep 23, 2006 Jkt 208001 PO 00000 Frm 00028 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55857

loss incorporated into a bank’s charge- designed this deduction to offset based capital rules. Under the agencies’ off and reserving practices. accounting treatments that produce an current rules, a national or state bank The agencies believe that, for increase in a bank’s equity capital and that controls or holds an interest in a defaulted exposures, any difference tier 1 capital at the inception of a financial subsidiary does not between a bank’s best estimate of securitization—for example, a gain consolidate the assets and liabilities of economic losses and its impairment attributable to a CEIO that results from the financial subsidiary with those of estimate for ALLL purposes is likely to Financial Accounting Standard (FAS) the bank for risk-based capital purposes. be small. As a result, the agencies are 140 accounting treatment for the sale of In addition, the bank must deduct its proposing to use a bank’s ALLL underlying exposures to a securitization equity investment (including retained impairment estimate in the special purpose entity (SPE). Over time, earnings) in the financial subsidiary determination of ECL for defaulted as the bank, from an accounting from regulatory capital—at least 50 exposures to reduce implementation perspective, realizes the increase in percent from tier 1 capital and up to 50 burden for banks. The agencies equity capital and tier 1 capital that was percent from tier 2 capital.37 A BHC recognize that this proposed treatment booked at the inception of the generally does not deconsolidate the would require a bank to specify how securitization through actual receipt of assets and liabilities of the financial much of its ALLL is attributable to cash flows, the amount of the required subsidiaries of the BHC’s subsidiary defaulted exposures, and that a bank deduction would shrink accordingly. banks and does not deduct from its still would need to capture all material Under the general risk-based capital regulatory capital the equity economic losses on defaulted exposures rules,36 a bank must deduct CEIOs, investments of its subsidiary banks in when building its databases for whether purchased or retained, from tier financial subsidiaries. Rather, a BHC estimating ELGDs and LGDs for non- 1 capital to the extent that the CEIOs generally fully consolidates the defaulted exposures. Question 22: The exceed 25 percent of the bank’s tier 1 financial subsidiaries of its subsidiary agencies seek comment on the proposed capital. Under the proposed rule, a bank banks. These treatments would continue ECL approach for defaulted exposures must deduct CEIOs from tier 1 capital to under the proposed rule. as well as on an alternative treatment, the extent they represent gain-on-sale, For BHCs with consolidated under which ECL for a defaulted and must deduct any remaining CEIOs insurance underwriting subsidiaries that exposure would be calculated as the 50 percent from tier 1 capital and 50 are functionally regulated (or subject to bank’s current carrying value of the percent from tier 2 capital. comparable supervision and minimum exposure multiplied by the bank’s best Under the proposed rule, certain other regulatory capital requirements in their estimate of the expected economic loss securitization exposures also would be home jurisdiction), the following rate associated with the exposure deducted from tier 1 and tier 2 capital. treatment would apply. The assets and (measured relative to the current These exposures include, for example, liabilities of the subsidiary would be carrying value), that would be more securitization exposures that have an consolidated for purposes of consistent with the proposed treatment applicable external rating (defined determining the BHC’s risk-weighted of ECL for non-defaulted exposures. The below) that is more than one category assets. However, the BHC must deduct agencies also seek comment on whether below investment grade (for example, from tier 1 capital an amount equal to these two approaches would likely below BB) and most subordinated the insurance underwriting subsidiary’s produce materially different ECL unrated securitization exposures. When minimum regulatory capital estimates for defaulted exposures. In a bank must deduct a securitization requirement as determined by its addition, the agencies seek comment on exposure (other than gain-on-sale) from functional (or equivalent) regulator. For the appropriate measure of ECL for regulatory capital, the bank must take U.S. regulated insurance subsidiaries, assets held at fair value with gains and the deduction 50 percent from tier 1 this amount generally would be 200 losses flowing through earnings. capital and 50 percent from tier 2 percent of the subsidiary’s Authorized A bank must compare the total dollar capital. Moreover, a bank may calculate Control Level as established by the amount of its ECL to its eligible credit any deductions from regulatory capital appropriate state insurance regulator. reserves. If there is a shortfall of eligible with respect to a securitization exposure This approach with respect to credit reserves compared to total ECL, (including after-tax gain-on-sale) net of functionally-regulated consolidated the bank would deduct 50 percent of the any deferred tax liabilities associated insurance underwriting subsidiaries is shortfall from tier 1 capital and 50 with the exposure. different from the New Accord, which percent from tier 2 capital. If eligible The proposed rule also requires a broadly endorses a deconsolidation and credit reserves exceed total ECL, the bank to deduct the bank’s exposure on deduction approach for insurance excess portion of eligible credit reserves certain unsettled and failed capital subsidiaries. The Board believes a full may be included in tier 2 capital up to markets transactions 50 percent from deconsolidation and deduction 0.6 percent of credit-risk-weighted tier 1 capital and 50 percent from tier 2 assets. The proposed rule defines credit- capital, as discussed in more detail 37 See 12 CFR 5.39(h)(1) (national banks); 12 CFR risk-weighted assets as 1.06 multiplied below in section V.D. of the preamble. 208.73(a) (state member banks); 12 CFR part 325, by the sum of total wholesale and retail The agencies note that investments in Appendix A, section I.B.2. (state nonmember risk-weighted assets, risk-weighted banks). Again, OTS rules are formulated differently. unconsolidated banking and finance For example, OTS rules do not use the terms assets for securitization exposures, and subsidiaries and reciprocal holdings of ‘‘unconsolidated banking and finance subsidiary’’ risk-weighted assets for equity bank capital instruments would or ‘‘financial subsidiary.’’ Rather, as required by exposures. continue to be deducted from regulatory section 5(t)(5) of the Home Owners’ Loan Act A bank must deduct from tier 1 (HOLA), equity and debt investments in non- capital as described in the general risk- includable subsidiaries (generally subsidiaries that capital any increase in the bank’s equity are engaged in activities that are not permissible for capital at the inception of a 36 See 12 CFR part 3, Appendix A, section 2(c)(4) a national bank) are deducted from assets and tier securitization transaction (gain-on-sale), (national banks); 12 CFR part 208, Appendix A, 1 (core) capital. 12 CFR 567.5(a)(2)(iv) and (v). As other than an increase in equity capital section I.B.1.c. (state member banks); 12 CFR part required by HOLA, OTS will continue to deduct 225, Appendix A, section I.B.1.c. (bank holding non-includable subsidiaries. Reciprocal holdings of that results from the bank’s receipt of companies); 12 CFR part 325, Appendix A, section bank capital instruments are deducted from a cash in connection with the I.B.5. (state nonmember banks); 12 CFR savings association’s total capital under 12 CFR securitization. The agencies have 567.5(a)(2)(iii) (savings associations). 567.5(c)(2).

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00029 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55858 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

approach does not fully capture the risk for operational risk, minus the sum of bank to a third party in which the bank in insurance underwriting subsidiaries its excess eligible credit reserves (that is, retains full recourse; (v) an OTC at the consolidated BHC level and, thus, its eligible credit reserves in excess of derivative contract entered into by a has proposed the consolidation and its total ECL) not included in tier 2 bank with a company; (vi) an exposure deduction approach described above. capital and allocated transfer risk to an individual that is not managed by Question 23: The Board seeks comment reserves. the bank as part of a segment of exposures with homogeneous risk on this proposed treatment and in A. Categorization of Exposures particular on how a minimum insurance characteristics; and (vii) a commercial regulatory capital proxy for tier 1 To calculate credit risk-weighted lease. deduction purposes should be assets, a bank must group its exposures The agencies are proposing two determined for insurance underwriting into four general categories: wholesale, subcategories of wholesale exposures— subsidiaries that are not subject to U.S. retail, securitization, and equity. It must HVCRE exposures and non-HVCRE functional regulation. also identify assets not included in an exposures. Under the proposed rule, A March 10, 2005, final rule issued by exposure category and any non-material HVCRE exposures would be subject to a the Board defined restricted core capital portfolios of exposures to which the separate IRB risk-based capital formula elements for BHCs and generally limited bank elects not to apply the IRB that would produce a higher risk-based restricted core capital elements for framework. In order to exclude a capital requirement for a given set of internationally active banking portfolio from the IRB framework, a risk parameters than the IRB risk-based organizations to 15 percent of the sum bank must demonstrate to the capital formula for non-HVCRE of all core capital elements net of satisfaction of its primary Federal wholesale exposures. An HVCRE goodwill less any associated deferred supervisor that the portfolio (when exposure is defined as a credit facility tax liability.38 Restricted core capital combined with all other portfolios of that finances or has financed the elements are defined as qualifying exposures that the bank seeks to exclude acquisition, development, or cumulative perpetual preferred stock from the IRB framework) is not material construction of real property, excluding (and related surplus), minority interest to the bank. facilities used to finance (i) one- to four- related to qualifying cumulative 1. Wholesale Exposures family residential properties or (ii) perpetual preferred stock directly issued commercial real estate projects where: The proposed rule defines a (A) The exposure’s LTV ratio is less by a consolidated DI or foreign bank wholesale exposure as a credit exposure subsidiary, minority interest related to than or equal to the applicable to a company, individual, sovereign or maximum supervisory LTV ratio in the qualifying common or qualifying governmental entity (other than a perpetual preferred stock issued by a real estate lending standards of the securitization exposure, retail exposure, agencies; 41 (B) the borrower has consolidated subsidiary that is neither a 39 or equity exposure). The term contributed capital to the project in the DI nor a foreign bank, and qualifying ‘‘company’’ is broadly defined to mean trust preferred securities. The final rule form of cash or unencumbered readily a corporation, partnership, limited marketable assets (or has paid defined an internationally active liability company, depository banking organization to be a BHC that development expenses out-of-pocket) of institution, business trust, SPE, at least 15 percent of the real estate’s (i) as of its most recent year-end FR Y– association, or similar organization. 9C reports total consolidated assets appraised ‘‘as completed’’ value; and (C) Examples of a wholesale exposure the borrower contributed the amount of equal to $250 billion or more or (ii) on include: (i) A non-tranched guarantee capital required before the bank a consolidated basis, reports total on- issued by a bank on behalf of a advances funds under the credit facility, balance sheet foreign exposure of $10 company; 40 (ii) a repo-style transaction and the capital contributed by the billion or more in its filing of the most entered into by a bank with a company borrower or internally generated by the recent year-end FFIEC 009 Country and any other transaction in which a project is contractually required to Exposure Report. The Board intends to bank posts collateral to a company and remain in the project throughout the life change the definition of an faces counterparty credit risk; (iii) an internationally active banking of the project. exposure that the bank treats as a Once an exposure is determined to be organization in the Board’s capital covered position under the MRA for HVCRE, it would remain an HVCRE adequacy guidelines for BHCs to make which there is a counterparty credit risk exposure until paid in full, sold, or it consistent with the definition of a charge in section 32 of the proposed converted to permanent financing. After core bank. This change would be less rule; (iv) a sale of corporate loans by a restrictive on BHCs because the BHC considering comments received on the ANPR, the agencies are proposing to threshold in this proposed rule uses 39 The proposed rule excludes from the definition total consolidated assets excluding of a wholesale exposure certain pre-sold one-to-four retain a separate IRB risk-based capital insurance rather than total consolidated family residential construction loans and certain formula for HVCRE exposures in multifamily residential loans. The treatment of such assets including insurance. recognition of the high levels of loans is discussed below in section V.B.5. of the systematic risk inherent in some of V. Calculation of Risk-Weighted Assets preamble. 40 As described below, tranched guarantees (like these exposures. The agencies believe A bank’s total risk-weighted assets most transactions that involve a tranching of credit that the revised definition of HVCRE in would be the sum of its credit risk- risk) generally would be securitization exposures the proposed rule appropriately under this proposal. The proposal defines a identifies exposures that are particularly weighted assets and risk-weighted assets guarantee broadly to include almost any transaction (other than a credit derivative executed under susceptible to systematic risk. Question 38 70 FR 11827 (Mar. 10, 2005). The final rule also standard industry credit derivative documentation) 24: The agencies seek comment on how allowed internationally active banking that involves the transfer of the credit risk of an to strike the appropriate balance organizations to include restricted core capital exposure from one party to another party. This between the enhanced risk sensitivity elements in their tier 1 capital up to 25 percent of definition of guarantee generally would include, for the sum of all core capital elements net of goodwill example, a credit spread option under which a bank and marginally higher risk-based capital less associated deferred tax liability so long as any has agreed to make payments to its counterparty in amounts of restricted core capital elements in the event of an increase in the credit spread 41 12 CFR part 34, Subpart D (OCC); 12 CFR part excess of the 15 percent limit were in the form of associated with a particular reference obligation 208, Appendix C (Board); 12 CFR part 365, Subpart mandatory convertible preferred securities. issued by a company. D (FDIC); and 12 CFR 560.100–560.101 (OTS).

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00030 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55859

requirements obtained by separating both term loans and revolving home would aggregate all business exposures HVCRE exposures from other wholesale equity lines of credit (HELOCs). An to a particular legal entity and its exposures and the additional exposure primarily secured by a first or affiliates that are consolidated under complexity the separation entails. subsequent lien on residential property GAAP. If that legal entity is a natural The New Accord identifies five sub- that is not one-to-four family would also person, any consumer loans (for classes of specialized lending for which be included as a residential mortgage example, personal credit card loans or the primary source of repayment of the exposure as long as the exposure has mortgage loans) to that borrower would obligation is the income generated by both an original and current outstanding not be part of the aggregate. A bank the financed asset(s) rather than the amount of no more than $1 million. could distinguish a consumer loan from independent capacity of a broader There would be no upper limit on the a business loan by the loan department commercial enterprise. The sub-classes size of an exposure that is secured by through which the loan is made. are project finance, object finance, one-to-four-family residential Exposures to a borrower for business commodities finance, income-producing properties. To be a residential mortgage purposes primarily secured by real estate, and HVCRE. The New exposure, the bank must manage the residential property would count Accord provides a methodology to exposure as part of a segment of toward the $1 million single-borrower accommodate banks that cannot meet exposures with homogeneous risk other retail business exposure the requirements for the estimation of characteristics. Residential mortgage threshold.43 PD for these exposure types. The loans that are managed on an individual The residual value portion of a retail sophisticated banks that would apply basis, rather than managed as part of a lease exposure is excluded from the the advanced approaches in the United segment, would be categorized as definition of an other retail exposure. A States should be able to estimate risk wholesale exposures. bank would assign the residual value parameters for specialized lending QREs would be defined as exposures portion of a retail lease exposure a risk- exposures, and therefore the agencies to individuals that are (i) revolving, weighted asset amount equal to its are not proposing a separate treatment unsecured, and unconditionally residual value as described in section 31 for specialized lending beyond the cancelable by the bank to the fullest of the proposed rule. separate IRB risk-based capital formula extent permitted by Federal law; (ii) for HVCRE exposures specified in the have a maximum exposure amount 3. Securitization Exposures New Accord. (drawn plus undrawn) of up to The proposed rule defines a In contrast to the New Accord, the $100,000; and (iii) are managed as part securitization exposure as an on-balance agencies are not including in this of a segment with homogeneous risk sheet or off-balance sheet credit proposed rule an adjustment that would characteristics. In practice, QREs exposure that arises from a traditional or result in a lower risk weight for a loan typically would include exposures synthetic securitization. A traditional to a small- and medium-size enterprise where customers’ outstanding securitization is a transaction in which (SME) that has the same risk parameter borrowings are permitted to fluctuate (i) all or a portion of the credit risk of values as a loan to a larger firm. The based on their decisions to borrow and one or more underlying exposures is agencies are not aware of compelling repay, up to a limit established by the transferred to one or more third parties evidence that smaller firms with the bank. Most credit card exposures to other than through the use of credit same PD and LGD as larger firms are individuals and overdraft lines on derivatives or guarantees; (ii) the credit subject to less systematic risk. Question individual checking accounts would be risk associated with the underlying 25: The agencies request comment and QREs. exposures has been separated into at supporting evidence on the consistency The category of other retail exposures least two tranches reflecting different of the proposed treatment with the would include two types of exposures. levels of seniority; (iii) performance of underlying riskiness of SME portfolios. First, all exposures to individuals for the securitization exposures depends on Further, the agencies request comment non-business purposes (other than the performance of the underlying on any competitive issues that this residential mortgage exposures and exposures; and (iv) all or substantially aspect of the proposed rule may cause QREs) that are managed as part of a all of the underlying exposures are for U.S. banks. segment of similar exposures would be financial exposures. Examples of 2. Retail Exposures other retail exposures. Such exposures financial exposures are loans, may include personal term loans, commitments, receivables, asset-backed Under the proposed rule, a retail margin loans, auto loans and leases, securities, mortgage-backed securities, exposure would generally include credit card accounts with credit lines corporate bonds, equity securities, or exposures (other than securitization above $100,000, and student loans. The credit derivatives. For purposes of the exposures or equity exposures) to an agencies are not proposing an upper proposed rule, mortgage-backed pass- individual or small business that are limit on the size of these types of retail through securities guaranteed by Fannie managed as part of a segment of similar exposures to individuals. Second, Mae or Freddie Mac (whether or not exposures, that is, not on an individual- exposures to individuals or companies issued out of a structure that tranches exposure basis. Under the proposed for business purposes (other than credit risk) also would be securitization rule, there are three subcategories of residential mortgage exposures and exposures.44 retail exposure: (i) Residential mortgage QREs), up to a single-borrower exposure exposures; (ii) QREs; and (iii) other threshold of $1 million, that are 43 The proposed rule excludes from the definition retail exposures. The agencies propose managed as part of a segment of similar of an other retail exposure certain pre-sold one-to- generally to define residential mortgage exposures would be other retail four family residential construction loans and exposure as an exposure that is exposures. For the purpose of assessing certain multi-family residential loans. The primarily secured by a first or treatment of such loans is discussed below in exposure to a single borrower, the bank section V.B.5. of the preamble. subsequent lien on one-to-four-family 44 42 In addition, margin loans and other credit residential property. This includes one-to-four family residential construction loans exposures to personal investment companies, all or and certain multi-family residential loans. The substantially all of whose assets are financial 42 The proposed rule excludes from the definition treatment of such loans is discussed below in exposures, typically would meet the definition of a of a residential mortgage exposure certain pre-sold section V.B.5. of the preamble. securitization exposure.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00031 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55860 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

A synthetic securitization is a requirement because the proposed (iv) Any other security or instrument transaction in which (i) all or a portion securitization framework was designed (other than a securitization exposure) to of the credit risk of one or more to address the tranching of the credit the extent the return on the security or underlying exposures is transferred to risk of exposures to which the IRB instrument is based on the performance one or more third parties through the framework can be applied. Accordingly, of security or instrument described in use of one or more credit derivatives or a specialized loan to finance the (i). For example, a short position in an guarantees (other than a guarantee that construction or acquisition of large-scale equity security or a total return equity transfers only the credit risk of an projects (for example, airports and swap would be characterized as an individual retail exposure); (ii) the power plants), objects (for example, equity exposure. credit risk associated with the ships, aircraft, or satellites), or Nonconvertible term or perpetual underlying exposures has been commodities (for example, reserves, preferred stock generally would be separated into at least two tranches inventories, precious metals, oil, or considered wholesale exposures rather reflecting different levels of seniority; natural gas) generally would not be a than equity exposures. Financial (iii) performance of the securitization securitization exposure because the instruments that are convertible into an exposures depends on the performance assets backing the loan typically would equity exposure only at the option of the of the underlying exposures; and (iv) all be nonfinancial assets (the facility, holder or issuer also generally would be or substantially all of the underlying object, or commodity being financed). In considered wholesale exposures rather exposures are financial exposures. addition, although some structured than equity exposures provided that the Accordingly, the proposed definition of transactions involving income- conversion terms do not expose the a securitization exposure would include producing real estate or HVCRE can bank to the risk of losses arising from tranched cover or guarantee resemble securitizations, these price movements in that equity arrangements—that is, arrangements in transactions generally would not be exposure. Upon conversion, the which an entity transfers a portion of securitizations because the underlying instrument would be treated as an the credit risk of an underlying exposure would be real estate. equity exposure. exposure to one or more other Consequently, exposures resulting from The agencies note that, as a general guarantors or credit derivative providers the tranching of the risks of matter, each of a bank’s exposures will nonfinancial assets are not subject to the but also retains a portion of the credit fit in one and only one exposure proposed rule’s securitization risk, where the risk transferred and the category. One principal exception to framework, but generally are subject to risk retained are of different seniority this rule is that equity derivatives 45 the proposal’s rules for wholesale levels. generally will meet the definition of an Provided that there is a tranching of exposures. Question 26: The agencies equity exposure (because of the bank’s credit risk, securitization exposures also request comment on the appropriate exposure to the underlying equity could include, among other things, treatment of tranched exposures to a security) and the definition of a asset-backed and mortgage-backed mixed pool of financial and non- wholesale exposure (because of the securities; loans, lines of credit, financial underlying exposures. The bank’s credit risk exposure to the liquidity facilities, and financial agencies specifically are interested in counterparty). In such cases, as standby letters of credit; credit the views of commenters as to whether discussed in more detail below, the derivatives and guarantees; loan the requirement that all or substantially bank’s risk-based capital requirement servicing assets; servicer cash advance all of the underlying exposures of a for the derivative generally would be the facilities; reserve accounts; credit- securitization be financial exposures sum of its risk-based capital enhancing representations and should be softened to require only that requirement for the derivative warranties; and CEIOs. Securitization some lesser portion of the underlying counterparty credit risk and for the exposures also could include assets sold exposures be financial exposures. underlying exposure. with retained tranched recourse. Both 4. Equity Exposures the designation of exposures as 5. Boundary Between Operational Risk securitization exposures and the The proposed rule defines an equity and Other Risks calculation of risk-based capital exposure to mean: With the introduction of an explicit requirements for securitization (i) A security or instrument whether risk-based capital requirement for exposures will be guided by the voting or non-voting that represents a operational risk, issues arise about the economic substance of a transaction direct or indirect ownership interest in, proper treatment of operational losses rather than its legal form. and a residual claim on, the assets and that could also be attributed to either As noted above, for a transaction to income of a company, unless: (A) The credit risk or market risk. The agencies constitute a securitization transaction issuing company is consolidated with recognize that these boundary issues are under the proposed rule, all or the bank under GAAP; (B) the bank is important and have significant substantially all of the underlying required to deduct the ownership implications for how banks would exposures must be financial exposures. interest from tier 1 or tier 2 capital; (C) compile loss data sets and compute risk- The proposed rule includes this the ownership interest is redeemable; (D) the ownership interest incorporates based capital requirements under the 45 If a bank purchases an asset-backed security a payment or other similar obligation on proposed rule. Consistent with the issued by a securitization SPE and purchases a the part of the issuing company (such as treatment in the New Accord, the credit derivative to protect itself from credit losses an obligation to pay periodic interest); agencies propose treating operational associated with the asset-backed security, the or (E) the ownership interest is a losses that are related to market risk as purchase of the credit derivative by the investing bank does not turn the traditional securitization securitization exposure. operational losses for purposes of into a synthetic securitization. Instead, under the (ii) A security or instrument that is calculating risk-based capital proposal, the investing bank would be viewed as mandatorily convertible into a security requirements under this proposed rule. having purchased a traditional securitization or instrument described in (i). For example, losses incurred from a exposure and would reflect the CRM benefits of the credit derivative through the securitization CRM (iii) An option or warrant that is failure of bank personnel to properly rules described later in the preamble and in section exercisable for a security or instrument execute a stop loss order, from trading 46 of the proposed rule. described in (i). fraud, or from a bank selling a security

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00032 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55861

when a purchase was intended, would B. Risk-Weighted Assets for General derivatives that are used as credit risk be treated as operational losses. Credit Risk (Wholesale Exposures, Retail mitigants. The agencies generally propose to Exposures, On-Balance Sheet Assets The treatment of HVCRE exposures and eligible purchased wholesale treat losses that are related to both That Are Not Defined by Exposure receivables is discussed below in this operational risk and credit risk as credit Category, and Immaterial Credit Portfolios) section. The treatment of eligible margin losses for purposes of calculating risk- Under the proposed rule, the loans, repo-style transactions, OTC based capital requirements. For derivative contracts, and eligible example, where a loan defaults (credit wholesale and retail risk-weighted assets calculation consists of four guarantees and eligible credit risk) and the bank discovers that the derivatives that are credit risk mitigants collateral for the loan was not properly phases: (1) Categorization of exposures; (2) assignment of wholesale exposures is discussed in section V.C. of the secured (operational risk), the bank’s preamble. In addition, sovereign resulting loss would be attributed to to rating grades and segmentation of retail exposures; (3) assignment of risk exposures and exposures to or directly credit risk (not operational risk). This and unconditionally guaranteed by the general separation between credit and parameters to wholesale obligors and exposures and segments of retail Bank for International Settlements, the operational risk is supported by current exposures; and (4) calculation of risk- International Monetary Fund, the U.S. accounting standards for the weighted asset amounts. Phase 1 European Commission, the European treatment of credit risk. , and multi-lateral involves the categorization of a bank’s 46 The proposed exception to this exposures into four general categories— development banks are exempt from standard is retail credit card fraud wholesale exposures, retail exposures, the 0.03 percent floor on PD discussed losses. More specifically, retail credit securitization exposures, and equity in the next section. In phase 1, a bank also must card losses arising from non-contractual, exposures. Phase 1 also involves the subcategorize its retail exposures as further classification of retail exposures third party-initiated fraud (for example, residential mortgage exposures, QREs, into subcategories and identifying identity theft) are to be treated as or other retail exposures. In addition, a certain wholesale exposures that receive external fraud operational losses under bank must identify any on-balance sheet a specific treatment within the this proposed rule. All other third party- asset that does not meet the definition wholesale framework. Phase 2 involves initiated losses are to be treated as credit of a wholesale, retail, securitization, or the assignment of wholesale obligors losses. Based on discussions with the equity exposure, as well as any non- and exposures to rating grades and the industry, this distinction is consistent material portfolio of exposures to which segmentation of retail exposures. Phase with prevailing practice in the credit it chooses, subject to supervisory 3 requires the bank to assign a PD, card industry, with banks commonly review, not to apply the IRB risk-based ELGD, LGD, EAD, and M to each considering these losses to be capital formulas. operational losses and treating them as wholesale exposure and a PD, ELGD, LGD, and EAD to each segment of retail 2. Phase 2 Assignment of Wholesale such for risk management purposes. exposures. In phase 4, the bank Obligors and Exposures to Rating Question 27: The agencies seek calculates the risk-weighted asset Grades and Retail Exposures to commenters’ perspectives on other loss amount (i) for each wholesale exposure Segments types for which the boundary between and segment of retail exposures by In phase 2, a bank must assign each credit and operational risk should be inserting the risk parameter estimates wholesale obligor to a single rating evaluated further (for example, with into the appropriate IRB risk-based grade (for purposes of assigning an respect to losses on HELOCs). capital formula and multiplying the estimated PD) and may assign each formula’s dollar risk-based capital wholesale exposure to loss severity 6. Boundary Between the Proposed Rule requirement output by 12.5; and (ii) for and the Market Risk Amendment (MRA) rating grades (for purposes of assigning on-balance sheet assets that are not an estimated ELGD and LGD). A bank Positions currently subject to the included in one of the defined exposure that elects not use a loss severity rating MRA include all positions classified as categories and for certain immaterial grade system for a wholesale exposure trading consistent with GAAP. The New portfolios of exposures by multiplying will directly assign ELGD and LGD to the carrying value or notional amount of Accord sets forth additional criteria for the wholesale exposure in phase 3. As the exposures by a 100 percent risk positions to be eligible for application of a part of the process of assigning weight. the MRA. The agencies propose to wholesale obligors to rating grades, a incorporate these additional criteria into 1. Phase 1—Categorization of Exposures bank must identify which of its wholesale obligors are in default. the MRA through a separate notice of In phase 1, a bank must determine proposed rulemaking concurrently In addition, a bank must divide its which of its exposures fall into each of retail exposures within each retail published in the Federal Register. the four principal IRB exposure subcategory into segments that have Advanced approaches banks subject to categories—wholesale exposures, retail homogeneous risk characteristics.47 the MRA would use the MRA as exposures, securitization exposures, and amended for trading exposures eligible equity exposures. In addition, a bank 46 Multi-lateral development bank is defined as for application of the MRA. Advanced must identify within the wholesale any multi-lateral lending institution or regional approaches banks not subject to the exposure category certain exposures that development bank in which the U.S. government is receive a special treatment under the a shareholder or contributing member. These MRA would use this proposed rule for institutions currently are the International Bank for all of their exposures. Question 28: The wholesale framework. These exposures Reconstruction and Development, the International agencies generally seek comment on the include HVCRE exposures, sovereign Finance Corporation, the Inter-American proposed treatment of the boundaries exposures, eligible purchased wholesale Development Bank, the Asian Development Bank, receivables, eligible margin loans, repo- the African Development Bank, and the European between credit, operational, and market Bank for Reconstruction and Development. risk. style transactions, OTC derivative 47 A bank must segment defaulted retail contracts, unsettled transactions, and exposures separately from non-defaulted retail eligible guarantees and eligible credit Continued

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00033 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55862 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

Segmentation is the grouping of the securitization framework, which base the segmentation of defaulted retail exposures within each subcategory applies to tranched wholesale exposures on characteristics that are according to the predominant risk exposures, is not appropriate for most predictive of current loss and characteristics of the borrower (for individual retail exposures. The recovery rates. This segmentation example, credit score, debt-to-income agencies therefore are proposing to should provide meaningful ratio, and delinquency) and the exclude tranched guarantees that apply differentiation so that individual exposure (for example, product type and only to an individual retail exposure exposures within each defaulted LTV ratio). In general, retail segments from the securitization framework. An segment do not have material should not cross national jurisdictions. important result of this exclusion is differences in their expected loss A bank would have substantial that, in contrast to the treatment of severity. flexibility to use the retail portfolio wholesale exposures, a bank may segmentation it believes is most recognize recoveries from both an Purchased wholesale receivables. A appropriate for its activities, subject to obligor and a guarantor for purposes of bank may also elect to use a top-down the following broad principles: estimating the ELGD and LGD for approach, similar to the treatment of • Differentiation of risk— certain retail exposures. Question 29: retail exposures, for eligible purchased Segmentation should provide The agencies seek comment on this wholesale receivables. Under this meaningful differentiation of risk. approach to tranched guarantees on approach, in phase 2, a bank would Accordingly, in developing its risk retail exposures and on alternative group its eligible purchased wholesale segmentation system, a bank should approaches that could more receivables that, when consolidated by consider the chosen risk drivers’ ability appropriately reflect the risk mitigating obligor, total less than $1 million into to separate risk consistently over time effect of such guarantees while segments that have homogeneous risk and the overall robustness of the bank’s addressing the agencies’ concerns about characteristics. To be an eligible approach to segmentation. counterparty credit risk and correlation purchased wholesale receivable, several • Reliable risk characteristics— between the credit quality of an obligor criteria must be met: Segmentation should use borrower- and a guarantor. • The purchased wholesale receivable related risk characteristics and Banks have expressed concern about must be purchased from an unaffiliated exposure-related risk characteristics that the treatment of retail margin loans reliably and consistently over time under the New Accord. Due to the seller and must not have been directly differentiate a segment’s risk from that highly collateralized nature and low or indirectly originated by the of other segments. loss frequency of margin loans, banks purchasing bank; • Consistency—Risk drivers for typically collect little customer-specific • The purchased wholesale receivable segmentation should be consistent with information that they could use to must be generated on an arm’s-length the predominant risk characteristics differentiate margin loans into basis between the seller and the obligor. used by the bank for internal credit risk segments. The agencies believe that a Intercompany accounts receivable and measurement and management. bank could appropriately segment its receivables subject to contra-accounts • Accuracy—The segmentation margin loan portfolio using only between firms that buy and sell to each system should generate segments that product-specific risk drivers, such as other are ineligible; separate exposures by realized product type and origination channel. A • The purchasing bank must have a performance and should be designed so bank could then use the retail definition claim on all proceeds from the that actual long-run outcomes closely of default to associate a PD, ELGD, and receivable or a pro-rata interest in the approximate the retail risk parameters LGD with each segment. As described in estimated by the bank. section 32 of the proposed rule, a bank proceeds; and A bank might choose to segment could adjust the EAD of eligible margin • The purchased wholesale receivable exposures by common risk drivers that loans to reflect the risk-mitigating effect must have an effective remaining are relevant and material in determining of financial collateral. For a segment of maturity of less than one year. the loss characteristics of a particular retail eligible margin loans, a bank retail product. For example, a bank may Wholesale lease residuals. The would associate an ELGD and LGD with agencies are proposing a treatment for segment mortgage loans by LTV band, the segment that do not reflect the age from origination, geography, wholesale lease residuals that differs presence of collateral. If a bank is not from the New Accord. A wholesale lease origination channel, and credit score. able to estimate PD, ELGD, and LGD for Statistical modeling, expert judgment, residual typically exposes a bank to the a segment of eligible margin loans, the risk of a decline in value of the leased or some combination of the two may bank may apply a 300 percent risk asset and to the credit risk of the lessee. determine the most relevant risk drivers. weight to the EAD of the segment. Although the New Accord provides for Alternatively, a bank might segment by Question 30: The agencies seek a flat 100 percent risk weight for grouping exposures with similar loss comment on wholesale and retail characteristics, such as loss rates or exposure types for which banks are not wholesale lease residuals, the agencies default rates, as determined by able to calculate PD, ELGD, and LGD believe this is excessively punitive for historical performance of segments with and on what an appropriate risk-based leases to highly creditworthy lessees. similar risk characteristics. capital treatment for such exposures Accordingly, the proposed rule would Banks commonly obtain tranched might be. require a bank to treat its net investment credit protection, for example first-loss In phase 3, each retail segment will in a wholesale lease as a single exposure or second-loss guarantees, on certain typically be associated with a separate to the lessee. There would not be a retail exposures such as residential PD, ELGD, LGD, and EAD. In some separate capital calculation for the mortgages. The agencies recognize that cases, it may be reasonable to use the wholesale lease residual. In contrast, a same PD, ELGD, LGD, or EAD estimate retail lease residual, consistent with the exposures and, if the bank determines the EAD for for multiple segments. New Accord, would be assigned a risk- eligible margin loans using the approach in section weighted asset amount equal to its 32(a) of the proposed rule, it must segment retail A bank must segment defaulted retail eligible margin loans for which the bank uses this exposures separately from non- residual value (as described in more approach separately from other retail exposures. defaulted retail exposures and should detail above).

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00034 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55863

3. Phase 3—Assignment of Risk step may include adjustments for segment of eligible purchased wholesale Parameters to Wholesale Obligors and differences between this proposed rule’s receivables. Exposures and Retail Segments definition of default and the default A bank may recognize the credit risk In phase 3, a bank would associate a definition in the reference data set, or mitigation benefits of collateral that PD with each wholesale obligor rating adjustments for data limitations. This secures a wholesale exposure by grade; associate an ELGD or LGD with step should also include adjustments for adjusting its estimate of the ELGD and each wholesale loss severity rating grade seasoning effects related to retail LGD of the exposure and may recognize or assign an ELGD and LGD to each exposures. the credit risk mitigation benefits of wholesale exposure; assign an EAD and A bank may use more than one collateral that secures retail exposures M to each wholesale exposure; and estimation technique to generate by adjusting its estimate of the PD, assign a PD, ELGD, LGD, and EAD to estimates of the risk parameters, ELGD, and LGD of the segment of retail each segment of retail exposures. The especially if there are multiple sets of exposures. In certain cases, however, a quantification phase can generally be reference data or multiple sample bank may take financial collateral into divided into four steps—obtaining periods. If multiple estimates are account in estimating the EAD of repo- historical reference data, estimating the generated, the bank must have a clear style transactions, eligible margin loans, risk parameters for the reference data, and consistent policy on reconciling and OTC derivative contracts (as mapping the historical reference data to and combining the different estimates. provided in section 32 of the proposed Once a bank estimates PD, ELGD, the bank’s current exposures, and rule). LGD, and EAD for its reference data sets, determining the risk parameters for the The proposed rule also provides that it would create a link between its bank’s current exposures. a bank may use an EAD of zero for (i) portfolio data and the reference data A bank should base its estimation of derivative contracts that are traded on based on corresponding characteristics. the values assigned to PD, ELGD, LGD, an exchange that requires the daily Variables or characteristics that are and EAD 48 on historical reference data receipt and payment of cash-variation available for the existing portfolio that are a reasonable proxy for the margin; (ii) derivative contracts and would be mapped or linked to the bank’s current exposures and that repo-style transactions that are variables used in the default, loss- provide meaningful predictions of the outstanding with a qualifying central severity, or exposure amount model. In performance of such exposures. A counterparty, but not for those ‘‘reference data set’’ consists of a set of order to effectively map the data, reference data characteristics would transactions that the qualifying central exposures to defaulted wholesale counterparty has rejected; and (iii) obligors and defaulted retail exposures need to allow for the construction of rating and segmentation criteria that are credit risk exposures to a qualifying (in the case of ELGD, LGD, and EAD central counterparty that arise from estimation) or to both defaulted and consistent with those used on the bank’s portfolio. An important element of derivative contracts and repo-style non-defaulted wholesale obligors and transactions in the form of clearing retail exposures (in the case of PD mapping is making adjustments for differences between reference data sets deposits and posted collateral. The estimation). proposed rule defines a qualifying The reference data set should be and the bank’s exposures. Finally, a bank would apply the risk central counterparty as a counterparty described using a set of observed (for example, a clearing house) that: (i) characteristics. Relevant characteristics parameters estimated for the reference data to the bank’s actual portfolio data. Facilitates trades between might include debt ratings, financial counterparties in one or more financial measures, geographic regions, the The bank would attribute a PD to each wholesale obligor and each segment of markets by either guaranteeing trades or economic environment and industry/ novating contracts; (ii) requires all sector trends during the time period of retail exposures, and an ELGD, LGD, and EAD to each wholesale exposure participants in its arrangements to be the reference data, borrower and loan fully collateralized on a daily basis; and characteristics related to the risk and to each segment of retail exposures. If multiple data sets or estimation (iii) the bank demonstrates to the parameters (such as loan terms, LTV satisfaction of its primary Federal ratio, credit score, income, debt-to- methods are used, the bank must adopt a means of combining the various supervisor is in sound financial income ratio, or performance history), or condition and is subject to effective other factors that are related in some estimates at this stage. The proposed rule, as noted above, oversight by a national supervisory way to the risk parameters. Banks may permits a bank to elect to segment its authority. use more than one reference data set to eligible purchased wholesale Some repo-style transactions and OTC improve the robustness or accuracy of receivables like retail exposures. A bank derivative contracts giving rise to the parameter estimates. that chooses to apply this treatment counterparty credit risk may give rise, A bank should then apply statistical must directly assign a PD, ELGD, LGD, from an accounting point of view, to techniques to the reference data to EAD, and M to each such segment. If a both on- and off-balance sheet determine a relationship between risk bank can estimate ECL (but not PD or exposures. Where a bank is using an characteristics and the estimated risk LGD) for a segment of eligible purchased EAD approach to measure the amount of parameter. The result of this step is a wholesale receivables, the bank must risk exposure for such transactions, model that ties descriptive assume that the ELGD and LGD of the factoring in collateral effects where characteristics to the risk parameter segment equal 100 percent and that the applicable, it would not also separately estimates. In this context, the term PD of the segment equals ECL divided apply a risk-based capital requirement ‘model’ is used in the most general by EAD. The bank must estimate ECL to an on-balance sheet receivable from sense; a model may be simple, such as for the receivables without regard to any the counterparty recorded in connection the calculation of averages, or more assumption of recourse or guarantees with that transaction. Because any complicated, such as an approach based from the seller or other parties. The exposure arising from the on-balance on advanced regression techniques. This bank would then use the wholesale sheet receivable is captured in the 48 EAD for repo-style transactions, eligible margin exposure formula in section 31(e) of the capital requirement determined under loans, and OTC derivatives is calculated as proposed rule to determine the risk- the EAD approach, a separate capital described in section 32 of the proposed rule. based capital requirement for each requirement would double count the

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00035 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55864 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

exposure for regulatory capital qualifying master netting agreement, M and enforceable under the law of the purposes. would be the weighted-average relevant jurisdictions; A bank may take into account the risk remaining maturity (measured in whole (iv) The bank establishes and reducing effects of eligible guarantees or fractional years) of the expected maintains procedures to monitor and eligible credit derivatives in contractual cash flows from the possible changes in relevant law and to support of a wholesale exposure by exposure, using the undiscounted ensure that the agreement continues to applying the PD substitution approach amounts of the cash flows as weights. A satisfy the requirements of this or the LGD adjustment approach to the bank may use its best estimate of future definition; and exposure as provided in section 33 of interest rates to compute expected (v) The agreement does not contain a the proposed rule or, if applicable, contractual interest payments on a walkaway clause (that is, a provision applying double default treatment to the floating-rate exposure, but it may not that permits a non-defaulting exposure as provided in section 34 of consider expected but noncontractually counterparty to make lower payments the proposed rule. A bank may decide required returns of principal, when than it would make otherwise under the separately for each wholesale exposure estimating M. A bank could, at its agreement, or no payment at all, to a that qualifies for the double default option, use the nominal remaining defaulter or the estate of a defaulter, treatment whether to apply the PD maturity (measured in whole or even if the defaulter or the estate of the substitution approach, the LGD fractional years) of the exposure. The M defaulter is a net creditor under the adjustment approach, or the double for repo-style transactions, eligible agreement). default treatment. A bank may take into margin loans, and OTC derivative The agencies would consider the account the risk reducing effects of contracts subject to a qualifying master following jurisdictions to be relevant for guarantees and credit derivatives in netting agreement would be the a qualifying master netting agreement: support of retail exposures in a segment weighted-average remaining maturity The jurisdiction in which each when quantifying the PD, ELGD, and (measured in whole or fractional years) counterparty is chartered or the LGD of the segment. of the individual transactions subject to equivalent location in the case of non- There are several supervisory the qualifying master netting agreement, corporate entities, and if a branch of a limitations imposed on risk parameters with the weight of each individual counterparty is involved, then also the assigned to wholesale obligors and transaction set equal to the notional jurisdiction in which the branch is exposures and segments of retail amount of the transaction. Question 31: located; the jurisdiction that governs the exposures. First, the PD for each The agencies seek comment on the individual transactions covered by the wholesale obligor or segment of retail appropriateness of permitting a bank to agreement; and the jurisdiction that exposures may not be less than 0.03 consider prepayments when estimating governs the agreement. percent, except for exposures to or M and on the feasibility and advisability For most exposures, M may be no directly and unconditionally guaranteed of using discounted (rather than greater than five years and no less than by a sovereign entity, the Bank for undiscounted) cash flows as the basis one year. For exposures that have an International Settlements, the for estimating M. original maturity of less than one year International Monetary Fund, the Under the proposed rule, a qualifying and are not part of a bank’s ongoing European Commission, the European master netting agreement is defined to financing of the obligor, however, a Central Bank, or a multi-lateral mean any written, legally enforceable bank may set M equal to the greater of development bank, to which the bank bilateral agreement, provided that: one day and M. An exposure is not part assigns a rating grade associated with a (i) The agreement creates a single of a bank’s ongoing financing of the PD of less than 0.03 percent. Second, legal obligation for all individual obligor if the bank (i) has a legal and the LGD of a segment of residential transactions covered by the agreement practical ability not to renew or roll over mortgage exposures (other than upon an event of default, including the exposure in the event of credit segments of residential mortgage bankruptcy, insolvency, or similar deterioration of the obligor; (ii) makes exposures for which all or substantially proceeding, of the counterparty; an independent credit decision at the all of the principal of the exposures is (ii) The agreement provides the bank inception of the exposure and at every directly and unconditionally guaranteed the right to accelerate, terminate, and renewal or rollover; and (iii) has no by the full faith and credit of a sovereign close-out on a net basis all transactions substantial commercial incentive to entity) may not be less than 10 percent. under the agreement and to liquidate or continue its credit relationship with the These supervisory floors on PD and LGD set off collateral promptly upon an obligor in the event of credit apply regardless of whether the bank event of default, including upon an deterioration of the obligor. Examples of recognizes an eligible guarantee or event of bankruptcy, insolvency, or transactions that may qualify for the eligible credit derivative as provided in similar proceeding, of the counterparty, exemption from the one-year maturity sections 33 and 34 of the proposed rule. provided that, in any such case, any floor include due from other banks, The agencies would not allow a bank exercise of rights under the agreement including deposits in other banks; to artificially group exposures into will not be stayed or avoided under bankers’ acceptances; sovereign segments specifically to avoid the LGD applicable law in the relevant exposures; short-term self-liquidating floor for mortgage products. A bank jurisdictions; trade finance exposures; repo-style should use consistent risk drivers to (iii) The bank has conducted and transactions; eligible margin loans; determine its retail exposure documented sufficient legal review to unsettled trades and other exposures segmentations and not artificially conclude with a well-founded basis that resulting from payment and settlement segment low LGD loans with higher the agreement meets the requirements of processes; and collateralized OTC LGD loans to avoid the floor. paragraph (ii) of this definition and that derivative contracts subject to daily A bank also must calculate the in the event of a legal challenge remargining. effective remaining maturity (M) for (including one resulting from default or each wholesale exposure. For wholesale from bankruptcy, insolvency, or similar 4. Phase 4—Calculation of Risk- exposures other than repo-style proceeding) the relevant court and Weighted Assets transactions, eligible margin loans, and administrative authorities would find After a bank assigns risk parameters to OTC derivative contracts subject to a the agreement to be legal, valid, binding, each of its wholesale obligors and

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00036 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55865

exposures and retail segments, the bank 34 of the proposed rule) by inserting the in the risk-weighted assets amount of would calculate the dollar risk-based risk parameters for the wholesale the hedged exposure (i) through capital requirement for each wholesale obligor and exposure or retail segment adjustments made to the risk parameters exposure to a non-defaulted obligor or into the appropriate IRB risk-based of the hedged exposure under the PD segment of non-defaulted retail capital formula specified in Table C and substitution or LGD adjustment exposures (except eligible guarantees multiplying the output of the formula approach in section 33 of the proposed and eligible credit derivatives that (K) by the EAD of the exposure or rule or (ii) through a separate double hedge another wholesale exposure and segment. Eligible guarantees and eligible default risk-based capital requirement exposures to which the bank is applying credit derivatives that are hedges of a formula in section 34 of the proposed the double default treatment in section wholesale exposure would be reflected rule.

The sum of the dollar risk-based would be converted into a risk-weighted immediately before the obligor became capital requirements for wholesale asset amount by multiplying it by 12.5. defaulted), multiplied by the EAD of the exposures to a non-defaulted obligor To compute the risk-weighted asset exposure immediately before the and segments of non-defaulted retail amount for a wholesale exposure to a exposure became defaulted. If the exposures (including exposures subject defaulted obligor, a bank would first amount calculated in (i) is equal to or to the double default treatment have to compare two amounts: (i) The greater than the amount calculated in described below) would equal the total sum of 0.08 multiplied by the EAD of (ii), the dollar risk-based capital dollar risk-based capital requirement for the wholesale exposure plus the amount requirement for the exposure is 0.08 those exposures and segments. The total of any charge-offs or write-downs on the multiplied by the EAD of the exposure. dollar risk-based capital requirement exposure; and (ii) K for the wholesale If the amount calculated in (i) is less exposure (as determined in Table C than the amount calculated in (ii), the

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00037 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.077 55866 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

dollar risk-based capital requirement for exposures, wholesale exposures to addressed by the RTCRRI Act should the exposure is K for the exposure (as defaulted obligors and segments of continue to receive the risk weights determined in Table C immediately defaulted retail exposures, assets not provided in the Act. Specifically, before the obligor became defaulted), included in an exposure category, non- consistent with the general risk-based multiplied by the EAD of the exposure. material portfolios of exposures, and capital rules, the proposed rule requires The reason for this comparison is to unsettled transactions minus the a bank to use the following risk weights ensure that a bank does not receive a amounts deducted from capital (instead of the risk weights that would regulatory capital benefit as a result of pursuant to the general risk-based otherwise be produced under the IRB the exposure moving from non- capital rules (excluding those risk-based capital formulas): (i) A 50 defaulted to defaulted status. deductions reversed in section 12 of the percent risk weight for one- to four- The proposed rule provides a simpler proposed rule). family residential construction loans if approach for segments of defaulted the residences have been pre-sold under retail exposures. The dollar risk-based 5. Statutory Provisions on the firm contracts to purchasers who have capital requirement for a segment of Regulatory Capital Treatment of Certain obtained firm commitments for defaulted retail exposures equals 0.08 Mortgage Loans permanent qualifying mortgages and multiplied by the EAD of the segment. The general risk-based capital rules have made substantial earnest money The agencies are proposing this uniform assign 50 and 100 percent risk weights deposits, and the loans meet the other 8 percent risk-based capital requirement to certain one- to four-family residential underwriting characteristics established for defaulted retail exposures to ease pre-sold construction loans and by the agencies in the general risk-based implementation burden on banks and in multifamily residential loans.49 The capital rules; 52 (ii) a 50 percent risk light of accounting and other agencies adopted these provisions as a weight for multifamily residential loans supervisory policies in the retail context result of the Resolution Trust that meet certain statutory loan-to-value, that would help prevent the sum of a Corporation Refinancing, Restructuring, debt-to-income, amortization, and bank’s ECL and risk-based capital and Improvement Act of 1991 (RTCRRI performance requirements, and meet the requirement for a retail exposure from Act).50 The RTCRRI Act mandates that other underwriting characteristics declining at the time of default. each agency provide in its capital established by the agencies in the To convert the dollar risk-based regulations (i) a 50 percent risk weight general risk-based capital rules; 53 and capital requirements to a risk-weighted for certain one- to four-family (iii) a 100 percent risk weight for one- asset amount, the bank would sum the residential pre-sold construction loans to four-family residential pre-sold dollar risk-based capital requirements and multifamily residential loans that construction loans for a residence for for all wholesale exposures to defaulted meet specific statutory criteria set forth which the purchase contract is obligors and segments of defaulted retail in the Act and any other underwriting canceled.54 Mortgage loans that do not exposures and multiply the sum by criteria imposed by the agencies; and (ii) meet the relevant criteria do not qualify 12.5. a 100 percent risk weight for one- to for the statutory risk weights and will be A bank could assign a risk-weighted four-family residential pre-sold risk-weighted according to the IRB risk- asset amount of zero to cash owned and construction loans for residences for based capital formulas. held in all offices of the bank or in which the purchase contract is The agencies understand that there is transit, and for gold bullion held in the cancelled.51 a tension between the statutory risk bank’s own vaults or held in another When Congress enacted the RTCRRI weights provided by the RTCRRI Act bank’s vaults on an allocated basis, to Act in 1991, the agencies’ risk-based and the more risk-sensitive IRB the extent it is offset by gold bullion capital rules reflected the Basel I approaches to risk-based capital that are liabilities. On-balance-sheet assets that framework. Consequently, the risk contained in this proposed rule. do not meet the definition of a weight treatment for certain categories Question 32: The agencies seek wholesale, retail, securitization, or of mortgage loans in the RTCRRI Act comment on whether the agencies equity exposure—for example, property, assumes a risk weight bucketing should impose the following plant, and equipment and mortgage approach, instead of the more risk- underwriting criteria as additional servicing rights—and portfolios of sensitive IRB approach in the Basel II requirements for a Basel II bank to exposures that the bank has framework. qualify for the statutory 50 percent risk demonstrated to its primary Federal For purposes of this proposed rule weight for a particular mortgage loan: (i) supervisor’s satisfaction are, when implementing the Basel II IRB approach, That the bank has an IRB risk combined with all other portfolios of the agencies are proposing that the three measurement and management system exposures that the bank seeks to treat as types of residential mortgage loans in place that assesses the PD and LGD immaterial for risk-based capital of prospective residential mortgage purposes, not material to the bank 49 See 12 CFR part 3, Appendix A, section exposures; and (ii) that the bank’s IRB generally would be assigned risk- 3(a)(3)(iii) (national banks); 12 CFR part 208, system generates a 50 percent risk weighted asset amounts equal to their Appendix A, section III.C.3. (state member banks); weight for the loan under the IRB risk- carrying value (for on-balance-sheet 12 CFR part 225, Appendix A, section III.C.3. (bank holding companies); 12 CFR part 325, Appendix A, based capital formulas. The agencies exposures) or notional amount (for off- section II.C.a. (state nonmember banks); 12 CFR note that a capital-related provision of balance-sheet exposures). For this 567.6(a)(1)(iii) and (iv) (savings associations). the Federal Deposit Insurance purpose, the notional amount of an OTC 50 See sections 618(a) and (b) of the RTCRRI Act. Corporation Improvement Act of 1991 derivative contract that is not a credit The first class includes loans for the construction (FDICIA), enacted by Congress just four derivative is the EAD of the derivative of a residence consisting of 1- to 4-family dwelling units that have been pre-sold under firm contracts days after its adoption of the RTCRRI as calculated in section 32 of the to purchasers who have obtained firm commitments Act, directs each agency to revise its proposed rule. for permanent qualifying mortgages and have made risk-based capital standards for DIs to Total wholesale and retail risk- substantial earnest money deposits. The second ensure that those standards ‘‘reflect the weighted assets would be the sum of class includes loans that are secured by a first lien on a residence consisting of more than 4 dwelling risk-weighted assets for wholesale units if the loan meets certain criteria outlined in 52 See section 618(a)(1)((B) of the RTCRRI Act. exposures to non-defaulted obligors and the RTCRRI Act. 53 See section 618(b)(1)(B) of the RTCRRI Act. segments of non-defaulted retail 51 See sections 618(a) and (b) of the RTCRRI Act. 54 See section 618(a)(2) of the RTCRRI Act.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00038 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55867

actual performance and expected risk of as described above in section V.B.3. of ongoing basis, the market value of the loss of multifamily mortgages.’’ 55 the preamble. However, in certain collateral, taking into account factors Question 33: The agencies seek limited circumstances described in the that could affect that value (for example, comment on all aspects of the proposed next section, a bank may adjust EAD to the liquidity of the market for the treatment of one- to four-family reflect the risk mitigating effect of collateral and obsolescence or residential pre-sold construction loans financial collateral. deterioration of the collateral), and (B) and multifamily residential loans. When reflecting the credit risk where applicable, periodically verifying C. Credit Risk Mitigation (CRM) mitigation benefits of collateral in its the collateral (for example, through Techniques estimation of the risk parameters of a physical inspection of collateral such as wholesale or retail exposure, a bank inventory and equipment); and Banks use a number of techniques to should: (v) The bank has in place systems for mitigate credit risk. This section of the (i) Conduct sufficient legal review to preamble describes how the proposed promptly requesting and receiving ensure, at inception and on an ongoing additional collateral for transactions rule recognizes the risk-mitigating basis, that all documentation used in the effects of both financial collateral whose terms require maintenance of collateralized transaction is binding on collateral values at specified thresholds. (defined below) and nonfinancial all parties and legally enforceable in all collateral, as well as guarantees and relevant jurisdictions; 2. EAD for Counterparty Credit Risk credit derivatives, for risk-based capital (ii) Consider the relation (that is, purposes. To recognize credit risk This section describes two EAD-based correlation) between obligor risk and methodologies—a collateral haircut mitigants for risk-based capital collateral risk in the transaction; purposes, a bank should have in place approach and an internal models (iii) Consider any currency and/or methodology—that a bank may use operational procedures and risk maturity mismatch between the hedged management processes that ensure that instead of an ELGD/LGD estimation exposure and the collateral; methodology to recognize the benefits of all documentation used in (iv) Ground its risk parameter financial collateral in mitigating the collateralizing or guaranteeing a estimates for the transaction in counterparty credit risk associated with transaction is legal, valid, binding, and historical data, using historical recovery repo-style transactions, eligible margin enforceable under applicable law in the rates where available; and loans, collateralized OTC derivative relevant jurisdictions. The bank should (v) Fully take into account the time contracts, and single product groups of have conducted sufficient legal review and cost needed to realize the such transactions with a single to reach a well-founded conclusion that liquidation proceeds and the potential counterparty subject to a qualifying the documentation meets this standard for a decline in collateral value over this master netting agreement. A third and should reconduct such a review as time period. methodology, the simple VaR necessary to ensure continuing The bank also should ensure that: methodology, is also available to enforceability. (i) The legal mechanism under which Although the use of CRM techniques recognize financial collateral mitigating the collateral is pledged or transferred may reduce or transfer credit risk, it the counterparty credit risk of single ensures that the bank has the right to simultaneously may increase other product netting sets of repo-style liquidate or take legal possession of the risks, including operational, liquidity, transactions and eligible margin loans. collateral in a timely manner in the and market risks. Accordingly, it is event of the default, insolvency, or A bank may use any combination of imperative that banks employ robust bankruptcy (or other defined credit the three methodologies for collateral procedures and processes to control event) of the obligor and, where recognition; however, it must use the risks, including roll-off risk and same methodology for similar concentration risk, arising from the applicable, the custodian holding the collateral; exposures. A bank may choose to use bank’s use of CRM techniques and to one methodology for agency securities monitor the implications of using CRM (ii) The bank has taken all steps necessary to fulfill legal requirements to lending transactions—that is, repo-style techniques for the bank’s overall credit transactions in which the bank, acting risk profile. secure its interest in the collateral so that it has and maintains an enforceable as agent for a customer, lends the 1. Collateral security interest; customer’s securities and indemnifies the customer against loss—and another Under the proposed rule, a bank (iii) The bank has clear and robust methodology for all other repo-style generally recognizes collateral that procedures for the timely liquidation of transactions. This section also describes secures a wholesale exposure as part of collateral to ensure observation of any the methodology for calculating EAD for the ELGD and LGD estimation process legal conditions required for declaring an OTC derivative contract or set of and generally recognizes collateral that the default of the borrower and prompt OTC derivative contracts subject to a secures a retail exposure as part of the liquidation of the collateral in the event qualifying master netting agreement. PD, ELGD, and LGD estimation process, of default; (iv) The bank has established Table D illustrates which EAD 55 Section 305(b)(1)(B) of FDICIA (12 U.S.C. 1828 procedures and practices for (A) estimation methodologies may be notes). conservatively estimating, on a regular applied to particular types of exposure.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00039 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55868 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

TABLE D

Models approach Current ex- Collateral Internal posure haircut ap- Simple method- VaR 56 models ology proach method- method- ology ology

OTC derivative ...... X X Recognition of collateral for OTC derivatives ...... X 57 X Repo-style transaction ...... X X X Eligible margin loan ...... X X X Cross-product netting set ...... X

Question 34: For purposes of single-product group of such customer and indemnifies the customer determining EAD for counterparty credit transactions with a single counterparty against loss), provided that: risk and recognizing collateral subject to a qualifying master netting (i) The transaction is based solely on mitigating that risk, the proposed rule agreement (netting set) through an liquid and readily marketable securities allows banks to take into account only adjustment to EAD rather than ELGD or cash; financial collateral, which, by and LGD. The bank may use a collateral (ii) The transaction is marked to definition, does not include debt haircut approach or one of two models securities that have an external rating market daily and subject to daily margin approaches: a simple VaR methodology maintenance requirements; lower than one rating category below (for single-product netting sets of repo- (iii) The transaction is executed under investment grade. The agencies invite style transactions or eligible margin an agreement that provides the bank the comment on the extent to which lower- loans) or an internal models right to accelerate, terminate, and close- rated debt securities or other securities methodology. Figure 2 illustrates the out the transaction on a net basis and to that do not meet the definition of methodologies available for calculating liquidate or set off collateral promptly financial collateral are used in these EAD and LGD for eligible margin loans transactions and on the CRM value of upon an event of default (including and repo-style transactions. such securities. upon an event of bankruptcy, EAD for repo-style transactions and The proposed rule defines repo-style insolvency, or similar proceeding) of the eligible margin loans. Under the transaction as a repurchase or reverse counterparty, provided that, in any such proposal, a bank could recognize the repurchase transaction, or a securities case, any exercise of rights under the risk mitigating effect of financial borrowing or securities lending agreement will not be stayed or avoided collateral that secures a repo-style transaction (including a transaction in under applicable law in the relevant transaction, eligible margin loan, or which the bank acts as agent for a jurisdictions; 58 and

56 Only repo-style transactions and eligible 58 This requirement is met where all transactions U.S.C. 1821(e)(8)), or netting contracts between or margin loans subject to a single-product qualifying under the agreement are (i) executed under U.S. law among financial institutions under sections 401– master netting agreement are eligible for the simple and (ii) constitute ‘‘securities contracts’’ or 407 of the Federal Deposit Insurance Corporation VaR methodology. ‘‘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 57 the Federal Reserve Board’s Regulation EE (12 CFR In conjunction with the current exposure or 559), qualified financial contracts under section methodology. 11(e)(8) of the Federal Deposit Insurance Act (12 part 231).

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00040 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55869

(iv) The bank has conducted and (ii) The collateral is marked to market security interest or the legal equivalent documented sufficient legal review to daily and the transaction is subject to thereof: (i) Cash on deposit with the conclude with a well-founded basis that daily margin maintenance requirements; bank (including cash held for the bank the agreement meets the requirements of (iii) The extension of credit is by a third-party custodian or trustee); paragraph (iii) of this definition and is conducted under an agreement that (ii) gold bullion; (iii) long-term debt legal, valid, binding, and enforceable provides the bank the right to accelerate securities that have an applicable under applicable law in the relevant and terminate the extension of credit external rating of one category below jurisdictions. and to liquidate or set off collateral investment grade or higher (for example, promptly upon an event of default at least BB–); (iv) short-term debt Question 35: The agencies recognize (including upon an event of bankruptcy, instruments that have an applicable that criterion (iii) above may pose insolvency, or similar proceeding) of the external rating of at least investment challenges for certain transactions that counterparty, provided that, in any such grade (for example, at least A–3); (v) would not be eligible for certain case, any exercise of rights under the equity securities that are publicly exemptions from bankruptcy or agreement will not be stayed or avoided traded; (vi) convertible bonds that are receivership laws because the under applicable law in the relevant publicly traded; and (vii) mutual fund counterparty—for example, a sovereign jurisdictions;59 and shares for which a share price is entity or a pension fund—is not subject (iv) The bank has conducted and publicly quoted daily and money to such laws. The agencies seek documented sufficient legal review to market mutual fund shares. Question comment on ways this criterion could be conclude with a well-founded basis that 36: The agencies seek comment on the crafted to accommodate such the agreement meets the requirements of appropriateness of requiring that a bank transactions when justified on paragraph (iii) of this definition and is have a perfected, first priority security prudential grounds, while ensuring that legal, valid, binding, and enforceable interest, or the legal equivalent thereof, under applicable law in the relevant the requirements in criterion (iii) are in the definition of financial collateral. jurisdictions. met for transactions that are eligible for The proposed rule describes various The proposed rule defines an external those exemptions. ways that a bank may recognize the risk rating as a credit rating assigned by a The proposed rule defines an eligible mitigating impact of financial collateral. nationally recognized statistical rating margin loan as an extension of credit The proposed rule defines financial organization (NRSRO) to an exposure where: collateral as collateral in the form of any that fully reflects the entire amount of credit risk the holder of the exposure (i) The credit extension is of the following instruments in which the bank has a perfected, first priority has with regard to all payments owed to collateralized exclusively by debt or it under the exposure. For example, if a equity securities that are liquid and 59 This requirement is met under the holder is owed principal and interest on readily marketable; circumstances described in the previous footnote. an exposure, the external rating must

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00041 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.078 55870 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

fully reflect the credit risk associated security the bank has borrowed, seek comment on other approaches to with timely repayment of principal and purchased subject to resale, or taken as consider in determining a given security interest. Moreover, the external rating collateral from the counterparty) for purposes of the collateral haircut must be published in an accessible form multiplied by the market price volatility approach. and must be included in the transition haircut appropriate to that security; and Standard Supervisory Haircuts matrices made publicly available by the (iii) the sum of the absolute values of NRSRO that summarize the historical the net position of both cash and If a bank chooses to use standard performance of positions it has rated.60 securities in each currency that is supervisory haircuts, it would use an 8 Under the proposed rule, an exposure’s different from the settlement currency percent haircut for each currency applicable external rating is the lowest multiplied by the haircut appropriate to mismatch and the haircut appropriate to external rating assigned to the exposure each currency mismatch. To determine each security in table E below. These by any NRSRO. the appropriate haircuts, a bank could haircuts are based on the 10-business- Collateral haircut approach. Under choose to use standard supervisory day holding period for eligible margin the collateral haircut approach, a bank haircuts or its own estimates of haircuts. loans and may be multiplied by the would set EAD equal to the sum of three For purposes of the collateral haircut square root of 1⁄2 to convert the standard quantities: (i) The value of the exposure approach, a given security would supervisory haircuts to the 5-business- less the value of the collateral; (ii) the include, for example, all securities with day minimum holding period for repo- absolute value of the net position in a a single Committee on Uniform style transactions. A bank must adjust given security (where the net position in Securities Identification Procedures the standard supervisory haircuts a given security equals the sum of the (CUSIP) number and would not include upward on the basis of a holding period current market values of the particular securities with different CUSIP longer than 10 business days for eligible security the bank has lent, sold subject numbers, even if issued by the same margin loans or 5 business days for to repurchase, or posted as collateral to issuer with the same maturity date. repo-style transactions where and as the counterparty minus the sum of the Question 37: The agencies recognize appropriate to take into account the current market values of that same that this is a conservative approach and illiquidity of an instrument.

TABLE E.—STANDARD SUPERVISORY MARKET PRICE VOLATILITY HAIRCUTS

Issuers exempt Applicable external rating grade category for debt securities Residual maturity for debt from the 3 b.p. Other issuers securities floor

Two highest investment grade rating categories for long-term ratings/highest ≤1 year ...... 005 .01 investment grade rating category for short-term ratings. >1 year, ≤5 years ...... 02 .04 >5 years ...... 04 .08

Two lowest investment grade rating categories for both short- and long-term ≤1 year ...... 01 .02 ratings. >1 year, ≤5 years ...... 03 .06 >5 years ...... 06 .12

One rating category below investment grade ...... All ...... 15 .25

Main index equities 61 (including convertible bonds) and gold ...... 15

Other publicly traded equities (including convertible bonds) ...... 25

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

As an example, assume a bank that primary Federal supervisor, a bank may style transactions and a minimum 10- uses standard supervisory haircuts has calculate security type and currency business-day holding period for all extended an eligible margin loan of mismatch haircuts using its own other transactions; (ii) the bank must $100 that is collateralized by 5-year U.S. internal estimates of market price adjust holding periods upward where Treasury notes with a market value of volatility and foreign exchange and as appropriate to take into account $100. The value of the exposure less the volatility. The bank’s primary Federal the illiquidity of an instrument; (iii) the value of the collateral would be zero, supervisor would base approval to use bank must select a historical observation and the net position in the security internally estimated haircuts on the period for calculating haircuts of at least ($100) times the supervisory haircut satisfaction of certain minimum one year; and (iv) the bank must update (.02) would be $2. There is no currency qualitative and quantitative standards. its data sets and recompute haircuts no mismatch. Therefore, the EAD of the These standards include: (i) The bank less frequently than quarterly and must exposure would be $0 + $2 = $2. must use a 99th percentile one-tailed update its data sets and recompute Own estimates of haircuts. With the confidence interval and a minimum 5- haircuts whenever market prices change prior written approval of the bank’s business-day holding period for repo- materially. A bank must estimate

60 Banks should take particular care with these 61 The proposed rule defines a ‘‘main index’’ as that the equities represented in the index have requirements where the financial collateral is in the the S&P 500 Index, the FTSE All-World Index, and comparable liquidity, depth of market, and size of form of a securitization exposure. any other index for which the bank demonstrates bid-ask spreads as equities in the S&P 500 Index to the satisfaction of its primary Federal supervisor and the FTSE All-World Index.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00042 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55871

individually the volatilities of the (ii) TN = holding period used by the bank to margin loans using a minimum one-year exposure, the collateral, and foreign derive HN; and historical observation period of price exchange rates, and may not take into (iii) HN = haircut based on the holding period data representing the instruments that account the correlations between them. TN. the bank has lent, sold subject to A bank that uses internally estimated Simple VaR methodology. As noted repurchase, posted as collateral, haircuts would have to adhere to the above, a bank may use one of two borrowed, purchased subject to resale, following rules. The bank may calculate internal models approaches to recognize or taken as collateral. internally estimated haircuts for the risk mitigating effects of financial The qualifying requirements for the categories of debt securities that have an collateral that secures a repo-style use of a VaR model are less stringent applicable external rating of at least transaction or eligible margin loan. This than the qualification requirements for investment grade. The haircut for a section of the preamble describes the the internal models methodology category of securities would have to be simple VaR methodology; a later section described below. The main ongoing representative of the internal volatility of the preamble describes the internal qualification requirement for using a estimates for securities in that category models methodology (which also may VaR model is that the bank must that the bank has actually lent, sold be used to determine the EAD for OTC validate its VaR model by establishing subject to repurchase, posted as derivative contracts). and maintaining a rigorous and regular With the prior written approval of its collateral, borrowed, purchased subject backtesting regime. to resale, or taken as collateral. In primary Federal supervisor, a bank may determining relevant categories, the estimate EAD for repo-style transactions 3. EAD for OTC Derivative Contracts and eligible margin loans subject to a bank would have to take into account (i) A bank may use either the current the type of issuer of the security; (ii) the single product qualifying master netting agreement using a VaR model. Under exposure methodology or the internal applicable external rating of the the simple VaR methodology, a bank’s models methodology to determine the security; (iii) the maturity of the EAD for the transactions subject to such EAD for OTC derivative contracts. An security; and (iv) the interest rate a netting agreement would be equal to OTC derivative contract is defined as a sensitivity of the security. A bank would the value of the exposures minus the derivative contract that is not traded on calculate a separate internally estimated value of the collateral plus a VaR-based an exchange that requires the daily haircut for each individual debt security estimate of the potential future exposure receipt and payment of cash-variation that has an applicable external rating (PFE), that is, the maximum exposure margin. A derivative contract is defined below investment grade and for each expected to occur on a future date with to include interest rate derivative individual equity security. In addition, a high level of confidence. The value of contracts, exchange rate derivative a bank would internally estimate a the exposures is the sum of the current contracts, equity derivative contracts, separate currency mismatch haircut for market values of all securities and cash commodity derivative contracts, credit each individual mismatch between each the bank has lent, sold subject to derivatives, and any other instrument net position in a currency that is repurchase, or posted as collateral to a that poses similar counterparty credit different from the settlement currency. counterparty under the netting set. The risks. The proposed rule also would When a bank calculates an internally value of the collateral is the sum of the define derivative contracts to include estimated haircut on a TN-day holding current market values of all securities unsettled securities, commodities, and period, which is different from the and cash the bank has borrowed, foreign exchange trades with a minimum holding period for the purchased subject to resale, or taken as contractual settlement or delivery lag transaction type, the applicable haircut collateral from a counterparty under the that is longer than the normal settlement (HM) must be calculated using the netting set. period (which the proposed rule defines following square root of time formula: The VaR model must estimate the as the lesser of the market standard for bank’s 99th percentile, one-tailed the particular instrument or 5 business days). This would include, for example, TM confidence interval for an increase in HH= , agency mortgage-backed securities MNT the value of the exposures minus the N value of the collateral (ΣE ¥ ΣC) over transactions conducted in the To-Be- Where: a 5-business-day holding period for Announced market.

(i) TM = 5 for repo-style transactions and 10 repo-style transactions or over a 10- Figure 3 illustrates the treatment of for eligible margin loans; business-day holding period for eligible OTC derivative contracts.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00043 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.039 55872 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

Current exposure methodology. The written and reasoned legal opinion The proposed rule’s conversion factor proposed current exposure methodology representing that, in the event of a legal (CF) matrix used to compute PFE is for determining EAD for single OTC challenge, the bank’s exposure would be based on the matrices in the general derivative contracts is similar to the found to be the net amount in the risk-based capital rules, with two methodology in the general risk-based relevant jurisdictions. The agencies are exceptions. First, under the proposed capital rules, in that the EAD for an OTC proposing to retain this standard for rule the CF for credit derivatives that are derivative contract would be equal to netting agreements covering OTC not used to hedge the credit risk of the sum of the bank’s current credit derivative contracts. While the legal exposures subject to an IRB credit risk exposure and PFE on the derivative enforceability of contracts is necessary capital requirement is specified to be 5.0 contract. The current credit exposure for for a bank to recognize netting effects in percent for contracts with investment a single OTC derivative contract is the the capital calculation, there may be grade reference obligors and 10.0 greater of the mark-to-market value of ways other than obtaining an explicit percent for contracts with non- the derivative contract or zero. investment grade obligors.62 The CF for written opinion to ensure the The proposed current exposure a credit derivative contract does not enforceability of a contract. For methodology for OTC derivative depend on the remaining maturity of the contracts subject to qualifying master example, the use of industry developed contract. The second change is that netting agreements is also similar to the standardized contracts for certain OTC floating/floating basis swaps would no treatment set forth in the agencies’ products and reliance on commissioned longer be exempted from the CF for general risk-based capital rules. Banks legal opinions as to the enforceability of interest rate derivative contracts. The would need to calculate net current these contracts in many jurisdictions exemption was put into place when exposure and adjust the gross PFE using may be sufficient. Question 38: The such swaps were very simple, and the a formula that includes the net to gross agencies seek comment on methods current exposure ratio. Moreover, under banks would use to ensure 62 The counterparty credit risk of a credit the agencies’ general risk-based capital enforceability of single product OTC derivative that is used to hedge the credit risk of rules, a bank may not recognize netting derivative netting agreements in the an exposure subject to an IRB credit risk capital requirement is captured in the IRB treatment of the agreements for OTC derivative contracts absence of an explicit written legal hedged exposure, as detailed in sections 33 and 34 for capital purposes unless it obtains a opinion requirement. of the proposed rule.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00044 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25se06.079 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55873

agencies believe it is no longer counterparty credit risk capital financial transactions or qualifying appropriate given the evolution of the requirement for the credit derivative, so master netting agreements in the event product. The computation of the PFE of long as it does so consistently for all of a counterparty’s default, provided multiple OTC derivative contracts such credit derivatives and either that: subject to a qualifying master netting includes all or excludes all such credit (i) The underlying financial agreement would not change from the derivatives that are subject to a master transactions are OTC derivative general risk-based capital rules. netting contract from any measure used contracts, eligible margin loans, or repo- If an OTC derivative contract is to determine counterparty credit risk style transactions; and collateralized by financial collateral, a exposure to all relevant counterparties (ii) The bank obtains a written legal bank would first determine an for risk-based capital purposes. Where opinion verifying the validity and unsecured EAD as described above and the bank provides protection through a enforceability of the netting agreement in section 32(b) of the proposed rule. To credit derivative treated as a covered under applicable law of the relevant take into account the risk-reducing position under the MRA, it must jurisdictions if the counterparty fails to effects of the financial collateral, the compute a counterparty credit risk perform upon an event of default, bank may either adjust the ELGD and capital requirement under section 32 of including upon an event of bankruptcy, LGD of the contract or, if the transaction the proposed rule. insolvency, or similar proceeding. is subject to daily marking-to-market Banks use several measures to manage 4. Internal Models Methodology and remargining, adjust the EAD of the their exposure to counterparty credit contract using the collateral haircut This proposed rule includes an risk including PFE, expected exposure approach for repo-style transactions and internal models methodology for the (EE), and expected positive exposure eligible margin loans described above calculation of EAD for transactions with (EPE). PFE is the maximum exposure and in section 32(a) of the proposed counterparty credit exposure, namely, estimated to occur on a future date at a rule. OTC derivatives, eligible margin loans, high level of statistical confidence. Under part VI of the proposed rule, a and repo-style transactions. The internal Banks often use PFE when measuring bank must treat an equity derivative models methodology requires a risk counterparty credit risk exposure contract as an equity exposure and model that captures counterparty credit against counterparty credit limits. EE is compute a risk-weighted asset amount risk and estimates EAD at the level of a the probability-weighted average for that exposure. If the bank is using ‘‘netting set.’’ A netting set is a group of exposure to a counterparty estimated to the internal models approach for its transactions with a single counterparty exist at any specified future date, equity exposures, it also must compute that are subject to a qualifying master whereas EPE is the time-weighted a risk-weighted asset amount for its netting agreement. A transaction not average of individual expected counterparty credit risk exposure on the subject to a qualifying master netting exposures estimated for a given equity derivative contract. However, if agreement is considered to be its own forecasting horizon (one year in the the bank is using the simple risk weight netting set and EAD must be calculated proposed rule). Banks typically compute approach for its equity exposures, it for each such transaction individually. EPE, EE, and PFE using a common may choose not to hold risk-based A bank may use the internal models stochastic model. capital against the counterparty credit methodology for OTC derivatives A paper published by the BCBS in risk of the equity derivative contract. (collateralized or uncollateralized) and July 2005 titled ‘‘The Application of Likewise, a bank that purchases a credit single-product netting sets thereof, for Basel II to Trading Activities and the derivative that is recognized under eligible margin loans and single-product Treatment of Double Default Effects’’ section 33 or 34 of the proposed rule as netting sets thereof, or for repo-style notes that EPE is an appropriate EAD a credit risk mitigant for an exposure transactions and single-product netting measure for determining risk-based that is not a covered position under the sets thereof. A bank that uses the capital requirements for counterparty MRA does not have to compute a internal models methodology for a credit risk because transactions with separate counterparty credit risk capital particular transaction type (that is, OTC counterparty credit risk ‘‘are given the requirement for the credit derivative. If derivative contracts, eligible margin same standing as loans with the goal of a bank chooses not to hold risk-based loans, or repo-style transactions) must reducing the capital treatment’s capital against the counterparty credit use the internal models methodology for influence on a firm’s decision to extend risk of such equity or credit derivative all transactions in that transaction type. an on-balance sheet loan rather than contracts, it must do so consistently for However, a bank may choose whether or engage in an economically equivalent all such equity derivative contracts or not to use the internal models transaction that involves exposure to for all such credit derivative contracts. methodology for each transaction type. counterparty credit risk.’’63 An Further, where the contracts are subject A bank also may use the internal adjustment to EPE, called effective EPE to a qualifying master netting models methodology for OTC and described below, is used in the agreement, the bank must either include derivatives, eligible margin loans, and calculation of EAD under the internal them all or exclude them all from any repo-style transactions subject to a models methodology. EAD is calculated measure used to determine counterparty qualifying cross-product master netting as a multiple of effective EPE. credit risk exposure to all relevant agreement if (i) the bank effectively To address the concern that EE and counterparties for risk-based capital integrates the risk mitigating effects of EPE may not capture risk arising from purposes. cross-product netting into its risk the replacement of existing short-term Where a bank provides protection management and other information positions over the one year horizon used through a credit derivative that is not technology systems; and (ii) the bank for capital requirements (that is, rollover treated as a covered position under the obtains the prior written approval of its risk) or may underestimate the MRA, it must treat the credit derivative primary Federal supervisor. exposures of eligible margin loans, repo- A qualifying cross-product master as a wholesale exposure to the reference style transactions, and OTC derivatives obligor and compute a risk-weighted netting agreement is defined as a asset amount for the credit derivative qualifying master netting agreement that 63 BCBS, ‘‘The Application of Basel II to Trading under section 31 of the proposed rule. provides for termination and close-out Activities and the Treatment of Double Default The bank need not compute a netting across multiple types of Effects,’’ July 2005, ¶ 15.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00045 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55874 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

with short maturities, the proposed rule demonstrate that it is capable of this context, wrong-way risk is the risk uses a netting set’s ‘‘effective EPE’’ as performing the estimation daily. that future exposure to a counterparty the basis for calculating EAD for Second, the bank must estimate EE at will be high when the counterparty’s counterparty credit risk. Consistent with enough future time points to accurately probability of default is also high. the use of a one-year PD horizon, reflect all future cash flows of contracts Wrong-way risk generally arises from effective EPE is the time-weighted in the netting set. To accurately reflect events specific to the counterparty, average of effective EE over one year the exposure arising from a transaction, rather than broad market downturns. where the weights are the proportion the model should incorporate those Eighth, the data used by the bank that an individual effective EE contractual provisions, such as reset should be adequate for the measurement represents in a one-year time interval. If dates, that can materially affect the and modeling of the exposures. In all contracts in a netting set mature timing, probability, or amount of any particular, current exposures must be payment. The requirement reflects the before one year, effective EPE is the calculated on the basis of current market need for an accurate estimate of EPE. average of effective EE until all contracts data. When historical data are used to However, in order to balance the ability in the netting set mature. For example, estimate model parameters, at least to calculate exposures with the need for if the longest maturity contract in the three years of data that cover a wide information on timely basis, the number netting set matures in six months, range of economic conditions must be effective EPE would be the average of of time points is not specified. Third, the bank must have been using used. This requirement reflects the effective EE over six months. longer horizon for counterparty credit Effective EE is defined as: an internal model that broadly meets the minimum standards to calculate the risk exposures compared to market risk Effective EE tk = max(Effective EE tk¥1, distributions of exposures upon which exposures. The data must be updated at EE tk) where exposure is measured at least quarterly. Banks are encouraged future dates t1, t2, t3, * * * and the EAD calculation is based for a period of at least one year prior to also to incorporate model parameters effective EE t0 equals current exposure. approval. This requirement is to insure based on forward looking measures ‘‘ for Alternatively, a bank may use a measure example, using implied volatilities in that is more conservative than effective that the bank has integrated the modeling into its counterparty credit situations where historic volatilities EPE for every counterparty (that is, a may not capture changes in the risk measure based on peak exposure) with risk management process. Fourth, the bank’s model must drivers anticipated by the market— prior approval of the primary Federal account for the non-normality of where appropriate. supervisor. exposure distribution where Ninth, the bank must subject its The EAD for instruments with appropriate. Non-normality of models used in the calculation of EAD counterparty credit risk must be exposures means high loss events occur to an initial validation and annual determined assuming economic more frequently than would be expected model review process. The model downturn conditions. To accomplish on the basis of a normal distribution, the review should consider whether the this determination in a prudent manner, statistical term for which is inputs and risk factors, as well as the the internal models methodology sets leptokurtosis. In many instances, there model outputs, are appropriate. The EAD equal to EPE multiplied by a may not be a need to account for this. review of outputs should include a scaling factor termed ‘‘alpha.’’ Alpha is Expected exposures are much less likely rigorous program of backtesting model set at 1.4; a bank’s primary Federal to be affected by leptokurtosis than peak outputs against realized exposures. supervisor would have the flexibility to exposures or high percentile losses. Maturity under the internal models raise this value based on the bank’s However, the bank must demonstrate specific characteristics of counterparty methodology. Like corporate loan that its EAD measure is not affected by exposures, counterparty exposure on credit risk. With supervisory approval, a leptokurtosis or must account for it netting sets is susceptible to changes in bank may use its own estimate of alpha within the model. economic value that stem from as described below, subject to a floor of Fifth, the bank must measure, 1.2. Question 39: The agencies request monitor, and control the exposure to a deterioration in the counterparty’s comment on all aspect of the effective counterparty over the whole life of all creditworthiness short of default. The EPE approach to counterparty credit contracts in the netting set, in addition effective maturity parameter (M) reflects risk, and in particular on the to accurately measuring and actively the impact of these changes on capital. appropriateness of the monotonically monitoring the current exposure to The formula used to compute M for increasing effective EE function, the counterparties. The bank should netting sets with maturities greater than alpha constant of 1.4, and the floor on exercise active management of both one year must be different than that internal estimates of alpha of 1.2. existing exposure and exposure that generally applied to wholesale A bank’s primary Federal supervisor could change in the future due to exposures in order to reflect how must determine that the bank meets market moves. counterparty credit exposures change certain qualifying criteria before the Sixth, the bank must measure and over time. The proposed approach is bank may use the internal models manage current exposures gross and net based on a weighted average of expected methodology. These criteria consist of of collateral held, where appropriate. exposures over the life of the operational requirements, modeling The bank must estimate expected transactions relative to their one year standards, and model validation exposures for OTC derivative contracts exposures. requirements. both with and without the effect of If the remaining maturity of the First, the bank must have the systems collateral agreements. exposure or the longest-dated contract capability to estimate EE on a daily Seventh, the bank must have contained in a netting set is greater than basis. While this requirement does not procedures to identify, monitor, and one year, the bank must set M for the require the bank to report EE daily, or control specific wrong-way risk exposure or netting set equal to the even estimate EE daily, the bank must throughout the life of an exposure. In lower of 5 years or M(EPE), where:

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00046 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55875

maturity ××∆ ∑ EEk tdfkk tk >1 year ()i M (EPE) =1+ ≤ ; tk 1 year × ∆ × ∑ effectiveEE k tkkkdf k=1

and (ii) df k is the risk-free discount permitted, the agencies expect banks this calculation, economic capital is the factor for future time period t k. The cap that make extensive use of collateral unexpected losses for all counterparty of five years on M is consistent with the agreements to develop the modeling credit risks measured at the 99.9 percent treatment of wholesale exposures under capacity to measure the impact of such confidence level over a one-year section 31 o the proposed rule. agreements on EAD. horizon. Internal estimates of alpha are If the remaining maturity of the The ‘‘shortcut’’ method sets effective subject to a floor of 1.2. To obtain exposure or the longest-dated contract EPE for a counterparty subject to a supervisory approval to use an internal in the netting set is one year or less, the collateral agreement equal to the lesser estimate of alpha in the calculation of bank must set M for the exposure or of: EAD, a bank must meet the following netting set equal to 1 year except as (i) The threshold, defined as the minimum standards to the satisfaction provided in section 31(d)(7) of the exposure amount at which the of its primary Federal supervisor: proposed rule. In this case, repo-style counterparty is required to post (i) The bank’s own estimate of alpha transactions, eligible margin loans, and collateral under the collateral must capture the effects in the collateralized OTC derivative agreement, if the threshold is positive, numerator of: transactions subject to daily remargining plus an add-on that reflects the potential (A) The material sources of stochastic agreements may use the effective increase in exposure over the margin dependency of distributions of market maturity of the longest maturity period of risk. The add-on is computed values of transactions or portfolios of transaction in the netting set as M. as the expected increase in the netting transactions across counterparties; Collateral agreements under the set’s exposure beginning from current (B) Volatilities and correlations of internal models methodology. If the exposure of zero over the margin period market risk factors used in the joint bank has prior written approval from its of risk; and simulation, which must be related to the primary Federal supervisor, it may (ii) Effective EPE without a collateral credit risk factor used in the simulation capture the effect on EAD of a collateral agreement. to reflect potential increases in volatility agreement that requires receipt of The margin period of risk means, with or correlation in an economic downturn, collateral when exposure to the respect to a netting set subject to a where appropriate; and counterparty increases within its collateral agreement, the time period (C) The granularity of exposures, that internal model. In no circumstances from the most recent exchange of is, the effect of a concentration in the may the bank take into account in EAD collateral with a counterparty until the proportion of each counterparty’s collateral agreements triggered by next required exchange of collateral exposure that is driven by a particular deterioration of counterparty credit plus the period of time required to sell risk factor; quality. For this purpose, a collateral and realize the proceeds of the least (ii) The bank must assess the potential agreement means a legal contract that: liquid collateral that can be delivered model risk in its estimates of alpha; (i) Specifies the time when, and under the terms of the collateral (iii) The bank must calculate the circumstances under which, the agreement, and, where applicable, the numerator and denominator of alpha in counterparty is required to exchange period of time required to re-hedge the a consistent fashion with respect to collateral with the bank for a single resulting market risk, upon the default modeling methodology, parameter financial contract or for all financial of the counterparty. The minimum specifications, and portfolio contracts covered under a qualifying margin period of risk is 5 business days composition; and master netting agreement; and (ii) for repo-style transactions and 10 days (iv) The bank must review and adjust confers upon the bank a perfected, first for other transactions when liquid as appropriate its estimates of the priority security interest, or the legal financial collateral is posted under a numerator and denominator on at least equivalent thereof, in the collateral daily margin maintenance requirement. a quarterly basis and more frequently as posted by the counterparty under the This period should be extended to cover appropriate when the composition of agreement. This security interest must any additional time between margin the portfolio varies over time. provide the bank with a right to close calls; any potential closeout difficulties; Alternative models. The proposed out the financial positions and the any delays in selling collateral, rule allows a bank to use an alternative collateral upon an event of default of or particularly if the collateral is illiquid; model to determine EAD, provided that failure to perform by the counterparty and any impediments to prompt re- the bank can demonstrate to its primary under the collateral agreement. A hedging of any market risk. Federal supervisor that the model contract would not satisfy this Own estimate of alpha. This proposed output is more conservative than an requirement if the bank’s exercise of rule would allow a bank to estimate a alpha of 1.4 (or higher) times effective rights under the agreement may be bank-wide alpha, subject to prior EPE. This may be appropriate where a stayed or avoided under applicable law written approval from its primary new product or business line is being in the relevant jurisdictions. Federal supervisor. The internal developed, where a recent acquisition If the internal model does not capture estimate of alpha would be the ratio of has occurred, or where the bank the effects of collateral agreements, the economic capital from a full simulation believes that other more conservative following ‘‘shortcut’’ method is of counterparty credit risk exposure that methods to measure counterparty credit proposed that will provide some benefit, incorporates a joint simulation of risk for a category of transactions are in the form of a smaller EAD, for market and credit risk factors prudent. The alternative method should collateralized counterparties. Although (numerator) to economic capital based be applied to all similar transactions. this ‘‘shortcut’’ method will be on EPE (denominator). For purposes of When an alternative model is used, the

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00047 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.040 55876 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

bank should either treat the particular (i) The contract meets the derivative’s cash settlement value, transactions concerned as a separate requirements of an eligible guarantee deliverable obligation, or occurrence of netting set with the counterparty or and has been confirmed by the a credit event only if: apply the alternative model to the entire protection purchaser and the protection (i) The reference exposure ranks pari original netting set. provider; passu (that is, equal) or junior to the (ii) Any assignment of the contract hedged exposure; and 5. Guarantees and Credit Derivatives has been confirmed by all relevant (ii) The reference exposure and the That Cover Wholesale Exposures parties; hedged exposure share the same obligor The New Accord specifies that a bank (iii) If the credit derivative is a credit (that is, the same legal entity) and may adjust either the PD or the LGD of default swap or nth-to-default swap, the legally enforceable cross-default or a wholesale exposure to reflect the risk contract includes the following credit cross-acceleration clauses are in place. mitigating effects of a guarantee or events: PD substitution approach. Under the credit derivative. Under the proposed (A) Failure to pay any amount due PD substitution approach, if the rule, a bank may choose either a PD under the terms of the reference protection amount (as defined below) of substitution or an LGD adjustment exposure (with a grace period that is the eligible guarantee or eligible credit approach to recognize the risk closely in line with the grace period of derivative is greater than or equal to the mitigating effects of an eligible the reference exposure); and EAD of the hedged exposure, a bank guarantee or eligible credit derivative on (B) Bankruptcy, insolvency, or would substitute for the PD of the a wholesale exposure (or in certain inability of the obligor on the reference hedged exposure the PD associated with circumstances may choose to use a exposure to pay its debts, or its failure the rating grade of the protection double default treatment, as discussed or admission in writing of its inability provider. If the bank determines that below). In all cases a bank must use the generally to pay its debts as they full substitution leads to an same risk parameters for calculating become due, and similar events; inappropriate degree of risk mitigation, ECL for a wholesale exposure as it uses (iv) The terms and conditions the bank may substitute a higher PD for for calculating the risk-based capital dictating the manner in which the that of the protection provider. If the guarantee or credit derivative requirement for the exposure. Moreover, contract is to be settled are incorporated provides the bank with the option to in all cases, a bank’s ultimate PD and into the contract; receive immediate payout on triggering LGD for the hedged wholesale exposure (v) If the contract allows for cash the protection, then the bank would use may not be lower than the PD and LGD settlement, the contract incorporates a the lower of the LGD of the hedged floors discussed above and described in robust valuation process to estimate loss exposure (not adjusted to reflect the section 31(d) of the proposed rule. reliably and specifies a reasonable period for obtaining post-credit event guarantee or credit derivative) and the Eligible guarantees and eligible credit LGD of the guarantee or credit derivatives. To be recognized as CRM valuations of the reference exposure; (vi) If the contract requires the derivative. The bank also would use the for a wholesale exposure under the protection purchaser to transfer an ELGD associated with the required LGD. proposed rule, guarantees and credit exposure to the protection provider at If the guarantee or credit derivative does derivatives must meet specific eligibility settlement, the terms of the exposure not provide the bank with the option to requirements. The proposed rule defines provide that any required consent to receive immediate payout on triggering an eligible guarantee as a guarantee that: transfer may not be unreasonably the protection (and instead provides for (i) Is written and unconditional; withheld; the guarantor to assume the payment (ii) Covers all or a pro rata portion of (vii) If the credit derivative is a credit obligations of the obligor over the all contractual payments of the obligor default swap or nth-to-default swap, the remaining life of the hedged exposure), on the reference exposure; contract clearly identifies the parties the bank would use the LGD and ELGD (iii) Gives the beneficiary a direct responsible for determining whether a of the guarantee or credit derivative. claim against the protection provider; credit event has occurred, specifies that If the protection amount of the (iv) Is non-cancelable by the this determination is not the sole eligible guarantee or eligible credit protection provider for reasons other responsibility of the protection derivative is less than the EAD of the than the breach of the contract by the provider, and gives the protection hedged exposure, however, the bank beneficiary; purchaser the right to notify the must treat the hedged exposure as two (v) Is legally enforceable against the protection provider of the occurrence of separate exposures (protected and protection provider in a jurisdiction a credit event; and unprotected) in order to recognize the where the protection provider has (viii) If the credit derivative is a total credit risk mitigation benefit of the sufficient assets against which a return swap and the bank records net guarantee or credit derivative. The bank judgment may be attached and enforced; payments received on the swap as net must calculate its risk-based capital and income, the bank records offsetting requirement for the protected exposure (vi) Requires the protection provider deterioration in the value of the hedged under section 31 of the proposed rule to make payment to the beneficiary on exposure (either through reductions in (using a PD equal to the protection the occurrence of a default (as defined fair value or by an addition to reserves). provider’s PD, an ELGD and LGD in the guarantee) of the obligor on the Question 40: The agencies request determined as described above, and an reference exposure without first comment on the appropriateness of EAD equal to the protection amount of requiring the beneficiary to demand these criteria in determining whether the guarantee or credit derivative). If the payment from the obligor. Clearly, a the risk mitigation effects of a credit bank determines that full substitution bank could not provide an eligible derivative should be recognized for risk- leads to an inappropriate degree of risk guarantee on its own exposures. based capital purposes. mitigation, the bank may use a higher The proposed rule defines an eligible Under the proposed rule, a bank may PD than that of the protection provider. credit derivative as a credit derivative in recognize an eligible credit derivative The bank must calculate its risk-based the form of a credit default swap, nth- that hedges an exposure that is different capital requirement for the unprotected to-default swap, or total return swap from the credit derivative’s reference exposure under section 31 of the provided that: exposure used for determining the proposed rule (using a PD equal to the

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00048 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55877

obligor’s PD, an ELGD and LGD equal to of the proposed rule (using the bank’s The effective residual maturity of a the hedged exposure’s ELGD and LGD PD for the protection provider, the hedged exposure should be gauged as not adjusted to reflect the guarantee or bank’s ELGD and LGD for the guarantee the longest possible remaining time credit derivative, and an EAD equal to or credit derivative, and an EAD set before the obligor is scheduled to fulfil the EAD of the original hedged exposure equal to the protection amount of the its obligation on the exposure. When minus the protection amount of the guarantee or credit derivative). The bank determining the effective residual guarantee or credit derivative). must calculate its risk-based capital maturity of the guarantee or credit The protection amount of an eligible requirement for the unprotected derivative, embedded options that may guarantee or eligible credit derivative exposure under section 31 of the reduce the term of the credit risk would be the effective notional amount proposed rule using a PD set equal to mitigant should be taken into account so of the guarantee or credit derivative the obligor’s PD, an ELGD and LGD set that the shortest possible residual reduced by any applicable haircuts for equal to the hedged exposure’s ELGD maturity for the credit risk mitigant is maturity mismatch, lack of and LGD (not adjusted to reflect the used to determine the potential maturity restructuring, and currency mismatch guarantee or credit derivative), and an mismatch. Where a call is at the (each described below). The effective EAD set equal to the EAD of the original discretion of the protection provider, notional amount of a guarantee or credit hedged exposure minus the protection the residual maturity of the guarantee or derivative would be the lesser of the amount of the guarantee or credit credit derivative would be deemed to be contractual notional amount of the derivative. at the first call date. If the call is at the credit risk mitigant and the EAD of the The PD substitution approach allows discretion of the bank purchasing the hedged exposure, multiplied by the a bank to effectively assess risk-based protection, but the terms of the percentage coverage of the credit risk capital against a hedged exposure as if arrangement at inception of the mitigant. For example, the effective it were a direct exposure to the guarantee or credit derivative contain a notional amount of a guarantee that protection provider, and the LGD positive incentive for the bank to call covers, on a pro rata basis, 40 percent adjustment approach produces a risk- the transaction before contractual of any losses on a $100 bond would be based capital requirement for a hedged maturity, the remaining time to the first $40. exposure that is never lower than that call date would be deemed to be the LGD adjustment approach. Under the of a direct exposure to the protection residual maturity of the credit risk LGD adjustment approach, if the provider. Accordingly, these approaches mitigant. For example, where there is a protection amount of the eligible do not fully reflect the risk mitigation step-up in the cost of credit protection guarantee or eligible credit derivative is benefits certain types of guarantees and in conjunction with a call feature or greater than or equal to the EAD of the credit derivatives may provide because where the effective cost of protection hedged exposure, the bank’s risk-based increases over time even if credit quality capital requirement for the hedged the resulting risk-based capital requirement does not consider the joint remains the same or improves, the exposure would be the greater of (i) the residual maturity of the credit risk risk-based capital requirement for the probability of default of the obligor of the hedged exposure and the protection mitigant would be the remaining time to exposure as calculated under section 31 the first call. provider, sometimes referred to as the of the proposed rule (with the ELGD and Eligible guarantees and eligible credit ‘‘double default’’ benefit. The agencies LGD of the exposure adjusted to reflect derivatives with maturity mismatches the guarantee or credit derivative); or (ii) have decided, consistent with the New may only be recognized if their original the risk-based capital requirement for a Accord, to recognize double default maturities are equal to or greater than direct exposure to the protection benefits in the wholesale framework one year. As a result, a guarantee or provider as calculated under section 31 only for certain hedged exposures credit derivative would not be of the proposed rule (using the bank’s covered by certain guarantees and credit recognized for a hedged exposure with PD for the protection provider, the derivatives. A later section of the an original maturity of less than one bank’s ELGD and LGD for the guarantee preamble describes which hedged year unless the credit risk mitigant has or credit derivative, and an EAD equal exposures would be eligible for the an original maturity of equal to or to the EAD of the hedged exposure). proposed double default treatment and greater than one year or an effective If the protection amount of the describes the double default treatment residual maturity equal to or greater eligible guarantee or eligible credit that would be available to those than that of the hedged exposure. In all derivative is less than the EAD of the exposures. cases, credit risk mitigants with hedged exposure, however, the bank Maturity mismatch haircut. A bank maturity mismatches may not be must treat the hedged exposure as two that seeks to reduce the risk-based recognized when they have an effective separate exposures (protected and capital requirement on a wholesale residual maturity of three months or unprotected) in order to recognize the exposure by recognizing an eligible less. credit risk mitigation benefit of the guarantee or eligible credit derivative When a maturity mismatch exists, a guarantee or credit derivative. The would have to adjust the protection bank would apply the following bank’s risk-based capital requirement amount of the credit risk mitigant maturity mismatch adjustment to for the protected exposure would be the downward to reflect any maturity determine the protection amount of the greater of (i) the risk-based capital mismatch between the hedged exposure guarantee or credit derivative adjusted requirement for the protected exposure and the credit risk mitigant. A maturity for maturity mismatch: Pm = E × as calculated under section 31 of the mismatch occurs when the effective (t¥0.25)/(T–0.25), where: proposed rule (with the ELGD and LGD residual maturity of a credit risk (i) Pm = protection amount of the of the exposure adjusted to reflect the mitigant is less than that of the hedged guarantee or credit derivative adjusted guarantee or credit derivative and EAD exposure(s). When the hedged for maturity mismatch; set equal to the protection amount of the exposures have different residual (ii) E = effective notional amount of guarantee or credit derivative); or (ii) the maturities, the longest residual maturity the guarantee or credit derivative; risk-based capital requirement for a of any of the hedged exposures would (iii) t = lesser of T or effective residual direct exposure to the protection be used as the residual maturity of all maturity of the guarantee or credit provider as calculated under section 31 hedged exposures. derivative, expressed in years; and

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00049 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55878 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

(iv) T = lesser of 5 or effective residual scale these haircuts up using a square certain nth-to-default credit derivatives) maturity of the hedged exposure, root of time formula if the bank revalues provided by an eligible double default expressed in years. the guarantee or credit derivative less guarantor (as defined below). Moreover, Restructuring haircut. An originating frequently than once every 10 business the hedged exposure must be a bank that seeks to recognize an eligible days. wholesale exposure other than a 66 credit derivative that does not include a Example. Assume that a bank holds a five- sovereign exposure. In addition, the distressed restructuring as a credit event year $100 corporate exposure, purchases a obligor of the hedged exposure must not that triggers payment under the $100 credit derivative to mitigate its credit be an eligible double default guarantor, derivative would have to reduce the risk on the exposure, and chooses to use the an affiliate of an eligible double default recognition of the credit derivative by PD substitution approach. The unsecured guarantor, or an affiliate of the 40 percent. A distressed restructuring is ELGD and LGD of the corporate exposure are guarantor. a restructuring of the hedged exposure 20 and 30 percent, respectively; the ELGD The proposed rule defines eligible involving forgiveness or postponement and LGD of the credit derivative are 75 and double default guarantor to include a of principal, interest, or fees that results 80 percent, respectively. The credit depository institution (as defined in derivative is an eligible credit derivative, has in a charge-off, specific provision, or the bank’s exposure as its reference exposure, section 3 of the Federal Deposit other similar debit to the profit and loss has a three-year maturity, immediate cash Insurance Act (12 U.S.C. 1813)); a bank account. payout on default, no restructuring provision, holding company (as defined in section In other words, the protection amount and no currency mismatch with the bank’s 2 of the Bank Holding Company Act (12 of the credit derivative adjusted for lack hedged exposure. The effective notional U.S.C. 1841)); a savings and loan of restructuring credit event (and amount and initial protection amount of the holding company (as defined in 12 maturity mismatch, if applicable) would credit derivative would be $100. The U.S.C. 1467a) provided all or × maturity mismatch would reduce the be: Pr = Pm 0.60, where: × ¥ ¥ substantially all of the holding (i) Pr = protection amount of the protection amount to $100 (3 .25)/(5 .25) company’s activities are permissible for or $57.89. The haircut for lack of credit derivative, adjusted for lack of restructuring would reduce the protection a financial holding company under 12 restructuring credit event (and maturity amount to $57.89 × 0.6 or $34.74. So the bank U.S.C. 1843(k)); a securities broker or mismatch, if applicable); and would treat the $100 corporate exposure as dealer registered (under the Securities (ii) Pm = effective notional amount of two exposures: (i) An exposure of $34.74 Exchange Act of 1934) with the the credit derivative (adjusted for with the PD of the protection provider, an Securities and Exchange Commission maturity mismatch, if applicable). ELGD of 20 percent, an LGD of 30 percent, (SEC); an insurance company in the Currency mismatch haircut. Where and an M of 5; and (ii) an exposure of $65.26 business of providing credit protection the eligible guarantee or eligible credit with the PD of the obligor, an ELGD of 20 (such as a monoline bond insurer or re- derivative is denominated in a currency percent, an LGD of 30 percent, and an M of insurer) that is subject to supervision by 5. different from that in which any hedged a state insurance regulator; a foreign exposure is denominated, the protection Multiple credit risk mitigants. The bank (as defined in section 211.2 of the amount of the guarantee or credit New Accord provides that if multiple Federal Reserve Board’s Regulation K derivative adjusted for currency credit risk mitigants (for example, two (12 CFR 211.2)); a non-U.S. securities mismatch (and maturity mismatch and eligible guarantees) cover a single firm; or a non-U.S. based insurance lack of restructuring credit event, if exposure, a bank must disaggregate the company in the business of providing applicable) would be: Pc = Pr × exposure into portions covered by each credit protection. To be an eligible (1¥Hfx), where: credit risk mitigant (for example, the double default guarantor, the entity (i) Pc = protection amount of the portion covered by each guarantee) and must (i) have a bank-assigned PD that, guarantee or credit derivative, adjusted must calculate separately the risk-based at the time the guarantor issued the for currency mismatch (and maturity capital requirement of each portion.64 guarantee or credit derivative, was equal mismatch and lack of restructuring The New Accord also indicates that to or lower than the PD associated with credit event, if applicable); when credit risk mitigants provided by a long-term external rating of at least the (ii) Pr = effective notional amount of a single protection provider have third highest investment grade rating the guarantee or credit derivative differing maturities, they should be category; and (ii) have a current bank- (adjusted for maturity mismatch and subdivided into separate layers of assigned PD that is equal to or lower lack of restructuring credit event, if protection.65 Question 41: The agencies than the PD associated with a long-term applicable); and are interested in the views of external rating of at least investment (iii) Hfx = haircut appropriate for the commenters as to whether and how the grade. In addition, a non-U.S. based currency mismatch between the agencies should address these and other bank, securities firm, or insurance guarantee or credit derivative and the similar situations in which multiple company may qualify as an eligible hedged exposure. credit risk mitigants cover a single double default guarantor only if the firm A bank may use a standard exposure. is subject to consolidated supervision supervisory haircut of 8 percent for Hfx Double default treatment. As noted and regulation comparable to that (based on a 10-business day holding above, the proposed rule contains a imposed on U.S. depository institutions, period and daily marking-to-market and separate risk-based capital methodology securities firms, or insurance companies remargining). Alternatively, a bank may for hedged exposures eligible for double (as the case may be) or has issued and use internally estimated haircuts for Hfx default treatment. To be eligible for outstanding an unsecured long-term based on a 10-business day holding double default treatment, a hedged debt security without credit period and daily marking-to-market and exposure must be fully covered or enhancement that has a long-term remargining if the bank qualifies to use covered on a pro rata basis (that is, there applicable external rating in one of the the own-estimates haircuts in paragraph must be no tranching of credit risk) by (a)(2)(iii) of section 32, the simple VaR an uncollateralized single-reference- 66 The New Accord permits certain retail small methodology in paragraph (a)(3) of obligor credit derivative or guarantee (or business exposures to be eligible for double default section 32, or the internal models treatment. Under this proposal, however, a bank must effectively desegment a retail small business methodology in paragraph (c) of section 64 New Accord, ¶ 206. exposure (thus rendering it a wholesale exposure) 32 of the proposed rule. The bank must 65 Id. to make it eligible for double default treatment.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00050 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55879

three highest investment grade rating if it were unhedged) by an adjustment explicitly limit the extent to which a categories. factor that considers the PD of the bank may take into account the credit Effectively, the scope of an eligible protection provider (see section 34 of risk mitigation benefits of guarantees double default guarantor is limited to the proposed rule). Thus, the PDs of and credit derivatives in its estimation financial firms whose normal business both the obligor of the hedged exposure of the PD, ELGD, and LGD of retail includes the provision of credit and the protection provider are factored segments, except by the application of protection, as well as the management into the hedged exposure’s risk-based overall floors on certain PD and LGD of a diversified portfolio of credit risk. capital requirement. In addition, as assignments. This approach has the This restriction arises from the agencies’ under the PD substitution treatment in principal advantage of being relatively concern to limit double default section 33 of the proposed rule, the easy for banks to implement—the recognition to professional bank would be allowed to set LGD equal approach generally would not disrupt counterparties that have a high level of to the lower of the LGD of the unhedged the existing retail segmentation credit risk management expertise and exposure or the LGD of the guarantee or practices of banks and would not that provide sufficient market credit derivative if the guarantee or interfere with banks’ quantification of disclosure. The restriction is also credit derivative provides the bank with PD, ELGD, and LGD for retail segments. designed to limit the risk of excessive the option to receive immediate payout The agencies are concerned, however, correlation between the on the occurrence of a credit event. that because this approach would creditworthiness of the guarantor and Otherwise, the bank must set LGD equal provide banks with substantial the obligor of the hedged exposure due to the LGD of the guarantee or credit discretion to incorporate double default to their performance depending on derivative. In addition, the bank must and double recovery effects, the common economic factors beyond the set ELGD equal to the ELGD associated resulting treatment for guarantees of systematic risk factor. As a result, with the required LGD. Accordingly, in retail exposures would be inconsistent hedged exposures to potential credit order to apply the double default with the treatment for guarantees of protection providers or affiliates of treatment, the bank must estimate a PD wholesale exposures. credit protection providers would not be for the protection provider and an ELGD To address these concerns, the eligible for the double default treatment. and LGD for the guarantee or credit agencies are considering for purposes of In addition, the agencies have excluded derivative. Finally, a bank using the the final rule two principal alternative hedged exposures to sovereign entities double default treatment must make treatments for guarantees of retail from eligibility for double default applicable adjustments to the protection exposures. The first alternative would treatment because of the potential high amount of the guarantee or credit distinguish between eligible retail correlation between the derivative to reflect maturity guarantees and all other (non-eligible) creditworthiness of a sovereign and that mismatches, currency mismatches, and guarantees of retail exposures. Under of a guarantor. lack of restructuring coverage (as under this alternative, an eligible retail In addition to limiting the types of the PD substitution and LGD adjustment guarantee would be an eligible guarantees, credit derivatives, approaches in section 33 of the guarantee that applies to a single retail guarantors, and hedged exposures proposed rule). exposure and is (i) PMI issued by an eligible for double default treatment, the insurance company that (A) has issued proposed rule limits wrong-way risk 6. Guarantees and Credit Derivatives a senior unsecured long-term debt further by requiring a bank to That Cover Retail Exposures security without credit enhancement implement a process to detect excessive The proposed rule provides a that has an applicable external rating in correlation between the different treatment for guarantees and one of the two highest investment grade creditworthiness of the obligor of the credit derivatives that cover retail rating categories or (B) has a claims hedged exposure and the protection exposures. The approach set forth above payment ability that is rated in one of provider. The bank must receive prior for guarantees and credit derivatives the two highest rating categories by an written approval from its primary that cover wholesale exposures is an NRSRO; or (ii) issued by a sovereign Federal supervisor for this process in exposure-by-exposure approach entity or a political subdivision of a order to recognize double default consistent with the overall exposure-by- sovereign entity. Under this alternative, benefits for risk-based capital purposes. exposure approach the proposed rule PMI would be defined as insurance To apply double default treatment to a takes to wholesale exposures. The provided by a regulated mortgage particular hedged exposure, the bank agencies believe that a different insurance company that protects a must determine that there is not treatment for guarantees that cover retail mortgage lender in the event of the excessive correlation between the exposures is necessary and appropriate default of a mortgage borrower up to a creditworthiness of the obligor of the because of the proposed rule’s predetermined portion of the value of a hedged exposure and the protection segmentation approach to retail single one-to four-family residential provider. For example, the exposures. The approaches to retail property. creditworthiness of an obligor and a guarantees described in this section Under this alternative, a bank would protection provider would be generally apply only to guarantees of be able to recognize the credit risk excessively correlated if the obligor individual retail exposures. Guarantees mitigation benefits of eligible retail derives a high proportion of its income of multiple retail exposures (such as guarantees that cover retail exposures in or revenue from transactions with the pool private mortgage insurance (PMI)) a segment by adjusting its estimates of protection provider. If excessive are typically tranched (that is, they ELGD and LGD for the segment to reflect correlation is present, the bank may not cover less than the full amount of the recoveries from the guarantor. However, use the double default treatment for the hedged exposures) and, therefore, the bank would have to estimate the PD hedged exposure. would be securitization exposures. of a segment without reflecting the The risk-based capital requirement for The proposed rule does not specify benefit of guarantees; that is, a a hedged exposure subject to double the ways in which guarantees and credit segment’s PD would be an estimate of default treatment is calculated by derivatives may be taken into account in the stand-alone probability of default for multiplying a risk-based capital the segmentation of retail exposures. the retail exposures in the segment, requirement for the hedged exposure (as Likewise, the proposed rule does not before taking account of any guarantees.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00051 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55880 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

Accordingly, for this limited set of exposures by adjusting its estimates of The proposed rule contains separate traditional guarantees of retail ELGD and LGD for the relevant treatments for delivery-versus-payment exposures by high credit quality segments, but would subject a bank’s (DvP) and payment-versus-payment guarantors, a bank would be allowed to risk-based capital requirement for a (PvP) transactions with a normal recognize the benefit of the guarantee segment of retail exposures that are settlement period, on the one hand, and when estimating ELGD and LGD, but covered by one or more non-eligible non-DvP/non-PvP transactions with a not when estimating PD. Question 42: retail guarantees to a floor. Under this normal settlement period, on the other The agencies seek comment on this second alternative, the agencies could hand. The proposed rule provides the alternative approach’s definition of impose a floor on risk-based capital following definitions of a DvP eligible retail guarantee and treatment requirements of between 2 percent and transaction, a PvP transaction, and a for eligible retail guarantees, and on 6 percent on such a segment of retail normal settlement period. A DvP whether the agencies should provide exposures. transaction is a securities or similar treatment for any other forms of Question 44: The agencies seek commodities transaction in which the wholesale credit insurance or comment on both of these alternative buyer is obligated to make payment only guarantees on retail exposures, such as approaches to guarantees that cover if the seller has made delivery of the student loans, if the agencies adopt this retail exposures. The agencies also securities or commodities and the seller approach. invite comment on other possible is obligated to deliver the securities or This alternative approach would prudential treatments for such commodities only if the buyer has made provide a different treatment for non- guarantees. payment. A PvP transaction is a foreign eligible retail guarantees. In short, exchange transaction in which each within the retail framework, a bank D. Unsettled Securities, Foreign counterparty is obligated to make a final would not be able to recognize non- Exchange, and Commodity Transactions transfer of one or more currencies only eligible retail guarantees when Section 35 of the proposed rule sets if the other counterparty has made a estimating PD, ELGD, and LGD for any forth the risk-based capital requirements final transfer of one or more currencies. segment of retail exposures. In other for unsettled and failed securities, A transaction has a normal settlement words, a bank would be required to foreign exchange, and commodities period if the contractual settlement estimate PD, ELGD, and LGD for transactions. Certain transaction types period for the transaction is equal to or segments containing retail exposures are excluded from the scope of this less than the market standard for the with non-eligible guarantees as if the section, including: instrument underlying the transaction exposures were not guaranteed. (i) Transactions accepted by a and equal to or less than five business However, a bank would be permitted to qualifying central counterparty that are days. recognize non-eligible retail guarantees subject to daily marking-to-market and A bank must hold risk-based capital provided by a wholesale guarantor by daily receipt and payment of variation against a DvP or PvP transaction with a treating the hedged retail exposure as a margin (which do not have a risk-based normal settlement period if the bank’s direct exposure to the guarantor and capital requirement);67 counterparty has not made delivery or applying the appropriate wholesale IRB (ii) Repo-style transactions (the risk- payment within five business days after risk-based capital formula. In other based capital requirements of which are the settlement date. The bank must words, for retail exposures covered by determined under sections 31 and 32 of determine its risk-weighted asset non-eligible retail guarantees, a bank the proposed rule); amount for such a transaction by would be permitted to reflect the (iii) One-way cash payments on OTC multiplying the positive current guarantee by ‘‘desegmenting’’ the retail derivative contracts (the risk-based exposure of the transaction for the bank exposures (which effectively would capital requirements of which are by the appropriate risk weight in Table convert the retail exposures into determined under sections 31 and 32 of F. The positive current exposure of a wholesale exposures) and then applying the proposed rule); and transaction of a bank is the difference the rules set forth above for guarantees (iv) Transactions with a contractual between the transaction value at the that cover wholesale exposures. Thus, settlement period that is longer than the agreed settlement price and the current under this approach, a bank would not normal settlement period (defined market price of the transaction, if the be allowed to recognize either double below), which transactions are treated difference results in a credit exposure of default or double recovery effects for as OTC derivative contracts and the bank to the counterparty. non-eligible retail guarantees. assessed a risk-based capital The agencies understand that this requirement under sections 31 and 32 of TABLE F.—RISK WEIGHTS FOR UNSET- approach to non-eligible retail TLED DVP AND PVP TRANSACTIONS guarantees, while addressing the the proposed rule. The proposed rule prudential concerns of the agencies, is also provides that, in the case of a system-wide failure of a settlement or Risk weight to conservative and may not harmonize Number of business days be applied to with banks’ internal risk measurement clearing system, the bank’s primary after contractual settlement positive cur- and management practices in this area. Federal supervisor may waive risk- date rent exposure Question 43: The agencies seek based capital requirements for unsettled (percent) comment on the types of non-eligible and failed transactions until the situation is rectified. From 5 to 15 ...... 100 retail guarantees banks obtain and the From 16 to 30 ...... 625 extent to which banks obtain credit risk From 31 to 45 ...... 937.5 mitigation in the form of non-eligible 67 The agencies consider a qualifying central 46 or more ...... 1,250 counterparty to be the functional equivalent of an retail guarantees. exchange, and have long exempted exchange-traded A second alternative that the agencies contracts from risk-based capital requirements. A bank must hold risk-based capital are considering for purposes of the final Transactions rejected by a qualifying central against any non-DvP/non-PvP rule would permit a bank to recognize counterparty (because, for example, of a transaction with a normal settlement discrepancy in the details of the transaction such period if the bank has delivered cash, the credit risk mitigation benefits of all as in quantity, price, or in the underlying security, eligible guarantees (whether eligible between the buyer and seller) potentially give rise securities, commodities, or currencies to retail guarantees or not) that cover retail to risk exposure to either party. its counterparty but has not received its

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00052 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55881

corresponding deliverables by the end securitization exposures, which generally must apply the following of the same business day. The bank typically are tranched exposures to a hierarchy of approaches to determine must continue to hold risk-based capital pool of underlying exposures, such the risk-based capital requirement for a against the transaction until the bank assessments would require implicit or securitization exposure. has received its corresponding explicit estimates of correlations among First, a bank must deduct from tier 1 deliverables. From the business day the losses on the underlying exposures capital any after-tax gain-on-sale after the bank has made its delivery and estimates of the credit risk resulting from a securitization and must until five business days after the consequences of tranching. Such deduct from total capital any portion of counterparty delivery is due, the bank correlation and tranching effects are a CEIO that does not constitute a gain- must calculate its risk-based capital difficult to estimate and validate in an on-sale, as described in section 42(c) of requirement for the transaction by objective manner and on a going- the proposed rule. Second, a bank must treating the current market value of the forward basis. Instead, the proposed apply the RBA to a securitization deliverables owed to the bank as a securitization framework relies exposure if the exposure qualifies for wholesale exposure. principally on two sources of the RBA. As a general matter, an A bank may assign an internal obligor information, where available, to exposure qualifies for the RBA if the rating to a counterparty for which it is determine risk-based capital exposure has an external rating from an not otherwise required under the requirements: (i) An assessment of the NRSRO or has an inferred rating (that is, proposed rule to assign an obligor rating securitization exposure’s credit risk the exposure is senior to another on the basis of the applicable external made by an NRSRO; or (ii) the risk- securitization exposure in the rating of any outstanding senior based capital requirement for the transaction that has an external rating unsecured long-term debt security underlying exposures as if the from an NRSRO). For example, a bank without credit enhancement issued by exposures had not been securitized generally must use the RBA approach to the counterparty. A bank may estimate (along with certain other objective determine the risk-based capital loss severity ratings or ELGD and LGD information about the securitization requirement for an asset-backed security for the exposure, or may use a 45 exposure, such as the size and relative that has an applicable external rating of percent ELGD and LGD for the exposure seniority of the exposure). AA+ from an NRSRO and for another provided the bank uses the 45 percent A bank must use the securitization tranche of the same securitization that is ELGD and LGD for all such exposures. framework for exposures to any unrated but senior in all respects to the Alternatively, a bank may use a 100 transaction that involves the tranching asset-backed security that was rated. In percent risk weight for the exposure as of credit risk (with the exception of a this example, the senior unrated tranche long as the bank uses this risk weight for tranched guarantee that applies only to would be treated as if it were rated AA+. all such exposures. an individual retail exposure), If a securitization exposure does not If, in a non-DvP/non-PvP transaction regardless of the number of underlying qualify for the RBA but is an exposure with a normal settlement period, the exposures in the transaction.69 A single, to an ABCP program—such as a credit bank has not received its deliverables by unified approach to dealing with the enhancement or liquidity facility—the the fifth business day after counterparty tranching of credit risk is important to bank may apply the IAA (if the bank, delivery was due, the bank must deduct create a level playing field across the the exposure, and the ABCP program the current market value of the securitization, credit derivatives, and qualify for the IAA) or the SFA (if the deliverables owed to the bank 50 other financial markets. The agencies bank and the exposure qualify for the percent from tier 1 capital and 50 believe that basing the applicability of SFA) to the exposure. As a general percent from tier 2 capital. the proposed securitization framework matter, a bank would qualify for use of The total risk-weighted asset amount on the presence of some minimum the IAA if the bank establishes and for unsettled transactions equals the number of underlying exposures would maintains an internal risk rating system sum of the risk-weighted asset amount complicate the proposed rule without for exposures to ABCP programs that for each DvP and PvP transaction with any material improvement in risk has been approved by the bank’s a normal settlement period and the risk- sensitivity. The proposed securitization primary Federal supervisor. weighted asset amount for each non- framework is designed specifically to Alternatively, a bank may use the SFA DvP/non-PvP transaction with a normal deal with tranched exposures to credit if the bank is able to calculate a set of settlement period. risk, and the principal risk-based capital risk factors relating to the securitization, approaches of the proposed including the risk-based capital E. Securitization Exposures securitization framework take into requirement for the underlying This section describes the framework account the effective number of exposures as if they were held directly for calculating risk-based capital underlying exposures. by the bank. A bank that chooses to use the IAA must use the IAA for all requirements for securitization 1. Hierarchy of Approaches exposures under the proposed rule (the exposures that qualify for the IAA. securitization framework). In contrast to The proposed securitization If a securitization exposure is not a the proposed framework for wholesale framework contains three general gain-on-sale or a CEIO, does not qualify and retail exposures, the proposed approaches for determining the risk- for the RBA and is not an exposure to securitization framework does not based capital requirement for a an ABCP program, the bank may apply permit a bank to rely on its internal securitization exposure: A Ratings- the SFA to the exposure if the bank is assessments of the risk parameters of a Based Approach (RBA), an Internal able to calculate the SFA risk factors for securitization exposure.68 For Assessment Approach (IAA), and a the securitization. In many cases an Supervisory Formula Approach (SFA). originating bank would use the SFA to 68 Although the Internal Assessment Approach Under the proposed rule, banks determine its risk-based capital described below does allow a bank to use an requirements for retained securitization internal-ratings-based approach to determine its correlation of the underlying exposures in the exposures. If a securitization exposure is risk-based capital requirement for an exposure to an ABCP program. not a gain-on-sale or a CEIO and does ABCP program, banks are required to follow 69 As noted above, mortgage-backed pass-through NRSRO rating criteria and therefore are required securities guaranteed by Fannie Mae or Freddie not qualify for the RBA, the IAA, or the implicitly to use the NRSRO’s determination of the Mac are also securitization exposures. SFA, the bank must deduct the exposure

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00053 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55882 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

from total capital. Total risk-weighted capital requirement for exposure to a must determine a risk-based capital assets for securitization exposures pool of underlying exposures generally requirement for two separate would be the sum of risk-weighted would not be greater than the applicable exposures—the retained recourse assets calculated under the RBA, IAA, risk-based capital requirement if the obligation on the swapped loans and the and SFA, plus any risk-weighted asset underlying exposures were held directly percentage of the mortgage-backed amounts calculated under the early by the bank, taking into consideration security or participation certificate that amortization provisions in section 47 of the agencies’ safety and soundness is not covered by the recourse the proposed rule. concerns with respect to CEIOs. obligation. The total risk-based capital Numerous commenters criticized the This proposed maximum risk-based requirement is capped at the risk-based complexity of the ANPR’s treatment of capital requirement would be different capital requirement for the underlying approaches to securitization exposures from the general risk-based capital rules. exposures as if they were held directly and the different treatment accorded to Under the general risk-based capital on the bank’s balance sheet. originating banks versus investing rules, banks generally are required to The proposed rule also addresses the banks. As discussed elsewhere in this hold a dollar in capital for every dollar risk-based capital treatment of a section, the agencies have responded to in residual interest, regardless of the securitization of non-IRB assets. these comments by eliminating most of effective risk-based capital requirement Specifically, if a bank has a the differences in treatment for on the underlying exposures. The securitization exposure and any originating banks and investing banks agencies adopted this dollar-for-dollar underlying exposure of the and by eliminating the ‘‘Alternative capital treatment for a residual interest securitization is not a wholesale, retail, RBA’’ from the hierarchy of approaches. to recognize that in many instances the securitization or equity exposure, the As discussed in more detail below, there relative size of the residual interest bank must (i) apply the RBA if the is one difference in treatment between retained by the originating bank reveals securitization exposure qualifies for the originating and investing banks in the market information about the quality of RBA and is not gain-on-sale or a CEIO; RBA, consistent with the general risk- the underlying exposures and or (ii) otherwise, deduct the exposure based capital rules. transaction structure that may not have from total capital. Music concert and Some commenters expressed been captured under the general risk- film receivables are examples of types of dissatisfaction that the ANPR required based capital rules. Given the assets that are not wholesale, retail, banks to use the RBA to assess risk- significantly heightened risk sensitivity securitization, or equity exposures. based capital requirements against a of the IRB framework, the agencies securitization exposure with an external believe that the proposed maximum The proposed rule contains several or inferred rating. These commenters risk-based capital requirement in the additional exceptions to the general argued that banks should be allowed to proposed securitization framework is hierarchy. For example, in light of the choose between the RBA and the SFA more appropriate. substantial volatility in asset value when both approaches are available. In addition, the proposed rule would related to prepayment risk and interest The agencies have not altered the address various situations involving rate risk associated with interest-only proposed securitization framework to overlapping exposures. Consistent with mortgage-backed securities, the provide this element of choice to banks the general risk-based capital rules, if a proposed rule provides that the risk because the agencies believe it would bank has multiple securitization weight for such a security may not be likely create a means for regulatory exposures to an ABCP program that less than 100 percent. In addition, the capital arbitrage. provide duplicative coverage of the proposed rule follows the general risk- Exceptions to the general hierarchy of underlying exposures of the program based capital rules by allowing a approaches. Under the proposed (such as when a bank provides a sponsoring bank that qualifies as a securitization framework, unless one or program-wide credit enhancement and primary beneficiary and must more of the underlying exposures does multiple pool-specific liquidity facilities consolidate an ABCP program as a not meet the definition of a wholesale, to an ABCP program), the bank is not variable interest entity under GAAP to retail, securitization, or equity exposure, required to hold duplicative risk-based exclude the consolidated ABCP program the total risk-based capital requirement capital against the overlapping position. assets from risk-weighted assets. In such for all securitization exposures held by Instead, the bank would apply to the cases, the bank would hold risk-based a single bank associated with a single overlapping position the applicable risk- capital only against any securitization securitization (including any regulatory based capital treatment under the exposures of the bank to the ABCP capital requirement that relates to an securitization framework that results in program.70 Moreover, the proposed rule early amortization provision, but the highest capital requirement. If follows the general risk-based capital excluding any capital requirements that different banks have overlapping rules and a Federal statute 71 by relate to the bank’s gain-on-sale or exposures to an ABCP program, including a special set of more lenient CEIOs associated with the however, each bank must hold capital rules for the transfer of small business securitization) cannot exceed the sum of against the entire maximum amount of loans and leases with recourse by well- (i) the bank’s total risk-based capital its exposure. Although duplication of capitalized depository institutions.72 requirement for the underlying capital requirements will not occur for exposures as if the bank directly held individual banks, some systemic 70 See Financial Accounting Standards Board, the underlying exposures; and (ii) the duplication may occur where multiple Interpretation No. 46: Consolidation of Certain bank’s total ECL for the underlying banks have overlapping exposures to the Variable Interest Entities (Jan. 2003). 71 exposures. The ECL of the underlying same ABCP program. See 12 U.S.C. 1835, which places a cap on the risk-based capital requirement applicable to a well- exposures is included in this calculation The proposed rule also addresses capitalized depository institution that transfers because if the bank held the underlying overlapping exposures that arise when a small business loans with recourse. exposures on its balance sheet, the bank bank holds a securitization exposure in 72 The proposed rule does not expressly state that would have had to estimate the ECL of the form of a mortgage-backed security the agencies may permit adequately capitalized banks to use the small business recourse rule on a the exposures and hold reserves or or participation certificate that results case-by-case basis because the agencies may do this capital against the ECL. This cap from a mortgage loan swap with under the general reservation of authority contained ensures that a bank’s effective risk-based recourse. In these situations, a bank in section 1 of the rule.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00054 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55883

Servicer cash advances. A traditional balance sheet securitization exposure is fail to meet these conditions must hold securitization typically employs a the notional amount of the exposure. regulatory capital against the transferred servicing bank that—on a day-to-day For a commitment, such as a liquidity exposures as if they had not been basis—collects principal, interest, and facility extended to an ABCP program, securitized and must deduct from tier 1 other payments from the underlying the notional amount may be reduced to capital any gain-on-sale resulting from exposures of the securitization and the maximum potential amount that the the transaction. forwards such payments to the bank currently would be required to Clean-up calls. For purposes of these securitization SPE or to investors in the fund under the arrangement’s operational requirements, a clean-up securitization. Such servicing banks documentation (that is, the amount that call is a contractual provision that often provide to the securitization a could be drawn given the assets held by credit facility under which the servicing the program). For an OTC derivative permits a servicer to call securitization bank may advance cash to ensure an contract that is not a credit derivative, exposures (for example, asset-backed uninterrupted flow of payments to the notional amount is the EAD of the securities) before the stated (or investors in the securitization derivative contract (as calculated in contractual) maturity or call date. In the (including advances made to cover section 32). case of a traditional securitization, a foreclosure costs or other expenses to Implicit support. The proposed rule clean-up call is generally accomplished facilitate the timely collection of the also sets forth the regulatory capital by repurchasing the remaining underlying exposures). These servicer consequences if a bank provides support securitization exposures once the cash advance facilities are securitization to a securitization in excess of the amount of underlying exposures or exposures, and a servicing bank must bank’s predetermined contractual outstanding securitization exposures determine its risk-based capital obligation to provide credit support to has fallen below a specified level. In the requirement for the funded portion of the securitization. First, consistent with case of a synthetic securitization, the any such facility by using the proposed the general risk-based capital rules,73 a clean-up call may take the form of a securitization framework. bank that provides such implicit clause that extinguishes the credit Consistent with the general risk-based support must hold regulatory capital protection once the amount of capital rules with respect to residential against all of the underlying exposures underlying exposures has fallen below a mortgage servicer cash advances, associated with the securitization as if specified level. however, a servicing bank would not be the exposures had not been securitized, To satisfy the operational required to hold risk-based capital and must deduct from tier 1 capital any requirements for securitizations—and, against the undrawn portion of an after-tax gain-on-sale resulting from the therefore, to enable an originating bank ‘‘eligible’’ servicer cash advance facility. securitization. Second, the bank must to exclude the underlying exposures Under the proposed rule, an eligible disclose publicly (i) that it has provided from the calculation of its risk-based servicer cash advance facility is a implicit support to the securitization, capital requirements—any clean-up call servicer cash advance facility in which and (ii) the regulatory capital impact to associated with a securitization must be (i) the servicer is entitled to full the bank of providing the implicit an eligible clean-up call. An eligible reimbursement of advances (except that support. The bank’s primary Federal clean-up call is a clean-up call that: a servicer may be obligated to make supervisor also may require the bank to non-reimburseable advances if any such hold regulatory capital against all the (i) Is exercisable solely at the advance with respect to any underlying underlying exposures associated with discretion of the servicer; exposure is limited to an insignificant some or all the bank’s other (ii) Is not structured to avoid amount of the outstanding principal securitizations as if the exposures had allocating losses to securitization balance of the underlying exposure); (ii) not been securitized, and to deduct from exposures held by investors or the servicer’s right to reimbursement is tier 1 capital any after-tax gain-on-sale otherwise structured to provide credit senior in right of payment to all other resulting from such securitizations. enhancement to the securitization (for claims on the cash flows from the Operational requirements for example, to purchase non-performing underlying exposures of the traditional securitizations. In a underlying exposures); and securitization; and (iii) the servicer has traditional securitization, an originating no legal obligation to, and does not, bank typically transfers a portion of the (iii) (A) For a traditional make advances to the securitization if credit risk of exposures to third parties securitization, is only exercisable when the servicer concludes the advances are by selling them to an SPE. Banks 10 percent or less of the principal unlikely to be repaid. If these conditions engaging in a traditional securitization amount of the underlying exposures or are not satisfied, a bank that provides a may exclude the underlying exposures securitization exposures (determined as servicer cash advance facility must from the calculation of risk-weighted of the inception of the securitization) is determine its risk-based capital assets only if each of the following outstanding. requirement for the undrawn portion of conditions is met: (i) The transfer is a (B) For a synthetic securitization, is the facility in the same manner as the sale under GAAP; (ii) the originating only exercisable when 10 percent or less bank would determine its risk-based bank transfers to third parties credit risk of the principal amount of the reference capital requirement for any other associated with the underlying portfolio of underlying exposures undrawn securitization exposure. exposures; and (iii) any clean-up calls (determined as of the inception of the Amount of a securitization exposure. relating to the securitization are eligible securitization) is outstanding. For all of the securitization approaches, clean-up calls (as discussed below). Over the last several years, the the amount of an on-balance sheet Originating banks that meet these agencies have published a significant securitization exposure is the bank’s conditions must hold regulatory capital amount of supervisory guidance to carrying value, if the exposure is held- against any securitization exposures assist banks with assessing the extent to to-maturity or for trading, or the bank’s they retain in connection with the which they have transferred credit risk carrying value minus any unrealized securitization. Originating banks that gains and plus any unrealized losses on and, consequently, may recognize any reduction in required regulatory capital the exposure, if the exposure is 73 Interagency Guidance on Implicit Recourse in available for sale. The amount of an off- Asset Securitizations, May 23, 2002. as a result of a securitization or other

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00055 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55884 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

form of credit risk transfer.74 In general, banks and investing banks and on A ‘‘senior securitization exposure’’ is the agencies would expect banks to alternative mechanisms that could be a securitization exposure that has a first continue to use this guidance, most of employed to ensure the reliability of priority claim on the cash flows from which remains applicable to the external and inferred ratings of non- the underlying exposures, disregarding securitization framework. Banks are traded securitization exposures retained the claims of a service provider (such as encouraged to consult with their by originating banks. a swap counterparty or trustee, primary Federal supervisor about Under the proposed rule, a bank also custodian, or paying agent for a transactions that require additional must use the RBA for securitization securitization) to fees from the guidance. exposures with an inferred rating. securitization. A liquidity facility that Similar to the general risk-based capital supports an ABCP program is a senior 2. Ratings-Based Approach (RBA) rules, an unrated securitization securitization exposure if the liquidity Under the RBA, a bank would exposure would have an inferred rating facility provider’s right to determine the risk-weighted asset if another securitization exposure reimbursement of the drawn amounts is amount for a securitization exposure associated with the securitization senior to all claims on the cash flow that has an external rating or inferred transaction (that is, issued by the same from the underlying exposures except rating by multiplying the amount of the issuer and backed by the same claims of a service provider to fees. exposure by the appropriate risk-weight underlying exposures) has an external Question 47: The agencies seek provided in the tables in section 43 of rating and the rated securitization comment on the appropriateness of the proposed rule. An originating bank exposure (i) is subordinated in all basing the risk-based capital must use the RBA if its retained respects to the unrated securitization requirement for a securitization securitization exposure has at least two exposure; (ii) does not benefit from any exposure under the RBA on the seniority external ratings or an inferred rating credit enhancement that is not available level of the exposure. based on at least two external ratings; an to the unrated securitization exposure; Under the RBA, a bank must use investing bank must use the RBA if its and (iii) has an effective remaining Table G below when the securitization securitization exposure has one or more maturity that is equal to or longer than exposure’s external rating represents a external or inferred ratings. For the unrated securitization exposure. long-term credit rating or its inferred purposes of the proposed rule, an Under the RBA, securitization rating is based on a long-term credit originating bank means a bank that exposures with an inferred rating are rating. A bank must apply the risk meets either of the following conditions: treated the same as securitization weights in column 1 of Table G to the (i) The bank directly or indirectly exposures with an identical external securitization exposure if the effective originated or securitized the underlying rating. Question 46: The agencies seek number of underlying exposures (N) is exposures included in the comment on whether they should 6 or more and the securitization securitization; or (ii) the securitization consider other bases for inferring a exposure is a senior securitization is an ABCP program and the bank serves rating for an unrated securitization exposure. If the notional number of as a sponsor of the ABCP program. position, such as using an applicable underlying exposures of a securitization This two-rating requirement for credit rating on outstanding long-term is 25 or more or if all the underlying originating banks is the only material debt of the issuer or guarantor of the exposures are retail exposures, a bank difference between the treatment of securitization exposure. may assume that N is 6 or more (unless originating banks and investing banks Under the RBA, the risk-based capital the bank knows or has reason to know under the securitization framework. requirement per dollar of securitization that N is less than 6). If the notional Although this two-rating requirement is exposure would depend on four factors: number of underlying exposures of a not included in the New Accord, it is (i) The applicable rating of the exposure; securitization is less than 25 and one or generally consistent with the treatment (ii) whether the rating reflects a long- more of the underlying exposures is a of originating and investing banks in the term or short-term assessment of the non-retail exposure, the bank must general risk-based capital rules. The exposure’s credit risk; (iii) whether the compute N as described in the SFA agencies believe that the market exposure is a ‘‘senior’’ exposure; and section below. If N is 6 or more but the discipline evidenced by a third party (iv) a measure of the effective number securitization exposure is not a senior purchasing a securitization exposure (‘‘N’’) of underlying exposures. For a securitization exposure, the bank must obviates the need for a second rating for securitization exposure with only one apply the risk weights in column 2 of an investing bank. Question 45: The external or inferred rating, the Table G. A bank must apply the risk agencies seek comment on this applicable rating of the exposure is that weights in column 3 of Table G to the differential treatment of originating external or inferred rating. For a securitization exposure if N is less than securitization exposure with more than 6. Question 48: The agencies seek 74 See, e.g., OCC Bulletin 99–46 (Dec. 14, 1999) one external or inferred rating, the comment on how well this approach (OCC); FDIC Financial Institution Letter 109–99 (Dec. 13, 1999) (FDIC); SR Letter 99–37 (Dec. 13, applicable rating of the exposure is the captures the most important risk factors 1999) (Board); CEO Ltr. 99–119 (Dec. 14, 1999) lowest external or inferred rating for securitization exposures of varying (OTS). assigned to the exposure. degrees of seniority and granularity.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00056 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55885

TABLE G.—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 senior non-senior securitization ex- Applicable rating (illustrative rating example) securitization ex- securitization ex- posures 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

More than one category below investment grade ...... Deduction from tier 1 and tier 2 capital.

A bank must apply the risk weights in short-term credit rating or its inferred rules outlined in the previous paragraph Table H when the securitization rating is based on a short-term credit to determine which column of Table H exposure’s external rating represents a rating. A bank must apply the decision applies.

TABLE H.—SHORT-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA

Column 1 Column 2 Column 3 Risk weights for Risk weights for Risk weights for senior non-senior securitization ex- Applicable rating (illustrative rating example) securitization ex- securitization ex- posures backed posures backed posures backed by non-granular by granular pools by granular pools pools (percent) (percent) (percent)

Highest investment grade (for example, A1) ...... 7 12 20 Second highest investment grade (for example, A2) ...... 12 20 35 Third highest investment grade (for example, A3) ...... 60 75 75 All other ratings ...... Deduction from tier 1 and tier 2 capital.

Within tables G and H, risk weights measured by its expected loss rate), a rated securitization exposure with six or increase as rating grades decline. Under securitization tranche having the same more effective underlying exposures. column 2 of Table G, for example, the level of stand-alone credit risk—but The agencies have designed the risk risk weights range from 12 percent for backed by a reasonably granular and weights in this manner to discourage a exposures with the highest investment diversified pool—will tend to exhibit bank from engaging in regulatory capital grade rating to 650 percent for more systematic risk.76 This effect is arbitrage by securitizing very high- exposures rated one category below most pronounced for below-investment- quality wholesale exposures (that is, investment grade with a negative grade tranches and is the primary reason wholesale exposures with a low PD and designation. This pattern of risk weights why the RBA risk-weights increase LGD), obtaining external ratings on the is broadly consistent with analyses rapidly as ratings deteriorate over this securitization exposures issued by the employing standard credit risk models range—much more rapidly than for securitization, and retaining essentially and a range of assumptions regarding similarly rated corporate bonds. all the credit risk of the pool of correlation effects and the types of Under the RBA, a securitization underlying exposures. exposures being securitized.75 These exposure that has an investment grade Consistent with the ANPR, the analyses imply that, compared with a rating and has fewer than six effective proposed rule requires a bank to deduct corporate bond having a given level of underlying exposures generally receives from regulatory capital any stand-alone credit risk (for example, as a higher risk weight than a similarly securitization exposure with an external or inferred rating below one category 75 See Vladislav Peretyatkin and William 76 See, e.g., Michael Pykhtin and Ashish Dev, below investment grade for long-term Perraudin, ‘‘Capital for Asset-Backed Securities,’’ ‘‘Credit Risk in Asset Securitizations: An Analytical ratings or below investment grade for Bank of England, February 2003. Model,’’ Risk (May 2002) S16–S20. short-term ratings. Several commenters

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00057 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55886 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

argued that this deduction is excessive securitization exposures that have long- 3. Internal Assessment Approach (IAA) in light of the credit risk of such term external ratings in the third-highest The proposed rule permits a bank to exposures. Although this proposed investment grade rating category compute its risk-based capital capital treatment is more conservative depending on whether the rating has requirement for a securitization than suggested by credit risk modeling positive, negative, or no designation. exposure to an ABCP program (such as analyses, the agencies have decided to The agencies also have modified the a liquidity facility or credit retain the deduction approach for low- ANPR RBA to expand the set of lower enhancement) using the bank’s internal non-investment grade exposures. The risk-weights applicable to the most assessment of the credit quality of the agencies believe that there are senior tranches of reasonably granular securitization exposure. To do so, the significant modeling uncertainties for securitizations to better reflect the low bank’s internal assessment process and such low-rated securitization tranches. systematic risk of such tranches. For the ABCP program must meet certain Moreover, external ratings of these example, under the ANPR, certain qualification requirements in section 44 tranches are subject to less market of the proposed rule, and the discipline because these positions relatively senior tranches of reasonably granular securitizations with long-term securitization exposure must initially be generally are retained by the bank. internally rated at least equivalent to The proposed RBA differs in several external ratings in the two highest investment grade. A bank that elects to important respects from the RBA in the investment grade rating categories use the IAA for any securitization ANPR. First, under the ANPR, an received a lower risk-weight than more exposure to an ABCP program must use originating bank (but not an investing subordinated tranches of the same the IAA to compute risk-based capital bank) would have to deduct from securitizations. Under the proposed requirements for all securitization regulatory capital the amount of any rule, the most senior tranches of securitization exposure below the risk- reasonably granular securitizations with exposures that qualify for the IAA based capital requirement for the long-term investment grade external approach. Under the IAA, a bank would underlying exposures as if they were ratings receive a more favorable risk- map its internal credit assessment of a held directly by the bank, regardless of weight as compared to more securitization exposure to an equivalent whether the exposure would have subordinated tranches of the same external credit rating from an NRSRO. qualified for a lower risk-based capital securitizations. In addition, in response The bank would determine the risk- requirement under the RBA. The to comments, the agencies have reduced weighted asset amount for a agencies took this position in the ANPR, the granularity requirement for a senior securitization exposure by multiplying in part, to provide incentives for securitization exposure to qualify for the the amount of the exposure (using the originating banks to shed deeply lower risk weights. Under the ANPR methodology set forth above in the RBA subordinated, high risk, difficult-to- RBA, only securitization exposures to a section) by the appropriate risk weight value securitization exposures. The securitization that has an N of 100 or provided in Table G or H above. agencies also were concerned that an more could qualify for the lower risk- The agencies included the IAA for external credit rating may be less weights. Under the proposed rule, securitization exposures to ABCP reliable when the rating applies to a securitization exposures to a programs in response to comments on retained, non-traded exposure and is securitization that has an N of 6 or more the ANPR. The ANPR indicated that the sought by an originating bank primarily would qualify for the lower risk agencies expected banks to use the SFA for regulatory capital purposes. weights. or a ‘‘Look-Through Approach’’ to Numerous commenters criticized this determine risk-based capital Although the proposed rule’s RBA requirements for exposures to ABCP aspect of the ANPR as lacking risk expands the availability of the lower sensitivity and inconsistently treating programs. Under the Look-Through risk weights for senior securitization Approach, a bank would determine its originating and investing banks. After exposures in several respects, it also has further review, the agencies have risk-based capital requirement for an a more conservative but simpler eligible liquidity facility provided to an concluded that the risk sensitivity and definition of a senior securitization logic of the securitization framework ABCP program by multiplying (i) 8 exposure. The ANPR RBA imposed a percent; (ii) the maximum potential would be enhanced by permitting mathematical test for determining the originating banks and investing banks to drawdown on the facility; (iii) an relative seniority of a securitization applicable conversion factor of between use the RBA on generally equal terms. tranche. This test allowed the The agencies have revised the RBA to 50 and 100 percent; and (iv) the designation of multiple senior applicable risk weight (which would permit originating banks to use the RBA securitization tranches for a particular even if the retained securitization typically be 100 percent). Commenters securitization. By contrast, the proposed exposure is below the risk-based capital expressed concern that ABCP program RBA designates the most senior requirement for the underlying sponsors would not have sufficient data securitization tranche in a particular exposures as if they were held directly about the underlying exposures in the securitization as the only securitization by the bank. ABCP program to use the SFA and that In addition, the agencies have tranche eligible for the lower risk the Look-Through Approach produced enhanced the risk sensitivity of the RBA weights. economically unreasonable capital in the ANPR by introducing more risk- In addition, some commenters argued requirements for these historically safe weight gradations for securitization that the ANPR RBA risk weights for credit exposures. The agencies are exposures with a long-term external or highly-rated senior retail securitization proposing to replace the Look-Through inferred rating in the third-highest exposures were excessive in light of the Approach with the IAA, which is investment grade rating category. credit risk associated with such similar to an approach already available Although the ANPR RBA applied the exposures. The agencies have to qualifying banks under the general same risk weight to all securitization determined that empirical research on risk-based capital rules for credit exposures with long-term external this point (including that provided by enhancements to ABCP programs and ratings in the third-highest investment commenters) is inconclusive and does which the agencies believe would grade rating category, the proposed rule not warrant a reduction in the RBA risk provide a more risk-sensitive and provides three different risk weights to weights of these exposures. economically appropriate risk-based

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00058 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55887

capital treatment for bank exposures to frequently than annually. The bank deduct the exposure from total capital ABCP programs. must also validate its internal credit rather than risk weight the exposure. To use the IAA, a bank must receive assessment process on an ongoing basis, Deduction is consistent with the prior written approval from its primary but not less frequently than annually. treatment of other high-risk Federal supervisor. To receive such To use the IAA on a specific exposure securitization exposures, such as CEIOs. approval, the bank would have to to an ABCP program, the program must The SFA capital requirement for a demonstrate that its internal credit exhibit the following characteristics: securitization exposure depends on the assessment process satisfies all the (i) All the commercial paper issued by following seven inputs: following criteria. The bank’s internal the ABCP program must have an (i) The amount of the underlying credit assessments of securitization external rating. exposures (UE); (ii) The ABCP program must have exposures to ABCP programs must be (ii) The securitization exposure’s based on publicly available rating robust credit and investment guidelines (that is, underwriting standards). proportion of the tranche in which it criteria used by an NRSRO for resides (TP); evaluating the credit risk of the (iii) The ABCP program must perform a detailed credit analysis of the asset (iii) The sum of the risk-based capital underlying exposures. The bank’s requirement and ECL for the underlying internal credit assessments of sellers’ risk profiles. (iv) The ABCP program’s exposures as if they were held directly securitization exposures used for underwriting policy must establish on the bank’s balance sheet divided by regulatory capital purposes must be minimum asset eligibility criteria that the amount of the underlying exposures consistent with those used in the bank’s include a prohibition of the purchase of (KIRB); internal risk management process, assets that are significantly past due or (iv) The tranche’s credit enhancement capital adequacy assessment process, defaulted, as well as limitations on level (L); and management information reporting concentrations to an individual obligor systems. (v) The tranche’s thickness (T); or geographic area and the tenor of the (vi) The securitization’s effective In addition, the bank’s internal credit assets to be purchased. assessment process must have sufficient number of underlying exposures (N); (v) The aggregate estimate of loss on and granularity to identify gradations of risk. an asset pool that the ABCP program is (vii) The securitization’s exposure- Each of the bank’s internal credit considering purchasing must consider weighted average loss given default assessment categories must correspond all sources of potential risk, such as (EWALGD). to an external credit rating of an credit and dilution risk. NRSRO. The proposed rule also requires (vi) The ABCP program must A bank may only use the SFA to that the bank’s internal credit incorporate structural features into each determine its risk-based capital assessment process, particularly the purchase of assets to mitigate potential requirement for a securitization stress test factors for determining credit credit deterioration of the underlying exposure if the bank can calculate each enhancement requirements, be at least exposures. Such features may include of these seven inputs on an ongoing as conservative as the most conservative wind-down triggers specific to a pool of basis. In particular, if a bank cannot of the publicly available rating criteria underlying exposures. compute KIRB because the bank cannot of the NRSROs that have provided compute the risk-based capital external credit ratings to the commercial 4. Supervisory Formula Approach (SFA) requirement for all underlying paper issued by the ABCP program. General requirements. Under the SFA, exposures, the bank may not use the Moreover, the bank must have an a bank would determine the risk- SFA to compute its risk-based capital effective system of controls and weighted asset amount for a requirement for the securitization oversight that ensures compliance with securitization exposure by multiplying exposure. In those cases, the bank these operational requirements and the SFA risk-based capital requirement would deduct the exposure from maintains the integrity of the internal for the exposure (as determined by the regulatory capital. credit assessments. The bank must supervisory formula set forth below) by The SFA capital requirement for a review and update each internal credit 12.5. If the SFA risk weight for a securitization exposure is UE multiplied assessment whenever new material securitization exposure is 1,250 percent by TP multiplied by the greater of (i) information is available, but no less or greater, however, the bank must 0.0056 * T; or (ii) S[L+T]¥S[L], where:

 ≤  Y when Y KIRB  20 ⋅−()K Y  ⋅  IRB  ()i S[Y]= d K K  K ++−KY[] KK [ ] +IRB 1− ewhIRB  een Y > K  IRB IRB   IRB   20   

()ii K[Y] = (1−⋅ h) [(1 −ββ [Y;a,b]) ⋅ Y + [Y;a +1,b] ⋅ c]

 K N ()iii h = 1− IRB   EWALGD 

()iv a = g⋅ c

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00059 Fmt 4701 Sfmt 4725 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.041 EP25SE06.042 EP25SE06.043 EP25SE06.044 55888 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

()vc b = g⋅− (1 )

K ()vi c =IRB 1− h

()1−⋅cc ()vii g =−1 f

vK+ 2 ()1− KKv⋅− ()viii f =IRB −+c2 IRB IRB 1− h ()1−⋅h 1000

().()EWALGD−+⋅− K25 1 EWALGD ()ix v = K ⋅ IRB IRB N

−− ⋅−β ()xhKab d =11 ( )( 1 [IRB ;,])

In these expressions, b[Y; a, b] refers terms of L and T), the tranche’s capital requirement on the exposure to the cumulative beta distribution with systematic risk can be represented as could climb rapidly in the event of parameters a and b evaluated at Y. In S[L+T] ¥ S[L]. The second feature marked deterioration in the credit the case where N=1 and EWALGD=100 involves a supervisory add-on primarily quality of the underlying exposures. percent, S[Y] in formula (1) must be intended to avoid behavioral distortions Apart from the risk-weight floor and calculated with K[Y] set equal to the associated with what would otherwise other supervisory adjustments described product of KIRB and Y, and d set equal be a discontinuity in capital ¥ above, the supervisory formula attempts to 1 KIRB. The major inputs to the SFA requirements for relatively thin formula (UE, TP, K , L, T, EWALGD, to be as consistent as possible with the IRB mezzanine tranches lying just below parameters and assumptions of the IRB and N) are defined below and in section and just above the K boundary: all IRB framework that would apply to the 45 of the proposed rule. tranches at or below K would be IRB underlying exposures if held directly by The SFA formula effectively imposes deducted from capital, whereas a very a bank.77 The specification of S[Y] a 56 basis point minimum risk-based thin tranche just above K would IRB assumes that K is an accurate capital requirement (8 percent of the 7 incur a pure model-based percentage IRB measure of the total systematic credit percent risk weight) per dollar of capital requirement that could vary risk of the pool of underlying exposures securitization exposure. A number of between zero and one, depending on the commenters on the ANPR contended number of effective underlying and that a securitization merely that this floor capital requirement in the exposures (N). The supervisory add-on redistributes this systematic risk among SFA would be excessive for many senior applies primarily to positions just above its various tranches. In this way, S[Y] securitization exposures. Although such K , and its quantitative effect embodies precisely the same asset a floor may impose a capital IRB diminishes rapidly as the distance from correlations as are assumed elsewhere requirement that is too high for some within the IRB framework. In addition, KIRB widens. securitization exposures, the agencies this specification embodies the result continue to believe that some minimum Under the SFA, a bank must deduct that a pool’s systematic risk (that is, from regulatory capital any prudential capital requirement is KIRB) tends to be redistributed toward appropriate in the securitization securitization exposures (or parts more senior tranches as the effective context. This 7 percent risk-weight floor thereof) that absorb losses at or below number of underlying exposures in the is also consistent with the lowest capital the level of KIRB. However, the specific pool (N) declines.78 The importance of securitization exposures that are subject requirement available under the RBA pool granularity depends on the pool’s to this deduction treatment under the and, thus, should reduce incentives for average loss severity rate, EWALGD. For SFA may change over time in response regulatory capital arbitrage. small values of N, the framework The SFA formula is a blend of credit to variation in the credit quality of the implies that, as EWALGD increases, risk modeling results and supervisory pool of underlying exposures. For systematic risk is shifted toward senior judgment. The function S[Y] example, if the pool’s IRB capital tranches. For highly granular pools, incorporates two distinct features. First, requirement were to increase after the a pure model-based estimate of the inception of a securitization, additional such as securitizations of retail pool’s aggregate systematic or non- portions of unrated securitization exposures, EWALGD would have no diversifiable credit risk that is exposures may fall below KIRB and thus attributable to a first loss position become subject to deduction under the 77 The conceptual basis for specification of K[x] is developed in Michael B. Gordy and David Jones, covering losses up to and including Y. SFA. Therefore, if a bank owns an ‘‘Random Tranches,’’ Risk. (Mar. 2003) 78–83. Because the tranche of interest covers unrated first-loss securitization 78 See Michael Pykhtin and Ashish Dev, ‘‘Coarse- losses over a specified range (defined in exposure well in excess of KIRB, the grained CDOs,’’ Risk (Jan. 2003) 113–116.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00060 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.045 EP25SE06.046 EP25SE06.047 EP25SE06.048 EP25SE06.049 EP25SE06.050 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55889

influence on the SFA capital underlying exposures that is have individual underlying exposures of requirement. subordinated to the tranche that different sizes. An approach that simply Inputs to the SFA formula. The contains the bank’s securitization counts the gross number of underlying proposed rule provides the following exposure may be included in the exposures in a pool treats all exposures definitions of the seven inputs into the numerator and denominator of L to the in the pool equally. This simplifying SFA formula. extent cash has accumulated in the assumption could radically overestimate (i) Amount of the underlying account. Unfunded reserve accounts the granularity of a pool with numerous exposures (UE). This input (measured in (that is, reserve accounts that are to be small exposures and one very large dollars) is the EAD of any underlying funded from future cash flows from the exposure. The effective exposure wholesale and retail exposures plus the underlying exposures) may not be approach captures the notion that the amount of any underlying exposures included in the calculation of L. risk profile of such an unbalanced pool that are securitization exposures (as In some cases, the purchase price of is more like a pool of several medium- defined in section 42(e) of the proposed receivables will reflect a discount that sized exposures than like a pool of a rule) plus the adjusted carrying value of provides credit enhancement (for large number of equally sized small any underlying equity exposures (as example, first loss protection) for all or exposures. defined in section 51(b) of the proposed certain tranches. When this arises, L rule). UE also would include any should be calculated inclusive of this For example, suppose Pool A contains funded spread accounts, cash collateral discount if the discount provides credit four loans with EADs of $100 each. accounts, and other similar funded enhancement for the securitization Under the formula set forth above, N for credit enhancements. exposure. Pool A would be four, precisely equal to (ii) Tranche percentage (TP). TP is the (v) Thickness of tranche (T). T is the the actual number of exposures. ratio of (i) the amount of the bank’s ratio of (i) the size of the tranche that Suppose Pool B also contains four loans: securitization exposure to (ii) the contains the bank’s securitization One loan with an EAD of $100 and three amount of the securitization tranche exposure to (ii) UE. loans with an EAD of $1. Although both that contains the bank’s securitization (vi) Effective number of exposures (N). pools contain four loans, Pool B is much exposure. As a general matter, the effective less diverse and granular than Pool A (iii) KIRB. KIRB is the ratio of (i) the number of exposures would be because Pool B is dominated by the risk-based capital requirement for the calculated as follows: presence of a single $100 loan. underlying exposures plus the ECL of Intuitively, therefore, N for Pool B the underlying exposures (all as  2 should be closer to one than to four. determined as if the underlying Under the formula in the rule, N for  ∑ EADi  exposures were directly held by the   Pool B is calculated as follows: N = i bank) to (ii) UE. The definition of KIRB ∑ EAD2 includes the ECL of the underlying i +++ 2 i (),100 1 1 1 10 609 exposures in the numerator because if N = ==106. 2222+++ the bank held the underlying exposures where EADi represents the EAD 100 1 1 1 10, 003 th on its balance sheet, the bank also associated with the i instrument in the (vii) Exposure-weighted average loss would hold reserves against the pool of underlying exposures. For given default (EWALGD). The EWALGD exposures. purposes of computing N, multiple is calculated as: The calculation of KIRB must reflect exposures to one obligor must be treated as a single underlying exposure. In the the effects of any credit risk mitigant ⋅ applied to the underlying exposures case of a re-securitization (that is, a ∑ LGDii EAD (either to an individual underlying securitization in which some or all of EWALGD = i exposure, a group of underlying the underlying exposures are ∑ EADi exposures, or to the entire pool of themselves securitization exposures), a i underlying exposures). In addition, all bank must treat each underlying securitization exposure as a single where LGDi represents the average LGD assets related to the securitization are to associated with all exposures to the ith be treated as underlying exposures for exposure and must not look through to obligor. In the case of a re-securitization, purposes of the SFA, including assets in the exposures that secure the underlying an LGD of 100 percent must be assumed a reserve account (such as a cash securitization exposures. The agencies for any underlying exposure that is itself collateral account). recognize that this simple and (iv) Credit enhancement level (L). L is conservative approach to re- a securitization exposure. the ratio of (i) the amount of all securitizations may result in the Under certain conditions, a bank may securitization exposures subordinated to differential treatment of economically employ the following simplifications to the securitization tranche that contains similar securitization exposures. the SFA. First, for securitizations all of the bank’s securitization exposure to (ii) Question 49: The agencies seek whose underlying exposures are retail UE. Banks must determine L before comment on suggested alternative exposures, a bank may set h = 0 and v considering the effects of any tranche- approaches for determining the N of a = 0. In addition, if the share of a specific credit enhancements (such as re-securitization. securitization corresponding to the third-party guarantees that benefit only N represents the granularity of a pool largest underlying exposure (C1) is no a single tranche). Any after-tax gain-on- of underlying exposures using an more than 0.03 (or 3 percent of the sale or CEIOs associated with the ‘‘effective’’ number of exposures underlying exposures), then for securitization may not be included in L. concept rather than a ‘‘gross’’ number of purposes of the SFA the bank may set Any reserve account funded by exposures concept to appropriately EWALGD=0.50 and N equal to the accumulated cash flows from the assess the diversification of pools that following amount:

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00061 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.051 EP25SE06.052 EP25SE06.053 55890 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

1 N =  CC−  CC +  m 1  max (1− mC ,)0 1 m  m −1  1

where Cm is the ratio of (i) the sum of a securitization exposure also may exposure using a collateral haircut the amounts of the largest ‘m’ recognize the credit risk mitigant, but approach. The bank’s risk-based capital underlying exposures of the only as provided in section 46. A bank requirement for a collateralized securitization; to (ii) UE. A bank may that has used the RBA or IAA to securitization exposure is equal to the select the level of ‘m’ in its discretion. calculate its risk-based capital risk-based capital requirement for the For example, if the three largest requirement for a securitization securitization exposure as calculated underlying exposures of a securitization exposure whose external or inferred under the RBA or the SFA multiplied by represent 15 percent of the pool of rating (or equivalent internal rating the ratio of adjusted exposure amount underlying exposures, C3 for the under the IAA) reflects the benefits of a (E*) to original exposure amount (E), securitization is 0.15. As an alternative particular credit risk mitigant provided where: simplification option, if only C1 is to the associated securitization or that (i) E* = max {0, [E ¥ C × (1 ¥ Hs available, and C1 is no more than 0.03, supports some or all of the underlying ¥ Hfx)]}; then the bank may set EWALGD=0.50 exposures, however, may not use the (ii) E = the amount of the and N=1/C1. securitization credit risk mitigation securitization exposure (as calculated rules to further reduce its risk-based under section 42(e) of the proposed 5. Eligible Disruption Liquidity capital requirement for the exposure rule); Facilities based on that credit risk mitigant. For (iii) C = the current market value of The version of the SFA contained in example, a bank that owns a AAA-rated the collateral; the New Accord provides a more asset-backed security that benefits, (iv) Hs = the haircut appropriate to favorable capital treatment for eligible along with all the other securities issued the collateral type; and disruption liquidity facilities than for by the securitization SPE, from an (v) Hfx = the haircut appropriate for other securitization exposures. Under insurance wrap that is part of the any currency mismatch between the the New Accord, an eligible disruption securitization transaction would collateral and the exposure. liquidity facility is a liquidity facility calculate its risk-based capital Where the collateral is a basket of that supports an ABCP program and that requirement for the security strictly different asset types or a basket of assets (i) is subject to an asset quality test that under the RBA; no additional credit denominated in different currencies, the precludes funding of underlying would be given for the presence of the haircut on the basket will be exposures that are in default; (ii) can be insurance wrap. On the other hand, if a = used to fund only those exposures that bank owns a BBB-rated asset-backed HaH∑ ii, have an investment grade external rating security and obtains a credit default i at the time of funding, if the underlying swap from a AAA-rated counterparty to where ai is the current market value of exposures that the facility must fund protect the bank from losses on the the asset in the basket divided by the against are externally rated exposures at security, the bank would be able to current market value of all assets in the the time that the exposures are sold to apply the securitization CRM rules to basket and Hi is the haircut applicable the program; and (iii) may only be recognize the risk mitigating effects of to that asset. drawn in the event of a general market the credit default swap and determine With the prior written approval of its disruption. Under the New Accord, a the risk-based capital requirement for primary Federal supervisor, a bank may bank that uses the SFA to compute its the position. calculate haircuts using its own internal risk-based capital requirement for an The proposed rule contains a separate estimates of market price volatility and eligible disruption liquidity facility may treatment of CRM for securitization foreign exchange volatility, subject to multiply the facility’s SFA-determined exposures (versus wholesale and retail the requirements for use of own- risk weight by 20 percent. Question 50: exposures) because the wholesale and estimates haircuts contained in section The agencies have not included this retail exposure CRM approaches rely on 32 of the proposed rule. Banks that use concept in the proposed rule but seek substitutions of, or adjustments to, the own-estimates haircuts for collateralized comment on the prevalence of eligible risk parameters of the hedged exposure. securitization exposures must assume a disruption liquidity facilities and a Because the securitization framework minimum holding period (TM) for bank’s expected use of the SFA to does not rely on risk parameters to securitization exposures of 65 business calculate risk-based capital determine risk-based capital days. requirements for such facilities. requirements for securitization A bank that does not qualify for and exposures, a different treatment of CRM use own-estimates haircuts must use the 6. Credit Risk Mitigation for for securitization exposures is collateral type haircuts (Hs) in Table 3 Securitization Exposures necessary. of this preamble and must use a An originating bank that has obtained The securitization CRM rules, like the currency mismatch haircut (Hfx) of 8 a credit risk mitigant to hedge its wholesale and retail CRM rules, address percent if the exposure and the securitization exposure to a synthetic or collateral separately from guarantees collateral are denominated in different traditional securitization that satisfies and credit derivatives. A bank is not currencies. To reflect the longer-term the operational criteria in section 41 of permitted to recognize collateral other nature of securitization exposures as the proposed rule may recognize the than financial collateral as a credit risk compared to eligible margin loans and credit risk mitigant, but only as mitigant for securitization exposures. A OTC derivative contracts, however, provided in section 46 of the proposed bank may recognize financial collateral these standard supervisory haircuts rule. An investing bank that has in determining the bank’s risk-based (which are based on a 10-business-day obtained a credit risk mitigant to hedge capital requirement for a securitization holding period and daily marking-to-

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00062 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.054 EP25SE06.055 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55891

market and remargining) must be securitization guarantor (as determined the PD associated with the guarantor’s adjusted to a 65-business-day holding in the wholesale risk weight function rating grade, the ELGD and LGD of the period (the approximate number of described in section 31 of the proposed guarantee, and an EAD equal to the business days in a calendar quarter) by rule), using the bank’s PD for the protection amount of the credit risk multiplying them by the square root of guarantor, the bank’s ELGD and LGD for mitigant); and (ii) add this ECL to the 6.5 (2.549510). A bank also must adjust the guarantee or credit derivative, and bank’s total ECL. the standard supervisory haircuts an EAD equal to the amount of the 7. Synthetic Securitizations upward on the basis of a holding period securitization exposure (as determined longer than 65 business days where and in section 42(e) of the proposed rule). Background. In a synthetic as appropriate to take into account the If, on the other hand, the protection securitization, an originating bank uses illiquidity of an instrument. amount of the eligible guarantee or credit derivatives or guarantees to A bank may only recognize an eligible eligible credit derivative is less than the transfer the credit risk, in whole or in guarantee or eligible credit derivative amount of the securitization exposure, part, of one or more underlying provided by an eligible securitization then the bank must divide the exposures to third-party protection guarantor in determining the bank’s securitization exposure into two providers. The credit derivative or risk-based capital requirement for a exposures in order to recognize the guarantee may be either collateralized or securitization exposure. Eligible guarantee or credit derivative. The risk- uncollateralized. In the typical synthetic guarantee and eligible credit derivative weighted asset amount for the securitization, the underlying exposures are defined the same way as in the CRM securitization exposure is equal to the remain on the balance sheet of the rules for wholesale and retail exposures. sum of the risk-weighted asset amount originating bank, but a portion of the An eligible securitization guarantor is for the covered portion and the risk- originating bank’s credit exposure is defined to mean (i) a sovereign entity, weighted asset amount for the transferred to the protection provider or the Bank for International Settlements, uncovered portion. The risk-weighted covered by collateral pledged by the the International Monetary Fund, the asset amount for the covered portion is protection provider. European Central Bank, the European equal to the risk-weighted asset amount In general, the proposed rule’s Commission, a Federal Home Loan for a direct exposure to the eligible treatment of synthetic securitizations is Bank, the Federal Agricultural Mortgage securitization guarantor (as determined identical to that of traditional Corporation (Farmer Mac), a multi- in the wholesale risk weight function securitizations. The operational lateral development bank, a depository described in section 31 of the proposed requirements for synthetic institution (as defined in section 3 of the rule), using the bank’s PD for the securitizations are more detailed than Federal Deposit Insurance Act (12 guarantor, the bank’s ELGD and LGD for those for traditional securitizations and U.S.C. 1813)), a bank holding company the guarantee or credit derivative, and are intended to ensure that the (as defined in section 2 of the Bank an EAD equal to the protection amount originating bank has truly transferred Holding Company Act (12 U.S.C. 1841)), of the credit risk mitigant. The risk- credit risk of the underlying exposures a savings and loan holding company (as weighted asset amount for the to one or more third-party protection defined in 12 U.S.C. 1467a) provided all uncovered portion is equal to the providers. or substantially all of the holding product of (i) 1.0 minus (the protection Although synthetic securitizations company’s activities are permissible for amount of the eligible guarantee or typically employ credit derivatives, a financial holding company under 12 eligible credit derivative divided by the which might suggest that such U.S.C. 1843(k)), a foreign bank (as amount of the securitization exposure); transactions would be subject to the defined in section 211.2 of the Federal and (ii) the risk-weighted asset amount CRM rules in section 33 of the proposed Reserve Board’s Regulation K (12 CFR for the securitization exposure without rule, banks must first apply the 211.2)), or a securities firm; (ii) any the credit risk mitigant (as determined securitization framework when other entity (other than an SPE) that has in sections 42–45 of the proposed rule). calculating risk-based capital issued and outstanding an unsecured For any hedged securitization requirements for a synthetic long-term debt security without credit exposure, the bank must make securitization exposure. Banks may enhancement that has a long-term applicable adjustments to the protection ultimately be redirected to the applicable external rating in one of the amount as required by the maturity securitization CRM rules to adjust the three highest investment grade rating mismatch, currency mismatch, and lack securitization framework capital categories; or (iii) any other entity (other of restructuring provisions in requirement for an exposure to reflect than an SPE) that has a PD assigned by paragraphs (d), (e), and (f) of section 33 the CRM technique used in the the bank that is lower than or equivalent of the proposed rule. If the risk- transaction. to the PD associated with a long-term weighted asset amount for a guaranteed Operational requirements for external rating in the third-highest securitization exposure is greater than synthetic securitizations. For synthetic investment grade rating category. the risk-weighted asset amount for the securitizations, an originating bank may A bank may recognize an eligible securitization exposure without the recognize for risk-based capital guarantee or eligible credit derivative guarantee or credit derivative, a bank purposes the use of CRM to hedge, or provided by an eligible securitization may always elect not to recognize the transfer credit risk associated with, guarantor in determining the bank’s guarantee or credit derivative. underlying exposures only if each of the risk-based capital requirement for the When a bank recognizes an eligible following conditions is satisfied: securitization exposure as follows. If the guarantee or eligible credit derivative (i) The credit risk mitigant is financial protection amount of the eligible provided by an eligible securitization collateral, an eligible credit derivative guarantee or eligible credit derivative guarantor in determining the bank’s from an eligible securitization guarantor equals or exceeds the amount of the risk-based capital requirement for a (defined above), or an eligible guarantee securitization exposure, then the bank securitization exposure, the bank also from an eligible securitization may set the risk-weighted asset amount must (i) calculate ECL for the exposure guarantor. for the securitization exposure equal to using the same risk parameters that it (ii) The bank transfers credit risk the risk-weighted asset amount for a uses for calculating the risk-weighted associated with the underlying direct exposure to the eligible asset amount of the exposure (that is, exposures to third-party investors, and

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00063 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55892 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

the terms and conditions in the credit securitization, the bank would apply the from which it obtains the guarantee or risk mitigants employed do not include securitization CRM rules to reduce its credit derivative when determining its provisions that: risk-based capital requirement for the risk-based capital requirement for the (A) Allow for the termination of the exposure. For example, if the credit risk exposure (that is, if the protection credit protection due to deterioration in mitigant is financial collateral, the bank provider hedges the guarantee or credit the credit quality of the underlying must use the standard supervisory or derivative with a guarantee or credit exposures; own-estimates haircuts to reduce its derivative from a third party, the bank (B) Require the bank to alter or risk-based capital requirement. If the may not look through the protection replace the underlying exposures to bank is a protection provider to a provider to that third party when improve the credit quality of the synthetic securitization and has calculating its risk-based capital underlying exposures; obtained a credit risk mitigant on its requirement for the exposure). (C) Increase the bank’s cost of credit exposure, the bank would also apply the For a bank providing credit protection protection in response to deterioration securitization CRM rules in section 46 on a mezzanine tranche of a synthetic in the credit quality of the underlying of the proposed rule to reduce its risk- securitization, the bank would use the exposures; based capital requirement on the RBA to determine the risk-based capital (D) Increase the yield payable to exposure. If neither the RBA nor the requirement for the exposure if the parties other than the bank in response SFA is available, a bank would deduct exposure has an external or inferred to a deterioration in the credit quality of the exposure from regulatory capital. rating. If the exposure does not have an the underlying exposures; or First-loss tranches. If a bank has a external or inferred rating and the (E) Provide for increases in a retained first-loss position in a pool of exposure qualifies for use of the SFA, first loss position or credit enhancement underlying exposures in connection the bank would use the SFA to calculate provided by the bank after the inception with a synthetic securitization, the bank the risk-based capital requirement for of the securitization. must deduct the position from the exposure. If neither the RBA nor the (iii) The bank obtains a well-reasoned regulatory capital unless (i) the position SFA are available, the bank would opinion from legal counsel that qualified for use of the RBA or (ii) the deduct the exposure from regulatory confirms the enforceability of the credit bank and the position qualified for use capital. If a bank providing credit risk mitigant in all relevant of the SFA and a portion of the position protection on the mezzanine tranche of jurisdictions. was above KIRB. a synthetic securitization obtains a (iv) Any clean-up calls relating to the Mezzanine tranches. In a typical credit risk mitigant to hedge its securitization are eligible clean-up calls synthetic securitization, an originating exposure, the bank could apply the (as discussed above). bank obtains credit protection on a securitization CRM rules to reflect the Failure to meet the above operational mezzanine, or second-loss, tranche of a risk reduction achieved by the credit requirements for a synthetic synthetic securitization by either (i) risk mitigant. securitization would prevent the obtaining a credit default swap or Super-senior tranches. A bank that originating bank from using the financial guarantee from a third-party has the most senior position in a pool securitization framework and would financial institution; or (ii) obtaining a of underlying exposures in connection require the originating bank to hold risk- credit default swap or financial with a synthetic securitization would based capital against the underlying guarantee from an SPE whose use the RBA to calculate its risk-based exposures as if they had not been obligations are secured by financial capital requirement for the exposure if synthetically securitized. A bank that collateral. the exposure has at least one external or provides credit protection to a synthetic For a bank that creates a synthetic inferred rating (in the case of an securitization must use the mezzanine tranche by obtaining an investing bank) or at least two external securitization framework to compute eligible credit derivative or guarantee or inferred ratings (in the case of an risk-based capital requirements for its from an eligible securitization originating bank). If the super-senior exposures to the synthetic securitization guarantor, the bank generally would tranche does not have an external or even if the originating bank failed to treat the notional amount of the credit inferred rating and the bank and the meet one or more of the operational derivative or guarantee (as adjusted to exposure qualify for use of the SFA, the requirements for a synthetic reflect any maturity mismatch, lack of bank would use the SFA to calculate the securitization. restructuring coverage, or currency risk-based capital requirement for the Consistent with the treatment of mismatch) as a wholesale exposure to exposure. If neither the RBA nor the traditional securitization exposures, the protection provider and use the IRB SFA are available, the bank would banks would be required to use the RBA framework for wholesale exposures to deduct the exposure from regulatory for synthetic securitization exposures determine the bank’s risk-based capital capital. If an investing bank in the that have an appropriate number of requirement for the exposure. A bank super-senior tranche of a synthetic external or inferred ratings. For an that creates the synthetic mezzanine securitization obtains a credit risk originating bank, the RBA would tranche by obtaining a guarantee or mitigant to hedge its exposure, however, typically be used only for the most credit derivative that is collateralized by the investing bank may apply the senior tranche of the securitization, financial collateral but provided by a securitization CRM rules to reflect the which often would have an inferred non-eligible securitization guarantor risk reduction achieved by the credit rating. If a bank has a synthetic generally would (i) first use the SFA to risk mitigant. securitization exposure that does not calculate the risk-based capital have an external or inferred rating, the requirement on the exposure (ignoring 8. Nth To Default Credit Derivatives bank would apply the SFA to the the guarantee or credit derivative and Credit derivatives that provide credit exposure (if the bank and the exposure the associated collateral); and (ii) then protection only for the nth defaulting qualify for use of the SFA) without use the securitization CRM rules to reference exposure in a group of considering any CRM obtained as part of calculate any reductions to the risk- reference exposures (nth to default the synthetic securitization. Then, if the based capital requirement resulting from credit derivatives) are similar to bank has obtained a credit risk mitigant the associated collateral. The bank may synthetic securitizations that provide on the exposure as part of the synthetic look only to the protection provider credit protection only after the first-loss

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00064 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55893

tranche has defaulted or become a loss. underlying exposures (as calculated not related to the performance of the A simplified treatment is available to under Table 2 of the proposed rule and underlying exposures or the originating banks that purchase and provide such excluding the n-1 underlying exposures bank (such as material changes in tax credit protection. A bank that obtains with the lowest risk-based capital laws or regulations). Under the credit protection on a group of requirements), up to a maximum of 100 proposed rule, an originating bank must underlying exposures through a first-to- percent. generally hold regulatory capital against default credit derivative must determine For example, a bank provides credit the sum of the originating bank’s its risk-based capital requirement for the protection in the form of a second-to- interest and the investors’ interest underlying exposures as if the bank had default credit derivative on a basket of arising from a revolving securitization synthetically securitized only the five reference exposures. The derivative that contains an early amortization underlying exposure with the lowest is unrated and the protection amount of provision. An originating bank must capital requirement (K) (as calculated the derivative is $100. The risk-based compute its capital requirement for its under Table 2 of the proposed rule) and capital requirements of the underlying interest using the hierarchy of had obtained no credit risk mitigant on exposures are 2.5 percent, 5.0 percent, approaches for securitization exposures the other (higher capital requirement) 10.0 percent, 15.0 percent, and 20 as described above. The originating underlying exposures. If the bank percent. The risk-weighted asset amount bank’s risk-weighted asset amount with purchases credit protection on a group of the derivative would be $100 × 12.5 respect to the investors’ interest in the of underlying exposures through an nth- × (.05 + .10 + .15 + .20) or $625. If the securitization is equal to the product of to-default credit derivative (other than a derivative were externally rated in the the following four quantities: (i) The first-to-default credit derivative), it may lowest investment grade rating category EAD associated with the investors’ only recognize the credit protection for with a positive designation, the risk- interest; (ii) the appropriate conversion risk-based capital purposes either if it weighted asset amount would be $100 × factor (CF) as determined below; (iii) has obtained credit protection on the 0.50 or $50. KIRB; and (iv) 12.5. same underlying exposures in the form 9. Early Amortization Provisions Under the proposed rule, as noted of first-through-(n-1)-to-default credit above, a bank is not required to hold derivatives, or if n-1 of the underlying Background. Many securitizations of regulatory capital against the investors’ exposures have already defaulted. In revolving credit facilities (for example, interest if early amortization is solely such a case, the bank would again credit card receivables) contain triggered by events not related to the determine its risk-based capital provisions that require the performance of the underlying requirement for the underlying securitization to be wound down and exposures or the originating bank, such exposures as if the bank had only investors to be repaid if the excess as material changes in tax laws or synthetically securitized the n-1 spread falls below a certain threshold.79 regulation. Under the New Accord, a underlying exposures with the lowest This decrease in excess spread may, in bank is also not required to hold capital requirement (K) (as calculated some cases, be caused by deterioration regulatory capital against the investors’ under Table 2 of the proposed rule) and in the credit quality of the underlying interest if (i) the securitization has a had obtained no credit risk mitigant on exposures. An early amortization event replenishment structure in which the the other underlying exposures. can increase a bank’s capital needs if individual underlying exposures do not A bank that provides credit protection new draws on the revolving credit revolve and the early amortization ends on a group of underlying exposures facilities would need to be financed by the ability of the originating bank to add through a first-to-default credit the bank using on-balance sheet sources new underlying exposures to the derivative must determine its risk- of funding. The payment allocations securitization; (ii) the securitization weighted asset amount for the derivative used to distribute principal and finance involves revolving assets and contains by applying the RBA (if the derivative charge collections during the early amortization features that mimic qualifies for the RBA) or, if the amortization phase of these transactions term structures (that is, where the risk derivative does not qualify for the RBA, also can expose a bank to greater risk of of the underlying exposures does not by setting its risk-weighted asset amount loss than in other securitization return to the originating bank); or (iii) for the derivative equal to the product transactions. To address the risks that investors in the securitization remain of (i) the protection amount of the early amortization of a securitization fully exposed to future draws by derivative; (ii) 12.5; and (iii) the sum of poses to originating banks, the agencies borrowers on the underlying exposures the risk-based capital requirements (K) propose the capital treatment described even after the occurrence of early of the individual underlying exposures below. amortization. Question 51: The agencies (as calculated under Table 2 of the The proposed rule would define an seek comment on the appropriateness of proposed rule), up to a maximum of 100 early amortization provision as a these additional exemptions in the U.S. percent. If a bank provides credit provision in a securitization’s governing markets for revolving securitizations. protection on a group of underlying documentation that, when triggered, Under the proposed rule, the exposures through an nth-to-default causes investors in the securitization investors’ interest with respect to a credit derivative (other than a first-to- exposures to be repaid before the revolving securitization captures both default credit derivative), the bank must original stated maturity of the the drawn balances and undrawn lines determine its risk-weighted asset securitization exposure, unless the of the underlying exposures that are amount for the derivative by applying provision is solely triggered by events allocated to the investors in the the RBA (if the derivative qualifies for securitization. The EAD associated with 79 The proposed rule defines excess spread for a the RBA) or, if the derivative does not period as gross finance charge collections the investors’ interest is equal to the qualify for the RBA, by setting the risk- (including market interchange fees) and other EAD of the underlying exposures weighted asset amount for the derivative income received by the SPE over the period minus multiplied by the ratio of the total equal to the product of (i) the protection interest paid to holders of securitization exposures, amount of securitization exposures servicing fees, charge-offs, and other senior trust amount of the derivative; (ii) 12.5; and similar expenses of the SPE over the period, all issued by the SPE to investors; divided (iii) the sum of the risk-based capital divided by the principal balance of the underlying by the outstanding principal amount of requirements (K) of the individual exposures at the end of the period. underlying exposures.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00065 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55894 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

In general, the applicable CF would bank’s and the investors’ relative shares Controlled early amortization. To depend on whether the early of the underlying exposures outstanding calculate the appropriate CF for a amortization provision repays investors measured on a consistent monthly basis; securitization of uncommitted revolving through a ‘‘controlled’’ or ‘‘non- (iii) The amortization period is retail exposures that contains a controlled’’ mechanism and whether the sufficient for at least 90 percent of the controlled early amortization provision, underlying exposures are revolving total underlying exposures outstanding a bank must compare the three-month retail credit facilities that are at the beginning of the early average excess spread for the uncommitted—that is, unconditionally amortization period to have been repaid securitization to the point at which the cancelable by the bank to the fullest or recognized as in default; and bank is required to trap excess spread extent of Federal law (for example, under the securitization transaction. In credit card receivables)—or are other (iv) The schedule for repayment of securitizations that do not require revolving credit facilities (for example, investor principal is not more rapid excess spread to be trapped, or that revolving corporate credit facilities). than would be allowed by straight-line specify a trapping point based primarily Under the proposed rule, a ‘‘controlled’’ amortization over an 18-month period. on performance measures other than the early amortization provision meets each An early amortization provision that three-month average excess spread, the of the following conditions: does not meet any of the above criteria excess spread trapping point is 4.5 (i) The originating bank has is a ‘‘non-controlled’’ early amortization percent. The bank must divide the appropriate policies and procedures to provision. Question 52: The agencies three-month average excess spread level ensure that it has sufficient capital and solicit comment on the distinction by the excess spread trapping point and liquidity available in the event of an between controlled and non-controlled apply the appropriate CF from Table I. early amortization; early amortization provisions and on Question 53: The agencies seek (ii) Throughout the duration of the the extent to which banks use controlled comment on the appropriateness of the securitization (including the early early amortization provisions. The 4.5 percent excess spread trapping point amortization period) there is the same agencies also invite comment on the and on other types and levels of early pro rata sharing of interest, principal, proposed definition of a controlled early amortization triggers used in expenses, losses, fees, recoveries, and amortization provision, including in securitizations of revolving retail other cash flows from the underlying particular the 18-month period set forth exposures that should be considered by exposures, based on the originating above. the agencies.

TABLE I.—CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed

Retail Credit Lines ...... 3-month average 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 75% to 50% of trapping point 10% CF. less than 50% to 25% of trapping point 20% CF. less than 25% of trapping point 40% CF. Non-retail Credit Lines ...... 90% CF ...... 90% CF.

A bank must apply a 90 percent CF account management tools are controlled early amortization provision, for all other revolving underlying unavailable for committed lines, and and on what an appropriate level of exposures (that is, committed exposures banks may be less proactive about using such a CF would be (for example, 10 or and non-retail exposures) in such tools in the case of uncommitted 20 percent). securitizations containing a controlled non-retail credit lines owing to lender Noncontrolled early amortization. To early amortization provision. The CFs liability concerns and the prominence of calculate the appropriate CF for for uncommitted revolving retail credit broad-based, longer-term customer lines are much lower than for relationships. securitizations of uncommitted committed retail credit lines or for non- Question 54: The agencies seek revolving retail exposures that contain a retail credit lines because of the comment on and supporting empirical noncontrolled early amortization demonstrated ability of banks to analysis of the appropriateness of a provision, a bank must perform the monitor and, when appropriate, to more simple alternative approach that excess spread calculations described in curtail promptly uncommitted retail would impose at all times a flat CF on the controlled early amortization section credit lines for customers of the entire investors’ interest of a above and then apply the CFs in Table deteriorating credit quality. Such revolving securitization with a J.

TABLE J.—NON-CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed

Retail Credit Lines ...... 3-month average excess spread Conversion Factor (CF) ...... 100% CF.

VerDate Aug<31>2005 23:59 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00066 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55895

TABLE J.—NON-CONTROLLED EARLY AMORTIZATION PROVISIONS—Continued

Uncommitted Committed

133.33% of trapping point or more 0% CF. less than 133.33% to 100% of trapping point 5% CF. less than 100% to 75% of trapping point 15% CF. less than 75% to 50% of trapping point 50% CF. less than 50% of trapping point 100% CF. Non-retail Credit Lines ...... 100% CF ...... 100% CF.

A bank must use a 100 percent CF for 100 percent; and certain community The agencies seek comment on this all other revolving underlying exposures development equity exposures, hedged definition. (that is, committed exposures and equity exposures, and, up to certain A bank using either the IMA or the nonretail exposures) in securitizations limits, non-significant equity exposures SRWA must determine the adjusted containing a noncontrolled early would receive a 100 percent risk weight. carrying value for each equity exposure. The proposed rule defines the adjusted amortization provision. In other words, Alternatively, a bank that meets carrying value of an equity exposure as: no risk transference would be certain minimum quantitative and recognized for these transactions; an (i) For the on-balance sheet qualitative requirements on an ongoing originating bank’s IRB capital component of an equity exposure, the basis and obtains the prior written requirement would be the same as if the bank’s carrying value of the exposure approval of its primary Federal underlying exposures had not been reduced by any unrealized gains on the supervisor could use the IMA to securitized. exposure that are reflected in such In circumstances where a determine its risk-based capital carrying value but excluded from the securitization contains a mix of retail requirement for all modeled equity bank’s tier 1 and tier 2 capital; 80 and and nonretail exposures or a mix of exposures. A bank that qualifies to use (ii) For the off-balance sheet committed and uncommitted exposures, the IMA may apply the IMA to its component of an equity exposure, the a bank may take a pro rata approach to publicly traded and non-publicly traded effective notional principal amount of determining the risk-based capital equity exposures, or may choose to the exposure, the size of which is requirement for the securitization’s apply the IMA only to its publicly equivalent to a hypothetical on-balance early amortization provision. If a pro traded equity exposures. However, if the sheet position in the underlying equity rata approach is not feasible, a bank bank applies the IMA to its publicly instrument that would evidence the must treat the securitization as a traded equity exposures, it must apply same change in fair value (measured in securitization of nonretail exposures if a the IMA to all such exposures. dollars) for a given small change in the single underlying exposure is a Similarly, if a bank applies the IMA to price of the underlying equity nonretail exposure and must treat the both publicly traded and non-publicly instrument, minus the adjusted carrying securitization as a securitization of traded equity exposures, it must apply value of the on-balance sheet committed exposures if a single the IMA to all such exposures. If a bank component of the exposure as underlying exposure is a committed does not qualify to use the IMA, or calculated in (i). The agencies created the definition of exposure. elects not to use the IMA, to compute its risk-based capital requirements for the effective notional principal amount F. Equity Exposures equity exposures, the bank must apply of the off-balance sheet portion of an 1. Introduction and Exposure the SRWA to assign risk weights to its equity exposure to provide a uniform method for banks to measure the on- Measurement equity exposures. balance sheet equivalent of an off- This section describes the proposed The proposed rule defines a publicly balance sheet exposure. For example, if rule’s risk-based capital treatment for traded equity exposure as an equity the value of a derivative contract equity exposures. Under the proposed exposure traded on (i) any exchange referencing the common stock of rule, a bank would have the option to registered with the SEC as a national company X changes the same amount as use either a simple risk-weight approach securities exchange under section 6 of the value of 150 shares of common stock (SRWA) or an internal models approach the Securities Exchange Act of 1934 (15 of company X, for a small (for example, (IMA) for equity exposures that are not U.S.C. 78f) or (ii) any non-U.S.-based 1 percent) change in the value of the exposures to an investment fund. A securities exchange that is registered common stock of company X, the bank would use a look-through with, or approved by, a national effective notional principal amount of approach for equity exposures to an securities regulatory authority, provided the derivative contract is the current investment fund. Under the SRWA, a that there is a liquid, two-way market value of 150 shares of common stock of bank would generally assign a 300 for the exposure (that is, there are company X regardless of the number of percent risk weight to publicly traded enough bona fide offers to buy and sell shares the derivative contract equity exposures and a 400 percent risk so that a sales price reasonably related weight to non-publicly traded equity to the last sales price or current bona 80 The potential downward adjustment to the exposures. Certain equity exposures to fide competitive bid and offer carrying value of an equity exposure reflects the fact quotations can be determined promptly that 100 percent of the unrealized gains on sovereigns, multilateral institutions, and available-for-sale equity exposures are included in public sector enterprises would have a and a trade can be settled at such a price carrying value but only up to 45 percent of any such risk weight of 0 percent, 20 percent, or within five business days). Question 55: unrealized gains are included in regulatory capital.

VerDate Aug<31>2005 23:59 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00067 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55896 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

references. The adjusted carrying value exposure A and $100 of equity exposure Xt = At ¥ Bt of the off-balance sheet component of B as a hedge pair, and the remaining A = the value at time t of the one the derivative is the current value of 150 $200 of its equity exposure A as a exposure in a hedge pair, and shares of common stock of company X separate, stand-alone position. minus the adjusted carrying value of The effective portion of a hedge pair Bt = the value at time t of the other any on-balance sheet amount associated is E multiplied by the greater of the exposure in a hedge pair. with the derivative. Question 56: The adjusted carrying values of the equity The value of t will range from zero to agencies seek comment on the approach exposures forming a hedge pair, T, where T is the length of the to adjusted carrying value for the off- whereas the ineffective portion is (1–E) observation period for the values of A balance sheet component of equity multiplied by the greater of the adjusted and B, and is comprised of shorter exposures and on alternative carrying values of the equity exposures values each labeled t. approaches that may better capture the forming a hedge pair. In the above The regression method of measuring market risk of such exposures. example, the effective portion of the effectiveness is based on a regression in Hedge transactions. For purposes of hedge pair would be 0.8 × $100 = $80 determining risk-weighted assets under and the ineffective portion of the hedge which the change in value of one ¥ × both the SRWA and the IMA, a bank pair would be (1 0.8) $100 = $20. exposure in a hedge pair is the may identify hedge pairs, which the Measures of hedge effectiveness. dependent variable and the change in proposed rule defines as two equity Under the dollar-offset method of value of the other exposure in a hedge exposures that form an effective hedge measuring effectiveness, the bank must pair is the independent variable. E so long as each equity exposure is determine the ratio of the cumulative equals the coefficient of determination publicly traded or has a return that is sum of the periodic changes in the value of this regression, which is the primarily based on a publicly traded of one equity exposure to the proportion of the variation in the equity exposure. A bank may risk cumulative sum of the periodic changes dependent variable explained by weight only the effective and ineffective in the value of the other equity variation in the independent variable. portions of a hedge pair rather than the exposure, termed the ratio of value The closer the relationship between the entire adjusted carrying value of each change (RVC). If the changes in the values of the two exposures, the higher values of the two exposures perfectly exposure that makes up the pair. Two ¥ E will be. equity exposures form an effective offset each other, the RVC will be 1. hedge if the exposures either have the If RVC is positive, implying that the 2. Simple Risk-Weight Approach values of the two equity exposures same remaining maturity or each has a (SRWA) moved in the same direction, the hedge remaining maturity of at least three is not effective and E = 0. If RVC is Under the SRWA in section 52 of the months; the hedge relationship is negative and greater than or equal to ¥1 proposed rule, a bank would determine formally documented in a prospective (that is, between zero and ¥1), then E the risk-weighted asset amount for each manner (that is, before the bank acquires equals the absolute value of RVC. If RVC equity exposure, other than an equity at least one of the equity exposures); the is negative and less than ¥1, then E documentation specifies the measure of exposure to an investment fund, by equals 2 plus RVC. effectiveness (E) the bank will use for multiplying the adjusted carrying value The variability-reduction method of of the equity exposure, or the effective the hedge relationship throughout the measuring effectiveness compares life of the transaction; and the hedge portion and ineffective portion of a changes in the value of the combined hedge pair as described below, by the relationship has an E greater than or position of the two equity exposures in equal to 0.8. A bank must measure E at lowest applicable risk weight in Table the hedge pair (labeled X) to changes in K. A bank would determine the risk- least quarterly and must use one of three the value of one exposure as though that weighted asset amount for an equity alternative measures of E—the dollar- one exposure were not hedged (labeled offset method, the variability-reduction A). This measure of E expresses the exposure to an investment fund as set method, or the regression method. time-series variability in X as a forth below (and in section 54 of the It is possible that only part of a bank’s proportion of the variability of A. As the proposed rule). Use of the SRWA would exposure to a particular equity variability described by the numerator be most appropriate when a bank’s instrument would be part of a hedge becomes small relative to the variability equity holdings are principally pair. For example, assume a bank has an described by the denominator, the composed of non-traded instruments. equity exposure A with a $300 adjusted measure of effectiveness improves, but If a bank exclusively uses the SRWA carrying value and chooses to hedge a is bounded from above by a value of 1. for its equity exposures, the bank’s portion of that exposure with an equity E can be computed as: aggregate risk-weighted asset amount for exposure B with an adjusted carrying its equity exposures (other than equity value of $100. Also assume that the T 2 combination of equity exposure B and ∑()XX− exposures to investment funds) would tt−1 be equal to the sum of the risk-weighted $100 of the adjusted carrying value of =−t=1 , E 1 T where asset amounts for each of the bank’s equity exposure A form an effective ()− 2 hedge with an E of 0.8. In this situation ∑ AAtt−1 individual equity exposures. the bank would treat $100 of equity t=1

TABLE K

Risk weight Equity exposure

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 if the equity exposure is not publicly traded and is held as a condition of membership in that entity. 100 ...... • Community development equity exposures 81 • Equity exposures to a Federal Home Loan Bank or Farmer Mac not subject to a 20 percent risk weight.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00068 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.057 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55897

TABLE K—Continued

Risk weight Equity exposure

• 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.

Non-significant equity exposures. A held through consolidated small containing adverse market movements bank may apply a 100 percent risk business investment companies relevant to the risk profile of the bank’s weight to non-significant equity described in section 302 of the Small modeled equity exposures. If the bank’s exposures, which the proposed rule Business Investment Act of 1958 (15 model uses a scenario methodology, the defines as equity exposures to the extent U.S.C. 682) and then must include bank must demonstrate that the model that the aggregate adjusted carrying publicly traded equity exposures produces a conservative estimate of value of the exposures does not exceed (including those held indirectly through potential losses on the bank’s modeled 10 percent of the bank’s tier 1 capital investment funds) and then must equity exposures over a relevant long- plus tier 2 capital. To compute the include non-publicly traded equity term market cycle. If the bank employs aggregate adjusted carrying value of a exposures (including those held risk factor models, the bank must bank’s equity exposures for determining indirectly through investment funds). demonstrate through empirical analysis non-significance, the bank may exclude the appropriateness of the risk factors 3. Internal Models Approach (IMA) (i) equity exposures that receive less used. than a 300 percent risk weight under the The IMA is designed to provide banks The agencies also would require that SRWA (other than equity exposures with a more sophisticated and risk- daily market prices be available for all determined to be non-significant), (ii) sensitive mechanism for calculating modeled equity exposures, either direct the equity exposure in a hedge pair with risk-based capital requirements for holdings or proxies. Finally, the bank the smaller adjusted carrying value, and equity exposures. To qualify to use the must be able to demonstrate, using (iii) a proportion of each equity IMA, a bank must receive prior written theoretical arguments and empirical exposure to an investment fund equal to approval from its primary Federal evidence, that any proxies used in the the proportion of the assets of the supervisor. To receive such approval, modeling process are comparable to the investment fund that are not equity the bank must demonstrate to its bank’s modeled equity exposures and exposures. If a bank does not know the primary Federal supervisor’s that the bank has made appropriate actual holdings of the investment fund, satisfaction that the bank meets the adjustments for differences. The bank the bank may calculate the proportion of following quantitative and qualitative must derive any proxies for its modeled the assets of the fund that are not equity criteria. equity exposures or benchmark portfolio exposures based on the terms of the IMA qualification. First, the bank using historical market data that are prospectus, partnership agreement, or must have a model that (i) assesses the relevant to the bank’s modeled equity similar contract that defines the fund’s potential decline in value of its modeled exposures or benchmark portfolio (or, permissible investments. If the sum of equity exposures; (ii) is commensurate where not, must use appropriately the investment limits for all exposure with the size, complexity, and adjusted data), and such proxies must classes81 within the fund exceeds 100 composition of the bank’s modeled be robust estimates of the risk of the percent, the bank must assume that the equity exposures; and (iii) adequately bank’s modeled equity exposures. investment fund invests to the captures both general market risk and In evaluating a bank’s internal model maximum extent possible in equity idiosyncratic risks. Second, the bank’s for equity exposures, the bank’s primary exposures. model must produce an estimate of Federal supervisor would consider, When determining which of a bank’s potential losses for its modeled equity among other factors, (i) the nature of the equity exposures qualify for a 100 exposures that is no less than the bank’s equity exposures, including the percent risk weight based on non- estimate of potential losses produced by number and types of equity exposures significance, a bank must first include a VaR methodology employing a 99.0 (for example, publicly traded, non- equity exposures to unconsolidated percent one-tailed confidence interval of publicly traded, long, short); (ii) the risk small business investment companies or the distribution of quarterly returns for characteristics and makeup of the bank’s a benchmark portfolio of equity equity exposures, including the extent 81 The proposed rule generally defines these exposures comparable to the bank’s to which publicly available price exposures as exposures that would qualify as modeled equity exposures using a long- information is obtainable on the community development investments under 12 U.S.C. 24(Eleventh), excluding equity exposures to term sample period. exposures; and (iii) the level and degree an unconsolidated small business investment In addition, the number of risk factors of concentration of, and correlations company and equity exposures held through a and exposures in the sample and the among, the bank’s equity exposures. consolidated small business investment company data period used for quantification in Banks with equity portfolios containing described in section 302 of the Small Business Investment Act of 1958 (15 U.S.C. 682). For savings the bank’s model and benchmarking equity exposures with values that are associations, community development investments exercise must be sufficient to provide highly nonlinear in nature (for example, would be defined to mean equity investments that confidence in the accuracy and equity derivatives or convertibles) are designed primarily to promote community robustness of the bank’s estimates. The welfare, including the welfare of low- and would have to employ an internal moderate-income communities or families, such as bank’s model and benchmarking model designed to appropriately capture by providing services or jobs, and excluding equity exercise also must incorporate data that the risks associated with these exposures to an unconsolidated small business are relevant in representing the risk instruments. investment company and equity exposures held profile of the bank’s modeled equity The agencies do not intend to dictate through a consolidated small business investment company described in section 302 of the Small exposures, and must include data from the form or operational details of a Business Investment Act of 1958 (15 U.S.C. 682). at least one equity market cycle bank’s internal model for equity

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00069 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55898 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

exposures. Accordingly, the agencies provide information about the effect of outside of the IMA section of the would not prescribe any particular type tail events beyond the level of proposed rule) and the risk-weighted of model for determining risk-based confidence assumed in the IMA. asset amount of the non-excluded equity capital requirements. Although the Banks using non-VaR internal models exposures (calculated under the IMA proposed rule requires a bank that uses that are based on stress tests or scenario section of the proposed rule). The risk- the IMA to ensure that its internal analyses would have to estimate losses weighted asset amount of the non- model produces an estimate of potential under worst-case modeled scenarios. excluded equity exposures is generally losses for its modeled equity exposures These scenarios would have to reflect set equal to the estimate of potential that is no less than the estimate of the composition of the bank’s equity losses on the bank’s non-excluded potential losses produced by a VaR portfolio and should produce risk-based equity exposures generated by the methodology employing a 99.0 percent capital requirements at least as large as bank’s internal model multiplied by one-tailed confidence interval of the those that would be required to be held 12.5. To ensure that a bank holds a distribution of quarterly returns for a against a representative market index or minimum amount of risk-based capital benchmark portfolio of equity other relevant benchmark portfolio against its modeled equity exposures, exposures, the proposed rule does not under a VaR approach. For example, for however, the proposed rule contains a require a bank to use a VaR-based a portfolio consisting primarily of supervisory floor on the risk-weighted model. The agencies recognize that the publicly held equity securities that are asset amount of the non-excluded equity type and sophistication of internal actively traded, risk-based capital exposures. As a result of this floor, the models will vary across banks due to requirements produced using historical risk-weighted asset amount of the non- differences in the nature, scope, and scenario analyses should be greater than excluded equity exposures could not complexity of business lines in general or equal to risk-based capital fall below the sum of (i) 200 percent and equity exposures in particular. The requirements produced by a baseline multiplied by the aggregate adjusted agencies recognize that some banks VaR approach for a major index or sub- carrying value or ineffective portion of employ models for internal risk index that is representative of the bank’s hedge pairs, as appropriate, of the management and capital allocation holdings. Similarly, non-publicly traded bank’s non-excluded publicly traded purposes that can be more relevant to equity exposures may be benchmarked equity exposures; and (ii) 300 percent the bank’s equity exposures than some against a representative portfolio of multiplied by the aggregate adjusted VaR models. For example, some banks publicly traded equity exposures. carrying value of the bank’s non- employ rigorous historical scenario The loss estimate derived from the excluded non-publicly traded equity analysis and other techniques for bank’s internal model would constitute exposures. assessing the risk of their equity the regulatory capital requirement for If, on the other hand, a bank applies portfolios. the modeled equity exposures. The the IMA only to its publicly traded Banks that choose to use a VaR-based equity capital requirement would be equity exposures, the bank’s aggregate internal model under the IMA should incorporated into a bank’s risk-based risk-weighted asset amount for its equity use a historical observation period that capital ratio through the calculation of exposures would be equal to the sum of includes a sufficient amount of data risk-weighted equivalent assets. To (i) the risk-weighted asset amount of points to ensure statistically reliable and convert the equity capital requirement each excluded equity exposure robust loss estimates relevant to the into risk-weighted equivalent assets, a (calculated outside of the IMA section of long-term risk profile of the bank’s bank would multiply the capital the proposed rule); (ii) 400 percent specific holdings. The data used to requirement by 12.5. multiplied by the aggregate adjusted represent return distributions should Question 57: The agencies seek carrying value of the bank’s non- reflect the longest sample period for comment on the proposed rule’s excluded non-publicly traded equity which data are available and should requirements for IMA qualification, exposures; and (iii) the aggregate risk- meaningfully represent the risk profile including in particular the proposed weighted asset amount of its non- of the bank’s specific equity holdings. rule’s use of a 99.0 percent, quarterly excluded publicly traded equity The data sample should be long-term in returns standard. exposures. The risk-weighted asset nature and, at a minimum, should Risk-weighted assets under the IMA. amount of the non-excluded publicly encompass at least one complete equity As noted above, a bank may apply the traded equity exposures would be equal market cycle containing adverse market IMA only to its publicly traded equity to the estimate of potential losses on the movements relevant to the risk profile of exposures or may apply the IMA to its bank’s non-excluded publicly traded the bank’s modeled exposures. The data publicly traded and non-publicly traded equity exposures generated by the used should be sufficient to provide equity exposures. In either case, a bank bank’s internal model multiplied by conservative, statistically reliable, and is not allowed to apply the IMA to 12.5. The risk-weighted asset amount for robust loss estimates that are not based equity exposures that receive a 0 or 20 the non-excluded publicly traded equity purely on subjective or judgmental percent risk weight under Table 9, exposures would be subject to a floor of considerations. community development equity 200 percent multiplied by the aggregate The parameters and assumptions used exposures, equity exposures to a Federal adjusted carrying value or ineffective in a VaR model must be subject to a Home Loan Bank or Farmer Mac that portion of hedge pairs, as appropriate, of rigorous and comprehensive regime of receive a 100 percent risk weight, and the bank’s non-excluded publicly traded stress-testing. Banks utilizing VaR equity exposures to investment funds equity exposures. Question 58: The models must subject their internal (collectively, excluded equity agencies seek comment on the model and estimation procedures, exposures). operational aspects of these floor including volatility computations, to If a bank applies the IMA to both calculations. either hypothetical or historical publicly traded and non-publicly traded scenarios that reflect worst-case losses equity exposures, the bank’s aggregate 4. Equity Exposures to Investment given underlying positions in both risk-weighted asset amount for its equity Funds publicly traded and non-publicly traded exposures would be equal to the sum of A bank must determine the risk- equities. At a minimum, banks that use the risk-weighted asset amount of each weighted asset amount for equity a VaR model must employ stress tests to excluded equity exposure (calculated exposures to investment funds using

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00070 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55899

one of three approaches: the Full Look- requirement for equity exposures to approach, a bank would set the risk- Through Approach, the Simple investment funds that hold only low- weighted asset amount of the bank’s Modified Look-Through Approach, or risk assets. Question 59: The agencies equity exposure to the investment fund the Alternative Modified Look-Through seek comment on the necessity and equal to the greater of (i) the product of Approach, unless the equity exposure to appropriateness of the separate (A) the aggregate risk-weighted asset an investment fund is a community treatment for equity exposures to amounts of the exposures held by the development equity exposure. Such investment funds and the three fund as if they were held directly by the equity exposures would be subject to a approaches in the proposed rule. The bank and (B) the bank’s proportional 100 percent risk weight. If an equity agencies also seek comment on the ownership share of the fund; and (ii) 7 exposure to an investment fund is part proposed definition of an investment percent of the adjusted carrying value of of a hedge pair, a bank may use the fund. the bank’s equity exposure to the ineffective portion of a hedge pair as the Each of the approaches to equity investment fund. adjusted carrying value for the equity exposures to investment funds imposes a 7 percent minimum risk weight on Simple modified look-through exposure to the investment fund. A approach. Under this approach, a bank bank may choose to apply a different equity exposures to investment funds. This minimum risk weight is similar to may set the risk-weighted asset amount approach to different equity exposures for its equity exposure to an investment to investment funds; the proposed rule the minimum 7 percent risk weight under the RBA for securitization fund equal to the adjusted carrying does not require a bank to apply the value of the equity exposure multiplied same approach to all of its equity exposures and the effective 56 basis point minimum risk-based capital by the highest risk weight in Table L exposures to investment funds. requirement per dollar of securitization that applies to any exposure the fund is The proposed rule defines an exposure under the SFA. The agencies permitted to hold under its prospectus, investment fund as a company all or believe that this minimum prudential partnership agreement, or similar substantially all of the assets of which capital requirement is appropriate for contract that defines the fund’s are financial assets and which has no exposures not directly held by the bank. permissible investments. The bank may material liabilities. The agencies have Full look-through approach. A bank exclude derivative contracts that are proposed a separate treatment for equity may use the full look-through approach used for hedging, not speculative exposures to an investment fund to only if the bank is able to compute a purposes, and do not constitute a prevent banks from arbitraging the risk-weighted asset amount for each of material portion of the fund’s exposures. proposed rule’s high risk-based capital the exposures held by the investment A bank may not assign an equity requirements for certain high-risk fund (calculated under the proposed exposure to an investment fund to an exposures and to ensure that banks do rule as if the exposures were held aggregate risk weight of less than 7 not receive a punitive risk-based capital directly by the bank). Under this percent under this approach.

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

Risk weight Exposure class

0 percent ...... Sovereign exposures with a long-term external rating in the highest investment grade rating category and sovereign expo- sures 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 percent the lowest investment grade rating category. 200 percent ...... Exposures with a long-term external rating one rating category percent below investment grade. 300 percent ...... Publicly traded equity exposures. 400 percent ...... Non-publicly traded equity exposures; exposures with a long-percent term external rating two or more rating categories below investment grade; and unrated exposures (excluding publicly traded equity exposures). 1,250 percent ...... OTC derivative contracts and exposures that must be deducted percent from regulatory capital or receive a risk weight greater than 400 percent under this appendix.

Alternative modified look-through permitted under its investment limits in of the fund’s exposures. The overall risk approach. Under this approach, a bank the exposure class with the highest risk weight assigned to an equity exposure to may assign the adjusted carrying value weight under Table L, and continues to an investment fund under this approach of an equity exposure to an investment make investments in the order of the may not be less than 7 percent. fund on a pro rata basis to different risk- exposure class with the next highest VI. Operational Risk weight categories in Table L according risk-weight under Table L until the to the investment limits in the fund’s maximum total investment level is This section describes features of the prospectus, partnership agreement, or reached. If more than one exposure class AMA framework for determining the similar contract that defines the fund’s applies to an exposure, the bank must risk-based capital requirement for permissible investments. If the sum of use the highest applicable risk weight. operational risk. The proposed the investment limits for all exposure A bank may exclude derivative framework remains fundamentally classes within the fund exceeds 100 contracts held by the fund that are used similar to that described in the ANPR. percent, the bank must assume that the for hedging, not speculative, purposes Under this framework, a bank meeting fund invests to the maximum extent and do not constitute a material portion the AMA qualifying criteria would use

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00071 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55900 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

its internal operational risk described in the ANPR and a bank sufficient certainty to warrant inclusion quantification system to calculate its would continue to be allowed to in the adjustment to the operational risk risk-based capital requirement for recognize (i) certain offsets for EOL, and exposure. For a risk mitigant to meet operational risk. (ii) the effect of risk mitigants such as this standard, it must be insurance that: Currently, the agencies’ general risk- insurance in calculating its regulatory (i) Is provided by an unaffiliated based capital rules do not include an capital requirement for operational risk, company that has a claims paying explicit capital charge for operational the agencies have clarified certain ability that is rated in one of the three risk. Rather, the existing risk-based aspects of the proposed framework. In highest rating categories by an NRSRO; capital rules were designed to cover all particular, the agencies have re-assessed (ii) Has an initial term of at least one risks, and therefore implicitly cover the ability of banks to take prudent steps year and a residual term of more than operational risk. With the introduction to offset EOL through internal business 90 days; of the IRB framework for credit risk in practices. (iii) Has a minimum notice period for this NPR, which would result in a more After further analysis and discussions cancellation of 90 days; risk-sensitive treatment of credit risk, with the industry, the agencies believe (iv) Has no exclusions or limitations there no longer would be an implicit that certain reserves and other internal based upon regulatory action or for the capital buffer for other risks. business practices could qualify as an receiver or liquidator of a failed bank; The agencies recognize that EOL offset. Under the proposed rule, a and operational risk is a key risk in banks, bank’s risk-based capital requirement (v) Is explicitly mapped to an actual and evidence indicates that a number of for operational risk may be based on operational risk exposure of the bank. factors are driving increases in UOL alone if the bank can demonstrate The bank’s methodology for operational risk. These factors include it has offset EOL with eligible recognizing risk mitigants must also greater use of automated technology, operational risk offsets, which are capture, through appropriate discounts proliferation of new and highly complex defined as amounts (i) generated by in the amount of risk mitigants, the products, growth of e-banking internal business practices to absorb residual term of the risk mitigant, where transactions and related business highly predictable and reasonably stable less than one year; the risk mitigant’s applications, large-scale acquisitions, operational losses, including reserves cancellation terms, where less than one mergers, and consolidations, and greater calculated in a manner consistent with year; the risk mitigant’s timeliness of use of outsourcing arrangements. GAAP; and (ii) available to cover EOL payment; and the uncertainty of Furthermore, the recent experience of a with a high degree of certainty over a payment as well as mismatches in number of high-profile, high-severity one-year horizon. Eligible operational coverage between the risk mitigant and losses across the banking industry, risk offsets may only be used to offset the hedged operational loss event. The including those resulting from legal EOL, not UOL. bank may not recognize for regulatory settlements, highlight operational risk as In determining whether to accept a capital purposes risk mitigants with a a major source of unexpected losses. proposed EOL offset, the agencies will residual term of 90 days or less. Because the implicit regulatory capital consider whether the proposed offset Commenters on the ANPR raised buffer for operational risk would be would be available to cover EOL with a concerns that limiting the risk removed under the proposed rule, the high degree of certainty over a one-year mitigating benefits of insurance to 20 agencies propose to require banks using horizon. Supervisory recognition of EOL percent of the bank’s regulatory capital the IRB framework for credit risk to use offsets will be limited to those business requirement for operational risk the AMA to address operational risk lines and event types with highly represents an overly prescriptive and when computing a capital charge for predictable, routine losses. Based on arbitrary value. Concerns were raised regulatory capital purposes. discussions with the industry and that such a cap would inhibit As defined previously, operational empirical data, highly predictable and development of this important risk risk exposure is the 99.9th percentile of routine losses appear to be limited to mitigation tool. Commenters believed the distribution of potential aggregate those relating to securities processing that the full contract amount of operational losses as generated by the and to credit card fraud. Question 60: insurance should be recognized as the bank’s operational risk quantification The agencies are interested in risk mitigating value. The agencies, system over a one-year horizon. EOL is commenters’ views on other business however, believe that the 20 percent the expected value of the same lines or event types in which highly limit continues to be a prudent limit. distribution of potential aggregate predictable, routine losses have been Currently, the primary risk mitigant operational losses. The ANPR specified observed. available for operational risk is that a bank’s risk-based capital In determining its operational risk insurance. While certain securities requirement for operational risk would exposure, the bank could also take into products may be developed over time be the sum of EOL and UOL unless the account the effects of risk mitigants that could provide risk mitigation bank could demonstrate that an EOL such as insurance, subject to approval benefits, no specific products have offset would meet supervisory from its primary Federal supervisor. In emerged to-date that have standards. The agencies described two order to recognize the effects of risk characteristics sufficient to be approaches—reserving and budgeting— mitigants such as insurance for risk- considered a capital replacement for that might allow for some offset of EOL; based capital purposes, the bank must operational risk. However, as innovation however, the agencies expressed some estimate its operational risk exposure in this field continues, a bank may be reservation about both approaches. The with and without such effects. The able to realize the benefits of risk agencies believed that reserves reduction in a bank’s risk-based capital mitigation through certain capital established for expected operational requirement for operational risk due to markets instruments with the approval losses would likely not meet U.S. risk mitigants may not exceed 20 of its primary Federal supervisor. accounting standards and that budgeted percent of the bank’s risk-based capital If a bank does not qualify to use or funds might not be sufficiently capital- requirement for operational risk, after does not have qualifying operational like to cover EOL. approved adjustments for EOL offsets. A risk mitigants, the bank’s dollar risk- While the proposed framework bank must demonstrate that a risk based capital requirement for remains fundamentally similar to that mitigant is able to absorb losses with operational risk would be its operational

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00072 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55901

risk exposure minus eligible operational regard, improvements to risk those risks are important factors that risk offsets (if any). If a bank qualifies management processes and internal market participants consider in their to use operational risk mitigants and has reporting systems provide opportunities assessment of the institution. qualifying operational risk mitigants, to significantly improve public Accordingly, each bank that is subject to the bank’s dollar risk-based capital disclosures over time. Accordingly, the the disclosure requirements must have a requirement for operational risk would agencies strongly encourage the formal disclosure policy approved by be the greater of: (i) The bank’s management of each bank to regularly the board of directors that addresses the operational risk exposure adjusted for review its public disclosures and institution’s approach for determining qualifying operational risk mitigants enhance these disclosures, where the disclosures it should make. The minus eligible operational risk offsets (if appropriate, to clearly identify all policy should address the associated any); and (ii) 0.8 multiplied by the significant risk exposures —whether on- internal controls and disclosure controls difference between the bank’s or off-balance sheet—and their effects and procedures. The board of directors operational risk exposure and its on the bank’s financial condition and and senior management would be eligible operational risk offsets (if any). performance, cash flow, and earnings expected to ensure that appropriate The dollar risk-based capital potential. verification of the disclosures takes requirement for operational risk would Comments on ANPR. Some place and that effective internal controls be multiplied by 12.5 to convert it into commenters to the ANPR indicated that and disclosure controls and procedures an equivalent risk-weighted asset the proposed disclosures were are maintained. amount. The resulting amount would be burdensome, excessive, and overly A bank should decide which added to the comparable amount for prescriptive. Other commenters disclosures are relevant for it based on credit risk in calculating the believed that the information provided the materiality concept. Information institution’s risk-based capital in the disclosures would not be would be regarded as material if its denominator. comparable across banks because each omission or misstatement could change bank will use distinct internal or influence the assessment or decision VII. Disclosure methodologies to generate the of a user relying on that information for 1. Overview disclosures. These commenters also the purpose of making investment decisions. The agencies have long supported expressed concern that some disclosures could be misinterpreted or To the extent applicable, a bank meaningful public disclosure by banks would be able to fulfill its disclosure with the objective of improving market misunderstood by the public. The agencies believe, however, the requirements under this proposed rule discipline. The agencies recognize the by relying on disclosures made in importance of market discipline in required disclosures would enable market participants to gain key insights accordance with accounting standards encouraging sound risk management or SEC mandates that are very similar to regarding a bank’s capital structure, risk practices and fostering financial the disclosure requirements in this exposures, risk assessment processes, stability. proposed rule. In these situations, a and ultimately, the capital adequacy of Pillar 3 of the New Accord, market bank would explain material differences the institution. Some of the proposed discipline, complements the minimum between the accounting or other disclosure requirements will be new capital requirements and the disclosure and the disclosures required disclosures for banks. Nonetheless, the supervisory review process by under this proposed rule. encouraging market discipline through agencies believe that a significant Frequency/timeliness. Consistent with enhanced and meaningful public amount of the proposed disclosure longstanding requirements in the United disclosure. These proposed public requirements are already required by or States for robust quarterly disclosures in disclosure requirements are intended to consistent with existing GAAP, SEC financial and regulatory reports, and allow market participants to assess key disclosure requirements, or regulatory considering the potential for rapid information about an institution’s risk reporting requirements for banks. changes in risk profiles, the agencies profile and its associated level of 2. General Requirements would require that quantitative capital. disclosures be made quarterly. However, The agencies view public disclosure The public disclosure requirements qualitative disclosures that provide a as an important complement to the would apply to the top-tier legal entity general summary of a bank’s risk advanced approaches to calculating that is a core or opt-in bank within a management objectives and policies, minimum regulatory risk-based capital consolidated banking group (that is, the reporting system, and definitions may requirements, which will be heavily top-tier BHC or DI that is a core or opt- be disclosed annually, provided any based on internal systems and in bank). In general, DIs that are a significant changes to these are methodologies. With enhanced subsidiary of a BHC or another DI would disclosed in the interim. The transparency of the advanced not be subject to the disclosure disclosures must be timely, that is, must 82 approaches, investors can better requirements except that every DI be made no later than the reporting evaluate a bank’s capital structure, risk must disclose total and tier 1 capital deadlines for regulatory reports (for exposures, and capital adequacy. With ratios and their components, similar to example, FR Y–9C) and financial reports sufficient and relevant information, current requirements. If a DI is not a (for example, SEC Forms 10–Q and 10– market participants can better evaluate subsidiary of a BHC or another DI that K). When these deadlines differ, the a bank’s risk management performance, must make the full set of disclosures, later deadline would be used. earnings potential and financial the DI must make these disclosures. In some cases, management may strength. The risks to which a bank is exposed determine that a significant change has Improvements in public disclosures and the techniques that it uses to occurred, such that the most recent come not only from regulatory identify, measure, monitor, and control reported amounts do not reflect the standards, but also through efforts by bank’s capital adequacy and risk profile. 82 The bank regulatory reports and Thrift bank management to improve Financial Reports will be revised to collect some In those cases, banks should disclose communications to public shareholders additional Basel II-related information, as described the general nature of these changes and and other market participants. In this below in the regulatory reporting section. briefly describe how they are likely to

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00073 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55902 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

affect public disclosures going forward. information required by this proposed Table 11.1 disclosures, Scope of These interim disclosures should be rule. Application, include a description of made as soon as practicable after the Proprietary and confidential the level in the organization to which determination that a significant change information. The agencies believe that the disclosures apply and an outline of has occurred. the proposed requirements strike an any differences in consolidation for Location of disclosures and audit/ appropriate balance between the need accounting and regulatory capital certification requirements. The for meaningful disclosure and the purposes, as well as a description of any restrictions on the transfer of funds and disclosures would have to be publicly protection of proprietary and 85 capital within the organization. These available (for example, included on a confidential information. Accordingly, disclosures provide the basic context public Web site) for each of the last the agencies believe that banks would underlying regulatory capital three years (that is, twelve quarters) or be able to provide all of these disclosures without revealing calculations. such shorter time period since the bank Table 11.2 disclosures, Capital entered its first floor period. Except as proprietary and confidential information. However, in rare cases, Structure, provide information on discussed below, management would various components of regulatory have some discretion to determine the disclosure of certain items of information required in the proposed capital available to absorb losses and appropriate medium and location of the allow for an evaluation of the quality of disclosures required by this proposed rule may prejudice seriously the position of a bank by making public the capital available to absorb losses rule. Furthermore, banks would have within the bank. information that is either proprietary or flexibility in formatting their public Table 11.3 disclosures, Capital confidential in nature. In such cases, a disclosures, that is, the agencies are not Adequacy, provide information about specifying a fixed format for these reporting bank may request confidential how a bank assesses the adequacy of its disclosures. treatment for the information if the bank capital and require that the bank believes that disclosure of specific disclose its minimum capital Management would be encouraged to commercial or financial information in provide all of the required disclosures requirements for significant risk areas the report would likely result in and portfolios. The table also requires in one place on the entity’s public Web substantial harm to its competitive site. The public Web site address would disclosure of the regulatory capital position, or that disclosure of the ratios of the consolidated group and be reported in a regulatory report (for submitted information would result in example, the FR Y–9C).83 each DI subsidiary. Such disclosures unwarranted invasion of personal provide insight into the overall Disclosure of tier 1 and total capital privacy. adequacy of capital based on the risk ratios must be provided in the footnotes Question 61: The agencies seek profile of the organization. to the year-end audited financial commenters’ views on all of the Tables 11.4, 11.5, and 11.7 statements.84 Accordingly, these elements proposed to be captured disclosures, Credit Risk, provide market disclosures must be tested by external through the public disclosure participants with insight into different auditors as part of the financial requirements. In particular, the agencies types and concentrations of credit risk statement audit. Disclosures that are not seek comment on the extent to which to which the bank is exposed and the included in the footnotes to the audited the proposed disclosures balance techniques the bank uses to measure, financial statements would not be providing market participants with monitor, and mitigate those risks. These required to be subject to external audit sufficient information to appropriately disclosures are intended to enable reports for financial statements or assess the capital strength of individual market participants to assess the credit internal control reports from institutions, fostering comparability risk exposures under the IRB management and the external auditor. from bank to bank, and reducing burden framework, without revealing However, due to the importance of on the banks that are reporting the proprietary information or duplicating reliable disclosures, the agencies would information. the supervisor’s fundamental review of require the chief financial officer to the bank’s IRB framework. Table 11.6 3. Summary of Specific Public certify that the disclosures required by provides the disclosure requirements Disclosure Requirements the proposed rule are appropriate and related to credit exposures from that the board of directors and senior The public disclosure requirements derivatives. This table was added as a management are responsible for are comprised of 11 tables that provide supplement to the public disclosures establishing and maintaining an important information to market initially in the New Accord as a result effective internal control structure over participants on the scope of application, of the BCBS’s additional efforts to financial reporting, including the capital, risk exposures, risk assessment address certain exposures arising from processes, and, hence, the capital trading activities. See the July 2005 83 Alternatively, banks would be permitted to adequacy of the institution. Again, the BCBS publication entitled ‘‘The provide the disclosures in more than one place, as agencies note that the substantive Application of Basel II to Trading some of them may be included in public financial content of the tables is the focus of the Activities and the Treatment of Double reports (for example, in Management’s Discussion Default Effects.’’ and Analysis included in SEC filings) or other disclosure requirements, not the tables regulatory reports (for example, FR Y–9C Reports). themselves. The table numbers below Table 11.8 disclosures, Securitization, The agencies would require such banks to provide refer to the table numbers in the provide information to market a summary table on their public Web site that proposed rule. participants on the amount of credit risk specifically indicates where all the disclosures may transferred and retained by the be found (for example, regulatory report schedules, page numbers in annual reports). 85 Proprietary information encompasses organization through securitization 84 These ratios are required to be disclosed in the information that, if shared with competitors, would transactions and the types of products footnotes to the audited financial statements render a bank’s investment in these products/ securitized by the organization. These pursuant to existing GAAP requirements in Chapter systems less valuable, and, hence, could undermine disclosures provide users a better 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 understanding of how securitization Savings institutions, Credit unions, Finance provided under the terms of a legal agreement or transactions impact the credit risk of the companies and Mortgage companies.’’ counterparty relationship. bank.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00074 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55903

Table 11.9 disclosures, Operational proposed rule, banks would begin QRE Qualifying Revolving Exposure Risk, provide insight into the bank’s reporting this information during their RBA Ratings-Based Approach application of the AMA for operational parallel run on a confidential basis. The SFA Supervisory Formula Approach risk and what internal and external agencies will share this information SME Small and Medium-Size factors are considered in determining with each other for calibration and other Enterprise the amount of capital allocated to analytical purposes. Question 62: SPE Special Purpose Entity operational risk. Comments on regulatory reporting SRWA Simple Risk-Weight Approach Table 11.10 disclosures, Equities, issues may be submitted in response to UL Unexpected Loss UOL Unexpected Operational Loss provide market participants with an this NPR as well as through the VaR Value-at-Risk understanding of the types of equity regulatory reporting request for securities held by the bank and how comment noted above. Regulatory Flexibility Act Analysis they are valued. The table also provides The Regulatory Flexibility Act (RFA) information on the capital allocated to List of Acronyms requires an agency that is issuing a different equity products and the ABCP Asset Backed Commercial Paper proposed rule to prepare and make amount of unrealized gains and losses. ALLL Allowance for Loan and Lease available for public comment an initial Table 11.11 disclosures, Interest Rate Losses regulatory flexibility analysis that Risk in Non-Trading Activities, provide AMA Advanced Measurement describes the impact of the proposed information about the potential risk of Approaches rule on small entities. 5 U.S.C. 603(a). loss that may result from changes in ANPR Advance Notice of Proposed The RFA provides that an agency is not interest rates and how the bank Rulemaking required to prepare and publish an measures such risk. AVC Asset Value Correlation initial regulatory flexibility analysis if BCBS Basel Committee on Banking 4. Regulatory Reporting the agency certifies that the proposed Supervision In addition to the public disclosures BHC Bank Holding Company rule will not, if promulgated, have a that would be required by the CF Conversion Factor significant economic impact on a consolidated banking organization CEIO Credit-Enhancing Interest-Only substantial number of small entities. 5 subject to the advanced approaches, the Strip U.S.C. 605(b). agencies would require certain CRM Credit Risk Mitigation Pursuant to section 605(b) of the RFA additional regulatory reporting from DI Depository Institution (5 U.S.C. 605(b)), the agencies certify BHCs, their subsidiary DIs, and DIs DvP Delivery versus Payment that this proposed rule will not, if applying the advanced approaches that E Measure of Effectiveness promulgated in final form, have a are not subsidiaries of BHCs. The EAD Exposure at Default significant economic impact on a agencies believe that the reporting of ECL Expected Credit Loss substantial number of small entities key risk parameter estimates by each DI EL Expected Loss Pursuant to regulations issued by the applying the advanced approaches will ELGD Expected Loss Given Default Small Business Administration (13 CFR provide the primary Federal supervisor EOL Expected Operational Loss 121–201), a ‘‘small entity’’ includes a and other relevant supervisors with data FDIC Federal Deposit Insurance bank holding company, commercial important for assessing the Corporation bank, or savings association with assets reasonableness and accuracy of the FFIEC Federal Financial Institutions of $165 million or less (collectively, institution’s calculation of its minimum Examination Council small banking organizations). The capital requirements under this rule and FMI Future Margin Income proposed rule would require a bank the adequacy of the institution’s capital GAAP Generally Accepted Accounting holding company, national bank, state in relation to its risks. This information Principles member bank, state nonmember bank, or would be collected through regulatory HELOC Home Equity Line of Credit savings association to calculate its risk- reports. The agencies believe that HOLA Home Owners’ Loan Act based capital requirements according to requiring certain common reporting HVCRE High-Volatility Commercial certain internal-ratings-based and across banks will facilitate comparable Real Estate internal model approaches if the bank application of the proposed rules. IAA Internal Assessment Approach holding company, bank, or savings In this regard, the agencies published IMA Internal Models Approach association (i) has consolidated total for comment elsewhere in today’s IRB Internal Ratings Based assets (as reported on its most recent Federal Register a package of proposed KIRB Capital Requirement for year-end regulatory report) equal to reporting schedules. The package Underlying Pool of Exposures $250 billion or more; (ii) has includes a summary schedule with (securitizations) consolidated total on-balance sheet aggregate data that would be available to LGD Loss Given Default foreign exposures at the most recent the general public. It also includes LTV Loan-to-Value Ratio year-end equal to $10 billion or more; or supporting schedules that would be M Effective Maturity (iii) is a subsidiary of a bank holding viewed as confidential supervisory MRA Market Risk Amendment company, bank, or savings association information. These schedules are broken MRC Minimum Risk-Based Capital that would be required to use the out by exposure category and would OCC Office of the Comptroller of the proposed rule to calculate its risk-based collect risk parameter and other Currency capital requirements. pertinent data in a systematic manner. OTC Over-the-Counter The agencies estimate that zero small The agencies also are exploring ways to OTS Office of Thrift Supervision bank holding companies (out of a total obtain information that would improve PCA Prompt Corrective Action of approximately 2,934 small bank supervisors’ understanding of the causes PD Probability of Default holding companies), five small national behind changes in risk-based capital PFE Potential Future Exposure banks (out of a total of approximately requirements. For example, certain data PvP Payment versus Payment 1,090 small national banks), one small would help explain whether movements QIS–3 Quantitative Impact Study 3 state member bank (out of a total of are attributable to changes in key risk QIS–4 Quantitative Impact Study 4 approximately 491 small state member parameters or other factors. Under the QIS–5 Quantitative Impact Study 5 banks), one small state nonmember bank

VerDate Aug<31>2005 00:01 Sep 23, 2006 Jkt 208001 PO 00000 Frm 00075 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55904 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

(out of a total of approximately 3,249 [email protected]. You can 801 17th Street, NW., Washington, DC, small state nonmember banks), and zero inspect and photocopy the comments at between 9 a.m. and 4:30 p.m. on small savings associations (out of a total the OCC’s Public Information Room, 250 business days. of approximately 446 small savings E Street, SW., Washington, DC 20219. A copy of the comments may also be associations) would be subject to the You can make an appointment to submitted to the OMB desk officer for proposed risk-based capital inspect the comments by calling 202– the agencies: By mail to U.S. Office of requirements on a mandatory basis. In 874–5043. Management and Budget, 725 17th addition, each of the small banking Board: You may submit comments, Street, NW., #10235, Washington, DC organizations subject to the proposed identified by Docket No. R–1261, by any 20503 or by facsimile to 202–395–6974, rule on a mandatory basis would be a of the following methods: Attention: Federal Banking Agency Desk subsidiary of a bank holding company • Agency Web Site: http:// Officer. with over $250 billion in consolidated www.federalreserve.gov. Follow the OTS: Information Collection total assets or over $10 billion in instructions for submitting comments Comments, Chief Counsel’s Office, consolidated total on-balance sheet on the http://www.federalreserve.gov/ Office of Thrift Supervision, 1700 G foreign exposure. Therefore, the generalinfo/foia/ProposedRegs.cfm. Street, NW., Washington, DC 20552; agencies believe that the proposed rule • Federal eRulemaking Portal: http:// send a facsimile transmission to (202) will not, if promulgated in final form, www.regulations.gov. Follow the 906–6518; or send an e-mail to result in a significant economic impact instructions for submitting comments. [email protected]. • on a substantial number of small E-mail: OTS will post comments and the related entities. [email protected]. index on the OTS Internet site at http:// Include docket number in the subject www.ots.treas.gov. In addition, Paperwork Reduction Act line of the message. interested persons may inspect the A. Request for Comment on Proposed • FAX: 202–452–3819 or 202–452– comments at the Public Reading Room, Information Collection. In accordance 3102. 1700 G Street, NW., by appointment. To with the requirements of the Paperwork • Mail: Jennifer J. Johnson, Secretary, make an appointment, call (202) 906– Reduction Act of 1995, the agencies may Board of Governors of the Federal 5922, send an e-mail to not conduct or sponsor, and the Reserve System, 20th Street and [email protected], or send a respondent is not required to respond Constitution Avenue, NW., Washington, facsimile transmission to (202) 906– to, an information collection unless it DC 20551. 7755. displays a currently valid Office of All public comments are available B. Proposed Information Collection. Management and Budget (OMB) control from the Board’s Web site at http:// Title of Information Collection: Risk- number. The agencies are requesting www.federalreserve.gov/generalinfo/ Based Capital Standards: Advanced comment on a proposed information foia/ProposedRegs.cfm as submitted, Capital Adequacy Framework. collection. The agencies are also giving unless modified for technical reasons. Frequency of Response: event- notice that the proposed collection of Accordingly, your comments will not be generated. information has been submitted to OMB edited to remove any identifying or Affected Public: for review and approval. contact information. Public comments OCC: National banks and Federal Comments are invited on: may also be viewed electronically or in branches and agencies of foreign banks. (a) Whether the collection of paper form in Room MP–500 of the Board: State member banks, bank information is necessary for the proper Board’s Martin Building (20th and C holding companies, affiliates and performance of the agencies’ functions, Streets, NW.) between 9 a.m. and 5 p.m. certain non-bank subsidiaries of bank including whether the information has on weekdays. holding companies, uninsured state practical utility; FDIC: You may submit written agencies and branches of foreign banks, (b) The accuracy of the estimates of comments, which should refer to 3064– commercial lending companies owned the burden of the information AC73, by any of the following methods: or controlled by foreign banks, and Edge collection, including the validity of the • Agency Web Site: http:// and agreement corporations. methodology and assumptions used; www.fdic.gov/regulations/laws/federal/ FDIC: Insured nonmember banks, (c) Ways to enhance the quality, propose.html. Follow the instructions insured state branches of foreign banks, utility, and clarity of the information to for submitting comments on the FDIC and certain subsidiaries of these be collected; Web site. entities. (d) Ways to minimize the burden of • Federal eRulemaking Portal: http:// OTS: Savings associations and certain the information collection on www.regulations.gov. Follow the of their subsidiaries. respondents, including through the use instructions for submitting comments. Abstract: The proposed rule sets forth of automated collection techniques or • E-mail: [email protected]. a new risk-based capital adequacy other forms of information technology; • Mail: Robert E. Feldman, Executive framework that would require some and Secretary, Attention: Comments, FDIC, banks and allow other qualifying banks (e) Estimates of capital or start up 550 17th Street, NW., Washington, DC to use an internal ratings-based costs and costs of operation, 20429. approach to calculate regulatory credit maintenance, and purchase of services • Hand Delivery/Courier: Guard risk capital requirements and advanced to provide information. station at the rear of the 550 17th Street measurement approaches to calculate Comments should be addressed to: Building (located on F Street) on regulatory operational risk capital OCC: Communications Division, business days between 7 a.m. and 5 p.m. requirements. Office of the Comptroller of the Public Inspection: All comments The information collection Currency, Public Information Room, received will be posted without change requirements in the proposed rule are Mail stop 1–5, Attention: 1557–NEW, to http://www.fdic.gov/regulations/laws/ found in sections 21–23, 42, 44, 53, and 250 E Street, SW., Washington, DC federal/propose/html including any 71. The collections of information are 20219. In addition, comments may be personal information provided. necessary in order to implement the sent by fax to 202–874–4448, or by Comments may be inspected at the FDIC proposed advanced capital adequacy electronic mail to Public Information Center, Room 100, framework.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00076 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55905

Sections 21 and 22 require that a bank Impact Study (QIS–4 survey, FR 3045; communities.’’86 Regulatory actions that adopt a written implementation plan OMB No. 7100–0303). The agencies are satisfy one or more of these criteria are that addresses how it will comply with concurrently publishing notices, which referred to as ‘‘economically significant the proposed advanced capital adequacy will address burden associated with the regulatory actions.’’ framework’s qualification requirements, first item (published elsewhere in this The OCC anticipates that the including incorporation of a issue), and jointly publishing a proposed rule will meet the $100 comprehensive and sound planning and rulemaking which will address burden million criterion and therefore is an governance process to oversee the associated with the second item. For the economically significant regulatory implementation efforts. The bank must third item, the Federal Reserve action. In conducting the regulatory also develop processes for assessing previously took burden for the QIS–4 analysis for an economically significant capital adequacy in relation to an survey, and some institutions may regulatory action, Executive Order organization’s risk profile. It must leverage the requirements of the QIS–4 12866 requires each Federal agency to establish and maintain internal risk survey to fulfill the requirements of this provide to the Administrator of the rating and segmentation systems for rule. Office of Management and Budget’s wholesale and retail risk exposures, The burden associated with this (OMB) Office of Information and including comprehensive risk parameter collection of information may be Regulatory Affairs (OIRA): quantification processes and processes summarized as follows: • The text of the draft regulatory for annual reviews and analyses of OCC action, together with a reasonably reference data to determine their Number of Respondents: 52. detailed description of the need for the relevance. It must document its process Estimated Burden Per Respondent: regulatory action and an explanation of for identifying, measuring, monitoring, 15,570 hours. how the regulatory action will meet that controlling, and internally reporting Total Estimated Annual Burden: need; operational risk; verify the accurate and 809,640 hours. • An assessment of the potential costs timely reporting of risk-based capital Board and benefits of the regulatory action, requirements; and monitor, validate, Number of Respondents: 15. including an explanation of the manner and refine its advanced systems. Estimated Burden Per Respondent: in which the regulatory action is Section 23 requires a bank to notify its 14,422 hours. consistent with a statutory mandate and, primary Federal supervisor when it Total Estimated Annual Burden: to the extent permitted by law, promotes makes a material change to its advanced 216,330 hours. the President’s priorities and avoids systems and to develop an FDIC undue interference with State, local, implementation plan after any mergers. Number of Respondents: 19. and tribal governments in the exercise Section 42 outlines the capital Estimated Burden Per Respondent: of their governmental functions; treatment for securitization exposures. 410 hours. • An assessment, including the A bank must disclose publicly that it Total Estimated Annual Burden: underlying analysis, of benefits has provided implicit support to the 7,800 hours. anticipated from the regulatory action securitization and the regulatory capital OTS (such as, but not limited to, the impact to the bank of providing such Number of Respondents: 4. promotion of the efficient functioning of implicit support. Estimated Burden Per Respondent: the economy and private markets, the Section 44 describes the IAA. A bank 15,000 hours. enhancement of health and safety, the must receive prior written approval Total Estimated Annual Burden: protection of the natural environment, from its primary Federal supervisor 60,000 hours. and the elimination or reduction of before it can use the IAA. A bank must Plain Language discrimination or bias) together with, to review and update each internal credit the extent feasible, a quantification of assessment whenever new material is Section 722 of the GLB Act requires those benefits; available, but at least annually. It must the agencies to use ‘‘plain language’’ in • An assessment, including the validate its internal credit assessment all proposed and final rules published underlying analysis, of costs anticipated process on an ongoing basis and at least after January 1, 2000. In light of this from the regulatory action (such as, but annually. requirement, the agencies have sought not limited to, the direct cost both to the Section 53 outlines the IMA. A bank to present the proposed rule in a simple government in administering the must receive prior written approval and straightforward manner. The regulation and to businesses and others from its primary Federal supervisor agencies invite comments on whether in complying with the regulation, and before it can use the IMA. there are additional steps the agencies any adverse effects on the efficient Section 71 specifies that each could take to make the proposed rule functioning of the economy, private consolidated bank must publicly easier to understand. markets (including productivity, disclose its total and tier 1 risk-based OCC Executive Order 12866 employment, and competitiveness), capital ratios and their components. health, safety, and the natural Estimated Burden: The burden Executive Order 12866 requires environment), together with, to the estimates below exclude the following: Federal agencies to prepare a regulatory (1) Any burden associated with changes impact analysis for agency actions that 86 Executive Order 12866 (September 30, 1993), to the regulatory reports of the agencies are found to be ‘‘significant regulatory 58 FR 51735 (October 4, 1993), as amended by (such as the Consolidated Reports of actions.’’ ‘‘Significant regulatory Executive Order 13258, 67 FR 9385 (February 28, Income and Condition for banks (FFIEC actions’’ include, among other things, 2002). For the complete text of the definition of ‘‘significant regulatory action,’’ see E.O. 12866 at 031 and FFIEC 031; OMB Nos. 7100– rulemakings that ‘‘have an annual effect section 3(f). A ‘‘regulatory action’’ is ‘‘any 0036, 3064–0052, 1557–0081) and the on the economy of $100 million or more substantive action by an agency (normally Thrift Financial Report for thrifts (TFR; or adversely affect in a material way the published in the Federal Register) that promulgates OMB No. 1550–0023); (2) any burden economy, a sector of the economy, or is expected to lead to the promulgation of a final rule or regulation, including notices of inquiry, associated with capital changes in the productivity, competition, jobs, the advance notices of proposed rulemaking, and Basel II market risk rule; and (3) any environment, public health or safety, or notices of proposed rulemaking.’’ E.O. 12866 at burden associated with the Quantitative State, local, or tribal governments or section 3(e).

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00077 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55906 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

extent feasible, a quantification of those II. Costs and Benefits of the Proposed of the principal objectives of the costs; and Rule. proposed rule is to more closely align • An assessment, including the Under the proposed rule, current capital charges and risk. For any type of underlying analysis, of costs and capital rules would remain in effect in credit, risk increases as either the benefits of potentially effective and 2008 during a parallel run using both probability of default or the loss given reasonably feasible alternatives to the current non-Basel II-based and new default increases. Under the proposed planned regulation, identified by the Basel II-based capital rules. For the rule, risk weights depend on these risk agencies or the public (including following three years, the proposed rule measures and consequently capital improving the current regulation and would apply limits on the amount by requirements will more closely reflect reasonably viable nonregulatory which minimum required capital may risk. This enhanced link between capital actions), and an explanation why the decrease. This analysis, however, requirements and risk will encourage planned regulatory action is preferable considers the costs and benefits of the banking organizations to improve credit to the identified potential alternatives. proposed rule as fully phased in. risk management. Set forth below is a summary of the Cost and benefit analysis of changes 4. More efficient use of required bank OCC’s regulatory impact analysis, which in minimum capital requirements capital: Increased risk sensitivity and can be found in its entirety at http:// entails considerable measurement improvements in risk measurement will www.occ.treas.gov/law/basel.htm under problems. On the cost side, it can be allow prudential objectives to be the link of ‘‘Regulatory Impact Analysis difficult to attribute particular achieved more efficiently. If capital for Risk-Based Capital Standards: expenditures incurred by institutions to rules can better align capital with risk Revised Capital Adequacy Guidelines the costs of implementation because across the system, a given level of (Basel II), Office of the Comptroller of banking organizations would likely capital will be able to support a higher the Currency, International and incur some of these costs as part of their level of banking activity while Economic Affairs (2006)’’. ongoing efforts to improve risk maintaining the same degree of I. The Need for the Regulatory Action. measurement and management systems. confidence regarding the safety and Federal banking law directs Federal On the benefits side, measurement soundness of the banking system. Social banking agencies, including the OCC, to problems are even greater because the welfare is enhanced by either the require banking organizations to hold benefits of the proposal are more stronger condition of the banking qualitative than quantitative. adequate capital. The law authorizes system or the increased economic Measurement problems exist even with Federal banking agencies to set activity the additional banking services an apparently measurable benefit like minimum capital levels to ensure that facilitate. banking organizations maintain lower minimum capital because lower 5. Incorporates and encourages adequate capital. The law also gives minimum requirements do not advances in risk measurement and risk banking agencies broad discretion with necessarily mean lower capital. Healthy management: The proposed rule seeks respect to capital regulation by banking organizations generally hold to improve upon existing capital authorizing them to use any other capital well above regulatory minimums regulations by incorporating advances methods that they deem appropriate to for a variety of reasons, and the effect in risk measurement and risk ensure capital adequacy. of reducing the regulatory minimum is Capital regulation seeks to address uncertain and may vary across regulated management made over the past 15 market failures that stem from several institutions. years. An objective of the proposed rule sources. Asymmetric information about A. Benefits of the Proposed Rule. is to speed adoption of new risk the risk in a bank’s portfolio creates a 1. Better allocation of capital and management techniques and to promote market failure by hindering the ability reduced impact of moral hazard the further development of risk of creditors and outside monitors to through reduction in the scope for measurement and management through discern a bank’s actual risk and capital regulatory arbitrage: By assessing the the regulatory process. adequacy. Moral hazard creates market amount of capital required for each 6. Recognizes new developments and failure in which the bank’s creditors fail exposure or pool of exposures, the accommodates continuing innovation in to restrain the bank from taking advanced approach does away with the financial products by focusing on risk: excessive risks because deposit simplistic risk buckets of current capital The proposed rule also has the benefit insurance either fully or partially rules. Eliminating categorical risk of facilitating recognition of new protects them from losses. Public policy weighting and assigning capital based developments in financial products by addresses these market failures because on measured risk instead greatly curtails focusing on the fundamentals behind individual banks fail to adequately or eliminates the ability of troubled risk rather than on static product consider the positive externality or organizations to ‘‘game’’ regulatory categories. public benefit that adequate capital capital requirements by finding ways to 7. Better aligns capital and brings to financial markets and the comply technically with the operational risk and encourages economy as a whole. requirements while evading their intent banking organizations to mitigate Capital regulations cannot be static. and spirit. operational risk: Introducing an explicit Innovation in and transformation of 2. Improved signal quality of capital capital calculation for operational risk financial markets require periodic as an indicator of solvency: The eliminates the implicit and imprecise reassessments of what may count as advanced approaches of the proposed ‘‘buffer’’ that covers operational risk capital and what amount of capital is rule are designed to more accurately under current capital rules. Introducing adequate. Continuing changes in align regulatory capital with risk, which an explicit capital requirement for financial markets create both a need and should improve the quality of capital as operational risk improves assessments an opportunity to refine capital an indicator of solvency. The improved of the protection capital provides, standards in banking. The Basel II signaling quality of capital will enhance particularly at organizations where framework, and its proposed banking supervision and market operational risk dominates other risks. implementation in the United States, discipline. The explicit treatment also increases the reflects an appropriate step forward in 3. Encourages banking organizations transparency of operational risk, which addressing these changes. to improve credit risk management: One could encourage banking organizations

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00078 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55907

to take further steps to mitigate questions related to compliance costs in inconvenience of having to adapt to new operational risk. QIS–4.87 capital regulations. At a minimum this 8. Enhanced supervisory feedback: 1. Overall Costs: According to the 19 involves the increased time and Although U.S. banking organizations out of 26 QIS–4 questionnaire attention required of senior bank and have long been subject to close respondents that provided estimates of thrift management to introduce new supervision, aspects of all three pillars their implementation costs, programs and procedures and the need of the proposed rule aim to enhance organizations will spend roughly $42 to closely monitor the new activities supervisory feedback from Federal million on average to adapt to capital during the inevitable rough patches banking agencies to managers of banks requirements implementing Basel II. Not when the proposed rule first takes and thrifts. Enhanced feedback could all of these respondents are likely effect. further strengthen the safety and mandatory organizations. Counting just 5. Government administrative costs: soundness of the banking system. the likely mandatory organizations, the OCC expenditures fall into three broad 9. Incorporates market discipline into average is approximately $46 million, so categories: training, guidance, and the regulatory framework: The proposed there is little difference between supervision. Training includes expenses rule seeks to introduce market organizations that meet a mandatory for AMA workshops, IRB workshops, discipline directly into the regulatory threshold and those that do not. and other training courses and seminars framework by requiring specific Aggregating estimated expenditures for examiners. Guidance expenses disclosures relating to risk measurement from all 19 respondents indicates that reflect expenditures on the development and risk management. Market discipline these organizations will spend a total of of IRB and AMA guidance. Supervision could complement regulatory $791 million over several years to expenses reflect organization-specific supervision to bolster safety and implement the proposed rule. Estimated supervisory activities related to the soundness. costs for nine respondents meeting one development and implementation of the 10. Preserves the benefits of of the mandatory thresholds come to Basel II framework. The largest OCC international consistency and $412 million. expenditures have been on the coordination achieved with the 1988 2. Estimate of costs specific to the development of IRB and AMA policy Basel Accord: An important objective of proposal: Ten QIS–4 respondents guidance. The $4.6 million spent on the 1988 Accord was competitive provided estimates of the portion of guidance represents 65 percent of the consistency of capital requirements for costs they would have incurred even if estimated total OCC Basel II-related banking organizations competing in current capital rules remain in effect. expenditure of $7.1 million through the global markets. Basel II continues to Those ten indicated that they would 2005 fiscal year. In part, this large share pursue this objective. Because achieving have spent 45 percent on average, or reflects the absence of data for training this objective depends on the roughly half of their Basel II and supervision costs for several years, consistency of implementation in the expenditures on improving risk but it also is indicative of the large United States and abroad, the Basel management anyway. This suggests that guidance expenses in 2002 and 2003 Committee has established an Accord of the $42 million organizations expect when the Basel II framework was in Implementation Group to promote to spend on implementation, development. To date, Basel II consistency in the implementation of approximately $21 million may expenditures have not been a large part Basel II. represent expenditures each institution of overall OCC expenditures. The $3 11. Ability to opt in offers long-term would have undertaken even without million spent on Basel II in fiscal year flexibility to nonmandatory banking Basel II. Thus, pure implementation 2005 represents less than one percent of organizations: The proposed U.S. costs may be closer to roughly $395 the OCC’s $519 million budget for the implementation of Basel II allows million for the 19 QIS–4 respondents. year. banking organizations outside of the 3. Ongoing costs: Seven QIS–4 6. Total cost: The OCC’s estimate of mandatory group to individually judge respondents were able to estimate what the total cost of the proposed rule when the benefits they expect to realize their recurring costs might be under the includes expenditures by banking from adopting the advanced approaches proposed implementation of Basel II. On organizations and the OCC from the outweigh their costs. Even though the average, the seven organizations present through 2011, the final year of cost and complexity of adopting the estimate that annual recurring expenses the transition period. Combining advanced approaches may present attributable to the proposed capital expenditures by mandatory banking nonmandatory organizations with a framework will be $2.4 million. organizations and the OCC provides a substantial hurdle to opting in at Organizations indicated that the present value estimate of $545.9 million present, the potential long-term benefits ongoing costs to maintain related for the total cost of the proposed rule. 7. Procyclicality: Procyclicality refers of allowing nonmandatory organizations technology reflect costs for increased to the possibility that banking to partake in the benefits described personnel and system maintenance. The organizations may reduce lending above may be similarly substantial. larger one-time expenditures primarily during economic downturns and B. Costs of the Proposed Rule. involve money for system development Because banking organizations are increase lending during economic and software purchases. constantly developing programs and 4. Implicit costs: In addition to expansions as a consequence of systems to improve how they measure explicit setup and recurring costs, minimum capital requirements. There is some concern that the risk-sensitivity of and manage risk, it is difficult to banking organizations may also face the IRB approach may cause capital distinguish between expenditures implicit costs arising from the time and explicitly caused by adoption of the requirements for credit risk to increase proposed rule and costs that would have 87 For more information on QIS–4, see Office of during an economic downturn. occurred irrespective of any new the Comptroller of the Currency, Board of Although procyclicality may be inherent regulation. In an effort to identify how Governors of the Federal Reserve System, Federal in banking to some extent, elements of much banking organizations expect to Deposit Insurance Corporation, and Office of Thrift the advanced approaches could reduce Supervision, ‘‘Summary Findings of the Fourth spend to comply with the U.S. Quantitative Impact Study,’’ February 2006, inherent procyclicality. Risk implementation of Basel II, the Federal available online at http://www.occ.treas.gov/ftp/ management and information systems banking agencies included several release/2006–23a.pdf. may provide bank managers with more

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00079 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55908 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

forward-looking information about risk fact that the proposed rule may lead to 4. Mergers and Acquisitions: Another that would allow them to adjust substantial reductions in credit-risk concern related to potential changes in portfolios gradually and with more capital for residential mortgages. To the competitive conditions under the foresight as the economic outlook extent that corresponding operational- proposed rule is that bifurcation of changes over the business cycle. risk capital requirements do not offset capital standards might change the Regulatory stress-testing requirements these credit-risk-related reductions, landscape with regard to mergers and included in the proposal also will help overall capital requirements for acquisitions in banking and financial ensure that institutions anticipate residential mortgages could decline services. For example, banking cyclicality in capital requirements to the under the proposed rule. Studies by organizations operating under the new greatest extent possible, reducing the Calem and Follain 89 and Hancock, Basel II-based capital requirements potential economic impact of changes in Lehnert, Passmore, and Sherlund 90 might be placed in a better position to capital requirements. suggest that banking organizations acquire other banking organizations III. Competition Among Providers of operating under capital rules based on operating under the non-Basel II-based Financial Services Basel II may increase their holdings of rules, possibly leading to an undesirable One potential concern with any residential mortgages. Calem and consolidation of the banking sector. regulatory change is the possibility that Follain argue that the increase would be Research by Hannan and Pilloff 92 it might create a competitive advantage significant and come at the expense of suggests that the proposed rule is for some organizations relative to others, general organizations. Hancock et al. unlikely to have a significant impact on a possibility that certainly applies to a foresee a more modest increase in merger and acquisition activity in change with the scope of this proposed residential mortgage holdings at banking. rule. However, measurement difficulties institutions operating under the new 5. Credit Card Competition: The described in the preceding discussion of proposed U.S. implementation of Basel costs and benefits also extend to any Basel II-based rules, and they see this increase primarily as a shift away from II might also affect competition in the consideration of the impact on credit card market. Overall capital competition. Despite the inherent the large government sponsored mortgage enterprises. requirements for credit card loans could difficulty of drawing definitive increase under the proposed rule. This conclusions, this section considers 3. Small Business Lending: One raises the possibility of a change in the various ways in which competitive potential avenue for competitive effects competitive environment among effects might be manifest, as well as is small-business lending. Smaller banking organizations subject to the available evidence related to those banks—those that are less likely to new Basel II-based capital rules, potential effects. adopt the advanced approaches to nonbank credit card issuers, and 1. Explicit Capital for Operational regulatory capital under the proposed banking organizations not subject to the Risk: Some have noted that the explicit rule—tend to rely more heavily on new Basel II-based capital rules. A study computation of required capital for smaller loans within their commercial by Lang, Mester, and Vermilyea 93 finds operational risk could lead to an loan portfolios. To the extent that the that implementation of a rule based on increase in total minimum regulatory proposed rule reduces required capital Basel II will not affect credit card capital for U.S. ‘‘processing’’ banks, for such loans, general banking competition at most community and generally defined as banking organizations not operating under the regional banking organizations. The organizations that tend to engage in a proposed rule might be placed at a authors also suggest that higher capital variety of activities related to securities competitive disadvantage. A study by requirements for credit cards may only clearing, asset management, and 91 Berger finds some potential for a pose a modest disadvantage to custodial services. Some have suggested relatively small competitive effect on institutions that are subject to rules that the increase in required capital smaller banks in small business lending. based on Basel II. could place such firms at a competitive However, Berger concludes that the Overall, the evidence regarding the disadvantage relative to competitors that small business market for large banks is impact of the proposed rule on do not face a similar capital very different from the small business competitive equity is mixed. The body requirement. A careful analysis by market for smaller banks. For instance, of recent economic research discussed Fontnouvelle et al 88 considers the a ‘‘small business’’ at a larger banking in the body of this report does not reveal potential competitive impact of the organization is usually much larger than persuasive evidence of any sizeable explicit capital requirement for small businesses at community banking competitive effects. Nonetheless, the operational risk. Overall, the study organizations. Federal banking agencies recognize the concludes that competitive effects from need to closely monitor the competitive an explicit operational risk capital 89 Paul S. Calem and James R. Follain, ‘‘An landscape subsequent to any regulatory requirement should be, at most, Examination of How the Proposed Bifurcated change. In particular, the OCC and other extremely modest. Implementation of Basel II in the U.S. May Affect Federal banking agencies will be alert 2. Residential Mortgage Lending: The Competition Among Banking Organizations for issue of competitive effects has received Residential Mortgages,’’ manuscript, January 14, 2005. 92 Timothy H. Hannan and Steven J. Pilloff, ‘‘Will substantial attention with respect to the 90 Diana Hancock, Andreas Lehnert, Wayne the Proposed Application of Basel II in the United residential mortgage market. The focus Passmore, and Shane M. Sherlund, ‘‘An Analysis of States Encourage Increased Bank Merger Activity? on the residential mortgage market the Potential Competitive Impact of Basel II Capital Evidence from Past Merger Activity,’’ Federal stems from the size and importance of Standards on U.S. Mortgage Rates and Mortgage Reserve Board Finance and Economics Discussion Securitization’’, Federal Reserve Board manuscript, Series, 2004–13. Available at http:// the market in the United States and the April 2005. Available at http:// www.federalreserve.gov/generalinfo/basel2/ www.federalreserve.gov/generalinfo/basel2/ whitepapers.htm. 88 Patrick de Fontnouvelle, Victoria Garrity, Scott whitepapers.htm. 93 William W. Lang, Loretta J. Mester, and Todd Chu, and Eric Rosengren, ‘‘The Potential Impact of 91 Allen N. Berger, ‘‘Potential Competitive Effects A. Vermilyea, ‘‘Potential Competitive Effects on Explicit Operational Risk Capital Charges on Bank of Basel II on Banks in SME Credit Markets in the U.S. Bank Credit Card Lending from the Proposed Processing Activities,’’ Manuscript, Federal Reserve United States,’’ Federal Reserve Board Finance and Bifurcated Application of Basel II,’’ manuscript, Bank of Boston, January 12, 2005. Available at Economics Discussion Series, 2004–12. Available at December 2005. Available at http:// http://www.federalreserve.gov/generalinfo/basel2/ http://www.federalreserve.gov/generalinfo/basel2/ www.federalreserve.gov/generalinfo/basel2/ whitepapers.htm. whitepapers.htm. whitepapers.htm.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00080 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55909

for early signs of competitive inequities risk. Concerns regarding competition even the standardized approach. How that might result from this proposed usually center on these two Alternative A might affect benefits rule. A multi-year transition period characteristics of the proposed rule. depends entirely on how many banking before full implementation of proposed While continuing to use current capital organizations select each of the three rules based on Basel II should provide rules eliminates most of the benefits of available options. The most significant ample opportunity for the agencies to adopting the proposed capital rule, it drawback to Alternative A is the identify any emerging problems. To the does not eliminate many costs increased cost of applying a new set of extent that undesirable competitive associated with Basel II. Because Basel capital rules to all U.S. banking inequities emerge, the agencies have the II costs are difficult to separate from the organizations. The vast majority of power to respond to them through many banking organization’s ordinary banking organizations in the United channels, including but not limited to development costs and ordinary States would incur no direct costs from suitable changes to the capital adequacy supervisory costs at the agencies, new capital rules under the proposed regulations. dropping the proposal to implement rule. Under Alternative A, direct costs IV. Analysis of Baseline and Basel II would reduce but not eliminate would increase for every U.S. banking Alternatives. many of these costs associated with the organization that would have continued Executive Order 12866 requires a proposed rule.95 with current capital rules under the comparison between the proposed rule, 2. Baseline Scenario 2: Current capital proposed rule. Although it is not clear a baseline of what the world would look standards based on the 1988 Basel how high these costs might be, general like without the proposed rule, and Accord continue to apply in the United banking organizations would face higher several reasonable alternatives to the States, but the rest of the world adopts costs because they would be changing proposed rule. In this regulatory impact the Basel II framework: Like the first capital rules regardless of which option analysis, we analyze two baselines and baseline scenario, abandoning a they choose under Alternative A. three alternatives to the proposed rule. framework based on Basel II in favor of 4. Alternative B: Permit U.S. banking We consider two baselines because of current capital rules would eliminate organizations to choose among all three two very different outcomes that depend essentially all of the benefits of the Basel II operational risk approaches: on the capital rules that other countries proposed rule described earlier. Like the The operational risk approach that with internationally active banks might first baseline scenario, the one banking organizations ultimately adopt absent the implementation of the advantage of this scenario is that there selected would determine how the Basel II framework in the United would be no bifurcation of capital rules overall benefits of the new capital States.94 The first baseline considers the within the United States. However, the regulations would change under possibility that neither the United States emergence of different capital rules Alternative B. Just as Alternative A nor these other countries adopt capital across national borders would at least increases the flexibility of credit risk rules based on the Basel II framework. partially offset this advantage. Thus, rules for mandatory banking The second baseline analyzes the while concerns regarding competition organizations, Alternative B is more situation where the United States does among U.S. financial service providers flexible with respect to operational risk. not adopt the proposed rule, but the might diminish in this scenario, Because the Standardized Approach other countries with internationally concerns regarding cross-border tries to be more sensitive to variations active banking organizations do adopt competition would likely increase. Just in operational risk than the Basic Basel II. as the first baseline scenario eliminated Indicator Approach and the AMA is A. Presentation of Baselines and most of the benefits of adopting the more sensitive than the Standardized Alternatives. proposed rule, the same holds true for Approach, the effect of implementing 1. Baseline Scenario 1: Current capital the second baseline scenario with one Alternative B depends on how many standards based on the 1988 Basel important distinction. Because the banking organizations select the more Accord continue to apply both here and United States would be operating under risk sensitive approaches. As was the abroad: Abandoning the Basel II a set of capital rules different from the case with Alternative A, the most framework in favor of current capital rest of the world, U.S. banking significant drawback to Alternative B is rules would eliminate essentially all of organizations that are internationally the increased cost of applying a new set the benefits of the proposed rule active may face higher costs because of capital rules to all U.S. banking described earlier. In place of these lost they will have to track and comply with organizations. Under Alternative B, or diminished benefits, the only more than one set of capital direct costs would increase for every advantage of continuing to apply requirements. U.S. banking organization that would current capital rules to all banking 3. Alternative A: Permit U.S. banking have continued with current capital organizations is that maintaining the organizations to choose among all three rules under the proposed rule. It is not status quo should alleviate concerns Basel II credit risk approaches: The clear how much it might cost banking regarding competition among financial principal benefit of Alternative A that organizations to adopt these capital service providers. Although the effect of the proposed rule does not achieve is measures for operational risk, but the proposed rule on competition is the increased flexibility of the general banking organizations would uncertain in our estimation, staying regulation for banking organizations that face higher costs because they would be with current capital rules (or universally would be mandatory banking changing capital rules regardless of applying a revised rule that might organizations under the proposed rule. which option they choose under emerge from the Basel IA ANPR) Banking organizations that are not Alternative B. eliminates bifurcation and the explicit prepared for the adoption of the 5. Alternative C: Use a different asset assignment of capital for operational advanced IRB approach to credit risk amount to determine a mandatory under the proposed rule could choose to organization: The number of mandatory 94 In addition to the United States, members of use the foundation IRB approach or banking organizations decreases slowly the Basel Committee on Banking Supervision as the size thresholds increase, and the considering Basel II are Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the 95 Cost estimates for adopting a rule that might number of banking organizations grows Netherlands, Spain, Sweden, Switzerland, and the result from the Basel IA ANPR are not currently more quickly as the thresholds decrease. United Kingdom. available. Under Alternative C, the framework of

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00081 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55910 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

the proposed rule would remain the undertake the time and expense of Because of the low credit risk same and only the number of mandatory adjusting to these new rules. Alternative associated with residential mortgage- banking organizations would change. C would change the number of related assets, OTS believes that the Because the structure of the proposed mandatory banking organizations. If the risk-insensitive leverage ratio, rather implementation would remain intact, number of mandatory banking than the risk-based capital ratio, may be Alternative C would capture all of the organizations increases, then the new more binding on its institutions.96 As a benefits of the proposed rule. However, rule would lose some of the flexibility result, these institutions may be because these benefits derive from the proposed rule achieves with the opt- required to hold more capital than applying the proposed rule to in option. Furthermore, costs would would be required under proposed individual banking organizations, increase as the new rule would compel credit risk-based standards alone. changing the number of banking more banking organizations to incur the Therefore, the NPR may cause these organizations affected by the rule will expense of adopting the advanced institutions to incur much the same change the cumulative level of the approaches. Decreasing the number of implementation costs as banks with benefits achieved. Generally, the mandatory banking organizations would riskier assets, but with reduced benefits. benefits associated with the proposed decrease the aggregate social good of Costs. OTS adopts the OCC cost rule will rise and fall with the number each benefit achieved with the proposed analysis with the following of mandatory banking organizations. rule. The proposed rule seems to offer supplemental information on OTS’s Because Alternative C would change the a better balance between costs and administrative costs. OTS did not incur number of mandatory banking benefits than any of the three a meaningful amount of direct organizations subject to the proposed alternatives. expenditures until 2002 when it rule, aggregate costs will also rise or fall OTS Executive Order 12866 transitioned from a monitoring role to with the number of mandatory banking Determination. OTS commented on the active involvement in Basel II. organizations. development of, and concurs with, Thereafter, expenditures increased B. Overall Comparison of the OCC’s RIA. Rather than replicate that rapidly. The OTS expenditures fall into Proposed Rule with Baselines and analysis, OTS drafted an RIA two broad categories: Policymaking Alternatives. incorporating OCC’s analysis by expenses incurred in the development The Basel II framework and its reference and adding appropriate of the ANPR, this NPR, and related proposed U.S. implementation seek to material reflecting the unique aspects of guidance; and supervision expenses that incorporate risk measurement and risk the thrift industry. The full text of OTS’s reflect institution-specific supervisory management advances into capital RIA is available at the locations for activities. OTS estimates that it incurred requirements. On the basis of their viewing the OTS docket indicated in the total expenses of $3,780,000 for fiscal analysis, the agencies believe that the ADDRESSES section above. OTS believes years 2002 through 2005, including benefits of the proposed rule are that its analysis meets the requirements $2,640,000 in policymaking expenses significant, durable, and hold the of Executive Order 12866. The following and $1,140,000 in supervision expenses. potential to increase with time. The discussion supplements OCC’s OTS anticipates that supervision offsetting costs of implementing the expenses will continue to grow as a proposed rule are also significant, but summary of its RIA. The NPR would apply to percentage of the total expense as it appear to be largely because of moves from policy development to considerable start-up costs. However, approximately eight mandatory and potential opt-in savings associations implementation and training. To date, much of the apparent start-up costs Basel II expenditures have not been a reflect activities that the banking representing approximately 46 percent large part of overall expenditures. organizations would undertake as part of total thrift industry assets. Approximately 70 percent of the total Competition. OTS agrees with OCC’s of their ongoing efforts to improve the analysis of competition among quality of their internal risk assets in these eight institutions are concentrated in residential mortgage- providers of financial services. OTS measurement and management, even in adds, however, that some institutions the absence of Basel II and this related assets. By contrast, national banks tend to concentrate their assets in with low credit risk portfolios face an proposed rule. The advanced existing competitive disadvantage approaches seem to have fairly modest commercial loans and other kinds of because they are bound by a non-risk- ongoing expenses. Against these costs, non-mortgage loans. Only about 35 based capital requirement—the leverage the significant benefits of Basel II percent of national bank’s total assets ratio. Thus, the agencies regulate a class suggest that the proposed rule offers an are residential mortgage-related assets. of institutions that currently receive improvement over either of the two As a result, the costs and benefits of the fewer capital benefits from risk-based baseline scenarios. NPR for OTS-regulated savings With regard to the three alternative associations will differ in important capital rules because they are bound by approaches we consider, the proposed ways from OCC-regulated national the risk-insensitive leverage ratio. This rule seems to offer an important degree banks. These differences are the focus of anomaly will likely continue under the of flexibility while significantly OTS’s analysis. NPR. restricting the cost of the proposed rule Benefits. Among the benefits of the 96 The leverage ratio is the ratio of core capital to by limiting its application to large, NPR, OCC cites: (i) Better allocation of adjusted total assets. Under prompt corrective complex, internationally active banking capital and reduced impact of moral action requirements, savings associations must organizations. Alternatives A and B hazard through reduction in the scope maintain a leverage ratio of at least five percent to introduce more flexibility from the for regulatory arbitrage; (ii) improved be well capitalized and at least four percent to be adequately capitalized. Basel II will primarily affect perspective of the large mandatory signal quality of capital as an indicator the calculation of risk-weighted assets, rather than banking organizations, but each is less of institution solvency; and (iii) more the calculation of total assets and will have only a flexible with respect to other banking efficient use of required bank capital. modest impact on the calculation of core capital. organizations. Either Alternative A or B From OTS’s perspective, however, the Thus, the proposed Basel II changes should not significantly affect the calculated leverage ratio and would compel these banking NPR may not provide the degree of a savings association that is currently constrained organizations to select a new set of benefits anticipated by OCC from these by the leverage ratio would not significantly benefit capital rules and require them to sources. from the Basel II changes.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00082 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55911

In addition, the results from QIS–3 result in the expenditure by State, local, document titled Regulatory Impact and QIS–4 suggest that the largest and tribal governments, in the aggregate, Analysis for Risk-Based Capital reductions in regulatory credit-risk or by the private sector of $100 million Standards: Revised Capital Adequacy capital requirements from the or more (adjusted annually for inflation) Guidelines. The analysis is available at application of revised rules would occur in any one year. The current inflation- the locations for viewing the OTS in the residential mortgage loan area. adjusted expenditure threshold is docket indicated in the ADDRESSES Thus, to the extent regulatory credit-risk $119.6 million. The requirements of the section above. capital requirements affect pricing of UMRA include assessing a rule’s effects Text of Common Appendix (All such loans, it is possible that core and on future compliance costs; particular Agencies) opt-in institutions who are not regions or State, local, or tribal constrained by the leverage ratio may governments; communities; segments of The text of the agencies’ common experience an improvement in their the private sector; productivity; appendix appears below: competitive standing vis-a`-vis non- economic growth; full employment; [Appendix to Partll]—Capital 100 adopters and vis-a`-vis adopters who are creation of productive jobs; and the Adequacy Guidelines for [Bank]s: bound by the leverage ratio. Two international competitiveness of U.S. Internal-Ratings-Based and Advanced research papers—one by Calem and goods and services. The proposed rule Measurement Approaches Part I General Provisions Follain,97 and another by Hancock, qualifies as a significant regulatory 98 Section 1 Purpose, Applicability, and Lenhert, Passmore, and Sherlund action under the UMRA because its Reservation of Authority addressed this topic. The Calem and Federal mandates may result in the Section 2 Definitions Follain paper argues that Basel II will expenditure by the private sector of Section 3 Minimum Risk-Based Capital significantly affect the competitive $119.6 million or more in any one year. Requirements environment in mortgage lending; As permitted by section 202(c) of the Part II Qualifying Capital Hancock, et al. argue that it will not. UMRA, the required analyses have been Section 11 Additional Deductions Both papers are predicated, however, on prepared in conjunction with the Section 12 Deductions and Limitations the current capital regime for non- Not Required Executive Order 12866 analysis Section 13 Eligible Credit Reserves adopters. The agencies recently document titled Regulatory Impact Part III Qualification published an ANPR seeking comment Analysis for Risk-Based Capital Section 21 Qualification Process on various modifications to the existing Standards: Revised Capital Adequacy Section 22 Qualification Requirements risk-based capital rules.99 These changes Guidelines. The analysis is available on Section 23 Ongoing Qualification may reduce the competitive disparities the Internet at http://www.occ.treas.gov/ Part IV Risk-Weighted Assets for General between adopters and non-adopters of law/basel.htm under the link of Credit Risk Basel II by reducing the competitive Section 31 Mechanics for Calculating ‘‘Regulatory Impact Analysis for Risk- Total Wholesale and Retail Risk- advantage of Basel II adopters. Based Capital Standards: Revised Further, residential mortgages are Weighted Assets Capital Adequacy Guidelines (Basel II), Section 32 Counterparty Credit Risk subject to substantial interest rate risk. Office of the Comptroller of the Section 33 Guarantees and Credit The agencies will retain the authority to Currency, International and Economic Derivatives: PD Substitution and LGD require additional capital to cover Affairs (2006)’’. Adjustment Treatments interest rate risk. If regulatory capital Section 34 Guarantees and Credit requirements affect asset pricing, a OTS Unfunded Mandates Reform Act Derivatives: Double Default Treatment substantial regulatory capital interest of 1995 Determination. The Unfunded Section 35 Risk-Based Capital rate risk component could mitigate any Mandates Reform Act of 1995 (Pub. L. Requirement for Unsettled Transactions competitive advantages of the proposed 104–4) (UMRA) requires cost-benefit Part V Risk-Weighted Assets for and other analyses for a rule that would Securitization Exposures rule. Moreover, the capital requirement Section 41 Operational Criteria for for interest rate risk would be subject to include any Federal mandate that may result in the expenditure by State, local, Recognizing the Transfer of Risk interpretation by each agency. A Section 42 Risk-Based Capital consistent evaluation of interest rate risk and tribal governments, in the aggregate, Requirement for Securitization by the supervisory agencies would or by the private sector of $100 million Exposures present a level playing field among the or more (adjusted annually for inflation) Section 43 Ratings-Based Approach adopters—an important consideration in any one year. The current inflation- (RBA) adjusted expenditure threshold is Section 44 Internal Assessment Approach given the potential size of the capital (IAA) requirement. $119.6 million. The requirements of the UMRA include assessing a rule’s effects Section 45 Supervisory Formula OCC Unfunded Mandates Reform Act Approach (SFA) of 1995 Determination. The Unfunded on future compliance costs; particular Section 46 Recognition of Credit Risk Mandates Reform Act of 1995 (Pub. L. regions or State, local, or tribal Mitigants for Securitization Exposures 104–4) (UMRA) requires cost-benefit governments; communities; segments of Section 47 Risk-Based Capital and other analyses for a rule that would the private sector; productivity; Requirement for Early Amortization include any Federal mandate that may economic growth; full employment; Provisions creation of productive jobs; and the Part VI Risk-Weighted Assets for Equity Exposures 97 international competitiveness of U.S. Paul S. Calem and James R. Follain, ‘‘An Section 51 Introduction and Exposure Examination of How the Proposed Bifurcated goods and services. The proposed rule Measurement Implementation of Basel II in the U.S. May Affect qualifies as a significant regulatory Competition Among Banking Organizations for Section 52 Simple Risk Weight Approach Residential Mortgages,’’ manuscript, January 14, action under the UMRA because its (SRWA) 2005. Federal mandates may result in the Section 53 Internal Models Approach 98 Diana Hancock, Andreas Lenhert, Wayne expenditure by the private sector of (IMA) Passmore, and Shane M Sherlund, ‘‘An Analysis of $119.6 or more in any one year. As the Competitive Impacts of Basel II Capital permitted by section 202(c) of the 1 For simplicity, and unless otherwise noted, this Standards on U.S. Mortgage Rates and Mortgage UMRA, the required analyses have been NPR uses the term [bank] to include banks, savings Securitization, March 7, 2005, Board of Governors associations, and bank holding companies. of the Federal Reserve System, working paper.’’ prepared in conjunction with the [AGENCY] refers to the primary Federal supervisor 99 70 FR 61068 (Oct. 20, 2005). Executive Order 12866 analysis of the bank applying the rule.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00083 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55912 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

Section 54 Equity Exposures to appropriate in light of the [bank]’s asset assessment systems, or quantification Investment Funds size, level of complexity, risk profile, or systems, all as specified by the Section 55 Equity Derivative Contracts scope of operations. In making a [AGENCY]. Part VII Risk-Weighted Assets for determination under this paragraph, the (3) Other supervisory authority. Operational Risk Nothing in this appendix limits the Section 61 Qualification Requirements [AGENCY] will apply notice and for Incorporation of Operational Risk response procedures in the same authority of the [AGENCY] under any Mitigants manner and to the same extent as the other provision of law or regulation to Section 62 Mechanics of Risk-Weighted notice and response procedures in 12 take supervisory or enforcement action, Asset Calculation CFR 3.12 (for national banks), 12 CFR including action to address unsafe or Part VIII Disclosure 263.202 (for bank holding companies unsound practices or conditions, Section 71 Disclosure Requirements and state member banks), 12 CFR deficient capital levels, or violations of Part I. General Provisions 325.6(c) (for state nonmember banks), law. and 12 CFR 567.3(d) (for savings Section 1. Purpose, Applicability, and associations). Section 2. Definitions Reservation of Authority (c) Reservation of authority—(1) Advanced internal ratings-based (IRB) (a) Purpose. This appendix Additional capital in the aggregate. The systems means a [bank]’s internal risk establishes: [AGENCY] may require a [bank] to hold rating and segmentation system; risk (1) Minimum qualifying criteria for an amount of capital greater than parameter quantification system; data [bank]s using [bank]-specific internal otherwise required under this appendix management and maintenance system; risk measurement and management if the [AGENCY] determines that the and control, oversight, and validation processes for calculating risk-based [bank]’s risk-based capital requirement system for credit risk of wholesale and capital requirements; under this appendix is not retail exposures. (2) Methodologies for such [bank]s to commensurate with the [bank]’s credit, Advanced systems means a [bank]’s calculate their risk-based capital market, operational, or other risks. In advanced IRB systems, operational risk requirements; and making a determination under this management processes, operational risk (3) Public disclosure requirements for paragraph, the [AGENCY] will apply data and assessment systems, such [bank]s. notice and response procedures in the operational risk quantification systems, (b) Applicability. (1) This appendix same manner and to the same extent as and, to the extent the [bank] uses the applies to a [bank] that: the notice and response procedures in following systems, the counterparty (i) Has consolidated total assets, as 12 CFR 3.12 (for national banks), 12 CFR credit risk model, double default reported on the most recent year-end 263.202 (for bank holding companies excessive correlation detection process, Consolidated Report of Condition and and state member banks), 12 CFR IMA for equity exposures, and IAA for Income (Call Report) or Thrift Financial 325.6(c) (for state nonmember banks), securitization exposures to ABCP Report (TFR), equal to $250 billion or and 12 CFR 567.3(d) (for savings programs. more; associations). Affiliate with respect to a company (ii) Has consolidated total on-balance (2) Specific risk-weighted asset means any company that controls, is sheet foreign exposure at the most amounts. (i) If the [AGENCY] controlled by, or is under common recent year-end equal to $10 billion or determines that the risk-weighted asset control with, the company. For more (where total on-balance sheet amount calculated under this appendix purposes of this definition, a person or foreign exposure equals total cross- by the [bank] for one or more exposures company controls a company if it: border claims less claims with head is not commensurate with the risks (1) Owns, controls, or holds with office or guarantor located in another associated with those exposures, the power to vote 25 percent or more of a country plus redistributed guaranteed [AGENCY] may require the [bank] to class of voting securities of the amounts to the country of head office or assign a different risk-weighted asset company; or guarantor plus local country claims on amount to the exposures, to assign (2) Consolidates the company for local residents plus revaluation gains on different risk parameters to the financial reporting purposes. foreign exchange and derivative exposures (if the exposures are Applicable external rating means, products, calculated in accordance with wholesale or retail exposures), or to use with respect to an exposure, the lowest the Federal Financial Institutions different model assumptions for the external rating assigned to the exposure Examination Council (FFIEC) 009 exposures (if the exposures are equity by any NRSRO. Country Exposure Report); exposures under the Internal Models Asset-backed commercial paper (iii) Is a subsidiary of a depository Approach (IMA) or securitization (ABCP) program means a program that institution that uses 12 CFR part 3, exposures under the Internal primarily issues commercial paper that: Appendix C, 12 CFR part 208, Appendix Assessment Approach (IAA)), all as (1) Has an external rating; and F, 12 CFR part 325, Appendix D, or 12 specified by the [AGENCY]. (2) Is backed by underlying exposures CFR part 566, Appendix A, to calculate (ii) If the [AGENCY] determines that held in a bankruptcy-remote SPE. its risk-based capital requirements; or the risk-weighted asset amount for Asset-backed commercial paper (iv) Is a subsidiary of a bank holding operational risk produced by the [bank] (ABCP) program sponsor means a [bank] company (as defined in 12 U.S.C. 1841) under this appendix is not that: that uses 12 CFR part 225, Appendix F, commensurate with the operational (1) Establishes an ABCP program; to calculate its risk-based capital risks of the [bank], the [AGENCY] may (2) Approves the sellers permitted to requirements. require the [bank] to assign a different participate in an ABCP program; (2) Any [bank] may elect to use this risk-weighted asset amount for (3) Approves the exposures to be appendix to calculate its risk-based operational risk, to change elements of purchased by an ABCP program; or capital requirements. its operational risk analytical (4) Administers the ABCP program by (3) A [bank] that is subject to this framework, including distributional and monitoring the underlying exposures, appendix must use this appendix unless dependence assumptions, or to make underwriting or otherwise arranging for the [AGENCY] determines in writing other changes to the [bank]’s operational the placement of debt or other that application of this appendix is not risk management processes, data and obligations issued by the program,

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00084 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55913

compiling monthly reports, or ensuring connection with a transfer of underlying (ii) A retail exposure in default compliance with the program exposures (including loan servicing remains in default until the [bank] has documents and with the program’s assets) and that obligate a [bank] to reasonable assurance of repayment and credit and investment policy. protect another party from losses arising performance for all contractual Backtesting means the comparison of from the credit risk of the underlying principal and interest payments on the a [bank]’s internal estimates with actual exposures. Credit-enhancing exposure. outcomes during a sample period not representations and warranties include (2) Wholesale. (i) A [bank]’s obligor is used in model development. In this provisions to protect a party from losses in default if, for any wholesale exposure context, backtesting is one form of out- resulting from the default or of the [bank] to the obligor, the [bank] of-sample testing. nonperformance of the obligors of the has: Benchmarking means the comparison underlying exposures or from an (A) Placed the exposure on non- of a [bank]’s internal estimates with insufficiency in the value of the accrual status consistent with the Call relevant internal and external data collateral backing the underlying Report Instructions or the TFR and the sources or estimation techniques. exposures. Credit-enhancing TFR Instruction Manual; Business environment and internal representations and warranties do not (B) Taken a full or partial charge-off control factors means the indicators of include: or write-down on the exposure due to a [bank]’s operational risk profile that (1) Early default clauses and similar the distressed financial condition of the reflect a current and forward-looking warranties that permit the return of, or obligor; or assessment of the [bank]’s underlying premium refund clauses that cover, (C) Incurred a credit-related loss of 5 business risk factors and internal first-lien residential mortgage exposures percent or more of the exposure’s initial control environment. for a period not to exceed 120 days from carrying value in connection with the Carrying value means, with respect to the date of transfer, provided that the sale of the exposure or the transfer of an asset, the value of the asset on the date of transfer is within one year of the exposure to the held-for-sale, balance sheet of the [bank], determined origination of the residential mortgage available-for-sale, trading account, or in accordance with GAAP. exposure; other reporting category. Clean-up call means a contractual (2) Premium refund clauses that cover (ii) An obligor in default remains in provision that permits a servicer to call underlying exposures guaranteed, in default until the [bank] has reasonable securitization exposures before their whole or in part, by the U.S. assurance of repayment and stated maturity or call date. See also government, a U.S. government agency, performance for all contractual eligible clean-up call. or a U.S. government sponsored principal and interest payments on all Commodity derivative contract means enterprise, provided that the clauses are exposures of the [bank] to the obligor a commodity-linked swap, purchased for a period not to exceed 120 days from (other than exposures that have been commodity-linked option, forward the date of transfer; or fully written-down or charged-off). commodity-linked contract, or any other (3) Warranties that permit the return Dependence means a measure of the instrument linked to commodities that of underlying exposures in instances of association among operational losses gives rise to similar counterparty credit misrepresentation, fraud, or incomplete across and within business lines and risks. documentation. operational loss event types. Company means a corporation, Credit risk mitigant means collateral, Depository institution is defined in partnership, limited liability company, a credit derivative, or a guarantee. section 3 of the Federal Deposit depository institution, business trust, Credit-risk-weighted assets means Insurance Act (12 U.S.C. 1813). special purpose entity, association, or 1.06 multiplied by the sum of: Derivative contract means a financial similar organization. (1) Total wholesale and retail risk- contract whose value is derived from Credit derivative means a financial weighted assets; the values of one or more underlying contract executed under standard (2) Risk-weighted assets for assets, reference rates, or indices of asset industry credit derivative securitization exposures; and values or reference rates. Derivative documentation that allows one party (3) Risk-weighted assets for equity contracts include interest rate derivative (the protection purchaser) to transfer the exposures. contracts, exchange rate derivative credit risk of one or more exposures Current exposure means, with respect contracts, equity derivative contracts, (reference exposure) to another party to a netting set, the larger of zero or the commodity derivative contracts, credit (the protection provider). See also market value of a transaction or derivatives, and any other instrument eligible credit derivative. portfolio of transactions within the that poses similar counterparty credit Credit-enhancing interest-only strip netting set that would be lost upon risks. Derivative contracts also include (CEIO) means an on-balance sheet asset default of the counterparty, assuming no unsettled securities, commodities, and that, in form or in substance: recovery on the value of the foreign exchange transactions with a (1) Represents a contractual right to transactions. Current exposure is also contractual settlement or delivery lag receive some or all of the interest and called replacement cost. that is longer than the lesser of the no more than a minimal amount of Default—(1) Retail. (i) A retail market standard for the particular principal due on the underlying exposure of a [bank] is in default if: instrument or 5 business days. exposures of a securitization; and (A) The exposure is 180 days past Early amortization provision means a (2) Exposes the holder to credit risk due, in the case of a residential provision in the documentation directly or indirectly associated with the mortgage exposure or revolving governing a securitization that, when underlying exposures that exceeds a pro exposure; triggered, causes investors in the rata share of the holder’s claim on the (B) The exposure is 120 days past due, securitization exposures to be repaid underlying exposures, whether through in the case of all other retail exposures; before the original stated maturity of the subordination provisions or other or securitization exposures, unless the credit-enhancement techniques. (C) The [bank] has taken a full or provision is triggered solely by events Credit-enhancing representations and partial charge-off or write-down of not directly related to the performance warranties means representations and principal on the exposure for credit- of the underlying exposures or the warranties that are made or assumed in related reasons. originating [bank] (such as material

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00085 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55914 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

changes in tax laws or regulations). An derivative, the lesser of the contractual exposure to the protection provider at early amortization provision is a notional amount of the credit risk settlement, the terms of the exposure controlled early amortization provision mitigant and the EAD of the hedged provide that any required consent to if it meets all the following conditions: exposure, multiplied by the percentage transfer may not be unreasonably (1) The originating [bank] has coverage of the credit risk mitigant. For withheld; appropriate policies and procedures to example, the effective notional amount (7) If the credit derivative is a credit ensure that it has sufficient capital and of an eligible guarantee that covers, on default swap or nth-to-default swap, the liquidity available in the event of an a pro rata basis, 40 percent of any losses contract clearly identifies the parties early amortization; on a $100 bond would be $40. responsible for determining whether a (2) Throughout the duration of the Eligible clean-up call means a clean- credit event has occurred, specifies that securitization (including the early up call that: this determination is not the sole amortization period), there is the same (1) Is exercisable solely at the responsibility of the protection pro rata sharing of interest, principal, discretion of the servicer; provider, and gives the protection expenses, losses, fees, recoveries, and (2) Is not structured to avoid purchaser the right to notify the other cash flows from the underlying allocating losses to securitization protection provider of the occurrence of exposures based on the originating exposures held by investors or a credit event; and [bank]’s and the investors’ relative otherwise structured to provide credit (8) If the credit derivative is a total shares of the underlying exposures enhancement to the securitization; and return swap and the [bank] records net outstanding measured on a consistent (3) (i) For a traditional securitization, payments received on the swap as net monthly basis; is only exercisable when 10 percent or income, the [bank] records offsetting (3) The amortization period is less of the principal amount of the deterioration in the value of the hedged sufficient for at least 90 percent of the underlying exposures or securitization exposure (either through reductions in total underlying exposures outstanding exposures (determined as of the fair value or by an addition to reserves). at the beginning of the early inception of the securitization) is Eligible credit reserves means all amortization period to be repaid or outstanding; or general allowances that have been recognized as in default; and (ii) For a synthetic securitization, is established through a charge against (4) The schedule for repayment of only exercisable when 10 percent or less earnings to absorb credit losses investor principal is not more rapid of the principal amount of the reference associated with on-or off-balance sheet than would be allowed by straight-line portfolio of underlying exposures wholesale and retail exposures, amortization over an 18-month period. (determined as of the inception of the including the allowance for loan and Economic downturn conditions securitization) is outstanding. lease losses (ALLL) associated with such means, with respect to an exposure, Eligible credit derivative means a exposures but excluding allocated those conditions in which the aggregate credit derivative in the form of a credit transfer risk reserves established default rates for the exposure’s default swap, nth-to-default swap, or pursuant to 12 U.S.C. 3904 and other wholesale or retail exposure subcategory total return swap provided that: specific reserves created against (or subdivision of such subcategory (1) The contract meets the recognized losses. selected by the [bank]) in the exposure’s requirements of an eligible guarantee Eligible double default guarantor, national jurisdiction (or subdivision of and has been confirmed by the with respect to a guarantee or credit such jurisdiction selected by the [bank]) protection purchaser and the protection derivative obtained by a [bank], means: are significantly higher than average. provider; (1) U.S.-based entities. A depository Effective maturity (M) of a wholesale (2) Any assignment of the contract has institution, a bank holding company (as exposure means: been confirmed by all relevant parties; defined in section 2 of the Bank Holding (1) For wholesale exposures other (3) If the credit derivative is a credit Company Act (12 U.S.C. 1841)), a than repo-style transactions, eligible default swap or nth-to-default swap, the savings and loan holding company (as margin loans, and OTC derivative contract includes the following credit defined in 12 U.S.C. 1467a) provided all contracts subject to a qualifying master events: or substantially all of the holding netting agreement: (i) Failure to pay any amount due company’s activities are permissible for (i) The weighted-average remaining under the terms of the reference a financial holding company under 12 maturity (measured in years, whole or exposure (with a grace period that is U.S.C. 1843(k), a securities broker or fractional) of the expected contractual closely in line with the grace period of dealer registered (under the Securities cash flows from the exposure, using the the reference exposure); and Exchange Act of 1934) with the SEC, an undiscounted amounts of the cash flows (ii) Bankruptcy, insolvency, or insurance company in the business of as weights; or inability of the obligor on the reference providing credit protection (such as a (ii) The nominal remaining maturity exposure to pay its debts, or its failure monoline bond insurer or re-insurer) (measured in years, whole or fractional) or admission in writing of its inability that is subject to supervision by a State of the exposure. generally to pay its debts as they insurance regulator, if: (2) For repo-style transactions, eligible become due, and similar events; (i) At the time the guarantor issued margin loans, and OTC derivative (4) The terms and conditions dictating the guarantee or credit derivative, the contracts subject to a qualifying master the manner in which the contract is to [bank] assigned a PD to the guarantor’s netting agreement, the weighted-average be settled are incorporated into the rating grade that was equal to or lower remaining maturity (measured in years, contract; than the PD associated with a long-term whole or fractional) of the individual (5) If the contract allows for cash external rating in the third-highest transactions subject to the qualifying settlement, the contract incorporates a investment grade rating category; and master netting agreement, with the robust valuation process to estimate loss (ii) The [bank] currently assigns a PD weight of each individual transaction reliably and specifies a reasonable to the guarantor’s rating grade that is set equal to the notional amount of the period for obtaining post-credit event equal to or lower than the PD associated transaction. valuations of the reference exposure; with a long-term external rating in the Effective notional amount means, for (6) If the contract requires the lowest investment grade rating category; an eligible guarantee or eligible credit protection purchaser to transfer an or

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00086 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55915

(2) Non-U.S.-based entities. A foreign of credit and to liquidate or set off defined in section 2 of the Bank Holding bank (as defined in section 211.2 of the collateral promptly upon an event of Company Act (12 U.S.C. 1841)), a Federal Reserve Board’s Regulation K default (including upon an event of savings and loan holding company (as (12 CFR 211.2)), a non-U.S. securities bankruptcy, insolvency, or similar defined in 12 U.S.C. 1467a) provided all firm, or a non-U.S. based insurance proceeding) of the counterparty, or substantially all of the holding company in the business of providing provided that, in any such case, any company’s activities are permissible for credit protection, if: exercise of rights under the agreement a financial holding company under 12 (i) The [bank] demonstrates that the will not be stayed or avoided under U.S.C. 1843(k), a foreign bank (as guarantor is subject to consolidated applicable law in the relevant defined in section 211.2 of the Federal supervision and regulation comparable jurisdictions;2 and Reserve Board’s Regulation K (12 CFR to that imposed on U.S. depository (4) The [bank] has conducted and 211.2)), or a securities firm; institutions, securities broker-dealers, or documented sufficient legal review to (2) Any other entity (other than an insurance companies (as the case may conclude with a well-founded basis that SPE) that has issued and outstanding an be) or has issued and outstanding an the agreement meets the requirements of unsecured long-term debt security unsecured long-term debt security paragraph (3) of this definition and is without credit enhancement that has a without credit enhancement that has a legal, valid, binding, and enforceable long-term applicable external rating in long-term applicable external rating in under applicable law in the relevant one of the three highest investment one of the three highest investment jurisdictions. grade rating categories; or grade rating categories; Eligible operational risk offsets means (3) Any other entity (other than an (ii) At the time the guarantor issued amounts, not to exceed expected SPE) that has a PD assigned by the the guarantee or credit derivative, the operational loss, that: [bank] that is lower than or equal to the [bank] assigned a PD to the guarantor’s (1) Are generated by internal business PD associated with a long-term external rating grade that was equal to or lower practices to absorb highly predictable rating in the third highest investment than the PD associated with a long-term and reasonably stable operational losses, grade rating category. external rating in the third-highest including reserves calculated consistent Eligible servicer cash advance facility investment grade rating category; and with GAAP; and means a servicer cash advance facility (iii) The [bank] currently assigns a PD (2) Are available to cover expected in which: to the guarantor’s rating grade that is operational losses with a high degree of (1) The servicer is entitled to full equal to or lower than the PD associated certainty over a one-year horizon. reimbursement of advances, except that with a long-term external rating in the Eligible purchased wholesale a servicer may be obligated to make lowest investment grade rating category. receivable means a purchased wholesale non-reimbursable advances for a Eligible guarantee means a guarantee receivable that: particular underlying exposure if any that: (1) The [bank] purchased from an such advance is contractually limited to (1) Is written and unconditional; unaffiliated seller and did not directly an insignificant amount of the (2) Covers all or a pro rata portion of or indirectly originate; outstanding principal balance of that all contractual payments of the obligor (2) Was generated on an arm’s-length exposure; on the reference exposure; basis between the seller and the (2) The servicer’s right to (3) Gives the beneficiary a direct obligor;3 reimbursement is senior in right of claim against the protection provider; (3) Provides the [bank] with a claim payment to all other claims on the cash (4) Is non-cancelable by the protection on all proceeds from the receivable or a flows from the underlying exposures of provider for reasons other than the pro-rata interest in the proceeds from the securitization; and breach of the contract by the the receivable; and (3) The servicer has no legal beneficiary; (4) Has an M of less than one year. obligation to, and does not, make (5) Is legally enforceable against the Eligible securitization guarantor advances to the securitization if the protection provider in a jurisdiction means: servicer concludes the advances are where the protection provider has (1) A sovereign entity, the Bank for unlikely to be repaid. sufficient assets against which a International Settlements, the Equity derivative contract means an judgment may be attached and enforced; International Monetary Fund, the equity-linked swap, purchased equity- and European Central Bank, the European linked option, forward equity-linked (6) Requires the protection provider to Commission, a Federal Home Loan contract, or any other instrument linked make payment to the beneficiary on the Bank, Federal Agricultural Mortgage to equities that gives rise to similar occurrence of a default (as defined in Corporation (Farmer Mac), a multi- counterparty credit risks. the guarantee) of the obligor on the lateral development bank, a depository Equity exposure means: reference exposure without first institution, a bank holding company (as (1) A security or instrument (whether requiring the beneficiary to demand voting or non-voting) that represents a payment from the obligor. 2 This requirement is met where all transactions direct or indirect ownership interest in, Eligible margin loan means an under the agreement are (i) executed under U.S. law and a residual claim on, the assets and and (ii) constitute ‘‘securities contracts’’ or extension of credit where: ‘‘repurchase agreements’’ under section 555 or 559, income of a company, unless: (1) The extension of credit is respectively, of the Bankruptcy Code (11 U.S.C. (i) The issuing company is collateralized exclusively by debt or 555), qualified financial contracts under section consolidated with the [bank] under equity securities that are liquid and 11(e)(8) of the Federal Deposit Insurance Act (12 GAAP; U.S.C. 1821(e)(8)), or netting contracts between or readily marketable; among financial institutions under sections 401– (ii) The [bank] is required to deduct (2) The collateral is marked to market 407 of the Federal Deposit Insurance Corporation the ownership interest from tier 1 or tier daily, and the transaction is subject to Improvement Act of 1991 (12 U.S.C. 4401–4407) or 2 capital under this appendix; daily margin maintenance requirements; the Federal Reserve Board’s Regulation EE (12 CFR (iii) The ownership interest is (3) The extension of credit is part 231). redeemable; 3 Intercompany accounts receivable and conducted under an agreement that receivables subject to contra-accounts between (iv) The ownership interest provides the [bank] the right to firms that buy and sell to each other do not satisfy incorporates a payment or other similar accelerate and terminate the extension this criterion. obligation on the part of the issuing

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00087 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55916 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

company (such as an obligation to pay 325, Appendix A, section II.C.a. (for distribution of potential aggregate periodic interest); or state nonmember banks), or 12 CFR operational losses, as generated by the (v) The ownership interest is a 567.6(a)(1)(iii) and (iv) (for savings [bank]’s operational risk quantification securitization exposure; associations). system using a one-year horizon. (2) A security or instrument that is Expected credit loss (ECL) means, for Expected positive exposure (EPE) mandatorily convertible into a security a wholesale exposure to a non-defaulted means the weighted average over time of or instrument described in paragraph (1) obligor or segment of non-defaulted expected (non-negative) exposures to a of this definition; retail exposures, the product of PD counterparty where the weights are the (3) An option or warrant that is times ELGD times EAD for the exposure proportion of the time interval that an exercisable for a security or instrument or segment. ECL for a wholesale individual expected exposure described in paragraph (1) of this exposure to a defaulted obligor or represents. When calculating the definition; or segment of defaulted retail exposures is minimum capital requirement, the (4) Any other security or instrument equal to the [bank]’s impairment average is taken over a one-year horizon. (other than a securitization exposure) to estimate for allowance purposes for the Exposure at default (EAD). the extent the return on the security or exposure or segment. Total ECL is the (1) For the on-balance sheet instrument is based on the performance sum of expected credit losses for all component of a wholesale or retail of a security or instrument described in wholesale and retail exposures other exposure (other than an OTC derivative paragraph (1) of this definition. than exposures for which the [bank] has contract, repo-style transaction, or Excess spread for a period means: applied the double default treatment in eligible margin loan), EAD means: (1) Gross finance charge collections section 34. (i) If the exposure is held-to-maturity and other income received by a Expected exposure (EE) means the or for trading, the [bank]’s carrying securitization SPE (including market expected value of the probability value (including net accrued but unpaid interchange fees) over a period minus distribution of credit risk exposures to interest and fees) for the exposure less interest paid to the holders of the a counterparty at any specified future any allocated transfer risk reserve for securitization exposures, servicing fees, date before the maturity date of the the exposure; or charge-offs, and other senior trust or longest term transaction in the netting (ii) If the exposure is available-for- similar expenses of the SPE over the set. sale, the [bank]’s carrying value period; divided by Expected loss given default (ELGD) (including net accrued but unpaid (2) The principal balance of the means: interest and fees) for the exposure less underlying exposures at the end of the (1) For a wholesale exposure, the any allocated transfer risk reserve for period. [bank]’s empirically based best estimate the exposure, less any unrealized gains Exchange rate derivative contract of the default-weighted average on the exposure, and plus any means a cross-currency interest rate economic loss, per dollar of EAD, the unrealized losses on the exposure. swap, forward foreign-exchange [bank] expects to incur in the event that (2) For the off-balance sheet contract, currency option purchased, or the obligor of the exposure (or a typical component of a wholesale or retail any other instrument linked to exchange obligor in the loss severity grade exposure (other than an OTC derivative rates that gives rise to similar assigned by the [bank] to the exposure) contract, repo-style transaction, or counterparty credit risks. defaults within a one-year horizon over eligible margin loan) in the form of a Excluded mortgage exposure means: a mix of economic conditions, including loan commitment or line of credit, EAD (1) Any one-to-four family residential economic downturn conditions. means the [bank]’s best estimate of net pre-sold construction loan or (2) For a segment of retail exposures, additions to the outstanding amount multifamily residential loan that would the [bank]’s empirically based best owed the [bank], including estimated receive a 50 percent risk weight under estimate of the default-weighted average future additional draws of principal and section 618(a)(1) or (b)(1) of the economic loss, per dollar of EAD, the accrued but unpaid interest and fees, Resolution Trust Corporation [bank] expects to incur on exposures in that are likely to occur over the Refinancing, Restructuring, and the segment that default within a one- remaining life of the exposure assuming Improvement Act of 1991 (RTCRRI Act) year horizon over a mix of economic the exposure were to go into default. and under 12 CFR part 3, Appendix A, conditions (including economic This estimate of net additions must section 3(a)(3)(iii) (for national banks), downturn conditions). reflect what would be expected during 12 CFR part 208, Appendix A, section (3) The economic loss on an exposure economic downturn conditions. III.C.3. (for state member banks), 12 CFR in the event of default is all material (3) For the off-balance sheet part 225, Appendix A, section III.C.3. credit-related losses on the exposure component of a wholesale or retail (for bank holding companies), 12 CFR (including accrued but unpaid interest exposure (other than an OTC derivative part 325, Appendix A, section II.C.a. (for or fees, losses on the sale of collateral, contract, repo-style transaction, or state nonmember banks), or 12 CFR direct workout costs, and an appropriate eligible margin loan) in the form of 567.6(a)(1)(iii) and (iv) (for savings allocation of indirect workout costs). anything other than a loan commitment associations); and Where positive or negative cash flows or line of credit, EAD means the (2) Any one-to-four family residential on a wholesale exposure to a defaulted notional amount of the exposure. pre-sold construction loan for a obligor or a defaulted retail exposure (4) EAD for a segment of retail residence for which the purchase (including proceeds from the sale of exposures is the sum of the EADs for contract is cancelled that would receive collateral, workout costs, and draw- each individual exposure in the a 100 percent risk weight under section downs of unused credit lines) occur segment. 618(a)(2) of the RTCRRI Act and under after the date of default, the economic (5) EAD for OTC derivative contracts, 12 CFR part 3, Appendix A, section loss must reflect the net present value repo-style transactions, and eligible 3(a)(3)(iii) (for national banks), 12 CFR of cash flows as of the default date using margin loans is calculated as described part 208, Appendix A, section III.C.3. a discount rate appropriate to the risk of in section 32. (for state member banks), 12 CFR part the defaulted exposure. (6) For wholesale or retail exposures 225, Appendix A, section III.C.3. (for Expected operational loss (EOL) in which only the drawn balance has bank holding companies), 12 CFR part means the expected value of the been securitized, the [bank] must reflect

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00088 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55917

its share of the exposures’ undrawn RC of the Call Report, schedule HC of (iii) Does not benefit from any credit balances in EAD. Undrawn balances of the FR Y–9C Report, or Schedule SC of enhancement that is not available to the exposures for which the drawn balances the Thrift Financial Report) of a [bank] unrated securitization exposure; and have been securitized must be allocated that results from a securitization (other (iv) Has an effective remaining between the seller’s and investors’ than an increase in equity capital that maturity that is equal to or longer than interests on a pro rata basis, based on results from the [bank]’s receipt of cash that of the unrated securitization the proportions of the seller’s and in connection with the securitization). exposure. investors’ shares of the securitized Guarantee means a financial Interest rate derivative contract means drawn balances. guarantee, letter of credit, insurance, or a single-currency interest rate swap, Exposure category means any of the other similar financial instrument (other basis swap, forward rate agreement, wholesale, retail, securitization, or than a credit derivative) that allows one purchased interest rate option, when- equity exposure categories. party (beneficiary) to transfer the credit issued securities, or any other External operational loss event data risk of one or more specific exposures instrument linked to interest rates that means, with respect to a [bank], gross (reference exposure) to another party gives rise to similar counterparty credit operational loss amounts, dates, (protection provider). See also eligible risks. recoveries, and relevant causal guarantee. Internal operational loss event data information for operational loss events High volatility commercial real estate means, with respect to a [bank], gross occurring at organizations other than the (HVCRE) exposure means a credit operational loss amounts, dates, [bank]. facility that finances or has financed the recoveries, and relevant causal External rating means a credit rating acquisition, development, or information for operational loss events that is assigned by an NRSRO to an construction (ADC) of real property, occurring at the [bank]. exposure, provided: unless the facility finances: Investing [bank] means, with respect (1) The credit rating fully reflects the (1) One-to four-family residential to a securitization, a [bank] that assumes entire amount of credit risk with regard properties; or the credit risk of a securitization to all payments owed to the holder of (2) Commercial real estate projects in exposure (other than an originating the exposure. If a holder is owed which: [bank] of the securitization). In the principal and interest on an exposure, (i) The loan-to-value ratio is less than typical synthetic securitization, the the credit rating must fully reflect the or equal to the applicable maximum investing [bank] sells credit protection credit risk associated with timely supervisory loan-to-value ratio in the on a pool of underlying exposures to the repayment of principal and interest. If a [AGENCY]’s real estate lending originating [bank]. holder is owed only principal on an standards at 12 CFR part 34, Subpart D Investment fund means a company: (OCC); 12 CFR part 208, Appendix C exposure, the credit rating must fully (1) All or substantially all of the assets (Board); 12 CFR part 365, Subpart D reflect only the credit risk associated of which are financial assets; and (FDIC); and 12 CFR 560.100–560.101 with timely repayment of principal; and (2) That has no material liabilities. (2) The credit rating is published in (OTS); Investors’ interest EAD means, with (ii) The borrower has contributed an accessible form and is or will be respect to a securitization, the EAD of capital to the project in the form of cash included in the transition matrices the underlying exposures multiplied by or unencumbered readily marketable made publicly available by the NRSRO the ratio of: assets (or has paid development (1) The total amount of securitization that summarize the historical expenses out-of-pocket) of at least 15 performance of positions rated by the exposures issued by the SPE to percent of the real estate’s appraised ‘‘as investors; divided by NRSRO. completed’’ value; and Financial collateral means collateral: (2) The outstanding principal amount (iii) The borrower contributed the of underlying exposures. (1) In the form of: amount of capital required by paragraph (i) Cash on deposit with the [bank] Loss given default (LGD) means: (2)(ii) of this definition before the [bank] (including cash held for the [bank] by a (1) For a wholesale exposure: advances funds under the credit facility, third-party custodian or trustee); (i) If the [bank] has received prior and the capital contributed by the (ii) Gold bullion; written approval from [AGENCY] to use borrower, or internally generated by the (iii) Long-term debt securities that internal estimates of LGD for the project, is contractually required to have an applicable external rating of one exposure’s wholesale exposure remain in the project throughout the subcategory, the greater of: category below investment grade or 4 life of the project. (A) The [bank]’s ELGD for the higher; Inferred rating. A securitization (iv) Short-term debt instruments that exposure (or for the typical exposure in exposure has an inferred rating equal to have an applicable external rating of at the loss severity grade assigned by the the external rating referenced in least investment grade; [bank] to the exposure); or paragraph (2)(i) of this definition if: (B) The [bank]’s empirically based (v) Equity securities that are publicly (1) The securitization exposure does best estimate of the economic loss, per traded; not have an external rating; and (vi) Convertible bonds that are (2) Another securitization exposure dollar of EAD, the [bank] would expect publicly traded; or issued by the same issuer and secured to incur if the obligor (or a typical (vii) Money market mutual fund by the same underlying exposures: obligor in the loss severity grade shares and other mutual fund shares if (i) Has an external rating; assigned by the [bank] to the exposure) a price for the shares is publicly quoted (ii) Is subordinated in all respects to were to default within a one-year daily; and the unrated securitization exposure; horizon during economic downturn (2) In which the [bank] has a conditions. perfected, first priority security interest 4 The life of a project concludes only when the (ii) If the [bank] has not received such or the legal equivalent thereof. credit facility is converted to permanent financing prior approval, GAAP means U.S. generally accepted or is sold or paid in full. Permanent financing may (A) For an exposure that is not a repo- be provided by the [bank] that provided the ADC accounting principles. facility as long as the permanent financing is style transaction, eligible margin loan, Gain-on-sale means an increase in the subject to the [bank]’s underwriting criteria for or OTC derivative contract, the sum of: equity capital (as reported on Schedule long-term mortgage loans. (1) 0.08; and

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00089 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55918 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

(2) 0.92 multiplied by the [bank]’s of cash flows as of the default date using risk but excluding strategic and ELGD for the exposure (or for the typical a discount rate appropriate to the risk of reputational risk). exposure in the loss severity grade the defaulted exposure. Operational risk exposure means the assigned by the [bank] to the exposure); Main index means the Standard & 99.9th percentile of the distribution of or Poor’s 500 Index, the FTSE All-World potential aggregate operational losses, as (B) For an exposure that is a repo- Index, and any other index for which generated by the [bank]’s operational style transaction, eligible margin loan, the [bank] can demonstrate to the risk quantification system over a one- or OTC derivative contract, the [bank]’s satisfaction of [AGENCY] that the year horizon (and not incorporating ELGD for the exposure (or for the typical equities represented in the index have eligible operational risk offsets or exposure in the loss severity grade comparable liquidity, depth of market, qualifying operational risk mitigants). assigned by the [bank] to the exposure). and size of bid-ask spreads as equities Originating [bank], with respect to a (2) For a segment of retail exposures: in the Standard & Poor’s 500 Index and securitization, means a [bank] that: (i) If the [bank] has received prior FTSE All-World Index. (1) Directly or indirectly originated or written approval from [AGENCY] to use Multi-lateral development bank securitized the underlying exposures internal estimates of LGD for the means any multi-lateral lending included in the securitization; or segment’s retail exposure subcategory, institution or regional development (2) Serves as an ABCP program the greater of: bank in which the U.S. government is a sponsor to the securitization. (A) The [bank]’s ELGD for the segment shareholder or contributing member. Other retail exposure means an of exposures; or Nationally recognized statistical exposure (other than a securitization (B) The [bank]’s empirically based rating organization (NRSRO) means an exposure, an equity exposure, a best estimate of the economic loss, per entity recognized by the Division of residential mortgage exposure, an dollar of EAD, the [bank] would expect Market Regulation (or any successor excluded mortgage exposure, a to incur on exposures in the segment division) of the SEC as a nationally qualifying revolving exposure, or the that default within a one-year horizon recognized statistical rating organization residual value portion of a lease during economic downturn conditions. for various purposes, including the exposure) that is managed as part of a (ii) If the [bank] has not received such SEC’s net capital requirements for segment of exposures with prior approval, securities broker-dealers. homogeneous risk characteristics, not (A) For a segment of exposures that Netting set means a group of on an individual-exposure basis, and is are not eligible margin loans, the sum transactions with a single counterparty either: of: that are subject to a qualifying master (1) An exposure to an individual for (1) 0.08; and netting agreement or qualifying cross- non-business purposes; or (2) 0.92 multiplied by the [bank]’s (2) An exposure to an individual or product master netting agreement. Each ELGD for the segment of exposures; or company for business purposes if the transaction that is not subject to such a (B) For a segment of exposures that [bank]’s consolidated business credit master netting agreement is its own are eligible margin loans, the [bank]’s exposure to the individual or company netting set. ELGD for the segment of exposures. is $1 million or less. (3) In approving a [bank]’s use of Nth-to-default credit derivative means Over-the-counter (OTC) derivative internal estimates of LGD for a a credit derivative that provides credit contract means a derivative contract wholesale or retail exposure protection only for the nth-defaulting that is not traded on an exchange that subcategory, [AGENCY] will consider reference exposure in a group of requires the daily receipt and payment whether: reference exposures. of cash-variation margin. (A) The [bank]’s internal estimates of Operational loss means a loss Parallel run period means a period of LGD are reliable and sufficiently (excluding insurance or tax effects) at least four consecutive quarters after reflective of economic downturn resulting from an operational loss event. adoption of the [bank]’s implementation conditions; and Operational loss includes all expenses plan and before the [bank]’s first floor (B) The [bank] has rigorous and well- associated with an operational loss period during which the [bank] documented policies and procedures for event except for opportunity costs, complies with all the qualification identifying economic downturn forgone revenue, and costs related to requirements in section 22 to the conditions for the exposure subcategory, risk management and control satisfaction of the [AGENCY]. identifying material adverse correlations enhancements implemented to prevent Probability of default (PD) means: between the relevant drivers of default future operational losses. (1) For a wholesale exposure to a non- rates and loss rates given default, and Operational loss event means an event defaulted obligor, the [bank]’s incorporating identified correlations that results in loss and is associated empirically based best estimate of the into internal LGD estimates. with internal fraud; external fraud; 5 long-run average of one-year default (4) The economic loss on an exposure employment practices and workplace rates for the rating grade assigned by the in the event of default is all material safety; clients, products, and business [bank] to the obligor, capturing the credit-related losses on the exposure practices; damage to physical assets; average default experience for obligors (including accrued but unpaid interest business disruption and system failures; in a rating grade over a mix of economic or fees, losses on the sale of collateral, or execution, delivery, and process conditions (including economic direct workout costs, and an appropriate management. downturn conditions) sufficient to allocation of indirect workout costs). Operational risk means the risk of loss provide a reasonable estimate of the Where positive or negative cash flows resulting from inadequate or failed average one-year default rate over the on a wholesale exposure to a defaulted internal processes, people, and systems economic cycle for the rating grade. obligor or a defaulted retail exposure or from external events (including legal (2) For a segment of non-defaulted (including proceeds from the sale of retail exposures for which seasoning collateral, workout costs, and draw- 5 Retail credit card losses arising from non- effects are not material, or for a segment contractual, third-party initiated fraud (for example, downs of unused credit lines) occur identity theft) are external fraud operational losses. of non-defaulted retail exposures in a after the date of default, the economic All other third-party initiated credit losses are to be retail exposure subcategory for which loss must reflect the net present value treated as credit risk losses. seasoning effects are not material, the

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00090 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55919

[bank]’s empirically based best estimate effective oversight by a national than it would make otherwise under the of the long-run average of one-year supervisory authority. agreement, or no payment at all, to a default rates for the exposures in the Qualifying cross-product master defaulter or the estate of a defaulter, segment, capturing the average default netting agreement means a qualifying even if the defaulter or the estate of the experience for exposures in the segment master netting agreement that provides defaulter is a net creditor under the over a mix of economic conditions for termination and close-out netting agreement). (including economic downturn across multiple types of financial Qualifying revolving exposure (QRE) conditions) sufficient to provide a transactions or qualifying master netting means an exposure (other than a reasonable estimate of the average one- agreements in the event of a securitization exposure or equity year default rate over the economic counterparty’s default, provided that: exposure) to an individual that is cycle for the segment. (1) The underlying financial managed as part of a segment of (3) For any other segment of non- transactions are OTC derivative exposures with homogeneous risk defaulted retail exposures, the [bank]’s contracts, eligible margin loans, or repo- characteristics, not on an individual- empirically based best estimate of the style transactions; and exposure basis, and: annualized cumulative default rate over (2) The [bank] obtains a written legal (1) Is revolving (that is, the amount the expected remaining life of exposures opinion verifying the validity and outstanding fluctuates, determined in the segment, capturing the average enforceability of the agreement under largely by the borrower’s decision to default experience for exposures in the applicable law of the relevant borrow and repay, up to a pre- segment over a mix of economic jurisdictions if the counterparty fails to established maximum amount); conditions (including economic perform upon an event of default, (2) Is unsecured and unconditionally downturn conditions) sufficient to including upon an event of bankruptcy, cancelable by the [bank] to the fullest provide a reasonable estimate of the insolvency, or similar proceeding. extent permitted by Federal law; and average performance over the economic Qualifying master netting agreement (3) Has a maximum exposure amount cycle for the segment. means any written, legally enforceable (drawn plus undrawn) of up to (4) For a wholesale exposure to a bilateral agreement, provided that: $100,000. defaulted obligor or segment of (1) The agreement creates a single Repo-style transaction means a defaulted retail exposures, 100 percent. legal obligation for all individual repurchase or reverse repurchase Protection amount (P) means, with transactions covered by the agreement transaction, or a securities borrowing or respect to an exposure hedged by an upon an event of default, including securities lending transaction, including eligible guarantee or eligible credit bankruptcy, insolvency, or similar a transaction in which the [bank] acts as derivative, the effective notional amount proceeding, of the counterparty; agent for a customer and indemnifies of the guarantee or credit derivative as (2) The agreement provides the [bank] the customer against loss, provided that: reduced to reflect any currency the right to accelerate, terminate, and (1) The transaction is based solely on mismatch, maturity mismatch, or lack of close-out on a net basis all transactions liquid and readily marketable securities restructuring coverage (as provided in under the agreement and to liquidate or or cash; section 33). set off collateral promptly upon an (2) The transaction is marked-to- Publicly traded means traded on: event of default, including upon an market daily and subject to daily margin (1) Any exchange registered with the event of bankruptcy, insolvency, or maintenance requirements; SEC as a national securities exchange similar proceeding, of the counterparty, (3) The transaction is executed under under section 6 of the Securities provided that, in any such case, any an agreement that provides the [bank] Exchange Act of 1934 (15 U.S.C. 78f); or exercise of rights under the agreement the right to accelerate, terminate, and (2) Any non-U.S.-based securities will not be stayed or avoided under close-out the transaction on a net basis exchange that: applicable law in the relevant and to liquidate or set off collateral (i) Is registered with, or approved by, jurisdictions; promptly upon an event of default a national securities regulatory (3) The [bank] has conducted and (including upon an event of bankruptcy, authority; and documented sufficient legal review to insolvency, or similar proceeding) of the (ii) Provides a liquid, two-way market conclude with a well-founded basis counterparty, provided that, in any such for the instrument in question, meaning that: case, any exercise of rights under the that there are enough independent bona (i) The agreement meets the agreement will not be stayed or avoided fide offers to buy and sell so that a sales requirements of paragraph (2) of this under applicable law in the relevant price reasonably related to the last sales definition; and jurisdictions; 6 and price or current bona fide competitive (ii) In the event of a legal challenge (4) The [bank] has conducted and bid and offer quotations can be (including one resulting from default or documented sufficient legal review to determined promptly and a trade can be from bankruptcy, insolvency, or similar conclude with a well-founded basis that settled at such a price within five proceeding) the relevant court and the agreement meets the requirements of business days. administrative authorities would find paragraph (3) of this definition and is Qualifying central counterparty the agreement to be legal, valid, binding, legal, valid, binding, and enforceable means a counterparty (for example, a and enforceable under the law of the clearing house) that: relevant jurisdictions; 6 This requirement is met where all transactions (1) Facilitates trades between (4) The [bank] establishes and under the agreement are (i) executed under U.S. law counterparties in one or more financial maintains procedures to monitor and (ii) constitute ‘‘securities contracts’’ or markets by either guaranteeing trades or possible changes in relevant law and to ‘‘repurchase agreements’’ under section 555 or 559, respectively, of the Bankruptcy Code (11 U.S.C. 555 novating contracts; ensure that the agreement continues to or 559), qualified financial contracts under section (2) Requires all participants in its satisfy the requirements of this 11(e)(8) of the Federal Deposit Insurance Act (12 arrangements to be fully collateralized definition; and U.S.C. 1821(e)(8)), or netting contracts between or on a daily basis; and (5) The agreement does not contain a among financial institutions under sections 401– 407 of the Federal Deposit Insurance Corporation (3) The [bank] demonstrates to the walkaway clause (that is, a provision Improvement Act of 1991 (12 U.S.C. 4401–4407) or satisfaction of [AGENCY] is in sound that permits a non-defaulting the Federal Reserve Board’s Regulation EE (12 CFR financial condition and is subject to counterparty to make a lower payment part 231).

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00091 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55920 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

under applicable law in the relevant from the underlying exposures except after all deductions required in this jurisdictions. claims of a service provider to fees. appendix. Residential mortgage exposure means Servicer cash advance facility means Total risk-weighted assets means: an exposure (other than a securitization a facility under which the servicer of the (1) The sum of: exposure, equity exposure, or excluded underlying exposures of a securitization (i) Credit risk-weighted assets; and mortgage exposure) that is managed as may advance cash to ensure an (ii) Risk-weighted assets for part of a segment of exposures with uninterrupted flow of payments to operational risk; minus homogeneous risk characteristics, not investors in the securitization, including (2) The sum of: (i) Excess eligible credit reserves not on an individual-exposure basis, and is: advances made to cover foreclosure (1) An exposure that is primarily included in tier 2 capital; and costs or other expenses to facilitate the (ii) Allocated transfer risk reserves. secured by a first or subsequent lien on timely collection of the underlying Total wholesale and retail risk- one-to four-family residential property; exposures. See also eligible servicer weighted assets means the sum of risk- or cash advance facility. weighted assets for wholesale exposures (2) An exposure with an original and Sovereign entity means a central to non-defaulted obligors and segments outstanding amount of $1 million or less government (including the U.S. of non-defaulted retail exposures; risk- that is primarily secured by a first or government) or an agency, department, weighted assets for wholesale exposures subsequent lien on residential property ministry, or central bank of a central to defaulted obligors and segments of that is not one-to four-family. government. defaulted retail exposures; risk- Retail exposure means a residential Sovereign exposure means: weighted assets for assets not defined by mortgage exposure, a qualifying (1) A direct exposure to a sovereign an exposure category; and risk-weighted revolving exposure, or an other retail entity; or assets for non-material portfolios of exposure. (2) An exposure directly and exposures (all as determined in section Retail exposure subcategory means unconditionally backed by the full faith 31) and risk-weighted assets for the residential mortgage exposure, and credit of a sovereign entity. unsettled transactions (as determined in qualifying revolving exposure, or other Special purpose entity (SPE) means a section 35) minus the amounts deducted retail exposure subcategory. corporation, trust, or other entity Risk parameter means a variable used from capital pursuant to [the general organized for the specific purpose of risk-based capital rules] (excluding in determining risk-based capital holding underlying exposures of a those deductions reversed in section requirements for wholesale and retail securitization, the activities of which 12). exposures, specifically probability of are limited to those appropriate to Traditional securitization means a default (PD), expected loss given default accomplish this purpose, and the transaction in which: (ELGD), loss given default (LGD), structure of which is intended to isolate (1) All or a portion of the credit risk exposure at default (EAD), or effective the underlying exposures held by the of one or more underlying exposures is maturity (M). entity from the credit risk of the seller transferred to one or more third parties Scenario analysis means a systematic other than through the use of credit process of obtaining expert opinions of the underlying exposures to the entity. derivatives or guarantees; from business managers and risk (2) The credit risk associated with the management experts to derive reasoned Synthetic securitization means a transaction in which: underlying exposures has been assessments of the likelihood and loss separated into at least two tranches impact of plausible high-severity (1) All or a portion of the credit risk of one or more underlying exposures is reflecting different levels of seniority; operational losses. (3) Performance of the securitization SEC means the U.S. Securities and transferred to one or more third parties through the use of one or more credit exposures depends upon the Exchange Commission. performance of the underlying Securitization means a traditional derivatives or guarantees (other than a guarantee that transfers only the credit exposures; and securitization or a synthetic (4) All or substantially all of the risk of an individual retail exposure); securitization. underlying exposures are financial (2) The credit risk associated with the Securitization exposure means: exposures (such as loans, commitments, underlying exposures has been (1) An on-balance sheet or off-balance credit derivatives, guarantees, sheet credit exposure that arises from a separated into at least two tranches receivables, asset-backed securities, traditional or synthetic securitization reflecting different levels of seniority; mortgage-backed securities, other debt (including credit-enhancing (3) Performance of the securitization securities, or equity securities). representations and warranties); and exposures depends upon the Tranche means all securitization (2) Mortgage-backed pass-through performance of the underlying exposures associated with a securities guaranteed by Fannie Mae or exposures; and securitization that have the same Freddie Mac. (4) All or substantially all of the seniority level. Senior securitization exposure means underlying exposures are financial Underlying exposures means one or a securitization exposure that has a first exposures (such as loans, commitments, more exposures that have been priority claim on the cash flows from credit derivatives, guarantees, securitized in a securitization the underlying exposures, disregarding receivables, asset-backed securities, transaction. the claims of a service provider (such as mortgage-backed securities, other debt Unexpected operational loss (UOL) a swap counterparty or trustee, securities, or equity securities). means the difference between the custodian, or paying agent for the Tier 1 capital is defined in [the [bank]’s operational risk exposure and securitization) to fees from the general risk-based capital rules], as the [bank]’s expected operational loss. securitization. A liquidity facility that modified in part II of this appendix. Unit of measure means the level (for supports an ABCP program is a senior Tier 2 capital is defined in [the example, organizational unit or securitization exposure if the liquidity general risk-based capital rules], as operational loss event type) at which the facility provider’s right to modified in part II of this appendix. [bank]’s operational risk quantification reimbursement of the drawn amounts is Total qualifying capital means the system generates a separate distribution senior to all claims on the cash flows sum of tier 1 capital and tier 2 capital, of potential operational losses.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00092 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55921

Value-at-Risk (VaR) means the (1) A [bank] is not required to deduct [bank]’s exposure on certain failed estimate of the maximum amount that certain equity investments and CEIOs capital markets transactions. the value of one or more exposures (as explained in more detail in section Section 12. Deductions and Limitations could decline due to market price or 12); and Not Required rate movements during a fixed holding (2) A [bank] also must make the period within a stated confidence deductions from capital required by (a) Deduction of CEIOs. A [bank] is interval. paragraphs (b) and (c) of this section. not required to make the deductions Wholesale exposure means a credit (b) Deductions from tier 1 capital. A from capital for CEIOs in 12 CFR part exposure to a company, individual, [bank] must deduct from tier 1 capital 3, Appendix A, § 2(c) (for national sovereign, or governmental entity (other any gain-on-sale associated with a banks), 12 CFR part 208, Appendix A, than a securitization exposure, retail securitization exposure as provided in § II.B.1.e. (for state member banks), 12 exposure, excluded mortgage exposure, paragraph (a) of section 41 and CFR part 225, Appendix A, § II.B.1.e. or equity exposure). Examples of a paragraphs (a)(1), (c), (g)(1), and (h)(1) of (for bank holding companies), 12 CFR wholesale exposure include: section 42. part 325, Appendix A, § II.B.5. (for state (1) A non-tranched guarantee issued (c) Deductions from tier 1 and tier 2 nonmember banks), and 12 CFR by a [bank] on behalf of a company; capital. A [bank] must deduct the 567.5(a)(2)(iii) and 567.12(e) (for savings (2) A repo-style transaction entered following exposures 50 percent from tier associations). (b) Deduction of certain equity into by a [bank] with a company and 1 capital and 50 percent from tier 2 investments. A [bank] is not required to any other transaction in which a [bank] capital. If the amount deductible from make the deductions from capital for posts collateral to a company and faces tier 2 capital exceeds the [bank]’s actual nonfinancial equity investments in 12 counterparty credit risk; tier 2 capital, however, the [bank] must CFR part 3, Appendix A, § 2(c) (for (3) An exposure that the [bank] treats deduct the shortfall amount from tier 1 national banks), 12 CFR part 208, as a covered position under [the market capital. Appendix A, § II.B.5. (for state member risk rule] for which there is a (1) Credit-enhancing interest-only counterparty credit risk charge in banks), 12 CFR part 225, Appendix A, strips (CEIOs). In accordance with § II.B.5. (for bank holding companies), section 32; paragraphs (a)(1) and (c) of section 42, (4) A sale of corporate loans by a and 12 CFR part 325, Appendix A, any CEIO that does not constitute gain- § II.B. (for state nonmember banks). [bank] to a third party in which the on-sale. [bank] retains full recourse; (2) Non-qualifying securitization Section 13. Eligible Credit Reserves (5) An OTC derivative contract exposures. In accordance with entered into by a [bank] with a (a) Comparison of eligible credit paragraphs (a)(4) and (c) of section 42, company; reserves to expected credit losses—(1) (6) An exposure to an individual that any securitization exposure that does Shortfall of eligible credit reserves. If a is not managed by the [bank] as part of not qualify for the Ratings-Based [bank]’s eligible credit reserves are less a segment of exposures with Approach, Internal Assessment than the [bank]’s total expected credit homogeneous risk characteristics; and Approach, or the Supervisory Formula losses, the [bank] must deduct the (7) A commercial lease. Approach under sections 43, 44, and 45, shortfall amount 50 percent from tier 1 Wholesale exposure subcategory respectively. capital and 50 percent from tier 2 means the HVCRE or non-HVCRE (3) Securitizations of non-IRB capital. If the amount deductible from wholesale exposure subcategory. exposures. In accordance with tier 2 capital exceeds the [bank]’s actual paragraphs (c) and (g)(3) of section 42, tier 2 capital, the [bank] must deduct the Section 3. Minimum Risk-Based Capital certain exposures to a securitization any excess amount from tier 1 capital. Requirements underlying exposure of which is not a (2) Excess eligible credit reserves. If a (a) Except as modified by paragraph wholesale exposure, retail exposure, [bank]’s eligible credit reserves exceed (c) of this section or by section 23, each securitization exposure, or equity the [bank]’s total expected credit losses, [bank] must meet a minimum ratio of: exposure. the [bank] may include the excess (1) Total qualifying capital to total (4) Low-rated securitization amount in tier 2 capital to the extent risk-weighted assets of 8.0 percent; and exposures. In accordance with section that the excess amount does not exceed (2) Tier 1 capital to total risk-weighted 43 and paragraph (c) of section 42, any 0.6 percent of the [bank]’s credit-risk- assets of 4.0 percent. securitization exposure that qualifies for weighted assets. (b) Each [bank] must hold capital and must be deducted under the (b) Treatment of allowance for loan commensurate with the level and nature Ratings-Based Approach. and lease losses. Regardless of any of all risks to which the [bank] is (5) High-risk securitization exposures provision to the contrary in [general exposed. subject to the Supervisory Formula risk-based capital rules], ALLL is (c) When a [bank] subject to [the Approach. In accordance with included in tier 2 capital only to the market risk rule] calculates its risk- paragraph (b) of section 45 and extent provided in paragraph (a)(2) of based capital requirements under this paragraph (c) of section 42, any this section and paragraph (b) of section appendix, the [bank] must also refer to securitization exposure that qualifies for 23. [the market risk rule] for supplemental the Supervisory Formula Approach and Part III. Qualification rules to calculate risk-based capital has a risk weight equal to 1,250 percent requirements adjusted for market risk. as calculated under the Supervisory Section 21. Qualification Process Part II. Qualifying Capital Formula Approach. (a) Timing. (1) A [bank] that is (6) Eligible credit reserves shortfall. In described in paragraph (b)(1) of section Section 11. Additional Deductions accordance with paragraph (a)(1) of 1 must adopt a written implementation (a) General. A [bank] that uses this section 13, any eligible credit reserves plan no later than six months after the appendix must make the same shortfall. later of the effective date of this deductions from its tier 1 capital and (7) Certain failed capital markets appendix or the date the [bank] meets a tier 2 capital required in [the general transactions. In accordance with criterion in that section. The plan must risk-based capital rules], except that: paragraph (e)(3) of section 35, the incorporate an explicit first floor period

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00093 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55922 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

start date no later than 36 months after (7) Describe resources that have been (A) The [bank]’s total risk-weighted the later of the effective date of this budgeted and are available to assets as calculated under [the general appendix or the date the [bank] meets at implement the plan; and risk-based capital rules]; and least one criterion under paragraph (8) Receive board of directors (B) The appropriate transitional floor (b)(1) of section 1. [AGENCY] may approval. percentage in Table 1. extend the first floor period start date. (c) Parallel run. Before determining its (ii) A [bank]’s floor-adjusted total risk- (2) A [bank] that elects to be subject risk-based capital requirements under based capital ratio during a transitional to this appendix under paragraph (b)(2) this appendix and following adoption of floor period is equal to the sum of the of section 1 must adopt a written the implementation plan, the [bank] [bank]’s tier 1 and tier 2 capital as implementation plan and notify the must conduct a satisfactory parallel run. calculated under [the general risk-based [AGENCY] in writing of its intent at A satisfactory parallel run is a period of capital rules], divided by the product of: least 12 months before it proposes to no less than four consecutive calendar (A) The [bank]’s total risk-weighted begin its first floor period. quarters during which the [bank] assets as calculated under [the general risk-based capital rules]; and (b) Implementation plan. The [bank]’s complies with all of the qualification requirements in section 22 to the (B) The appropriate transitional floor implementation plan must address in percentage in Table 1. detail how the [bank] complies, or plans satisfaction of [AGENCY]. During the parallel run, the [bank] must report to (iii) A [bank] that meets the criteria in to comply, with the qualification paragraph (b)(1) or (b)(2) of section 1 as requirements in section 22. The [bank] the [AGENCY] on a calendar quarterly basis its risk-based capital ratios using of the effective date of this rule must use also must maintain a comprehensive [the general risk-based capital rules] and sound planning and governance [the general risk-based capital rules] and the risk-based capital requirements effective immediately before this rule process to oversee the implementation became effective during the parallel run efforts described in the plan. At a described in this appendix. During this period, the [bank] is subject to [the and as the basis for its transitional minimum, the plan must: floors. (1) Comprehensively address the general risk-based capital rules]. (d) Approval to calculate risk-based qualification requirements in section 22 TABLE 1—TRANSITIONAL FLOORS for the [bank] and each consolidated capital requirements under this subsidiary (U.S. and foreign-based) of appendix. The [AGENCY] will notify Transitional floor pe- Transitional floor per- the [bank] with respect to all portfolios the [bank] of the date that the [bank] riod centage and exposures of the [bank] and each of may begin its first floor period following its consolidated subsidiaries; a determination by the [AGENCY] that: First floor period ...... 95 percent (1) The [bank] fully complies with the Second floor period ... 90 percent (2) Justify and support any proposed Third floor period ...... 85 percent temporary or permanent exclusion of qualification requirements in section 22; (2) The [bank] has conducted a business lines, portfolios, or exposures (3) Advanced approaches risk-based satisfactory parallel run under from application of the advanced capital ratios. (i) A [bank]’s advanced paragraph (c) of this section; and approaches in this appendix (which approaches tier 1 risk-based capital ratio (3) The [bank] has an adequate business lines, portfolios, and exposures equals the [bank]’s tier 1 risk-based process to ensure ongoing compliance must be, in the aggregate, immaterial to capital ratio as calculated under this with the qualification requirements in the [bank]); appendix (other than this section on section 22. (3) Include the [bank]’s self- transitional floor periods). (e) Transitional floor periods. assessment of: (ii) A [bank]’s advanced approaches Following a satisfactory parallel run, a (i) The [bank]’s current status in total risk-based capital ratio equals the [bank] is subject to three transitional [bank]’s total risk-based capital ratio as meeting the qualification requirements floor periods. in section 22; and calculated under this appendix (other (1) Risk-based capital ratios during than this section on transitional floor (ii) The consistency of the [bank]’s the transitional floor periods—(i) Tier 1 current practices with the [AGENCY]’s periods). risk-based capital ratio. During a (4) Reporting. During the transitional supervisory guidance on the [bank]’s transitional floor periods, a qualification requirements; floor periods, a [bank] must report to the [bank]’s tier 1 risk-based capital ratio is [AGENCY] on a calendar quarterly basis (4) Based on the [bank]’s self- equal to the lower of: both floor-adjusted risk-based capital assessment, identify and describe the (A) The [bank]’s floor-adjusted tier 1 ratios and both advanced approaches areas in which the [bank] proposes to risk-based capital ratio; or risk-based capital ratios. undertake additional work to comply (B) The [bank]’s advanced approaches (5) Exiting a transitional floor period. with the qualification requirements in tier 1 risk-based capital ratio. A [bank] may not exit a transitional section 22 or to improve the consistency (ii) Total risk-based capital ratio. floor period until the [bank] has spent of the [bank]’s current practices with the During a [bank]’s transitional floor a minimum of four consecutive calendar [AGENCY]’s supervisory guidance on periods, a [bank]’s total risk-based quarters in the period and the the qualification requirements (gap capital ratio is equal to the lower of: [AGENCY] has determined that the analysis); (A) The [bank]’s floor-adjusted total [bank] may exit the floor period. The (5) Describe what specific actions the risk-based capital ratio; or [AGENCY]’s determination will be [bank] will take to address the areas (B) The [bank]’s advanced approaches based on an assessment of the [bank]’s identified in the gap analysis required total risk-based capital ratio. ongoing compliance with the by paragraph (b)(4) of this section; (2) Floor-adjusted risk-based capital qualification requirements in section 22. (6) Identify objective, measurable ratios. (i) A [bank]’s floor-adjusted tier 1 milestones, including delivery dates and risk-based capital ratio during a Section 22. Qualification Requirements a date when the [bank]’s transitional floor period is equal to the (a) Process and systems requirements. implementation of the methodologies [bank]’s tier 1 capital as calculated (1) A [bank] must have a rigorous described in this appendix will be fully under [the general risk-based capital process for assessing its overall capital operational; rules], divided by the product of: adequacy in relation to its risk profile

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00094 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55923

and a comprehensive strategy for identify all defaulted retail exposures compensate for the lack of data from maintaining an appropriate level of and group them in segments by periods of economic downturn capital. subcategories separate from non- conditions. (2) The systems and processes used by defaulted retail exposures. (6) The [bank]’s PD, ELGD, LGD, and a [bank] for risk-based capital purposes (4) The [bank]’s internal risk rating EAD estimates must be based on the under this appendix must be consistent policy for wholesale exposures must definition of default in this appendix. with the [bank]’s internal risk describe the [bank]’s rating philosophy (7) The [bank] must review and management processes and management (that is, must describe how wholesale update (as appropriate) its risk information reporting systems. obligor rating assignments are affected parameters and its risk parameter (3) Each [bank] must have an by the [bank]’s choice of the range of quantification process at least annually. appropriate infrastructure with risk economic, business, and industry (8) The [bank] must at least annually measurement and management conditions that are considered in the conduct a comprehensive review and processes that meet the qualification obligor rating process). analysis of reference data to determine requirements of this section and are (5) The [bank]’s internal risk rating relevance of reference data to [bank] appropriate given the [bank]’s size and system for wholesale exposures must exposures, quality of reference data to level of complexity. Regardless of provide for the review and update (as support PD, ELGD, LGD, and EAD whether the systems and models that appropriate) of each obligor rating and estimates, and consistency of reference generate the risk parameters necessary (if applicable) each loss severity rating data to the definition of default for calculating a [bank]’s risk-based whenever the [bank] receives new contained in this appendix. capital requirements are located at any material information, but no less (d) Counterparty credit risk model. A affiliate of the [bank], the [bank] itself frequently than annually. The [bank]’s [bank] must obtain the prior written must ensure that the risk parameters retail exposure segmentation system approval of [AGENCY] under section 32 and reference data used to determine its must provide for the review and update to use the internal models methodology risk-based capital requirements are (as appropriate) of assignments of retail for counterparty credit risk. representative of its own credit risk and exposures to segments whenever the (e) Double default treatment. A [bank] operational risk exposures. [bank] receives new material must obtain the prior written approval (b) Risk rating and segmentation information, but no less frequently than of [AGENCY] under section 34 to use systems for wholesale and retail quarterly. the double default treatment. exposures. (1) A [bank] must have an (c) Quantification of risk parameters (f) Securitization exposures. A [bank] internal risk rating and segmentation for wholesale and retail exposures. (1) must obtain the prior written approval system that accurately and reliably The [bank] must have a comprehensive of [AGENCY] under section 44 to use differentiates among degrees of credit risk parameter quantification process the internal assessment approach for risk for the [bank]’s wholesale and retail that produces accurate, timely, and securitization exposures to ABCP exposures. reliable estimates of the risk parameters programs. (2) For wholesale exposures, a [bank] for the [bank]’s wholesale and retail (g) Equity exposures model. A [bank] must have an internal risk rating system exposures. must obtain the prior written approval that accurately and reliably assigns each (2) Data used to estimate the risk of [AGENCY] under section 53 to use obligor to a single rating grade parameters must be relevant to the the internal models approach for equity (reflecting the obligor’s likelihood of [bank]’s actual wholesale and retail exposures. default). The [bank]’s wholesale obligor exposures, and of sufficient quality to (h) Operational risk—(1) Operational rating system must have at least seven support the determination of risk-based risk management processes. A [bank] discrete rating grades for non-defaulted capital requirements for the exposures. must: obligors and at least one rating grade for (3) The [bank]’s risk parameter (i) Have an operational risk defaulted obligors. Unless the [bank] has quantification process must produce management function that: chosen to directly assign ELGD and LGD conservative risk parameter estimates (A) Is independent of business line estimates to each wholesale exposure, where the [bank] has limited relevant management; and the [bank] must have an internal risk data, and any adjustments that are part (B) Is responsible for designing, rating system that accurately and of the quantification process must not implementing, and overseeing the reliably assigns each wholesale result in a pattern of bias toward lower [bank]’s operational risk data and exposure to loss severity rating grades risk parameter estimates. assessment systems, operational risk (reflecting the [bank]’s estimate of the (4) PD estimates for wholesale and quantification systems, and related ELGD and LGD of the exposure). A retail exposures must be based on at processes; [bank] employing loss severity rating least 5 years of default data. ELGD and (ii) Have and document a process to grades must have a sufficiently granular LGD estimates for wholesale exposures identify, measure, monitor, and control loss severity grading system to avoid must be based on at least 7 years of loss operational risk in [bank] products, grouping together exposures with severity data, and ELGD and LGD activities, processes, and systems widely ranging ELGDs or LGDs. estimates for retail exposures must be (which process must capture business (3) For retail exposures, a [bank] must based on at least 5 years of loss severity environment and internal control factors have a system that groups exposures data. EAD estimates for wholesale affecting the [bank]’s operational risk into segments with homogeneous risk exposures must be based on at least 7 profile); and characteristics and assigns accurate and years of exposure amount data, and EAD (iii) Report operational risk exposures, reliable PD, ELGD, and LGD estimates estimates for retail exposures must be operational loss events, and other for each segment on a consistent basis. based on at least 5 years of exposure relevant operational risk information to The [bank]’s system must group retail amount data. business unit management, senior exposures into the appropriate retail (5) Default, loss severity, and management, and the board of directors exposure subcategory and must group exposure amount data must include (or a designated committee of the the retail exposures in each retail periods of economic downturn board). exposure subcategory into separate conditions, or the [bank] must adjust its (2) Operational risk data and segments. The [bank]’s system must estimates of risk parameters to assessment systems. A [bank] must have

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00095 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55924 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

operational risk data and assessment its operational risk data and assessment (2) A [bank] must retain data using an systems that capture operational risks to systems; and electronic format that allows timely which the [bank] is exposed. The (B) Must employ a unit of measure retrieval of data for analysis, validation, [bank]’s operational risk data and that is appropriate for the [bank]’s range reporting, and disclosure purposes. assessment systems must: of business activities and the variety of (3) A [bank] must retain sufficient (i) Be structured in a manner operational loss events to which it is data elements related to key risk drivers consistent with the [bank]’s current exposed, and that does not combine to permit adequate monitoring, business activities, risk profile, business activities or operational loss validation, and refinement of its technological processes, and risk events with different risk profiles within advanced systems. management processes; and the same loss distribution. (j) Control, oversight, and validation (ii) Include credible, transparent, (C) May use internal estimates of mechanisms. (1) The [bank]’s senior systematic, and verifiable processes that dependence among operational losses management must ensure that all incorporate the following elements on within and across business lines and components of the [bank]’s advanced an ongoing basis: operational loss events if the [bank] can systems function effectively and comply (A) Internal operational loss event demonstrate to the satisfaction of with the qualification requirements in data. The [bank] must have a systematic [AGENCY] that its process for this section. process for capturing and using internal estimating dependence is sound, robust (2) The [bank]’s board of directors (or operational loss event data in its to a variety of scenarios, and a designated committee of the board) operational risk data and assessment implemented with integrity, and allows must at least annually evaluate the systems. for the uncertainty surrounding the effectiveness of, and approve, the (1) The [bank]’s operational risk data estimates. If the [bank] has not made [bank]’s advanced systems. and assessment systems must include such a demonstration, it must sum (3) A [bank] must have an effective an historical observation period of at operational risk exposure estimates system of controls and oversight that: least five years for internal operational across units of measure to calculate its (i) Ensures ongoing compliance with loss event data (or such shorter period total operational risk exposure. the qualification requirements in this approved by [AGENCY] to address (D) Must be reviewed and updated (as section; (ii) Maintains the integrity, reliability, transitional situations, such as appropriate) whenever the [bank] and accuracy of the [bank]’s advanced integrating a new business line). becomes aware of information that may (2) The [bank] may refrain from systems; and have a material effect on the [bank]’s collecting internal operational loss (iii) Includes adequate governance estimate of operational risk exposure, event data for individual operational and project management processes. but no less frequently than annually. losses below established dollar (4) The [bank] must validate, on an (ii) With the prior written approval of threshold amounts if the [bank] can ongoing basis, its advanced systems. [AGENCY], a [bank] may generate an demonstrate to the satisfaction of the The [bank]’s validation process must be estimate of its operational risk exposure [AGENCY] that the thresholds are independent of the advanced systems’ using an alternative approach to that reasonable, do not exclude important development, implementation, and specified in paragraph (h)(3)(i) of this internal operational loss event data, and operation, or the validation process section. A [bank] proposing to use such permit the [bank] to capture must be subjected to an independent an alternative operational risk substantially all the dollar value of the review of its adequacy and quantification system must submit a [bank]’s operational losses. effectiveness. Validation must include: (B) External operational loss event proposal to [AGENCY]. In considering a (i) The evaluation of the conceptual data. The [bank] must have a systematic [bank]’s proposal to use an alternative soundness of (including developmental process for determining its operational risk quantification system, evidence supporting) the advanced methodologies for incorporating [AGENCY] will consider the following systems; external operational loss data into its principles: (ii) An on-going monitoring process operational risk data and assessment (A) Use of the alternative operational that includes verification of processes systems. risk quantification system will be and benchmarking; and (C) Scenario analysis. The [bank] allowed only on an exception basis, (iii) An outcomes analysis process must have a systematic process for considering the size, complexity, and that includes back-testing. determining its methodologies for risk profile of a [bank]; (5) The [bank] must have an internal incorporating scenario analysis into its (B) The [bank] must demonstrate that audit function independent of business- operational risk data and assessment its estimate of its operational risk line management that at least annually systems. exposure generated under the assesses the effectiveness of the controls (D) Business environment and alternative operational risk supporting the [bank]’s advanced internal control factors. The [bank] must quantification system is appropriate and systems and reports its findings to the incorporate business environment and can be supported empirically; and [bank]’s board of directors (or a internal control factors into its (C) A [bank] must not use an committee thereof). operational risk data and assessment allocation of operational risk capital (6) The [bank] must periodically stress systems. The [bank] must also requirements that includes entities other test its advanced systems. The stress periodically compare the results of its than depository institutions or the testing must include a consideration of prior business environment and internal benefits of diversification across how economic cycles, especially control factor assessments against its entities. downturns, affect risk-based capital actual operational losses incurred in the (i) Data management and requirements (including migration intervening period. maintenance. (1) A [bank] must have across rating grades and segments and (3) Operational risk quantification data management and maintenance the credit risk mitigation benefits of systems. (i) The [bank]’s operational risk systems that adequately support all double default treatment). quantification systems: aspects of its advanced systems and the (k) Documentation. The [bank] must (A) Must generate estimates of the timely and accurate reporting of risk- adequately document all material [bank]’s operational risk exposure using based capital requirements. aspects of its advanced systems.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00096 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55925

Section 23. Ongoing Qualification acquired company’s exposures for up to which wholesale exposures are HVCRE (a) Changes to advanced systems. A 24 months after the calendar quarter exposures, sovereign exposures, OTC [bank] must meet all the qualification during which the acquisition or merger derivative contracts, repo-style requirements in section 22 on an consummates. [AGENCY] may extend transactions, eligible margin loans, ongoing basis. A [bank] must notify the this transition period for up to an eligible purchased wholesale [AGENCY] when the [bank] makes any additional 12 months. Within 30 days of receivables, unsettled transactions to change to an advanced system that consummating the merger or which section 35 applies, and eligible would result in a material change in the acquisition, the [bank] must submit to guarantees or eligible credit derivatives [bank]’s risk-weighted asset amount for [AGENCY] an implementation plan for that are used as credit risk mitigants. an exposure type, or when the [bank] using its advanced systems for the The [bank] must identify any on-balance makes any significant change to its merged or acquired company. sheet asset that does not meet the modeling assumptions. (c) Failure to comply with definition of a wholesale, retail, equity, (b) Mergers and acquisitions—(1) qualification requirements. If [AGENCY] or securitization exposure, as well as Mergers and acquisitions of companies determines that a [bank] that is subject any non-material portfolio of exposures without advanced systems. If a [bank] to this appendix and has conducted a described in paragraph (e)(4) of this merges with or acquires a company that satisfactory parallel run fails to comply section. does not calculate its risk-based capital with the qualification requirements in (c) Phase 2—Assignment of wholesale requirements using advanced systems, section 22, [AGENCY] will notify the obligors and exposures to rating grades the [bank] may use [the general risk- [bank] in writing of the [bank]’s failure and retail exposures to segments—(1) based capital rules] to determine the to comply. The [bank] must establish a Assignment of wholesale obligors and risk-weighted asset amounts for, and plan satisfactory to the [AGENCY] to exposures to rating grades. deductions from capital associated with, return to compliance with the (i) The [bank] must assign each the merged or acquired company’s qualification requirements and must obligor of a wholesale exposure to a exposures for up to 24 months after the disclose to the public its failure to single obligor rating grade and may calendar quarter during which the comply with the qualification assign each wholesale exposure to loss merger or acquisition consummates. requirements promptly after receiving severity rating grades. (ii) The [bank] must identify which of [AGENCY] may extend this transition notice from the [AGENCY]. In addition, its wholesale obligors are in default. period for up to an additional 12 if the [AGENCY] determines that the [bank]’s risk-based capital requirements (2) Segmentation of retail exposures. months. Within 30 days of (i) The [bank] must group the retail consummating the merger or are not commensurate with the [bank]’s credit, market, operational, or other exposures in each retail subcategory acquisition, the [bank] must submit to into segments that have homogeneous [AGENCY] an implementation plan for risks, the [AGENCY] may require such a [bank] to calculate its risk-based risk characteristics. using its advanced systems for the (ii) The [bank] must identify which of acquired company. During the period capital requirements: (1) Under [the general risk-based its retail exposures are in default. The when [the general risk-based capital [bank] must segment defaulted retail rules] apply to the merged or acquired capital rules]; or (2) Under this appendix with any exposures separately from non- company, any ALLL, net of allocated defaulted retail exposures. transfer risk reserves established modifications provided by the [AGENCY]. (iii) If the [bank] determines the EAD pursuant to 12 U.S.C. 3904, associated for eligible margin loans using the with the merged or acquired company’s Part IV. Risk-Weighted Assets for approach in paragraph (a) of section 32, exposures may be included in the General Credit Risk the [bank] must identify which of its [bank]’s tier 2 capital up to 1.25 percent Section 31. Mechanics for Calculating retail exposures are eligible margin of the acquired company’s risk-weighted loans for which the [bank] uses this assets. All general reserves of the Total Wholesale and Retail Risk- Weighted Assets EAD approach and must segment such merged or acquired company must be eligible margin loans separately from excluded from the [bank]’s eligible (a) Overview. A [bank] must calculate other retail exposures. credit reserves. In addition, the risk- its total wholesale and retail risk- (3) Eligible purchased wholesale weighted assets of the merged or weighted asset amount in four distinct receivables. A [bank] may group its acquired company are not included in phases: eligible purchased wholesale the [bank]’s credit-risk-weighted assets (1) Phase 1—categorization of receivables that, when consolidated by but are included in total risk-weighted exposures; obligor, total less than $1 million into assets. If a [bank] relies on this (2) Phase 2—assignment of wholesale segments that have homogeneous risk paragraph, the [bank] must disclose obligors and exposures to rating grades characteristics. A [bank] must use the publicly the amounts of risk-weighted and segmentation of retail exposures; wholesale exposure formula in Table 2 assets and qualifying capital calculated (3) Phase 3—assignment of risk in this section to determine the risk- under this appendix for the acquiring parameters to wholesale exposures and based capital requirement for each [bank] and under [the general risk-based segments of retail exposures; and segment of eligible purchased wholesale capital rules] for the acquired company. (4) Phase 4—calculation of risk- receivables. (2) Mergers and acquisitions of weighted asset amounts. (d) Phase 3—Assignment of risk companies with advanced systems. If a (b) Phase 1—Categorization. The parameters to wholesale exposures and [bank] merges with or acquires a [bank] must determine which of its segments of retail exposures—(1) company that calculates its risk-based exposures are wholesale exposures, Quantification process. Subject to the capital requirements using advanced retail exposures, securitization limitations in this paragraph (d), the systems, the acquiring [bank] may use exposures, or equity exposures. The [bank] must: the acquired company’s advanced [bank] must categorize each retail (i) Associate a PD with each systems to determine the risk-weighted exposure as a residential mortgage wholesale obligor rating grade; asset amounts for, and deductions from exposure, a QRE, or an other retail (ii) Associate an ELGD or LGD, as capital associated with, the merged or exposure. The [bank] must identify appropriate, with each wholesale loss

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00097 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55926 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

severity rating grade or assign an ELGD section 33 or, if applicable, applying (C) Credit risk exposures to a and LGD to each wholesale exposure; double default treatment to the exposure qualifying central counterparty in the (iii) Assign an EAD and M to each as provided in section 34. A [bank] may form of clearing deposits and posted wholesale exposure; and decide separately for each wholesale collateral that arise from transactions (iv) Assign a PD, ELGD, LGD, and exposure that qualifies for the double described in paragraph (d)(6)(ii)(B) of EAD to each segment of retail default treatment under section 34 this section. exposures. whether to apply the double default (7) Effective maturity. An exposure’s (2) Floor on PD assignment. The PD treatment or to use the PD substitution M must be no greater than five years and for each wholesale exposure or retail or LGD adjustment approach without no less than one year, except that a segment may not be less than 0.03 recognizing double default effects. [bank] may set the M of an exposure percent, except for exposures to or (ii) A [bank] may take into account the equal to the greater of one day or M if directly and unconditionally guaranteed risk reducing effects of guarantees and the exposure has an original maturity of by a sovereign entity, the Bank for credit derivatives in support of retail less than one year and is not part of the International Settlements, the exposures in a segment when [bank]’s ongoing financing of the International Monetary Fund, the quantifying the PD, ELGD, and LGD of obligor. An exposure is not part of a European Commission, the European the segment. [bank]’s ongoing financing of the obligor Central Bank, or a multi-lateral (iii) Except as provided in paragraph if the [bank]: development bank, to which the [bank] (d)(6) of this section, a [bank] may take (i) Has a legal and practical ability not assigns a rating grade associated with a into account the risk reducing effects of to renew or roll over the exposure in the PD of less than 0.03 percent. collateral in support of a wholesale event of credit deterioration of the (3) Floor on LGD estimation. The LGD obligor; for each segment of residential mortgage exposure when quantifying the ELGD and LGD of the exposure and may take (ii) Makes an independent credit exposures (other than segments of decision at the inception of the residential mortgage exposures for into account the risk reducing effects of collateral in support of retail exposures exposure and at every renewal or roll which all or substantially all of the over; and principal of each exposure is directly when quantifying the PD, ELGD, and LGD of the segment. (iii) Has no substantial commercial and unconditionally guaranteed by the incentive to continue its credit full faith and credit of a sovereign (6) EAD for derivative contracts, repo- style transactions, and eligible margin relationship with the obligor in the entity) may not be less than 10 percent. event of credit deterioration of the (4) Eligible purchased wholesale loans. (i) A [bank] must calculate its obligor. receivables. A [bank] must assign a PD, EAD for an OTC derivative contract as (e) Phase 4—Calculation of risk- ELGD, LGD, EAD, and M to each provided in paragraphs (b) and (c) of weighted assets—(1) Non-defaulted segment of eligible purchased wholesale section 32. A [bank] may take into exposures. (i) A [bank] must calculate receivables. If the [bank] can estimate account the risk-reducing effects of the dollar risk-based capital requirement ECL (but not PD or LGD) for a segment financial collateral in support of a repo- for each of its wholesale exposures to a of eligible purchased wholesale style transaction or eligible margin loan non-defaulted obligor and segments of receivables, the [bank] must assume that through an adjustment to EAD as non-defaulted retail exposures (except the ELGD and LGD of the segment provided in paragraphs (a) and (c) of eligible guarantees and eligible credit equals 100 percent and that the PD of section 32. A [bank] that takes financial derivatives that hedge another the segment equals ECL divided by collateral into account through such an wholesale exposure and exposures to EAD. The estimated ECL must be adjustment to EAD under section 32 which the [bank] applies the double calculated for the receivables without may not adjust ELGD or LGD to reflect default treatment in section 34) by regard to any assumption of recourse or the financial collateral. inserting the assigned risk parameters guarantees from the seller or other (ii) A [bank] may attribute an EAD of for the wholesale obligor and exposure parties. zero to: (5) Credit risk mitigation—credit (A) Derivative contracts that are or retail segment into the appropriate derivatives, guarantees, and collateral. publicly traded on an exchange that risk-based capital formula specified in (i) A [bank] may take into account the requires the daily receipt and payment Table 2 and multiplying the output of of cash-variation margin; the formula (K) by the EAD of the risk reducing effects of eligible 7 guarantees and eligible credit (B) Derivative contracts and repo-style exposure or segment. derivatives in support of a wholesale transactions that are outstanding with a 7 A [bank] may instead apply a 300 percent risk exposure by applying the PD qualifying central counterparty (but not weight to the EAD of an eligible margin loan if the substitution or LGD adjustment for those transactions that a qualifying [bank] is not able to assign a rating grade to the treatment to the exposure as provided in central counterparty has rejected); and obligor of the loan.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00098 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55927

(ii) The sum of all of the dollar risk- (1) 0.08 multiplied by the EAD of the before the obligor became defaulted) based capital requirements for each wholesale exposure, plus the amount of multiplied by the EAD of the wholesale wholesale exposure to a non-defaulted any charge-offs or write-downs on the exposure. obligor and segment of non-defaulted exposure; and (ii) Segments of defaulted retail retail exposures calculated in paragraph (2) K for the wholesale exposure (as exposures. The dollar risk-based capital (e)(1)(i) of this section and in paragraph determined in Table 2 immediately requirement for a segment of defaulted (e) of section 34 equals the total dollar before the obligor became defaulted), retail exposures equals 0.08 multiplied risk-based capital requirement for those multiplied by the EAD of the wholesale by the EAD of the segment. exposures and segments. exposure immediately before the obligor (iii) The sum of all the dollar risk- (iii) The aggregate risk-weighted asset became defaulted. based capital requirements for each amount for wholesale exposures to non- (B) If the amount calculated in wholesale exposure to a defaulted defaulted obligors and segments of non- paragraph (e)(2)(i)(A)1 is equal to or obligor calculated in paragraphs defaulted retail exposures equals the greater than the amount calculated in (e)(2)(i)(B) and (C) of this section plus total dollar risk-based capital paragraph (e)(2)(i)(A)2, the dollar risk- the dollar risk-based capital requirement calculated in paragraph based capital requirement for the requirements for each segment of (e)(1)(ii) of this section multiplied by exposure is 0.08 multiplied by the EAD defaulted retail exposures calculated in 12.5. of the wholesale exposure. paragraph (e)(2)(ii) of this section equals (2) Wholesale exposures to defaulted (C) If the amount calculated in the total dollar risk-based capital obligors and segments of defaulted retail paragraph (e)(2)(i)(A)1 is less than the requirement for those exposures. exposures—(i) Wholesale exposures to amount calculated in paragraph (iv) The aggregate risk-weighted asset defaulted obligors. (e)(2)(i)(A)2, the dollar risk-based amount for wholesale exposures to (A) For each wholesale exposure to a capital requirement for the exposure is defaulted obligors and segments of defaulted obligor, the [bank] must K for the wholesale exposure (as defaulted retail exposures equals the compare: determined in Table 2 immediately total dollar risk-based capital

VerDate Aug<31>2005 00:30 Sep 23, 2006 Jkt 208001 PO 00000 Frm 00099 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.080 55928 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

requirement calculated in paragraph counterparty credit risk of repo-style (A) SE equals the value of the (e)(2)(iii) of this section multiplied by transactions, eligible margin loans, and exposure (that is, the sum of the current 12.5. collateralized OTC derivative contracts, market values of all securities and cash (3) Assets not included in a defined and single product netting sets of such the [bank] has lent, sold subject to exposure category. A [bank] may assign transactions. A third methodology, the repurchase, or posted as collateral to the a risk-weighted asset amount of zero to simple VaR methodology, is available counterparty under the transaction (or cash owned and held in all offices of the for single product netting sets of repo- netting set)); [bank] or in transit and for gold bullion style transactions and eligible margin (B) SC equals the value of the held in the [bank]’s own vaults, or held loans. This section also describes the collateral (that is, the sum of the current in another [bank]’s vaults on an methodology for calculating EAD for an market values of all securities and cash allocated basis, to the extent it is offset OTC derivative contract or a set of OTC the [bank] has borrowed, purchased by gold bullion liabilities. The risk- derivative contracts subject to a subject to resale, or taken as collateral weighted asset amount for the residual qualifying master netting agreement. A from the counterparty under the value of a retail lease exposure equals [bank] also may use the internal models transaction (or netting set)); such residual value. The risk-weighted methodology to estimate EAD for (C) Es = absolute value of the net asset amount for an excluded mortgage qualifying cross-product master netting position in a given security (where the exposure is determined under 12 CFR agreements. net position in a given security equals part 3, Appendix A, section 3(a)(3)(iii) A [bank] may use any combination of the sum of the current market values of (for national banks), 12 CFR part 208, the three methodologies for collateral the particular security the [bank] has Appendix A, section III.C.3. (for state recognition; however, it must use the lent, sold subject to repurchase, or member banks), 12 CFR part 225, same methodology for similar posted as collateral to the counterparty Appendix A, section III.C.3. (for bank exposures. A [bank] may use separate minus the sum of the current market holding companies), 12 CFR part 325, methodologies for agency securities values of that same security the [bank] Appendix A, section II.C.a. (for state lending transactions—that is, securities has borrowed, purchased subject to nonmember banks), and 12 CFR lending transactions in which the resale, or taken as collateral from the 567.6(a)(1)(iii) and (iv) (for savings [bank], acting as agent for a customer, counterparty); associations). The risk-weighted asset lends the customer’s securities and amount for any other on-balance-sheet indemnifies the customer against loss— (D) Hs = market price volatility asset that does not meet the definition and all other repo-style transactions. haircut appropriate to the security (a) EAD for eligible margin loans and of a wholesale, retail, securitization, or referenced in Es; repo-style transactions—(1) General. A equity exposure equals the carrying [bank] may recognize the credit risk (E) Efx = absolute value of the net value of the asset. mitigation benefits of financial collateral position of both cash and securities in (4) Non-material portfolios of that secures an eligible margin loan, a currency that is different from the exposures. The risk-weighted asset repo-style transaction, or single-product settlement currency (where the net amount of a portfolio of exposures for group of such transactions with a single position in a given currency equals the which the [bank] has demonstrated to counterparty subject to a qualifying sum of the current market values of any [AGENCY]’s satisfaction that the master netting agreement (netting set) by cash or securities in the currency the portfolio (when combined with all other factoring the collateral into its ELGD [bank] has lent, sold subject to portfolios of exposures that the [bank] and LGD estimates for the exposure. repurchase, or posted as collateral to the seeks to treat under this paragraph) is Alternatively, a [bank] may estimate an counterparty minus the sum of the not material to the [bank] is the sum of unsecured ELGD and LGD for the current market values of any cash or the carrying values of on-balance sheet exposure and determine the EAD of the securities in the currency the [bank] has exposures plus the notional amounts of exposure using: borrowed, purchased subject to resale, off-balance sheet exposures in the (i) The collateral haircut approach or taken as collateral from the portfolio. For purposes of this paragraph described in paragraph (a)(2) of this counterparty); and (e)(4), the notional amount of an OTC section; (F) Hfx = haircut appropriate to the derivative contract that is not a credit (ii) For netting sets only, the simple mismatch between the currency derivative is the EAD of the derivative VaR methodology described in referenced in Efx and the settlement as calculated in section 32. paragraph (a)(3) of this section; or currency. Section 32. Counterparty Credit Risk (iii) The internal models methodology described in paragraph (c) of this (ii) Standard supervisory haircuts. (A) This section describes two section. Under the ‘‘standard supervisory methodologies—a collateral haircut (2) Collateral haircut approach—(i) haircuts’’ approach: approach and an internal models EAD equation. A [bank] may determine (1) A [bank] must use the haircuts for methodology—that a [bank] may use EAD for an eligible margin loan, repo- market price volatility (Hs) in Table 3, instead of an ELGD/LGD estimation style transaction, or netting set by as adjusted in certain circumstances as methodology to recognize the benefits of setting EAD = max {0, [(SE ¥ SC) + S(Es provided in paragraph (a)(2)(ii)(A)(3) financial collateral in mitigating the × Hs) + (Efx × Hfx)]}, where: and (4) of this section;

TABLE 3.—STANDARD SUPERVISORY MARKET PRICE VOLATILITY HAIRCUTS*

Issuers ex- Applicable external rating grade category for debt securities Residual maturity for debt securities empt from the Other issuers 3 b.p. floor

Two highest investment grade rating categories for long-term rat- ≤1 year ...... 005 .01 ings/highest investment grade rating category for short-term >1 year, ≤5 years ...... 02 .04 ratings. >5 years ...... 04 .08

VerDate Aug<31>2005 00:30 Sep 23, 2006 Jkt 208001 PO 00000 Frm 00100 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55929

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

Issuers ex- Applicable external rating grade category for debt securities Residual maturity for debt securities empt from the Other issuers 3 b.p. floor

Two lowest investment grade ratiing categories for both short- ≤1 year ...... 01 .02 and long-term ratings. >1 year, ≤5 years ...... 03 .06 >5 years ...... 06 .12

One rating category below investment grade ...... All ...... 15 .25

Main index equities (including convertible bonds) and gold ...... 15

Other publicly traded equities (including convertible bonds) ...... 25

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 *The market price volatility haircuts in Table 3 are based on a 10-business-day holding period.

(2) For currency mismatches, a [bank] or 5 business days (for repo-style (1) A [bank] must use a 99th must use a haircut for foreign exchange transactions) where and as appropriate percentile one-tailed confidence rate volatility (Hfx) of 8 percent, as to take into account the illiquidity of an interval. adjusted in certain circumstances as instrument. (2) The minimum holding period for provided in paragraph (a)(2)(ii)(A)(3) (iii) Own estimates for haircuts. With a repo-style transaction is 5 business and (4) of this section. the prior written approval of [AGENCY], (3) For repo-style transactions, a days and for an eligible margin loan is a [bank] may calculate haircuts (Hs and [bank] may multiply the supervisory 10 business days. When a [bank] Hfx) using its own internal estimates of haircuts provided in paragraphs calculates an own-estimates haircut on the volatilities of market prices and (a)(2)(ii)(A)(1) and (2) by the square root a TN-day holding period, which is foreign exchange rates. of 1⁄2 (which equals 0.707107). different from the minimum holding (4) A [bank] must adjust the (A) To receive [AGENCY] approval to period for the transaction type, the supervisory haircuts upward on the use internal estimates, a [bank] must applicable haircut (HM) is calculated basis of a holding period longer than 10 satisfy the following minimum using the following square root of time business days (for eligible margin loans) quantitative standards: formula:

T = M , HHMN where TN

(i) TM = 5 for repo-style transactions representative of the securities in that its net position in each mismatched and 10 for eligible margin loans; category that the [bank] has actually currency based on estimated volatilities (ii) TN = holding period used by the lent, sold subject to repurchase, posted of foreign exchange rates between the [bank] to derive HN; and as collateral, borrowed, purchased mismatched currency and the (iii) HN = haircut based on the holding subject to resale, or taken as collateral. settlement currency. period T . N In determining relevant categories, the (E) A [bank]’s own estimates of market (3) A [bank] must adjust holding [bank] must take into account: price and foreign exchange rate periods upwards where and as (1) The type of issuer of the security; volatilities may not take into account appropriate to take into account the (2) The applicable external rating of the correlations among securities and illiquidity of an instrument. the security; foreign exchanges rates on either the (4) The historical observation period (3) The maturity of the security; and must be at least one year. (4) The interest rate sensitivity of the exposure or collateral side of a (5) A [bank] must update its data sets security. transaction (or netting set) or the and recompute haircuts no less (C) With respect to debt securities that correlations among securities and frequently than quarterly and must also have an applicable external rating of foreign exchange rates between the reassess data sets and haircuts whenever below investment grade and equity exposure and collateral sides of the market prices change materially. securities, a [bank] must calculate a transaction (or netting set). (B) With respect to debt securities that separate haircut for each individual (3) Simple VaR methodology. With have an applicable external rating of security. the prior written approval of [AGENCY], investment grade, a [bank] may (D) Where an exposure or collateral a [bank] may estimate EAD for a netting calculate haircuts for categories of (whether in the form of cash or set using a VaR model that meets the securities. For a category of securities, securities) is denominated in a currency requirements in paragraph (a)(3)(iii) of the [bank] must calculate the haircut on that differs from the settlement this section. In such event, the [bank] the basis of internal volatility estimates currency, the [bank] must calculate a must set EAD = max {0, [(SE ¥ SC) + for securities in that category that are separate currency mismatch haircut for PFE]}, where:

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00101 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.058 55930 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

(i) SE equals the value of the exposure (i) A [bank] that purchases a credit credit risk of an equity derivative (that is, the sum of the current market derivative that is recognized under contract under this part. values of all securities and cash the section 33 or 34 as a credit risk mitigant (5) Single OTC derivative contract. [bank] has lent, sold subject to for an exposure that is not a covered Except as modified by paragraph (b)(7) repurchase, or posted as collateral to the position under [the market risk rule] of this section, the EAD for a single OTC counterparty under the netting set); need not compute a separate derivative contract that is not subject to (ii) SC equals the value of the counterparty credit risk capital a qualifying master netting agreement is collateral (that is, the sum of the current requirement under this section so long equal to the sum of the [bank]’s current market values of all securities and cash as it does so consistently for all such credit exposure and potential future the [bank] has borrowed, purchased credit derivatives and either includes all credit exposure on the derivative subject to resale, or taken as collateral or excludes all such credit derivatives contract. from the counterparty under the netting that are subject to a master netting (i) Current credit exposure. The set); and contract from any measure used to current credit exposure for a single OTC (iii) PFE (potential future exposure) determine counterparty credit risk derivative contract is the greater of the equals the [bank]’s empirically-based exposure to all relevant counterparties mark-to-market value of the derivative best estimate of the 99th percentile, one- for risk-based capital purposes. contract or zero. tailed confidence interval for an (ii) A [bank] that is the protection (ii) PFE. The PFE for a single OTC increase in the value of (SE ¥ SC) over provider in a credit derivative must treat derivative contract, including an OTC a 5-business-day holding period for the credit derivative as a wholesale derivative contract with a negative repo-style transactions or over a 10- exposure to the reference obligor and mark-to-market value, is calculated by business-day holding period for eligible need not compute a counterparty credit multiplying the notional principal margin loans using a minimum one-year risk capital requirement for the credit amount of the derivative contract by the historical observation period of price derivative under this section, so long as appropriate conversion factor in Table data representing the instruments that it does so consistently for all such credit 4. For purposes of calculating either the the [bank] has lent, sold subject to derivatives and either includes all or potential future credit exposure under repurchase, posted as collateral, excludes all such credit derivatives that this paragraph or the gross potential borrowed, purchased subject to resale, are subject to a master netting contract future credit exposure under paragraph or taken as collateral. The [bank] must from any measure used to determine (b)(6) of this section for exchange rate validate its VaR model, including by counterparty credit risk exposure to all contracts and other similar contracts in establishing and maintaining a rigorous relevant counterparties for risk-based which the notional principal amount is and regular back-testing regime. capital purposes (unless the [bank] is equivalent to the cash flows, notional treating the credit derivative as a principal amount is the net receipts to (b) EAD for OTC derivative contracts. covered position under [the market risk each party falling due on each value (1) A [bank] must determine the EAD for rule], in which case the [bank] must date in each currency. For any OTC an OTC derivative contract that is not compute a supplemental counterparty derivative contract that does not fall subject to a qualifying master netting credit risk capital requirement under within one of the specified categories in agreement using the current exposure this section). Table 4, the potential future credit methodology in paragraph (b)(5) of this (4) Counterparty credit risk for equity exposure must be calculated using the section or using the internal models derivatives. A [bank] must treat an ‘‘other commodity’’ conversion factors. methodology described in paragraph (c) equity derivative contract as an equity [Bank]s must use an OTC derivative of this section. exposure and compute a risk-weighted contract’s effective notional principal (2) A [bank] must determine the EAD asset amount for the equity derivative amount (that is, its apparent or stated for multiple OTC derivative contracts contract under part VI (unless the [bank] notional principal amount multiplied by that are subject to a qualifying master is treating the contract as a covered any multiplier in the OTC derivative netting agreement using the current position under [the market risk rule]). In contract) rather than its apparent or exposure methodology in paragraph addition, if the [bank] is treating the stated notional principal amount in (b)(6) of this section or using the contract as a covered position under calculating potential future credit internal models methodology described [the market risk rule] and in certain exposure. PFE of the protection provider in paragraph (c) of this section.8 other cases described in section 55, the of a credit derivative is capped at the (3) Counterparty credit risk for credit [bank] must also calculate a risk-based net present value of the amount of derivatives. Notwithstanding the above, capital requirement for the counterparty unpaid premiums.

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

Credit (in- Credit (non- Foreign ex- vestment investment Precious Remaining maturity** Interest rate change rate grade ref- grade ref- Equity metals (ex- Other com- and gold erence obli- erence obli- cept gold) modity gor)*** gor)

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 * 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.

8 For purposes of this determination, for OTC written and well reasoned legal opinion that this agreement meets the criteria set forth in the derivative contracts, a [bank] must maintain a definition of qualifying master netting agreement.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00102 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55931

** 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. *** A [bank] must use column 4 of this table—‘‘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 invest- ment grade. A [bank] must use column 5 of the table for all other credit derivatives.

(6) Multiple OTC derivative contracts (7) Collateralized OTC derivative methodology for all transactions of that subject to a qualifying master netting contracts. A [bank] may recognize the transaction type. A [bank] may choose agreement. Except as modified by credit risk mitigation benefits of to use the internal models methodology paragraph (b)(7) of this section, the EAD financial collateral that secures an OTC for one or two of these three types of for multiple OTC derivative contracts derivative contract or single-product set exposures and not the other types. A subject to a qualifying master netting of OTC derivatives subject to a [bank] may also use the internal models agreement is equal to the sum of the net qualifying master netting agreement methodology for OTC derivative current credit exposure and the adjusted (netting set) by factoring the collateral contracts, eligible margin loans, and sum of the PFE exposure for all OTC into its ELGD and LGD estimates for the repo-style transactions subject to a derivative contracts subject to the contract or netting set. Alternatively, a qualifying cross-product netting qualifying master netting agreement. [bank] may recognize the credit risk agreement if: (i) Net current credit exposure. The mitigation benefits of financial collateral (i) The [bank] effectively integrates net current credit exposure is the greater that secures such a contract or netting the risk mitigating effects of cross- of: set that is marked to market on a daily product netting into its risk (A) The net sum of all positive and basis and subject to a daily margin management and other information negative mark-to-market values of the maintenance requirement by estimating technology systems; and individual OTC derivative contracts an unsecured ELGD and LGD for the (ii) The [bank] obtains the prior subject to the qualifying master netting contract or netting set and adjusting the written approval of the [AGENCY]. EAD calculated under paragraph (b)(5) agreement; or A [bank] that uses the internal models or (b)(6) of this section using the (B) zero. methodology for a type of exposures collateral haircut approach in paragraph (ii) Adjusted sum of the PFE. The must receive approval from the (a)(2) of this section. The [bank] must adjusted sum of the PFE is calculated as [AGENCY] to cease using the substitute the EAD calculated under × × × methodology for that type of exposures Anet = (0.4 Agross) + (0.6 NGR paragraph (b)(5) or (b)(6) of this section or to make a material change to its Agross), where: for SE in the equation in paragraph internal model. (A) Anet = the adjusted sum of the (a)(2)(i) of this section and must use a PFE; 10-business-day minimum holding (2) Under the internal models methodology, a [bank] uses an internal (B) Agross = the gross PFE (that is, the period (TM = 10). sum of the PFE amounts (as determined (c) Internal models methodology. (1) model to estimate the expected under paragraph (b)(5)(ii) of this With prior written approval from exposure (EE) for a netting set and then section) for each individual OTC [AGENCY], a [bank] may use the calculates EAD based on that EE. derivative contract subject to the internal models methodology in this (i) The [bank] must use its internal qualifying master netting agreement); paragraph (c) to determine EAD for model’s probability distribution for and counterparty credit risk for OTC changes in the market value of an (C) NGR = the net to gross ratio (that derivative contracts (collateralized or exposure or netting set that are is, the ratio of the net current credit uncollateralized) and single-product attributable to changes in market exposure to the gross current credit netting sets thereof, for eligible margin variables to determine EE. The [bank] exposure). In calculating the NGR, the loans and single-product netting sets may include financial collateral gross current credit exposure equals the thereof, and for repo-style transactions currently posted by the counterparty as sum of the positive current credit and single-product netting sets thereof. collateral when calculating EE. exposures (as determined under A [bank] that uses the internal models (ii) Under the internal models paragraph (b)(5)(i) of this section) of all methodology for a particular transaction methodology, EAD = a × effective EPE, individual OTC derivative contracts type (OTC derivative contracts, eligible or, subject to [AGENCY] approval as subject to the qualifying master netting margin loans, or repo-style transactions) provided in paragraph (c)(7), a more agreement. must use the internal models conservative measure of EAD.

n ()A EffectiveEPE = ∑ EffectiveEE *∆ t ttkkk k=1

th (that is, effective EPE is the time- (2) tk represents the k future time (3) To obtain [AGENCY] approval to weighted average of effective EE where period in the model and there are n time calculate the distributions of exposures the weights are the proportion that an periods represented in the model over upon which the EAD calculation is individual effective EE represents in a the first year; and based, the [bank] must demonstrate to one year time interval) where: (B) a = 1.4 except as provided in the satisfaction of [AGENCY] that it has (1) Effective EEtk = max paragraph (c)(6), or when [AGENCY] has been using for at least one year an (EffectiveEEtk¥1,EEtk (that is, for a determined that the [bank] must set a internal model that broadly meets the specific date tk, effective EE is the higher based on the [bank]’s specific following minimum standards, with greater of EE at that date or the effective characteristics of counterparty credit which the [bank] must maintain EE at the previous date); and risk. compliance:

VerDate Aug<31>2005 00:24 Sep 23, 2006 Jkt 208001 PO 00000 Frm 00103 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.081 55932 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

(i) The model must have the systems of collateral held, where appropriate. updated quarterly or more frequently if capability to estimate the expected The [bank] must estimate expected market conditions warrant. The [bank] exposure to the counterparty on a daily exposures for OTC derivative contracts should consider using model parameters basis (but is not expected to estimate or both with and without the effect of based on forward-looking measures report expected exposure on a daily collateral agreements. such as implied volatilities, where basis). (vi) The [bank] must have procedures appropriate. to identify, monitor, and control specific (ii) The model must estimate expected (viii) A [bank] must subject its wrong-way risk throughout the life of an exposure at enough future dates to internal model to an initial validation accurately reflect all the future cash exposure. Wrong-way risk in this and annual model review process. The flows of contracts in the netting set. context is the risk that future exposure model review should consider whether (iii) The model must account for the to a counterparty will be high when the the inputs and risk factors, as well as the possible non-normality of the exposure counterparty’s probability of default is model outputs, are appropriate. distribution, where appropriate. also high. (iv) The [bank] must measure, (vii) The model must use current (4) Maturity. (i) If the remaining monitor, and control current market data to compute current maturity of the exposure or the longest- counterparty exposure and the exposure exposures. When estimating model dated contract in the netting set is to the counterparty over the whole life parameters based on historical data, at greater than one year, the [bank] must of all contracts in the netting set. least three years of historical data that set M for the exposure or netting set (v) The [bank] must measure and cover a wide range of economic equal to the lower of 5 years or M(EPE), manage current exposures gross and net conditions must be used and must be where:

maturity ××∆ ∑ EEk tdfkk tk >1 year ()A M (EPE) =1+ ≤ ; tk 1 year × ∆ × ∑ effectiveEE k tkkkdf k=1

(B) dfk is the risk-free discount factor rights under the agreement may be (ii) A [bank] that can model EPE for future time period tk; and stayed or avoided under applicable law without collateral agreements but (C) Dtk = tk ¥ tk¥1. in the relevant jurisdictions. Two cannot achieve the higher level of (ii) If the remaining maturity of the methods are available to capture the modeling sophistication to model EPE exposure or the longest-dated contract effect of a collateral agreement: with collateral agreements can set in the netting set is one year or less, the (i) With prior written approval from effective EPE for a collateralized [bank] must set M for the exposure or [AGENCY], a [bank] may include the counterparty equal to the lesser of: netting set equal to 1 year, except as (A) The threshold, defined as the effect of a collateral agreement within provided in paragraph (d)(7) of section exposure amount at which the its internal model used to calculate 31. counterparty is required to post EAD. The [bank] may set EAD equal to (5) Collateral agreements. A [bank] collateral under the collateral the expected exposure at the end of the may capture the effect on EAD of a agreement, if the threshold is positive, margin period of risk. The margin collateral agreement that requires plus an add-on that reflects the potential receipt of collateral when exposure to period of risk means, with respect to a increase in exposure over the margin the counterparty increases but may not netting set subject to a collateral period of risk. The add-on is computed capture the effect on EAD of a collateral agreement, the time period from the as the expected increase in the netting agreement that requires receipt of most recent exchange of collateral with set’s exposure beginning from current collateral when counterparty credit a counterparty until the next required exposure of zero over the margin period quality deteriorates. For this purpose, a exchange of collateral plus the period of of risk. The margin period of risk must collateral agreement means a legal time required to sell and realize the be at least five business days for contract that specifies the time when, proceeds of the least liquid collateral exposures or netting sets consisting only and circumstances under which, the that can be delivered under the terms of of repo-style transactions subject to counterparty is required to exchange the collateral agreement, and, where daily re-margining and daily marking- collateral with the [bank] for a single applicable, the period of time required to-market, and 10 business days for all financial contract or for all financial to re-hedge the resulting market risk, other exposures or netting sets; or contracts covered under a qualifying upon the default of the counterparty. (B) Effective EPE without a collateral master netting agreement and confers The minimum margin period of risk is agreement. upon the [bank] a perfected, first 5 business days for repo-style (6) Own estimate of alpha. With prior priority security interest, or the legal transactions and 10 business days for written approval of [AGENCY], a [bank] equivalent thereof, in the collateral other transactions when liquid financial may calculate alpha as the ratio of posted by the counterparty under the collateral is posted under a daily margin economic capital from a full simulation agreement. This security interest must maintenance requirement. This period of counterparty exposure across provide the [bank] with a right to close should be extended to cover any counterparties that incorporates a joint out the financial positions and the additional time between margin calls; simulation of market and credit risk collateral upon an event of default of, or any potential closeout difficulties; any factors (numerator) and economic failure to perform by, the counterparty delays in selling collateral, particularly capital based on EPE (denominator), under the collateral agreement. A if the collateral is illiquid; and any subject to a floor of 1.2. For purposes of contract would not satisfy this impediments to prompt re-hedging of this calculation, economic capital is the requirement if the [bank]’s exercise of any market risk. unexpected losses for all counterparty

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00104 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.059 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55933

credit risks measured at a 99.9 percent (2) Wholesale exposures on which provider’s PD leads to an inappropriate confidence level over a one-year there is a tranching of credit risk degree of risk mitigation, the [bank] may horizon. To receive approval, the [bank] (reflecting at least two different levels of substitute a higher PD than that of the must meet the following minimum seniority) are securitization exposures protection provider. standards to the satisfaction of subject to the securitization framework (ii) Partial coverage. If an eligible [AGENCY]: in part V. guarantee or eligible credit derivative (i) The [bank]’s own estimate of alpha (3) A [bank] may elect to recognize the meets the conditions in paragraphs (a) must capture in the numerator the credit risk mitigation benefits of an and (b) of this section and the protection effects of: eligible guarantee or eligible credit amount (P) of the guarantee or credit (A) The material sources of stochastic derivative covering an exposure derivative is less than the EAD of the dependency of distributions of market described in paragraph (a)(1) of this hedged exposure, the [bank] must treat values of transactions or portfolios of section by using the PD substitution the hedged exposure as two separate transactions across counterparties; approach or the LGD adjustment exposures (protected and unprotected) (B) Volatilities and correlations of approach in paragraph (c) of this section in order to recognize the credit risk market risk factors used in the joint or using the double default treatment in mitigation benefit of the guarantee or simulation, which must be related to the section 34 (if the transaction qualifies credit derivative. credit risk factor used in the simulation for the double default treatment in (A) The [bank] must calculate its risk- to reflect potential increases in volatility section 34). A [bank]’s PD and LGD for based capital requirement for the or correlation in an economic downturn, the hedged exposure may not be lower protected exposure under section 31, where appropriate; and than the PD and LGD floors described in where PD is the protection provider’s (C) The granularity of exposures, that paragraphs (d)(2) and (d)(3) of section PD, ELGD and LGD are determined is, the effect of a concentration in the 31. under paragraphs (c)(1)(iii) and (iv) of (4) A [bank] must use the same risk proportion of each counterparty’s this section, and EAD is P. If the [bank] parameters for calculating ECL as it uses exposure that is driven by a particular determines that full substitution leads to for calculating the risk-based capital risk factor. an inappropriate degree of risk requirement for the exposure. mitigation, the [bank] may use a higher (ii) The [bank] must assess the (b) Rules of recognition. (1) A [bank] PD than that of the protection provider. potential model risk in its estimates of may only recognize the credit risk alpha. mitigation benefits of eligible guarantees (B) The [bank] must calculate its risk- (iii) The [bank] must calculate the and eligible credit derivatives. based capital requirement for the numerator and denominator of alpha in (2) A [bank] may only recognize the unprotected exposure under section 31, a consistent fashion with respect to credit risk mitigation benefits of an where PD is the obligor’s PD, ELGD is modeling methodology, parameter eligible credit derivative to hedge an the hedged exposure’s ELGD (not specifications, and portfolio exposure that is different from the credit adjusted to reflect the guarantee or composition. derivative’s reference exposure used for credit derivative), LGD is the hedged (iv) The [bank] must review and determining the derivative’s cash exposure’s LGD (not adjusted to reflect adjust as appropriate its estimates of the settlement value, deliverable obligation, the guarantee or credit derivative), and numerator and denominator on at least or occurrence of a credit event if: EAD is the EAD of the original hedged a quarterly basis and more frequently (i) The reference exposure ranks pari exposure minus P. when the composition of the portfolio passu (that is, equally) with or is junior (C) The treatment in this paragraph varies over time. to the hedged exposure; and (c)(1)(ii) is applicable when the credit (7) Other measures of counterparty (ii) The reference exposure and the risk of a wholesale exposure is covered exposure. With prior written approval of hedged exposure share the same obligor on a pro rata basis or when an [AGENCY], a [bank] may set EAD equal (that is, the same legal entity), and adjustment is made to the effective to a measure of counterparty credit risk legally enforceable cross-default or notional amount of the guarantee or exposure, such as peak EAD, that is cross-acceleration clauses are in place. credit derivative under paragraphs (d), more conservative than an alpha of 1.4 (c) Risk parameters for hedged (e), or (f) of this section. (or higher under the terms of paragraph exposures—(1) PD substitution (iii) LGD of hedged exposures. The (c)(2)(ii)(B)) times EPE for every approach—(i) Full coverage. If an LGD of a hedged exposure under the PD counterparty whose EAD will be eligible guarantee or eligible credit substitution approach is equal to: measured under the alternative measure derivative meets the conditions in (A) The lower of the LGD of the of counterparty exposure. The [bank] paragraphs (a) and (b) of this section hedged exposure (not adjusted to reflect must demonstrate the conservatism of and the protection amount (P) of the the guarantee or credit derivative) and the measure of counterparty credit risk guarantee or credit derivative is greater the LGD of the guarantee or credit exposure used for EAD. than or equal to the EAD of the hedged derivative, if the guarantee or credit exposure, a [bank] may recognize the derivative provides the [bank] with the Section 33. Guarantees and Credit guarantee or credit derivative in option to receive immediate payout Derivatives: PD Substitution and LGD determining the [bank]’s risk-based upon triggering the protection; or Adjustment Treatments capital requirement for the hedged (B) The LGD of the guarantee or credit (a) Scope. (1) This section applies to exposure by substituting the PD derivative, if the guarantee or credit wholesale exposures for which: associated with the rating grade of the derivative does not provide the [bank] (i) Credit risk is fully covered by an protection provider for the PD with the option to receive immediate eligible guarantee or eligible credit associated with the rating grade of the payout upon triggering the protection. derivative; and obligor in the risk-based capital formula (iv) ELGD of hedged exposures. The (ii) Credit risk is covered on a pro rata in Table 2 and using the appropriate ELGD of a hedged exposure under the basis (that is, on a basis in which the ELGD and LGD as described in PD substitution approach is equal to the [bank] and the protection provider share paragraphs (c)(1)(iii) and (iv) of this ELGD associated with the LGD losses proportionately) by an eligible section. If the [bank] determines that determined under paragraph (c)(1)(iii) of guarantee or eligible credit derivative. full substitution of the protection this section.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00105 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55934 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

(2) LGD adjustment approach—(i) hedged exposure must adjust the derivative that does not include as a Full coverage. If an eligible guarantee or protection amount of the credit risk credit event a restructuring of the eligible credit derivative meets the mitigant to reflect any maturity hedged exposure involving forgiveness conditions in paragraphs (a) and (b) of mismatch between the hedged exposure or postponement of principal, interest, this section and the protection amount and the credit risk mitigant. or fees that results in a credit loss event (P) of the guarantee or credit derivative (2) A maturity mismatch occurs when (that is, a charge-off, specific provision, is greater than or equal to the EAD of the the residual maturity of a credit risk or other similar debit to the profit and hedged exposure, the [bank]’s risk-based mitigant is less than that of the hedged loss account), the [bank] must apply the capital requirement for the hedged exposure(s). When a credit risk mitigant following adjustment to reduce the exposure would be the greater of: covers multiple hedged exposures that protection amount of the credit (A) The risk-based capital have different residual maturities, the derivative: Pr = Pm × 0.60, where: requirement for the exposure as longest residual maturity of any of the (1) Pr = protection amount of the calculated under section 31, with the hedged exposures must be taken as the credit derivative, adjusted for lack of ELGD and LGD of the exposure adjusted residual maturity of the hedged restructuring event (and maturity to reflect the guarantee or credit exposures. mismatch, if applicable); and derivative; or (3) The residual maturity of a hedged (B) The risk-based capital requirement exposure is the longest possible (2) Pm = effective notional amount of for a direct exposure to the protection remaining time before the obligor is the credit derivative (adjusted for provider as calculated under section 31, scheduled to fulfill its obligation on the maturity mismatch, if applicable). using the PD for the protection provider, exposure. If a credit risk mitigant has (f) Currency mismatch. (1) If a [bank] the ELGD and LGD for the guarantee or embedded options that may reduce its recognizes an eligible guarantee or credit derivative, and an EAD equal to term, the [bank] (protection purchaser) eligible credit derivative that is the EAD of the hedged exposure. must use the shortest possible residual denominated in a currency different (ii) Partial coverage. If an eligible maturity for the credit risk mitigant. If from that in which the hedged exposure guarantee or eligible credit derivative a call is at the discretion of the is denominated, the protection amount meets the conditions in paragraphs (a) protection provider, the residual of the guarantee or credit derivative is and (b) of this section and the protection maturity of the credit risk mitigant is at reduced by application of the following amount (P) of the guarantee or credit the first call date. If the call is at the formula: Pc = Pr × (1 × HFX), where: derivative is less than the EAD of the discretion of the [bank] (protection (i) Pc = protection amount of the hedged exposure, the [bank] must treat purchaser), but the terms of the guarantee or credit derivative, adjusted the hedged exposure as two separate arrangement at origination of the credit for currency mismatch (and maturity exposures (protected and unprotected) risk mitigant contain a positive mismatch and lack of restructuring in order to recognize the credit risk incentive for the [bank] to call the event, if applicable); mitigation benefit of the guarantee or transaction before contractual maturity, credit derivative. the remaining time to the first call date (ii) Pr = effective notional amount of (A) The [bank]’s risk-based capital is the residual maturity of the credit risk the guarantee or credit derivative requirement for the protected exposure mitigant. For example, where there is a (adjusted for maturity mismatch and would be the greater of: step-up in cost in conjunction with a lack of restructuring event, if (1) The risk-based capital requirement call feature or where the effective cost applicable); and for the protected exposure as calculated of protection increases over time even if (iii) HFX = haircut appropriate for the under section 31, with the ELGD and credit quality remains the same or currency mismatch between the LGD of the exposure adjusted to reflect improves, the residual maturity of the guarantee or credit derivative and the the guarantee or credit derivative and credit risk mitigant will be the hedged exposure. EAD set equal to P; or remaining time to the first call. (2) The risk-based capital requirement (2) A [bank] must set HFX equal to 8 (4) A credit risk mitigant with a percent unless it qualifies for the use of for a direct exposure to the guarantor as maturity mismatch may be recognized calculated under section 31, using the and uses its own internal estimates of only if its original maturity is greater foreign exchange volatility based on a PD for the protection provider, the than or equal to one year and its ELGD and LGD for the guarantee or 10-business day holding period and residual maturity is greater than three daily marking-to-market and credit derivative, and an EAD set equal months. to P. remargining. A [bank] qualifies for the (5) When a maturity mismatch exists, use of its own internal estimates of (B) The [bank] must calculate its risk- the [bank] must apply the following based capital requirement for the foreign exchange volatility if it qualifies adjustment to reduce the protection for: unprotected exposure under section 31, amount of the credit risk mitigant: Pm where PD is the obligor’s PD, ELGD is = E × (t¥0.25)/(T¥0.25), where: (i) The own-estimates haircuts in the hedged exposure’s ELGD (not (i) Pm = protection amount of the paragraph (a)(2)(iii) of section 32; adjusted to reflect the guarantee or credit risk mitigant, adjusted for (ii) The simple VaR methodology in credit derivative), LGD is the hedged maturity mismatch; paragraph (a)(3) of section 32; or exposure’s LGD (not adjusted to reflect (ii) E = effective notional amount of (iii) The internal models methodology the guarantee or credit derivative), and the credit risk mitigant; EAD is the EAD of the original hedged (iii) t = the lesser of T or the residual in paragraph (c) of section 32. exposure minus P. maturity of the credit risk mitigant, (3) A [bank] must adjust HFX (3) M of hedged exposures. The M of expressed in years; and calculated in paragraph (f)(2) of this the hedged exposure is the same as the (iv) T = the lesser of 5 or the residual section upward if the [bank] revalues M of the exposure if it were unhedged. maturity of the hedged exposure, the guarantee or credit derivative less (d) Maturity mismatch. (1) A [bank] expressed in years. frequently than once every 10 business that recognizes an eligible guarantee or (e) Credit derivatives without days using the square root of time eligible credit derivative in determining restructuring as a credit event. If a formula provided in paragraph its risk-based capital requirement for a [bank] recognizes an eligible credit (a)(2)(iii)(A)(2) of section 32.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00106 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55935

Section 34. Guarantees and Credit (4) The obligor of the hedged section and the protection amount (P) of Derivatives: Double Default Treatment exposure is not: the guarantee or credit derivative is less (a) Eligibility and operational criteria (i) An eligible double default than the EAD of the hedged exposure, for double default treatment. A [bank] guarantor or an affiliate of an eligible the [bank] must treat the hedged may recognize the credit risk mitigation double default guarantor; or exposure as two separate exposures benefits of a guarantee or credit (ii) An affiliate of the guarantor. (protected and unprotected) in order to derivative covering an exposure (5) The [bank] does not recognize any recognize double default treatment on described in paragraph (a)(1) of section credit risk mitigation benefits of the the protected portion of the exposure. 33 by applying the double default guarantee or credit derivative for the (1) For the protected exposure, the treatment in this section if all the hedged exposure other than through [bank] must set EAD equal to P and following criteria are satisfied. application of the double default calculate its risk-weighted asset amount (1) The hedged exposure is fully treatment as provided in this section. as provided in paragraph (e) of this covered or covered on a pro rata basis (6) The [bank] has implemented a section. by: process (which has received the prior, (2) For the unprotected exposure, the (i) An eligible guarantee issued by an written approval of the [AGENCY]) to [bank] must set EAD equal to the EAD eligible double default guarantor; or detect excessive correlation between the of the original exposure minus P and (ii) An eligible credit derivative that creditworthiness of the obligor of the then calculate its risk-weighted asset meets the requirements of paragraph hedged exposure and the protection amount as provided in section 31. (b)(2) of section 33 and is issued by an provider. If excessive correlation is (d) Mismatches. For any hedged eligible double default guarantor. present, the [bank] may not use the exposure to which a [bank] applies (2) The guarantee or credit derivative double default treatment for the hedged double default treatment, the [bank] is: exposure. must make applicable adjustments to (i) An uncollateralized guarantee or (b) Full coverage. If the transaction the protection amount as required in uncollateralized credit derivative (for meets the criteria in paragraph (a) of this paragraphs (d), (e), and (f) of section 33. example, a credit default swap) that section and the protection amount (P) of (e) The double default dollar risk- provides protection with respect to a the guarantee or credit derivative is at based capital requirement. The dollar single reference obligor; or least equal to the EAD of the hedged risk-based capital requirement for a (ii) An nth-to-default credit derivative exposure, the [bank] may determine its hedged exposure to which a [bank] has (subject to the requirements of risk-weighted asset amount for the applied double default treatment is KDD paragraph (m) of section 42). hedged exposure under paragraph (e) of multiplied by the EAD of the exposure. (3) The hedged exposure is a this section. KDD is calculated according to the wholesale exposure (other than a (c) Partial coverage. If the transaction following formula: KDD = Ko × (0.15 + sovereign exposure). meets the criteria in paragraph (a) of this 160 × PDg), where:

  −−11   NPDN()+ ()0. 999 ρ 125+−()Mb. ×  =×  OOS −× × ()1 KLGDNog (ELGDgo PD )     1− ρ    115−×. b    OS  

(2) PDg = PD of the protection (8) M (maturity) is the effective period if the contractual settlement provider. maturity of the guarantee or credit period for the transaction is equal to or (3) PDo = PD of the obligor of the derivative, which may not be less than less than the market standard for the hedged exposure. one year or greater than five years. instrument underlying the transaction (4) LGDg = (i) The lower of the LGD Section 35. Risk-Based Capital and equal to or less than 5 business of the unhedged exposure and the LGD days. of the guarantee or credit derivative, if Requirement for Unsettled Transactions (4) Positive current exposure. The the guarantee or credit derivative (a) Definitions. For purposes of this positive current exposure of a [bank] for provides the [bank] with the option to section: a transaction is the difference between receive immediate payout on triggering (1) Delivery-versus-payment (DvP) the transaction value at the agreed the protection; or transaction means a securities or (ii) The LGD of the guarantee or credit commodities transaction in which the settlement price and the current market derivative, if the guarantee or credit buyer is obligated to make payment only price of the transaction, if the difference derivative does not provide the [bank] if the seller has made delivery of the results in a credit exposure of the [bank] with the option to receive immediate securities or commodities and the seller to the counterparty. payout on triggering the protection. is obligated to deliver the securities or (b) Scope. This section applies to all (5) ELGDg = The ELGD associated with LGD . commodities only if the buyer has made transactions involving securities, foreign g payment. (6) ros (asset value correlation of the exchange instruments, and commodities obligor) is calculated according to the (2) Payment-versus-payment (PvP) that have a risk of delayed settlement or appropriate formula for (R) provided in transaction means a foreign exchange delivery. This section does not apply to: Table 2 in section 31, with PD equal to transaction in which each counterparty (1) Transactions accepted by a is obligated to make a final transfer of PDo. qualifying central counterparty that are one or more currencies only if the other (7) b (maturity adjustment coefficient) subject to daily marking-to-market and counterparty has made a final transfer of is calculated according to the formula daily receipt and payment of variation one or more currencies. for b provided in Table 2 in section 31, margin; with PD equal to the lesser of PDo and (3) Normal settlement period. A PDg. transaction has a normal settlement

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00107 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.060 55936 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

(2) Repo-style transactions (which are deliverables owed to the [bank] as a (b) Operational criteria for synthetic addressed in sections 31 and 32); 9 wholesale exposure. securitizations. For synthetic (3) One-way cash payments on OTC (i) A [bank] may assign an obligor securitizations, a [bank] may recognize derivative contracts (which are rating to a counterparty for which it is for risk-based capital purposes the use addressed in sections 31 and 32); or not otherwise required under this rule of a credit risk mitigant to hedge (4) Transactions with a contractual to assign an obligor rating on the basis underlying exposures only if each of the settlement period that is longer than the of the applicable external rating of any conditions in this paragraph (b) is normal settlement period (which are outstanding unsecured long-term debt satisfied. A [bank] that fails to meet treated as OTC derivative contracts and security without credit enhancement these conditions must hold risk-based addressed in sections 31 and 32). issued by the counterparty. capital against the underlying exposures (c) System-wide failures. In the case of (ii) A [bank] may use a 45 percent as if they had not been synthetically a system-wide failure of a settlement or ELGD and LGD for the transaction rather securitized. The conditions are: clearing system, the [AGENCY] may than estimating ELGD and LGD for the (1) The credit risk mitigant is waive risk-based capital requirements transaction provided the [bank] uses the financial collateral, an eligible credit for unsettled and failed transactions 45 percent ELGD and LGD for all derivative from an eligible securitization until the situation is rectified. transactions described in paragraphs guarantor, or an eligible guarantee from (d) Delivery-versus-payment (DvP) (e)(1) and (e)(2) of this section. an eligible securitization guarantor; and payment-versus-payment (PvP) (iii) A [bank] may use a 100 percent (2) The [bank] transfers credit risk transactions. A [bank] must hold risk- risk weight for the transaction provided associated with the underlying based capital against any DvP or PvP the [bank] uses this risk weight for all exposures to third parties, and the terms transaction with a normal settlement transactions described in paragraphs and conditions in the credit risk period if the [bank]’s counterparty has (e)(1) and (e)(2) of this section. mitigants employed do not include not made delivery or payment within (3) If the [bank] has not received its provisions that: five business days after the settlement deliverables by the fifth business day (i) Allow for the termination of the date. The [bank] must determine its risk- after counterparty delivery was due, the credit protection due to deterioration in weighted asset amount for such a [bank] must deduct the current market the credit quality of the underlying transaction by multiplying the positive value of the deliverables owed to the exposures; current exposure of the transaction for [bank] 50 percent from tier 1 capital and (ii) Require the [bank] to alter or the [bank] by the appropriate risk 50 percent from tier 2 capital. replace the underlying exposures to weight in Table 5. (f) Total risk-weighted assets for improve the credit quality of the pool of unsettled transactions. Total risk- underlying exposures; TABLE 5.—RISK WEIGHTS FOR UNSET- weighted assets for unsettled (iii) Increase the [bank]’s cost of credit TLED DVP AND PVP TRANSACTIONS transactions is the sum of the risk- protection in response to deterioration weighted asset amounts of all DvP, PvP, in the credit quality of the underlying Risk weight to and non-DvP/non-PvP transactions. exposures; Number of business days be applied to (iv) Increase the yield payable to after contractual settlement positive cur- Part V. Risk-Weighted Assets for parties other than the [bank] in response date rent exposure Securitization Exposures (percent) to a deterioration in the credit quality of Section 41. Operational Criteria for the underlying exposures; or From 5 to 15 ...... 100 Recognizing the Transfer of Risk (v) Provide for increases in a retained From 16 to 30 ...... 625 first loss position or credit enhancement From 31 to 45 ...... 937.5 (a) Operational criteria for traditional provided by the [bank] after the 46 or more ...... 1,250 securitizations. A [bank] that transfers inception of the securitization; exposures it has originated or purchased (3) The [bank] obtains a well-reasoned (e) Non-DvP/non-PvP (non-delivery- to an SPE or other third party in opinion from legal counsel that versus-payment/non-payment-versus- connection with a traditional confirms the enforceability of the credit payment) transactions. (1) A [bank] securitization may exclude the risk mitigant in all relevant must hold risk-based capital against any exposures from the calculation of its jurisdictions; and non-DvP/non-PvP transaction with a risk-weighted assets only if each of the (4) Any clean-up calls relating to the normal settlement period if the [bank] conditions in this paragraph (a) is securitization are eligible clean-up calls. has delivered cash, securities, satisfied. A [bank] that meets these Section 42. Risk-Based Capital commodities, or currencies to its conditions must hold risk-based capital Requirement for Securitization counterparty but has not received its against any securitization exposures it Exposures corresponding deliverables by the end retains in connection with the of the same business day. The [bank] securitization. A [bank] that fails to (a) Hierarchy of approaches. Except as must continue to hold risk-based capital meet these conditions must hold risk- provided elsewhere in this section: against the transaction until the [bank] based capital against the transferred (1) A [bank] must deduct from tier 1 has received its corresponding exposures as if they had not been capital any after-tax gain-on-sale deliverables. securitized and must deduct from tier 1 resulting from a securitization and must (2) From the business day after the capital any after-tax gain-on-sale deduct from total capital in accordance [bank] has made its delivery until five resulting from the transaction. The with paragraph (c) of this section the business days after the counterparty conditions are: portion of any CEIO that does not delivery is due, the [bank] must (1) The transfer is considered a sale constitute gain-on-sale. calculate its risk-based capital under GAAP; (2) If a securitization exposure does requirement for the transaction by (2) The [bank] has transferred to third not require deduction under paragraph treating the current market value of the parties credit risk associated with the (a)(1) of this section and qualifies for the underlying exposures; and Ratings-Based Approach in section 43, a 9 Unsettled repo-style transactions are treated as (3) Any clean-up calls relating to the [bank] must apply the Ratings-Based repo-style transactions under sections 31 and 32. securitization are eligible clean-up calls. Approach to the exposure.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00108 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55937

(3) If a securitization exposure does (2) The total ECL of the underlying after-tax gain-on-sale resulting from the not require deduction under paragraph exposures. securitization and deduct from total (a)(1) of this section and does not (e) Amount of a securitization capital in accordance with paragraph (c) qualify for the Ratings-Based Approach, exposure. (1) The amount of an on- of this section the portion of any CEIO the [bank] may either apply the Internal balance sheet securitization exposure is: that does not constitute gain-on-sale; Assessment Approach in section 44 to (i) The [bank]’s carrying value, if the (2) If the securitization exposure does the exposure (if the [bank] and the exposure is held-to-maturity or for not require deduction under paragraph relevant ABCP program qualify for the trading; or (g)(1), apply the RBA in section 43 to Internal Assessment Approach) or the (ii) The [bank]’s carrying value minus the securitization exposure if the Supervisory Formula Approach in any unrealized gains and plus any exposure qualifies for the RBA; and section 45 to the exposure (if the [bank] unrealized losses on the exposure, if the (3) If the securitization exposure does and the exposure qualify for the exposure is available-for-sale. not require deduction under paragraph Supervisory Formula Approach). (2) The amount of an off-balance sheet (g)(1) and does not qualify for the RBA, (4) If a securitization exposure does securitization exposure is the notional deduct the exposure from total capital not require deduction under paragraph amount of the exposure. For a in accordance with paragraph (c) of this (a)(1) of this section and does not commitment, such as a liquidity facility section. qualify for the Ratings-Based Approach, extended to an ABCP program, the (h) Implicit support. If a [bank] the Internal Assessment Approach, or notional amount may be reduced to the provides support to a securitization in the Supervisory Formula Approach, the maximum potential amount that the excess of the [bank]’s contractual [bank] must deduct the exposure from [bank] currently would be required to obligation to provide credit support to total capital in accordance with fund under the arrangement’s the securitization (implicit support): paragraph (c) of this section. documentation. For an OTC derivative (1) The [bank] must hold regulatory (b) Total risk-weighted assets for contract that is not a credit derivative, capital against all of the underlying securitization exposures. A [bank]’s the notional amount is the EAD of the exposures associated with the total risk-weighted assets for derivative contract (as calculated in securitization as if the exposures had securitization exposures is equal to the section 32). not been securitized and must deduct sum of its risk-weighted assets (f) Overlapping exposures—(1) ABCP from tier 1 capital any after-tax gain-on- calculated using the Ratings-Based programs. If a [bank] has multiple sale resulting from the securitization; Approach in section 43, the Internal securitization exposures to an ABCP and Assessment Approach in section 44, and program that provide duplicative (2) The [bank] must disclose publicly: the Supervisory Formula Approach in coverage of the underlying exposures of (i) That it has provided implicit section 45, and its risk-weighted assets a securitization (such as when a [bank] support to the securitization; and amount for early amortization provides a program-wide credit (ii) The regulatory capital impact to provisions calculated in section 47. enhancement and multiple pool-specific the [bank] of providing such implicit (c) Deductions. (1) If a [bank] must liquidity facilities to an ABCP program), support. deduct a securitization exposure from the [bank] is not required to hold (i) Eligible servicer cash advance total capital, the [bank] must take the duplicative risk-based capital against facilities. Regardless of any other deduction 50 percent from tier 1 capital the overlapping position. Instead, the provisions of this part, a [bank] is not and 50 percent from tier 2 capital. If the [bank] may apply to the overlapping required to hold risk-based capital amount deductible from tier 2 capital position the applicable risk-based against the undrawn portion of an exceeds the [bank]’s tier 2 capital, the capital treatment that results in the eligible servicer cash advance facility. [bank] must deduct the excess from tier highest risk-based capital requirement. (j) Interest-only mortgage-backed 1 capital. (2) Mortgage loan swaps. If a [bank] securities. Regardless of any other (2) A [bank] may calculate any holds a mortgage-backed security or provisions of this part, the risk weight deduction from regulatory capital for a participation certificate as a result of a for a non-credit enhancing interest-only securitization exposure net of any mortgage loan swap with recourse, and mortgage-backed security may not be deferred tax liabilities associated with the transaction is a securitization less than 100 percent. the securitization exposure. exposure, the [bank] must determine a (k) Small-business loans and leases (d) Maximum risk-based capital risk-weighted asset amount for the on personal property transferred with requirement. Regardless of any other recourse obligation plus the percentage recourse. (1) Regardless of any other provisions of this part, unless one or of the mortgage-backed security or provisions of this appendix, a [bank] more underlying exposures does not participation certificate that is not that has transferred small-business loans meet the definition of a wholesale, covered by the recourse obligation. The and leases of personal property (small- retail, securitization, or equity exposure, total risk-weighted asset amount for the business obligations) with recourse the total risk-based capital requirement transaction is capped at the risk- must include in risk-weighted assets for all securitization exposures held by weighted asset amount for the only the contractual amount of retained a single [bank] associated with a single underlying exposures as if they were recourse if all the following conditions securitization (including any risk-based held directly on the [bank]’s balance are met: capital requirements that relate to an sheet. (i) The transaction is a sale under early amortization provision of the (g) Securitizations of non-IRB GAAP. securitization but excluding any risk- exposures. Regardless of paragraph (a) (ii) The [bank] establishes and based capital requirements that relate to of this section, if a [bank] has a maintains, pursuant to GAAP, a non- the [bank]’s gain-on-sale or CEIOs securitization exposure where any capital reserve sufficient to meet the associated with the securitization) may underlying exposure is not a wholesale [bank]’s reasonably estimated liability not exceed the sum of: exposure, retail exposure, securitization under the recourse arrangement. (1) The [bank]’s total risk-based exposure, or equity exposure, the [bank] (iii) The loans and leases are to capital requirement for the underlying must: businesses that meet the criteria for a exposures as if the [bank] directly held (1) If the [bank] is an originating small-business concern established by the underlying exposures; plus [bank], deduct from tier 1 capital any the Small Business Administration

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00109 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55938 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

under section 3(a) of the Small Business weighted assets, the [bank] must hold underlying exposures through a nth-to- Act. risk-based capital against the default credit derivative (other than a (iv) The [bank] is well capitalized, as consolidated ABCP program assets in first-to-default credit derivative) must defined in the [AGENCY]’s prompt accordance with this appendix but is determine its risk-weighted asset corrective action regulation—12 CFR not required to hold risk-based capital amount for the derivative by applying part 6 (for national banks), 12 CFR part against any securitization exposures of the RBA in section 43 (if the derivative 208, subpart D (for state member banks the [bank] to the ABCP program. qualifies for the RBA) or, if the or bank holding companies), 12 CFR (m) Nth-to-default credit derivatives— derivative does not qualify for the RBA, part 325, subpart B (for state (1) First-to-default credit derivatives—(i) by setting its risk-weighted asset amount nonmember banks), and 12 CFR part Protection purchaser. A [bank] that for the derivative equal to the product 565 (for savings associations). For obtains credit protection on a group of of: purposes of determining whether a underlying exposures through a first-to- (A) The protection amount of the [bank] is well capitalized for purposes default credit derivative must determine derivative; of paragraph (k) of this section, the its risk-based capital requirement for the (B) 12.5; and [bank]’s capital ratios must be underlying exposures as if the [bank] (C) The sum of the risk-based capital calculated without regard to the synthetically securitized the underlying requirements (K) of the individual preferential capital treatment for exposure with the lowest risk-based underlying exposures (as calculated transfers of small-business obligations capital requirement (K) (as calculated under Table 2 and excluding the n–1 with recourse specified in paragraph under Table 2) and had obtained no underlying exposures with the lowest (k)(1) of this section. credit risk mitigant on the other Ks), up to a maximum of 100 percent. (2) The total outstanding amount of underlying exposures. recourse retained by a [bank] on Section 43. Ratings-Based Approach (ii) Protection provider. A [bank] that (RBA) transfers of small-business obligations provides credit protection on a group of receiving the preferential capital underlying exposures through a first-to- (a) Eligibility requirements for use of treatment specified in paragraph (k)(1) default credit derivative must determine the RBA—(1) Originating [bank]. An of this section cannot exceed 15 percent its risk-weighted asset amount for the originating [bank] must use the RBA to of the [bank]’s total qualifying capital. derivative by applying the RBA in calculate its risk-based capital (3) If a [bank] ceases to be well section 43 (if the derivative qualifies for requirement for a securitization capitalized or exceeds the 15 percent the RBA) or, if the derivative does not exposure if the exposure has two or capital limitation, the preferential qualify for the RBA, by setting its risk- more external ratings or an inferred capital treatment specified in paragraph weighted asset amount for the derivative rating based on two or more external (k)(1) of this section will continue to equal to the product of: ratings (and may not use the RBA if the apply to any transfers of small-business (A) The protection amount of the exposure has fewer than two external obligations with recourse that occurred derivative; ratings or an inferred rating based on during the time that the [bank] was well (B) 12.5; and fewer than two external ratings). capitalized and did not exceed the (C) The sum of the risk-based capital (2) Investing [bank]. An investing capital limit. requirements (K) of the individual [bank] must use the RBA to calculate its (4) The risk-based capital ratios of the underlying exposures (as calculated risk-based capital requirement for a [bank] must be calculated without under Table 2), up to a maximum of 100 securitization exposure if the exposure regard to the preferential capital percent. has one or more external or inferred treatment for transfers of small-business (2) Second-or-subsequent-to-default ratings (and may not use the RBA if the obligations with recourse specified in credit derivatives—(i) Protection exposure has no external or inferred paragraph (k)(1) of this section as purchaser. (A) A [bank] that obtains rating). provided in 12 CFR part 3, Appendix A credit protection on a group of (b) Ratings-based approach. (1) A (for national banks), 12 CFR part 208, underlying exposures through a nth-to- [bank] must determine the risk-weighted Appendix A (for state member banks), default credit derivative (other than a asset amount for a securitization 12 CFR part 225, Appendix A (for bank first-to-default credit derivative) may exposure by multiplying the amount of holding companies), 12 CFR part 325, recognize the credit risk mitigation the exposure (as defined in paragraph Appendix A (for state nonmember benefits of the derivative only if: (e) of section 42) by the appropriate risk banks), and 12 CFR 567.6(b)(5)(v) (for (1) The [bank] also has obtained credit weight provided in the tables in this savings associations). protection on the same underlying section. (l) Consolidated ABCP programs—(1) exposures in the form of first-through- (2) The applicable rating of a A [bank] that qualifies as a primary (n–1)-to-default credit derivatives; or securitization exposure that has more beneficiary and must consolidate an (2) If n–1 of the underlying exposures than one external or inferred rating is ABCP program as a variable interest have already defaulted. the lowest rating. entity under GAAP may exclude the (B) If a [bank] satisfies the (3) A [bank] must apply the risk consolidated ABCP program assets from requirements of paragraph (m)(2)(i)(A) weights in Table 6 when the risk-weighted assets if the [bank] is the of this section, the [bank] must securitization exposure’s external or sponsor of the ABCP program. If a determine its risk-based capital inferred rating represents a long-term [bank] excludes such consolidated requirement for the underlying credit rating, and must apply the risk ABCP program assets from risk- exposures as if the [bank] had only weights in Table 7 when the weighted assets, the [bank] must hold synthetically securitized the underlying securitization exposure’s external or risk-based capital against any exposure with the nth lowest risk-based inferred rating represents a short-term securitization exposures of the [bank] to capital requirement (K) (as calculated credit rating. the ABCP program in accordance with under Table 2) and had obtained no (i) A [bank] must apply the risk this part. credit risk mitigant on the other weights in column 1 of Table 6 or 7 to (2) If a [bank] either is not permitted, underlying exposures. the securitization exposure if: or elects not, to exclude consolidated (ii) Protection provider. A [bank] that (A) N (as calculated under paragraph ABCP program assets from its risk- provides credit protection on a group of (e)(6) of section 45) is 6 or more (for

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00110 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55939

purposes of this section 43 only, if the has reason to know that N is less than the securitization exposure if N is less notional number of underlying 6); and than 6, regardless of the seniority of the exposures is 25 or more or if all of the (B) The securitization exposure is a securitization exposure. underlying exposures are retail senior securitization exposure. (iii) Otherwise, a [bank] must apply exposures, a [bank] may assume that N (ii) A [bank] must apply the risk the risk weights in column 2 of Table 6 is 6 or more unless the [bank] knows or weights in column 3 of Table 6 or 7 to or 7.

TABLE 6.—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 senior non-senior securitization ex- Applicable rating (illustrative rating example) securitization ex- securitization ex- posures 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 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

Column 1 Column 2 Column 3 Risk weights for Risk weights for Risk weights for senior non-senior securitization ex- Applicable Rating (illustrative rating example) securitization ex- securitization ex- posures backed posures backed posures backed by non-granular by granular pools by granular pools pools (percent) (percent) (percent)

Highest investment grade (for example, A1) ...... 7 12 20 Second highest investment grade (for example, A2) ...... 12 20 35 Third highest investment grade (for example, A3) ...... 60 75 75 All other ratings ...... Deduction from tier 1 and tier 2 capital.

Section 44. Internal Assessment must be based on publicly available rating criteria of the NRSROs that have Approach (IAA) rating criteria used by an NRSRO. provided external ratings to the (ii) The [bank]’s internal credit commercial paper issued by the ABCP (a) Eligibility requirements. A [bank] assessments of securitization exposures program. may apply the IAA to calculate the risk- used for risk-based capital purposes (A) Where the commercial paper weighted asset amount for a must be consistent with those used in issued by an ABCP program has an securitization exposure that the [bank] the [bank]’s internal risk management external rating from two or more has to an ABCP program (such as a process, management information NRSROs and the different NRSROs’ liquidity facility or credit enhancement) reporting systems, and capital adequacy benchmark stress factors require if the [bank], the ABCP program, and the assessment process. different levels of credit enhancement to exposure qualify for use of the IAA. (iii) The [bank]’s internal credit achieve the same external rating (1) [Bank] qualification criteria. A assessment process must have sufficient equivalent, the [bank] must apply the [bank] qualifies for use of the IAA if the granularity to identify gradations of risk. NRSRO stress factor that requires the [bank] has received the prior written Each of the [bank]’s internal credit highest level of credit enhancement. approval of the [AGENCY]. To receive assessment categories must correspond (B) If one of the NRSROs that provides such approval, the [bank] must to an external rating of an NRSRO. an external rating to the ABCP demonstrate to the [AGENCY]’s (iv) The [bank]’s internal credit program’s commercial paper changes its satisfaction that the [bank]’s internal assessment process, particularly the methodology (including stress factors), assessment process meets the following stress test factors for determining credit the [bank] must consider the NRSRO’s criteria: enhancement requirements, must be at revised rating methodology in (i) The [bank]’s internal credit least as conservative as the most evaluating whether the internal credit assessments of securitization exposures conservative of the publicly available assessments assigned by the [bank] to

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00111 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55940 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

securitization exposures must be include the prohibition of the purchase appropriate risk weight in the RBA revised. of assets that are significantly past due tables in paragraph (b) of section 43. (v) The [bank] must have an effective or defaulted, as well as limitations on Section 45. Supervisory Formula system of controls and oversight that concentration to individual obligor or Approach (SFA) ensures compliance with these geographic area and the tenor of the operational requirements and maintains assets to be purchased. (a) Eligibility requirements. A [bank] the integrity and accuracy of the (v) The aggregate estimate of loss on may use the SFA to determine its risk- internal credit assessments. The [bank] an asset pool that the ABCP program is based capital requirement for a must have an internal audit function considering purchasing must consider securitization exposure only if the independent from the ABCP program all sources of potential risk, such as [bank] can calculate on an ongoing basis business line and internal credit credit and dilution risk. each of the SFA parameters in assessment process that assesses at least (vi) The ABCP program must paragraph (e) of this section. annually whether the controls over the incorporate structural features into each (b) Mechanics. Under the SFA, a internal credit assessment process purchase of assets to mitigate potential [bank] must determine the risk-weighted function as intended. credit deterioration of the underlying asset amount for a securitization (vi) The [bank] must review and exposures. Such features may include exposure by multiplying the SFA risk- update each internal credit assessment wind-down triggers specific to a pool of based capital requirement for the whenever new material information is underlying exposures. exposure (as determined in paragraph available, but no less frequently than (3) Exposure qualification criteria. A (c) of this section) by 12.5. If the SFA annually. securitization exposure qualifies for use risk weight for a securitization exposure (vii) The [bank] must validate its of the IAA if the [bank] initially rated is 1,250 percent or greater, however, the internal credit assessment process on an the exposure at least the equivalent of [bank] must deduct the exposure from ongoing basis and at least annually. investment grade. total capital under paragraph (c) of (2) ABCP-program qualification (b) Mechanics. A [bank] that elects to section 42 rather than risk weight the criteria. An ABCP program qualifies for use the IAA to calculate the risk-based exposure. The SFA risk weight for a use of the IAA if the ABCP program capital requirement for any securitization exposure is equal to 1,250 meets the following criteria: securitization exposure must use the percent multiplied by the ratio of the (i) All commercial paper issued by the IAA to calculate the risk-based capital securitization exposure’s SFA risk-based ABCP program must have an external requirements for all securitization capital requirement to the amount of the rating. exposures that qualify for the IAA securitization exposure (as defined in (ii) The ABCP program must have approach. Under the IAA, a [bank] must paragraph (e) of section 42). robust credit and investment guidelines map its internal assessment of such a (c) The SFA risk-based capital (that is, underwriting standards). securitization exposure to an equivalent requirement. The SFA risk-based capital (iii) The ABCP program must perform external rating from an NRSRO. Under requirement for a securitization a detailed credit analysis of the asset the IAA, a [bank] must determine the exposure is UE multiplied by TP sellers’ risk profiles. risk-weighted asset amount for such a multiplied by the greater of: (iv) The ABCP program’s securitization exposure by multiplying (1) 0.0056 * T; or underwriting policy must establish the amount of the exposure (as defined (2) S[L+T] ¥ S[L]. minimum asset eligibility criteria that in paragraph (e) of section 42) by the (d) The supervisory formula:

 ≤  Y when Y KIRB  20 ⋅−()K Y  ⋅  IRB  ()1 S[Y]= d K K  K ++−KY[] KK [ ] +IRB 1− ewhIRB  een Y > K  IRB IRB   IRB   20   

()2 K[Y] = (1−⋅ h) [(1 −ββ [Y;a,b]) ⋅ Y + [Y;a +1,b] ⋅ c]

 K N ()3 h = 1− IRB   EWALGD 

()4 a = g⋅ c

()51 b = g⋅− (c )

K ()6 c =IRB 1− h

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00112 Fmt 4701 Sfmt 4725 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.061 EP25SE06.062 EP25SE06.063 EP25SE06.064 EP25SE06.065 EP25SE06.066 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55941

()1−⋅cc ()7 g =−1 f

vK+ 2 ()1− KKv⋅− ()8 f =IRB −+c2 IRB IRB 1− h ()1−⋅h 1000

().()EWALGD−+⋅− K25 1 EWALGD ()9 v =K ⋅ IRB IRB N

−− ⋅−β ()10 d = 1 ( 1hKab )( 1 [IRB ;,])

(11) In these expressions, b[Y; a, b] (4) Credit enhancement level (L). (i) L where EADi represents the EAD refers to the cumulative beta is the ratio of: associated with the ith instrument in the distribution with parameters a and b (A) The amount of all securitization pool of underlying exposures. exposures subordinated to the tranche evaluated at Y. In the case where N = (ii) Multiple exposures to one obligor 1 and EWALGD = 100 percent, S[Y] in that contains the [bank]’s securitization must be treated as a single underlying formula (1) must be calculated with exposure; to (B) UE. exposure. K[Y] set equal to the product of KIRB and (ii) [Bank]s must determine L before Y, and d set equal to 1¥KIRB. considering the effects of any tranche- (iii) In the case of a re-securitization (e) SFA Parameters—(1) Amount of specific credit enhancements. (that is, a securitization in which some the underlying exposures (UE). UE is the (iii) Any gain-on-sale or CEIO or all of the underlying exposures are EAD of any underlying wholesale and associated with the securitization may themselves securitization exposures), retail exposures (including the amount not be included in L. the [bank] must treat each underlying of any funded spread accounts, cash (iv) Any reserve account funded by exposure as a single underlying accumulated cash flows from the collateral accounts, and other similar exposure and must not look through to underlying exposures that is funded credit enhancements) plus the the originally securitized underlying subordinated to the tranche in question amount of any underlying exposures exposures. that are securitization exposures (as may be included in the numerator and (7) Exposure-weighted average loss defined in paragraph (e) of section 42) denominator of L to the extent cash has plus the adjusted carrying value of any accumulated in the account. Unfunded given default (EWALGD). EWALGD is underlying equity exposures (as defined reserve accounts (that is, reserve calculated as: in paragraph (b) of section 51). accounts that are to be funded from future cash flows from the underlying ⋅ (2) Tranche percentage (TP). TP is the ∑ LGDii EAD ratio of the amount of the [bank]’s exposures) may not be included in the EWALGD = i securitization exposure to the amount of calculation of L. ∑ EAD (v) In some cases, the purchase price i the tranche that contains the i securitization exposure. of receivables will reflect a discount that (3) Capital requirement on underlying provides credit enhancement (for where LGDi represents the average LGD example, first loss protection) for all or associated with all exposures to the ith exposures (KIRB). (i) KIRB is the ratio of: (A) The sum of the risk-based capital certain tranches of the securitization. obligor. In the case of a re-securitization, requirements for the underlying When this arises, L should be calculated an LGD of 100 percent must be assumed exposures plus the expected credit inclusive of this discount if the discount for the underlying exposures that are losses of the underlying exposures (as provides credit enhancement for the themselves securitization exposures. determined under this appendix as if securitization exposure. (5) Thickness of tranche (T). T is the (f) Simplified method for computing N the underlying exposures were directly and EWALGD. (1) If all underlying held by the [bank]); to ratio of: (i) The amount of the tranche that exposures of a securitization are retail (B) UE. exposures, a [bank] may apply the SFA (ii) The calculation of K must contains the [bank]’s securitization IRB using the following simplifications: reflect the effects of any credit risk exposure; to mitigant applied to the underlying (ii) UE. (i) h = 0; and (6) Effective number of exposures (N). exposures (either to an individual (i) Unless the [bank] elects to use the (ii) v = 0. underlying exposure, a group of formula provided in paragraph (f), (2) Under the conditions in underlying exposures, or to the entire paragraphs (f)(3) and (f)(4), a [bank] may pool of underlying exposures). 2 (iii) All assets related to the   employ a simplified method for ∑ EAD securitization are treated as underlying  i  calculating N and EWALGD.  i  = (3) If C1 is no more than 0.03, a [bank] exposures, including assets in a reserve N 2 account (such as a cash collateral ∑ EADi may set EWALGD = 0.50 and N equal to account). i the following amount:

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00113 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.067 EP25SE06.068 EP25SE06.069 EP25SE06.070 EP25SE06.071 EP25SE06.072 55942 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

1 N =  CC−  CC +  m 1  max (1− mC ,)0 1 m  m −1  1

Where: (v) Hfx = the haircut appropriate for securitization exposure, the [bank] must (i) Cm is the ratio of the sum of the amounts any currency mismatch between the also: of the ‘m’ largest underlying exposures to collateral and the exposure. (i) Calculate ECL for the exposure UE; and (2) Mixed collateral. Where the using the same risk parameters that it (ii) The level of m is to be selected by the [bank]. collateral is a basket of different asset uses for calculating the risk-weighted types or a basket of assets denominated asset amount of the exposure as (4) Alternatively, if only C1 is in different currencies, the haircut on described in paragraph (c)(3) of this available and C1 is no more than 0.03, the basket will be section; and the [bank] may set EWALGD = 0.50 and (ii) Add the exposure’s ECL to the N = 1/C1. n [bank]’s total ECL. ()A EffectiveEPE = ∑ EffectiveEE *∆ t ttkkk (3) Rules of recognition. A [bank] may Section 46. Recognition of Credit Risk k=1 Mitigants for Securitization Exposures recognize an eligible guarantee or where ai is the current market value of eligible credit derivative provided by an (a) General. An originating [bank] that the asset in the basket divided by the eligible securitization guarantor in has obtained a credit risk mitigant to current market value of all assets in the determining the [bank]’s risk-based hedge its securitization exposure to a basket and Hi is the haircut applicable capital requirement for the synthetic or traditional securitization to that asset. securitization exposure as follows: that satisfies the operational criteria in (3) Standard supervisory haircuts. (i) Full coverage. If the protection section 41 may recognize the credit risk Unless a [bank] qualifies for use of and amount of the eligible guarantee or mitigant, but only as provided in this uses own-estimates haircuts in eligible credit derivative equals or section. An investing [bank] that has paragraph (b)(4) of this section: exceeds the amount of the securitization obtained a credit risk mitigant to hedge (i) A [bank] must use the collateral exposure, then the [bank] may set the a securitization exposure may recognize type haircuts (Hs) in Table 3; risk-weighted asset amount for the the credit risk mitigant, but only as (ii) A [bank] must use a currency securitization exposure equal to the provided in this section. A [bank] that mismatch haircut (Hfx) of 8 percent if risk-weighted asset amount for a direct has used the RBA in section 43 or the the exposure and the collateral are exposure to the eligible securitization IAA in section 44 to calculate its risk- denominated in different currencies; guarantor (as determined in the based capital requirement for a (iii) A [bank] must multiply the wholesale risk weight function securitization exposure whose external supervisory haircuts obtained in described in section 31), using the or inferred rating (or equivalent internal paragraphs (b)(3)(i) and (ii) by the [bank]’s PD for the guarantor, the rating under the IAA) reflects the square root of 6.5 (which equals [bank]’s ELGD and LGD for the benefits of a particular credit risk 2.549510); and guarantee or credit derivative, and an mitigant provided to the associated (iv) A [bank] must adjust the EAD equal to the amount of the securitization or that supports some or supervisory haircuts upward on the securitization exposure (as determined all of the underlying exposures may not basis of a holding period longer than 65 in paragraph (e) of section 42). use the credit risk mitigation rules in business days where and as appropriate (ii) Partial coverage. If the protection this section to further reduce its risk- to take into account the illiquidity of the amount of the eligible guarantee or based capital requirement for the collateral. eligible credit derivative is less than the exposure to reflect that credit risk (4) Own estimates for haircuts. With amount of the securitization exposure, mitigant. the prior written approval of the then the [bank] may set the risk- (b) Collateral—(1) Rules of [AGENCY], a [bank] may calculate weighted asset amount for the recognition. A [bank] may recognize haircuts using its own internal estimates securitization exposure equal to the sum financial collateral in determining the of market price volatility and foreign of: [bank]’s risk-based capital requirement exchange volatility, subject to the (A) Covered portion. The risk- for a securitization exposure as follows. provisions of paragraph (a)(2)(iii) of weighted asset amount for a direct The [bank]’s risk-based capital section 32. The minimum holding exposure to the eligible securitization requirement for the collateralized period (TM) for securitization exposures guarantor (as determined in the securitization exposure is equal to the is 65 business days. wholesale risk weight function risk-based capital requirement for the (c) Guarantees and credit described in section 31), using the securitization exposure as calculated derivatives—(1) Limitations on [bank]’s PD for the guarantor, the under the RBA in section 43 or the SFA recognition. A [bank] may only [bank]’s ELGD and LGD for the in section 45 multiplied by the ratio of recognize an eligible guarantee or guarantee or credit derivative, and an adjusted exposure amount (E*) to eligible credit derivative provided by an EAD equal to the protection amount of original exposure amount (E), where: eligible securitization guarantor in the credit risk mitigant; and (i) E* = max {0, [E¥C × determining the [bank]’s risk-based (B) Uncovered portion. (1) 1.0 minus (1¥Hs¥Hfx)]}; capital requirement for a securitization (the protection amount of the eligible (ii) E = the amount of the exposure. guarantee or eligible credit derivative securitization exposure calculated (2) ECL for securitization exposures. divided by the amount of the under paragraph (e) of section 42; When a [bank] recognizes an eligible securitization exposure); multiplied by (iii) C = the current market value of guarantee or eligible credit derivative (2) The risk-weighted asset amount for the collateral; provided by an eligible securitization the securitization exposure without the (iv) Hs = the haircut appropriate to guarantor in determining the [bank]’s credit risk mitigant (as determined in the collateral type; and risk-based capital requirement for a sections 42–45).

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00114 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.073 EP25SE06.081 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55943

(4) Mismatches. For any hedged originating [bank] must calculate the securitization that contains a controlled securitization exposure, the [bank] must risk-based capital requirement for the early amortization provision and must make applicable adjustments to the originating [bank]’s interest under use Table 9 for a securitization that protection amount as required in sections 42–45, and the risk-based contains a non-controlled early paragraphs (d), (e), and (f) of section 33. capital requirement for the investors’ amortization provision. A [bank] must interest under paragraph (b) of this Section 47. Risk-Based Capital use the ‘‘uncommitted’’ column of section. Requirement for Early Amortization Tables 8 and 9 if all or substantially all (b) Risk-weighted asset amount for of the underlying exposures of the Provisions investors’ interest. The originating securitization are unconditionally (a) General. (1) An originating [bank] [bank]’s risk-weighted asset amount for cancelable by the [bank] to the fullest must hold risk-based capital against the the investors’ interest in the sum of the originating [bank]’s interest securitization is equal to the product of extent permitted by Federal law. and the investors’ interest in a the following four quantities: Otherwise, a [bank] must use the securitization that: (1) The investors’ interest EAD; ‘‘committed’’ column of the tables. To (i) Includes one or more underlying (2) The appropriate conversion factor calculate the trapping point described in exposures in which the borrower is in paragraph (c) of this section; the tables, a [bank] must divide the permitted to vary the drawn amount (3) Kirb (as defined in paragraph (e)(3) three-month excess spread level of the within an agreed limit under a line of of section 45); and securitization by the excess spread credit; and (4) 12.5. trapping point in the securitization (ii) Contains an early amortization (c) Conversion factor. To calculate the structure.10 provision. appropriate conversion factor discussed (2) For securitizations described in in paragraph (b)(2) of this section, a paragraph (a)(1) of this section, an [bank] must use Table 8 for a

TABLE 8.—CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed

Retail Credit Lines ...... 3-month average 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 75% to 50% of trapping point 10% CF. less than 50% to 25% of trapping point 20% CF. less than 25% of trapping point 40% CF. Non-retail Credit Lines ...... 90% CF ...... 90% CF

TABLE 9.—NON-CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed

Retail Credit Lines ...... 3-month average excess spread Conversion Factor (CF) ...... 100% CF. 133.33% of trapping point or more 0% CF. less than 133.33% to 100% of trapping point 5% CF. less than 100% to 75% of trapping point 15% CF. less than 75% to 50% of trapping point 50% CF. less than 50% of trapping point 100% CF. Non-retail Credit Lines ...... 100% CF ...... 100% CF

Part VI. Risk-Weighted Assets for (b) Adjusted carrying value. For instrument that would evidence the Equity Exposures purposes of this part, the ‘‘adjusted same change in fair value (measured in Section 51. Introduction and Exposure carrying value’’ of an equity exposure is: dollars) for a given small change in the Measurement (1) For the on-balance sheet price of the underlying equity component of an equity exposure, the instrument, minus the adjusted carrying (a) General. To calculate its risk- [bank]’s carrying value of the exposure value of the on-balance sheet weighted asset amounts for equity reduced by any unrealized gains on the component of the exposure as exposures that are not equity exposures exposure that are reflected in such calculated in paragraph (b)(1) of this to investment funds, a [bank] may apply carrying value but excluded from the section. either the Simple Risk Weight Approach [bank]’s tier 1 and tier 2 capital; and (SRWA) in section 52 or, if it qualifies (2) For the off-balance sheet to do so, the Internal Models Approach component of an equity exposure, the 10 (IMA) in section 53. A [bank] must use effective notional principal amount of In securitizations that do not require excess spread to be trapped, or that specify trapping points the look-through approaches in section the exposure, the size of which is 54 to calculate its risk-weighted asset based primarily on performance measures other equivalent to a hypothetical on-balance than the three-month average excess spread, the amounts for equity exposures to sheet position in the underlying equity excess spread trapping point is 4.5 percent. investment funds.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00115 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55944 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

Section 52. Simple Risk Weight (A) To compute the aggregate adjusted exposures); the documentation specifies Approach (SRWA) carrying value of a [bank]’s equity the measure of effectiveness (E) the (a) In general. Under the SRWA, a exposures for purposes of this paragraph [bank] will use for the hedge [bank]’s aggregate risk-weighted asset (b)(3)(iv), the [bank] may exclude equity relationship throughout the life of the amount for its equity exposures is equal exposures described in paragraphs transaction; and the hedge relationship to the sum of the risk-weighted asset (b)(1), (b)(2), and (b)(3)(i), (ii), and (iii) has an E greater than or equal to 0.8. A amounts for each of the [bank]’s of this section, the equity exposure in a [bank] must measure E at least quarterly individual equity exposures (other than hedge pair with the smaller adjusted and must use one of three alternative carrying value, and a proportion of each equity exposures to an investment fund) measures of E: equity exposure to an investment fund as determined in this section and the (i) Under the dollar-offset method of equal to the proportion of the assets of risk-weighted asset amounts for each of measuring effectiveness, the [bank] must the investment fund that are not equity the [bank]’s individual equity exposures determine the ratio of value change exposures. If a [bank] does not know the to an investment fund as determined in (RVC), that is, the ratio of the actual holdings of the investment fund, section 54. cumulative sum of the periodic changes the [bank] may calculate the proportion (b) SRWA computation for individual in value of one equity exposure to the of the assets of the fund that are not equity exposures. A [bank] must cumulative sum of the periodic changes equity exposures based on the terms of determine the risk-weighted asset in the value of the other equity the prospectus, partnership agreement, amount for an individual equity exposure. If RVC is positive, the hedge or similar contract that defines the exposure (other than an equity exposure is not effective and E = 0. If RVC is fund’s permissible investments. If the ¥ to an investment fund) by multiplying negative and greater than or equal to 1 sum of the investment limits for all ¥ the adjusted carrying value of the equity (that is, between zero and 1), then E exposure classes within the fund equals the absolute value of RVC. If RVC exposure or the effective portion and exceeds 100 percent, the [bank] must ¥ ineffective portion of a hedge pair (as is negative and less than 1, then E assume for purposes of this paragraph equals 2 plus RVC. defined in paragraph (c) of this section) (b)(3)(iv) that the investment fund by the lowest applicable risk weight in (ii) Under the variability-reduction invests to the maximum extent possible method of measuring effectiveness: this paragraph (b). in equity exposures. (1) 0 percent risk weight equity (B) When determining which of a T exposures. An equity exposure to an 2 [bank]’s equity exposures qualify for a ∑()XX− − entity whose credit exposures are tt1 100 percent risk weight under this =−t=1 , exempt from the 0.03 percent PD floor E 1 T where paragraph, a [bank] must first include ()− 2 in paragraph (d)(2) of section 31 is equity exposures to unconsolidated ∑ AAtt−1 assigned a 0 percent risk weight. small business investment companies or t=1 (2) 20 percent risk weight equity held through consolidated small (A) Xt = At ¥ Bt; exposures. An equity exposure to a business investment companies (B) At the value at time t of one Federal Home Loan Bank or Farmer Mac described in section 302 of the Small exposure in a hedge pair; and that is not publicly traded and is held Business Investment Act of 1958 (15 (C) Bt the value at time t of the other as a condition of membership in that U.S.C. 682) and then must include exposure in a hedge pair. entity is assigned a 20 percent risk publicly traded equity exposures (iii) Under the regression method of weight. (including those held indirectly through measuring effectiveness, E equals the (3) 100 percent risk weight equity investment funds) and then must coefficient of determination of a exposures. The following equity include non-publicly traded equity regression in which the change in value exposures are assigned a 100 percent exposures (including those held of one exposure in a hedge pair is the risk weight: indirectly through investment funds). dependent variable and the change in (i) Community development equity (4) 300 percent risk weight equity value of the other exposure in a hedge exposures. An equity exposure that exposures. A publicly traded equity pair is the independent variable. qualifies as a community development exposure (including the ineffective (3) The effective portion of a hedge investment under 12 U.S.C. portion of a hedge pair) is assigned a pair is E multiplied by the greater of the 24(Eleventh), excluding equity 300 percent risk weight. adjusted carrying values of the equity exposures to an unconsolidated small (5) 400 percent risk weight equity exposures forming a hedge pair. business investment company and exposures. An equity exposure that is (4) The ineffective portion of a hedge equity exposures held through a not publicly traded is assigned a 400 pair is (1¥E) multiplied by the greater consolidated small business investment percent risk weight. of the adjusted carrying values of the company described in section 302 of the (c) Hedge transactions—(1) Hedge equity exposures forming a hedge pair. Small Business Investment Act of 1958 pair. A hedge pair is two equity (15 U.S.C. 682). exposures that form an effective hedge Section 53. Internal Models Approach (ii) Certain equity exposures to a so long as each equity exposure is (IMA) Federal Home Loan Bank and Farmer publicly traded or has a return that is This section describes the two ways Mac. An equity exposure to a Federal primarily based on a publicly traded that a [bank] may calculate its risk- Home Loan Bank or Farmer Mac that is equity exposure. weighted asset amount for equity not assigned a 20 percent risk weight. (2) Effective hedge. Two equity exposures using the IMA. A [bank] may (iii) Effective portion of hedge pairs. exposures form an effective hedge if the model publicly traded and non-publicly The effective portion of a hedge pair. exposures either have the same traded equity exposures (in accordance (iv) Non-significant equity exposures. remaining maturity or each have a with paragraph (b) of this section) or Equity exposures to the extent that the remaining maturity of at least three model only publicly traded equity aggregate adjusted carrying value of the months; the hedge relationship is exposure (in accordance with paragraph exposures does not exceed 10 percent of formally documented in a prospective (c) of this section). the [bank]’s tier 1 capital plus tier 2 manner (that is, before the [bank] (a) Qualifying criteria. To qualify to capital. acquires at least one of the equity use the IMA to calculate risk-based

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00116 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS EP25SE06.074 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55945

capital requirements for equity portfolio using historical market data equity exposure to an investment fund exposures, a [bank] must receive prior that are relevant to the [bank]’s modeled (as determined under section 54); and written approval from the [AGENCY]. equity exposures and benchmark (2) The greater of: To receive such approval, the [bank] portfolio (or, where not, must use (i) The estimate of potential losses on must demonstrate to the [AGENCY]’s appropriately adjusted data), and such the [bank]’s equity exposures (other satisfaction that the [bank] meets the proxies must be robust estimates of the than equity exposures referenced in following criteria: risk of the [bank]’s modeled equity paragraph (c)(1) of this section) (1) The [bank] must have a model exposures. generated by the [bank]’s internal equity that: (b) Risk-weighted assets calculation exposure model multiplied by 12.5; or (i) Assesses the potential decline in for a [bank] modeling publicly traded (ii) The sum of: value of its modeled equity exposures; and non-publicly traded equity (A) 200 percent multiplied by the (ii) Is commensurate with the size, exposures. If a [bank] models publicly aggregate adjusted carrying value of the complexity, and composition of the traded and non-publicly traded equity [bank]’s publicly traded equity [bank]’s modeled equity exposures; and exposures, the [bank]’s aggregate risk- exposures that do not belong to a hedge (iii) Adequately captures both general weighted asset amount for its equity pair, do not qualify for a 0–100 percent market risk and idiosyncratic risk. exposures is equal to the sum of: (2) The [bank]’s model must produce risk weight under paragraphs (b)(1) (1) The risk-weighted asset amount of an estimate of potential losses for its through (b)(3)(ii) of section 52, and are each equity exposure that qualifies for a modeled equity exposures that is no less not equity exposures to an investment 0–100 percent risk weight under than the estimate of potential losses fund; and paragraphs (b)(1) through (b)(3)(ii) of produced by a VaR methodology (B) 200 percent multiplied by the section 52 (as determined under section employing a 99.0 percent, one-tailed aggregate ineffective portion of all hedge 52) and each equity exposure to an confidence interval of the distribution of pairs. investment fund (as determined under quarterly returns for a benchmark section 54); and Section 54. Equity Exposures to portfolio of equity exposures (2) The greater of: Investment Funds comparable to the [bank]’s modeled equity exposures using a long-term (i) The estimate of potential losses on (a) Available approaches. A [bank] sample period. the [bank]’s equity exposures (other must determine the risk-weighted asset (3) The number of risk factors and than equity exposures referenced in amount of an equity exposure to an exposures in the sample and the data paragraph (b)(1) of this section) investment fund under the Full Look- period used for quantification in the generated by the [bank]’s internal equity Through Approach in paragraph (b) of [bank]’s model and benchmarking exposure model multiplied by 12.5; or this section, the Simple Modified Look- exercise must be sufficient to provide (ii) The sum of: Through Approach in paragraph (c) of confidence in the accuracy and (A) 200 percent multiplied by the this section, or the Alternative Modified robustness of the [bank]’s estimates. aggregate adjusted carrying value of the Look-Through Approach in paragraph (4) The [bank]’s model and [bank]’s publicly traded equity (d) of this section unless the exposure benchmarking process must incorporate exposures that do not belong to a hedge would meet the requirements for a data that are relevant in representing the pair, do not qualify for a 0–100 percent community development equity risk profile of the [bank]’s modeled risk weight under paragraphs (b)(1) exposure in paragraph (b)(3)(i) of equity exposures, and must include data through (b)(3)(ii) of section 52, and are section 52. The risk-weighted asset from at least one equity market cycle not equity exposures to an investment amount of such an equity exposure to an containing adverse market movements fund; investment fund would be its adjusted relevant to the risk profile of the (B) 200 percent multiplied by the carrying value. If an equity exposure to [bank]’s modeled equity exposures. If aggregate ineffective portion of all hedge an investment fund is part of a hedge the [bank]’s model uses a scenario pairs; and pair, a [bank] may use the ineffective methodology, the [bank] must (C) 300 percent multiplied by the portion of the hedge pair as determined demonstrate that the model produces a aggregate adjusted carrying value of the under paragraph (c) of section 52 as the conservative estimate of potential losses [bank]’s equity exposures that are not adjusted carrying value for the equity on the [bank]’s modeled equity publicly traded, do not qualify for a 0– exposure to the investment fund. exposures over a relevant long-term 100 percent risk weight under (b) Full look-through approach. A market cycle. If the [bank] employs risk paragraphs (b)(1) through (b)(3)(ii) of [bank] that is able to calculate a risk- factor models, the [bank] must section 52, and are not equity exposures weighted asset amount for each demonstrate through empirical analysis to an investment fund. exposure held by the investment fund the appropriateness of the risk factors (c) Risk-weighted assets calculation (as calculated under this appendix as if used. for a [bank] using the IMA only for the exposures were held directly by the (5) Daily market prices must be publicly traded equity exposures. If a [bank]) may set the risk-weighted asset available for all modeled equity [bank] models only publicly traded amount of the [bank]’s exposure to the exposures, either direct holdings or equity exposures, the [bank]’s aggregate fund equal to the greater of: proxies. risk-weighted asset amount for its equity (1) The product of: (6) The [bank] must be able to exposures is equal to the sum of: (i) The aggregate risk-weighted asset demonstrate, using theoretical (1) The risk-weighted asset amount of amounts of the exposures held by the arguments and empirical evidence, that each equity exposure that qualifies for a fund (as calculated under this appendix) any proxies used in the modeling 0–100 percent risk weight under as if the exposures were held directly by process are comparable to the [bank]’s paragraphs (b)(1) through (b)(3)(ii) of the [bank]; and modeled equity exposures and that the section 52 (as determined under section (ii) The [bank]’s proportional [bank] has made appropriate 52), each equity exposure that qualifies ownership share of the fund; or adjustments for differences. The [bank] for a 400 percent risk weight under (2) 7 percent of the adjusted carrying must derive any proxies for its modeled paragraph (b)(5) of section 52 (as value of the [bank]’s equity exposure to equity exposures and benchmark determined under section 52), and each the fund.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00117 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55946 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

(c) Simple modified look-through (1) The highest risk weight in Table hedging rather than speculative approach. Under this approach, the 10 that applies to any exposure the fund purposes and do not constitute a risk-weighted asset amount for a is permitted to hold under its material portion of the fund’s [bank]’s equity exposure to an prospectus, partnership agreement, or exposures); or investment fund equals the adjusted similar contract that defines the fund’s (2) 7 percent. carrying value of the equity exposure permissible investments (excluding multiplied by the greater of: derivative contracts that are used for

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 ...... 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 rating cat- egory; 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. secu- rities 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 cat- egory. 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 ex- posures). 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- derivative contract under this part, a adjusted to incorporate qualifying Through Approach. Under this [bank] must hold risk-based capital operational risk mitigants; and approach, a [bank] may assign the against the counterparty credit risk in (2) The [bank]’s methodology for adjusted carrying value of an equity the equity derivative contract by also incorporating the effects of insurance, if exposure to an investment fund on a pro treating the equity derivative contract as the [bank] uses insurance as an rata basis to different risk weight a wholesale exposure and computing a operational risk mitigant, captures categories in Table 10 according to the supplemental risk-weighted asset through appropriate discounts to the investment limits in the fund’s amount for the contract under part IV. amount of risk mitigation: prospectus, partnership agreement, or Under the SRWA, a [bank] may choose (i) The residual term of the policy, similar contract that defines the fund’s not to hold risk-based capital against the where less than one year; permissible investments. If the sum of counterparty credit risk of equity (ii) The cancellation terms of the the investment limits for exposure derivative contracts, as long as it does policy, where less than one year; classes within the fund exceeds 100 so for all such contracts. Where the (iii) The policy’s timeliness of percent, the [bank] must assume that the equity derivative contracts are subject to payment; fund invests to the maximum extent a qualified master netting agreement, a (iv) The uncertainty of payment by permitted under its investment limits in [bank] using the SRWA must either the provider of the policy; and the exposure class with the highest risk include all or exclude all of the (v) Mismatches in coverage between weight under Table 10, and continues to contracts from any measure used to the policy and the hedged operational make investments in order of the determine counterparty credit risk loss event. exposure class with the next highest risk exposure. (b) Qualifying operational risk weight under Table 10 until the Part VII. Risk-Weighted Assets for mitigants. Qualifying operational risk maximum total investment level is Operational Risk mitigants are: reached. If more than one exposure class (1) Insurance that: applies to an exposure, the [bank] must Section 61. Qualification Requirements (i) Is provided by an unaffiliated use the highest applicable risk weight. for Incorporation of Operational Risk company that has a claims payment A [bank] may not assign an equity Mitigants ability that is rated in one of the three exposure to an investment fund to an (a) Qualification to use operational highest rating categories by a NRSRO; aggregate risk weight of less than 7 risk mitigants. A [bank] may adjust its (ii) Has an initial term of at least one percent. A [bank] may exclude estimate of operational risk exposure to year and a residual term of more than derivative contracts held by the fund reflect qualifying operational risk 90 days; that are used for hedging rather than mitigants if: (iii) Has a minimum notice period for speculative purposes and do not (1) The [bank]’s operational risk cancellation by the provider of 90 days; constitute a material portion of the quantification system is able to generate (iv) Has no exclusions or limitations fund’s exposures. an estimate of the [bank]’s operational based upon regulatory action or for the Section 55. Equity Derivative Contracts risk exposure (which does not receiver or liquidator of a failed incorporate qualifying operational risk depository institution; and Under the IMA, in addition to holding mitigants) and an estimate of the (v) Is explicitly mapped to a potential risk-based capital against an equity [bank]’s operational risk exposure operational loss event; and

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00118 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55947

(2) Operational risk mitigants other System, Mortgages, reporting and f. Remove ‘‘[Disclosure paragraph than insurance for which the [AGENCY] recordkeeping requirements, Securities. (b)]’’ and add in its place ‘‘(b) A bank has given prior written approval. In must comply with paragraph (c) of 12 CFR Part 225 evaluating an operational risk mitigant section 71 of appendix F to the Federal other than insurance, [AGENCY] will Administrative practice and Reserve Board’s Regulation Y (12 CFR consider whether the operational risk procedure, Banks, banking, Federal part 225, appendix F) unless it is a mitigant covers potential operational Reserve System, Holding companies, consolidated subsidiary of a bank losses in a manner equivalent to holding Reporting and recordkeeping holding company or depository regulatory capital. requirements, Securities. institution that is subject to these 12 CFR Part 325 requirements.’’ Section 62. Mechanics of Risk-Weighted g. Remove ‘‘[Disclosure paragraph Asset Calculation Administrative practice and (c)].’’ (a) If a [bank] does not qualify to use procedure, Banks, banking, Capital or does not have qualifying operational Adequacy, Reporting and recordkeeping Board of Governors of the Federal risk mitigants, the [bank]’s dollar risk- requirements, Savings associations, Reserve System based capital requirement for State nonmember banks. 12 CFR Chapter II operational risk is its operational risk 12 CFR Part 566 Authority and Issuance exposure minus eligible operational risk offsets (if any). Capital, reporting and recordkeeping For the reasons stated in the common (b) If a [bank] qualifies to use requirements, Savings associations. preamble, the Board of Governors of the operational risk mitigants and has Authority and Issuance Federal Reserve System proposes to qualifying operational risk mitigants, amend parts 208 and 225 of chapter II the [bank]’s dollar risk-based capital Adoption of Common Appendix of title 12 of the Code of Federal requirement for operational risk is the The adoption of the proposed Regulations as follows: greater of: common rules by the agencies, as (1) The [bank]’s operational risk modified by agency-specific text, is set PART 208—MEMBERSHIP OF STATE exposure adjusted for qualifying forth below: BANKING INSTITUTIONS IN THE operational risk mitigants minus eligible FEDERAL RESERVE SYSTEM Department of the Treasury operational risk offsets (if any); or (REGULATION H) (2) 0.8 multiplied by the difference Office of the Comptroller of the 1. The authority citation for part 208 between: Currency continues to read as follows: (i) The [bank]’s operational risk 12 CFR Chapter I exposure; and Authority: 12 U.S.C. 24, 36, 92a, 93a, (ii) Eligible operational risk offsets (if Authority and Issuance 248(a), 248(c), 321–338a, 371d, 461, 481–486, 601, 611, 1814, 1816, 1818, 1820(d)(9), any). For the reasons stated in the common 1823(j), 1828(o), 1831, 1831o, 1831p–1, (c) The [bank]’s risk-weighted asset preamble, the Office of the Comptroller 1831r–1, 1835a, 1882, 2901–2907, 3105, amount for operational risk equals the of the Currency proposes to amend Part 3310, 3331–3351, and 3906–3909; 15 U.S.C. [bank]’s dollar risk-based capital 3 of chapter I of Title 12, Code of 78b, 78l(b), 78l(g), 78l(i), 78o–4(c)(5), 78q, requirement for operational risk Federal Regulations as follows: 78q–1, and 78w, 6801, and 6805; 31 U.S.C. determined under paragraph (a) or (b) of 5318; 42 U.S.C. 4012a, 4104a, 4104b, 4106, this section multiplied by 12.5. PART 3—MINIMUM CAPITAL RATIOS; and 4128. Part VIII. Disclosure ISSUANCE OF DIRECTIVES 2. New Appendix F to part 208 is added as set forth at the end of the 1. The authority citation for part 3 Section 71. Disclosure Requirements common preamble. continues to read as follows: (a) Each [bank] must publicly disclose 3. Appendix F to part 208 is amended each quarter its total and tier 1 risk- Authority: 12 U.S.C. 93a, 161, 1818, as set forth below: based capital ratios and their 1828(n), 1828 note, 1831n note, 1835, 3907, a. Remove ‘‘[AGENCY]’’ and add and 3909. components (that is, tier 1 capital, tier ‘‘Board’’ in its place wherever it 2 capital, total qualifying capital, and 2. New Appendix C to part 3 is added appears. total risk-weighted assets).11 as set forth at the end of the common b. Remove ‘‘[bank]’’ and add ‘‘bank’’ [Disclosure paragraph (b)] preamble. in its place wherever it appears, and [Disclosure paragraph (c)] 3. Appendix C to part 3 is amended remove ‘‘[Bank]’’ and add ‘‘Bank’’ in its End of common rule. as set forth below: place wherever it appears. [End of common text] a. Remove ‘‘[AGENCY]’’ and add c. Remove ‘‘[Appendix l to Part l]’’ ‘‘OCC’’ in its place wherever it appears. and add ‘‘Appendix F to Part 208’’ in its List of Subjects b. Remove ‘‘[bank]’’ and add ‘‘bank’’ place wherever it appears. 12 CFR Part 3 in its place wherever it appears, and d. Remove ‘‘[the general risk-based capital rules]’’ and add ‘‘12 CFR part Administrative practices and remove ‘‘[Bank]’’ and add ‘‘Bank’’ in its 208, Appendix A’’ in its place wherever procedure, Capital, National banks, place wherever it appears. c. Remove ‘‘[Appendix l to Part l ]’’ it appears. Reporting and recordkeeping and add ‘‘Appendix C to Part 3’’ in its e. Remove ‘‘[the market risk rule]’’ requirements, Risk. place wherever it appears. and add ‘‘12 CFR part 208, Appendix E’’ 12 CFR Part 208 d. Remove ‘‘[the general risk-based in its place wherever it appears. f. Remove ‘‘[Disclosure paragraph Confidential business information, capital rules]’’ and add ‘‘12 CFR part 3, (b)]’’ and add in its place ‘‘(b) A bank Crime, Currency, Federal Reserve Appendix A’’ in its place wherever it appears. must comply with paragraph (c) of 11 Other public disclosure requirements continue e. Remove ‘‘[the market risk rule]’’ section 71 of appendix F to the Federal to apply—for example, Federal securities law and and add ‘‘12 CFR part 3, Appendix B’’ Reserve Board’s Regulation Y (12 CFR regulatory reporting requirements. in its place wherever it appears. part 225, appendix F) unless it is a

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00119 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55948 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

consolidated subsidiary of a bank subsidiary depository institution (as quarter of the information in tables holding company or depository defined in 12 U.S.C. 1813) that is 11.1–11.11 below. If a significant change institution that is subject to these required, or has elected, to use 12 CFR occurs, such that the most recent requirements.’’ part 3, Appendix C, 12 CFR part 208, reported amounts are no longer g. Remove ‘‘[Disclosure paragraph Appendix F, 12 CFR part 325, Appendix reflective of the bank holding (c)].’’ F, or 12 CFR 556 to calculate its risk- company’s capital adequacy and risk based capital requirements;’’. profile, then a brief discussion of this PART 225—BANK HOLDING h. At the end of section 11(b)(1) add change and its likely impact must be COMPANIES AND CHANGE IN BANK the following sentence: ‘‘A bank holding provided as soon as practicable CONTROL (REGULATION Y) company also must deduct an amount thereafter. Qualitative disclosures that 1. The authority citation for part 225 equal to the minimum regulatory capital typically do not change each quarter (for continues to read as follows: requirement established by the regulator example, a general summary of the bank of any insurance underwriting holding company’s risk management Authority: 12 U.S.C. 1817(j)(13), 1818, subsidiary of the holding company. For objectives and policies, reporting 1828(o), 1831i, 1831p–1, 1843(c)(8), 1844(b), U.S.-based insurance underwriting system, and definitions) may be 1972(1), 3106, 3108, 3310, 3331–3351, 3907, subsidiaries, this amount generally and 3909; 15 U.S.C. 6801 and 6805. disclosed annually, provided any would be 200 percent of the subsidiary’s significant changes to these are 2. New Appendix G to part 225 is Authorized Control Level as established disclosed in the interim. Management is added as set forth at the end of the by the appropriate state regulator of the encouraged to provide all of the common preamble. insurance company.’’ disclosures required by this appendix in 3. Appendix G to part 225 is amended i. Remove section 22(h)(3)(ii). one place on the bank holding as set forth below: j. In section 31(e)(3), remove ‘‘A bank company’s public Web site.12 The bank a. Remove ‘‘[AGENCY]’’ and add may assign a risk-weighted asset amount holding company must make these ‘‘Board’’ in its place wherever it of zero to cash owned and held in all disclosures publicly available for each appears. offices of the bank or in transit and for of the last three years (that is, twelve b. Remove ‘‘[bank]’’ and add in its gold bullion held in the bank’s own quarters) or such shorter period since it place ‘‘bank holding company’’ vaults, or held in another bank’s vaults began its first floor period. wherever it appears, and remove on an allocated basis, to the extent it is ‘‘[Bank]’’ and add ‘‘Bank holding offset by gold bullion liabilities’’ and (2) Each bank holding company is company’’ in its place wherever it add in its place ‘‘A bank holding required to have a formal disclosure appears. company may assign a risk-weighted policy approved by the board of c. Remove ‘‘[Appendix l to Part l]’’ asset amount of zero to cash owned and directors that addresses its approach for and add ‘‘Appendix G to Part 225’’ in its held in all offices of subsidiary determining the disclosures it makes. place wherever it appears. depository institutions or in transit and The policy must address the associated d. Remove ‘‘[the general risk-based for gold bullion held in either a internal controls and disclosure controls capital rules]’’ and add ‘‘12 CFR part subsidiary depository institution’s own and procedures. The board of directors 225, Appendix A’’ in its place wherever vaults, or held in another’s vaults on an and senior management must ensure it appears. allocated basis, to the extent it is offset that appropriate verification of the e. Remove ‘‘[the market risk rule]’’ by gold bullion liabilities.’’ disclosures takes place and that and add ‘‘12 CFR part 225, Appendix E’’ k. Remove ‘‘[Disclosure paragraph effective internal controls and in its place wherever it appears. (b)].’’ disclosure controls and procedures are f. Remove the text of section 1(b)(1)(i) l. Remove ‘‘[Disclosure paragraph maintained. The chief financial officer and add in its place: ‘‘Is a U.S.-based (c)].’’ of the bank holding company must bank holding company that has total m. In section 71, add new paragraph certify that the disclosures required by consolidated assets (excluding assets (b) to read as follows: this appendix are appropriate, and the held by an insurance underwriting Section 71. * * * board of directors and senior subsidiary), as reported on the most * * * * * management are responsible for recent year-end FR Y–9C, equal to $250 (b)(1) Each consolidated bank holding establishing and maintaining an billion or more;’’. company that has successfully effective internal control structure over g. Remove the text of section completed its parallel run must provide financial reporting, including the 1(b)(1)(iii) and add in its place: ‘‘Has a timely public disclosures each calendar disclosures required by this appendix.

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 13 within the group (a) that are fully consolidated; (b) that are deconsolidated and deducted; (c) for which the regulatory capital requirement is deducted; and (d) 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 of capital deficiencies 14 in all subsidiaries and the name(s) of such subsidiaries.

12 Alternatively, a bank holding company may provide a summary table on its public Web site that (where permitted), significant minority equity provide the disclosures in more than one place, as specifically indicates where all the disclosures may investments in insurance, financial and commercial some of them may be included in public financial be found (for example, regulatory report schedules, entities. reports (for example, in Management’s Discussion page numbers in annual reports). 14 A capital deficiency is the amount by which and Analysis included in SEC filings) or other 13 Entities include securities, insurance and other actual regulatory capital is less than the minimum regulatory reports. The bank holding company must financial subsidiaries, commercial subsidiaries regulatory capital requirement.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00120 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55949

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; 15 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.16 (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 simple risk weight approach; and • Equity exposures subject to internal models approach. (c) Risk-weighted assets for market risk as calculated under [the market risk rule]: 17 • 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: 18 • 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 11.4.19—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 applicable; • Discussion of the bank holding company’s credit risk management policy. Quantitative Disclosures ...... (b) Total gross credit risk exposures,20 and average gross credit risk exposures, over the period broken down by major types of credit exposure.21 (c) Geographic 22 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; 23 • 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.24 (h) Reconciliation of changes in the allowance for loan and lease losses.25

15 Representing 50% of the amount, if any, by 16 Including 50% of the amount, if any, by which 17 Risk-weighted assets determined under [the which total expected credit losses as calculated total expected credit losses as calculated within the market risk rule] are to be disclosed only for the within the IRB framework exceed eligible credit IRB framework exceed eligible credit reserves, approaches used. reserves, which must be deducted from Tier 1 which must be deducted from Tier 2 capital. 18 Total risk-weighted assets should also be capital. disclosed.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00121 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55950 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

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; 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: • Residential mortgage exposures; • 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; • The definitions, methods and data for estimation and validation of PD, ELGD, LGD, and EAD, including assumptions employed in the derivation of these variables.26 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: 27 • Total EAD; 28 • Exposure-weighted average ELGD and LGD (percentage); • Exposure weighted-average capital requirement (K); 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) Comparison of risk parameter estimates against actual outcomes over a longer period.29 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.30 Where appropriate, the bank holding company should further decompose this to provide analysis of PD, ELGD, LGD, and EAD outcomes against estimates provided in the quantitative risk assessment disclosures above.31

19 Table 4 does not include equity exposures. combinations, acquisitions and disposals of 29 These disclosures are a way of further 20 That is, after accounting offsets in accordance subsidiaries), including transfers between informing the reader about the reliability of the with U.S. GAAP (for example, FASB Interpretations allowances; and the closing balance of the information provided in the ‘‘quantitative 39 and 41) and without taking into account the allowance. Charge-offs and recoveries that have disclosures: Risk assessment’’ over the long run. effects of credit risk mitigation techniques, for been recorded directly to the income statement The disclosures are requirements from year-end example collateral and netting. should be disclosed separately. 2010; in the meantime, early adoption is 21 26 For example, banks could apply a breakdown This disclosure does not require a detailed encouraged. The phased implementation is to allow description of the model in full—it should provide similar to that used for accounting purposes. Such a bank holding company sufficient time to build up a breakdown might, for instance, be (a) loans, off- the reader with a broad overview of the model a longer run of data that will make these disclosures balance sheet commitments, and other non- approach, describing definitions of the variables, derivative off-balance sheet exposures, (b) debt and methods for estimating and validating those meaningful. securities, and (c) OTC derivatives. variables set out in the quantitative risk disclosures 30 This regulation is not prescriptive about the 22 Geographical areas may comprise individual below. This should be done for each of the four period used for this assessment. Upon countries, groups of countries or regions within category/subcategories. The bank holding company implementation, it might be expected that a bank countries. A bank holding company might choose should disclose any significant differences in holding company would provide these disclosures to define the geographical areas based on the way approach to estimating these variables within each for as long run of data as possible—for example, if the company’s portfolio is geographically managed. category/subcategories. a bank holding company has 10 years of data, it The criteria used to allocate the loans to 27 The PD, ELGD, LGD and EAD disclosures in might choose to disclose the average default rates geographical areas must be specified. Table 11.5(c) should reflect the effects of collateral, for each PD grade over that 10-year period. Annual 23 A bank holding company is encouraged also to qualifying master netting agreements, eligible amounts need not be disclosed. provide an analysis of the aging of past-due loans. guarantees and eligible credit derivatives as defined 31 A bank holding company should provide this 24 The portion of general allowance that is not in Part 1. Disclosure of each PD grade should further decomposition where it will allow users allocated to a geographical area should be disclosed include the exposure weighted-average PD for each greater insight into the reliability of the estimates separately. grade. Where a bank holding company aggregates provided in the ‘‘quantitative disclosures: Risk 25 The reconciliation should include the PD grades for the purposes of disclosure, this following: A description of the allowance; the should be a representative breakdown of the assessment.’’ In particular, it should provide this opening balance of the allowance; charge-offs taken distribution of PD grades used for regulatory capital information where there are material differences against the allowance during the period; amounts purposes. between is estimates of PD, ELGD, LGD or EAD provided (or reversed) for estimated probable loan 28 Outstanding loans and EAD on undrawn compared to actual outcomes over the long run. The losses during the period; any other adjustments (for commitments can be presented on a combined basis bank holding company should also provide example, exchange rate differences, business for these disclosures. explanations for such differences.

VerDate Aug<31>2005 00:25 Sep 23, 2006 Jkt 208001 PO 00000 Frm 00122 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55951

TABLE 11.6.—GENERAL DISCLOSURE FOR COUNTERPARTY CREDIT RISK-RELATED EXPOSURES

Qualitative Disclosures ...... (a) The general qualitative processes for 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 and 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 would have to provide given 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.32 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 the distribution of current credit ex- posure by types of credit exposure.33 (c) Notional amount of purchased and sold credit derivatives, segregated between use for the institution’s own credit portfolio, as well as in its intermediation activities, including the distribution of the credit deriv- ative 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 34, 35, 36

Qualitative Disclosure ...... (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 type of guarantors/credit derivative counterparties and their creditworthiness; and • Information about (market or credit) risk concentrations within the mitigation taken. Quantitative Disclosure ...... (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 and the risk-weighted asset amount asso- ciated with that exposure.

TABLE 11.8.—SECURITIZATION

Qualitative disclosures ...... (a) The general qualitative disclosure requirement disclosures with respect to securitization (including syn- thetics), including 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 37 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 reporting 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.

32 Net unsecured credit exposure is the credit 34 At a minimum, a bank holding company must securitization exposures should be excluded from exposure after considering both the benefits from give the disclosures in Table 11.7 in relation to the credit risk mitigation disclosures and included legally enforceable netting agreements and credit risk mitigation that has been recognized for within those relating to securitization. collateral arrangements without taking into account the purposes of reducing capital requirements 36 Counterparty credit risk-related exposures haircuts for price volatility, liquidity, etc. under this Appendix. Where relevant, bank holding disclosed pursuant to Table 11.6 should be 33 This may include interest rate derivative companies are encouraged to give further contracts, foreign exchange derivative contracts, information about mitigants that have not been excluded from the credit risk mitigation disclosures equity derivative contracts, credit derivatives, recognized for that purpose. in Table 11.7. commodity or other derivative contracts, repo-style 35 Credit derivatives that are treated, for the transactions, and eligible margin loans. purposes of this Appendix, as synthetic

VerDate Aug<31>2005 00:34 Sep 23, 2006 Jkt 208001 PO 00000 Frm 00123 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55952 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

TABLE 11.8.—SECURITIZATION—Continued Quantitative disclosures ...... (d) The total outstanding exposures securitized by the bank holding company in securitizations that meet the operation criteria in Section 41 (broken down into traditional/synthetic), by underlying exposure type.38, 39, 40 (e) For exposures securitized by the bank holding company in securitizations that meet the operational cri- teria in Section 41: ∑ Amount of securitized assets that are impaired/past due; and ∑ Losses recognized by the bank holding company during the current period 41 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 charges for these expo- sures broken down into a meaningful number of risk weight bands. Exposures that have been deducted from capital should be disclosed separately by type of underlying asset. (h) For securitizations subject to the early amortisation 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 investor’s 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 recognised 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 taken under other ob- jectives 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); 42 ∑ Total latent revaluation gains (losses); 43 and ∑ 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. 44

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.

37 For example: originator, investor, servicer, separately but need only be reported for the year balance sheet) or write-downs of I/O strips and provider of credit enhancement, sponsor of asset of inception. other residual interests. backed commercial paper facility, liquidity 40 Where relevant, a bank holding company is 42 Unrealized gains (losses) recognized in the provider, swap provider. encouraged to differentiate between exposures balance sheet but not through earnings. 38 Underlying exposure types may include, for resulting from activities in which they act only as 43 example, 1–4 family residential loans, home equity Unrealized gains (losses) not recognized either lines, credit card receivables, and auto loans. sponsors, and exposures that result from all other in the balance sheet or through earnings. 39 Securitization transactions in which the bank holding company securitization activities. 44 This disclosure should include a breakdown of originating bank holding company does not retain 41 For example, charge-offs/allowances (if the equities that are subject to the 0%, 20%, 100%, any securitization exposure should be shown assets remain on the bank holding company’s 300%, and 400% risk weights, as applicable.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00124 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55953

TABLE 11.11.—INTEREST RATE RISK FOR NON-TRADING ACTIVITIES—Continued 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).

* * * * * Department of the Treasury in real estate under that section. See 12 Office of Thrift Supervision CFR 567.1, which defines equity Federal Deposit Insurance Corporation investments, including equity securities 12 CFR Chapter III 12 CFR Chapter V and equity investments in real estate.’’ Authority and Issuance g. Remove the text of section Authority and Issuance 52(b)(3)(i) and add in its place: ‘‘An For the reasons stated in the common equity exposure that is designed For the reasons stated in the common preamble, the Office of Thrift preamble, the Federal Deposit Insurance primarily to promote community Supervision proposes to amend part 566 welfare, including the welfare of low- Corporation proposes to amend part 325 of chapter V of title 12 of the Code of of chapter III of title 12 of the Code of and moderate-income communities or Federal Regulations as follows: families, such as by providing services Federal Regulations as follows: 1. Add a new part 566 to read as or jobs, excluding equity exposures to follows: PART 325—CAPITAL MAINTENANCE an unconsolidated small business PART 566—ADVANCED CAPITAL investment company and equity 1. The authority citation for part 325 ADEQUACY FRAMEWORK AND exposures held through a consolidated continues to read as follows: MARKET RISK ADJUSTMENT small business investment company described in section 302 of the Small Authority: 12 U.S.C. 1815(a), 1815(b), Sec. Business Investment Act of 1958 (15 1816, 1818(a), 1818(b), 1818(c), 1818(t), 566.1 Purpose U.S.C. 682).’’ 1819(Tenth), 1828(c), 1828(d), 1828(i), Authority: 12 U.S.C. 1462, 1462a, 1463, h. Remove ‘‘[Disclosure paragraph 1828(n), 1828(o), 1831o, 1835, 3907, 3909, 1464, 1467a, 1828(note). (b)]’’ and add in its place ‘‘(b) A savings 4808; Pub. L. 102–233, 105 Stat. 1761, 1789, association must comply with paragraph 1790 (12 U.S.C. 1831n note); Pub. L. 102– § 566.1 Purpose. (c) of section 71 unless it is a 242, 105 Stat. 2236, 2355, 2386 (12 U.S.C. (a) Advanced Capital Framework. consolidated subsidiary of a depository 1828 note). Appendix A of this part establishes: institution or bank holding company 2. New Appendix D to part 325 is minimum qualifying criteria for savings that is subject to these requirements.’’ added as set forth at the end of the associations using internal risk i. Remove ‘‘[Disclosure paragraph measurement and management common preamble. (c)].’’ processes for calculating risk based j. In section 71, add new paragraph (c) 3. Appendix D to part 325 is amended capital requirements, methodologies for to read as follows: as set forth below: these savings associations to calculate Section 71 * * * a. Remove ‘‘[AGENCY]’’ and add their risk-based capital requirement, and * * * * * ‘‘FDIC’’ in its place wherever it appears. public disclosure requirements for these (c)(1) Each consolidated savings savings associations. b. Remove ‘‘[bank]’’ and add ‘‘bank’’ association described in paragraph (b) of (b) [Reserved] in its place wherever it appears, and this section that has successfully 2. Appendix A to part 566 is added completed its parallel run must provide remove ‘‘[Bank]’’ and add ‘‘Bank’’ in its to read as set forth at the end of the place wherever it appears. timely public disclosures each calendar common preamble. quarter of the information in tables c. Remove ‘‘[Appendix ll to Part 3. Appendix A to part 566 is amended 11.1–11.11 below. If a significant change ll]’’ and add ‘‘Appendix D to Part as set forth below: occurs, such that the most recent 325’’ in its place wherever it appears. a. Remove ‘‘[AGENCY]’’ and add reported amounts are no longer d. Remove ‘‘[the general risk-based ‘‘OTS’’ in its place wherever it appears. reflective of the savings association’s b. Remove ‘‘[bank]’’ and add ‘‘savings capital rules]’’ and add ‘‘12 CFR part capital adequacy and risk profile, then association’’ in its place wherever it 325, Appendix A’’ in its place wherever a brief discussion of this change and its appears, and remove ‘‘[Bank]’’ and add it appears. likely impact must be provided as soon ‘‘Savings association’’ in its place as practicable thereafter. Qualitative e. Remove ‘‘[the market risk rule]’’ wherever it appears. disclosures that typically do not change and add ‘‘12 CFR part 325, Appendix C’’ c. Remove ‘‘[Appendixllto each quarter (for example, a general in its place wherever it appears. Partll]’’ and add ‘‘Appendix A to Part summary of the savings association’s f. Remove ‘‘[Disclosure paragraph 566’’ in its place wherever it appears. risk management objectives and (b)]’’ and add in its place ‘‘(b) A bank d. Remove ‘‘[the general risk-based policies, reporting system, and must comply with paragraph (c) of capital rules]’’ and add ‘‘12 CFR part definitions) may be disclosed annually, section 71 of appendix F to the Federal 567’’ in its place wherever it appears. provided any significant changes to e. Remove ‘‘[the market risk rule]’’ Reserve Board’s Regulation Y (12 CFR these are disclosed in the interim. and add ‘‘12 CFR part 566, Subpart B’’ part 225, appendix F) unless it is a Management is encouraged to provide in its place wherever it appears. all of the disclosures required by this consolidated subsidiary of a bank f. Remove the text of section 12(b) and appendix in one place on the savings holding company or depository add in its place: ‘‘A savings association association’s public Web site.45 The institution that is subject to these is not required to deduct equity requirements.’’ securities from capital under 12 CFR 45 Alternatively, a savings association may g. Remove ‘‘Disclosure paragraph 567.5(c)(2)(ii). However, it must provide the disclosures in more than one place, as (c)].’’ continue to deduct equity investments Continued

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00125 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55954 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

savings association must make these The policy must address the associated of the savings association must certify disclosures publicly available for each internal controls and disclosure controls that the disclosures required by this of the last three years (that is, twelve and procedures. The board of directors appendix are appropriate, and the board quarters) or such shorter period since it and senior management must ensure of directors and senior management are began its first floor period. that appropriate verification of the responsible for establishing and (2) Each savings association is disclosures takes place and that maintaining an effective internal control required to have a formal disclosure effective internal controls and structure over financial reporting, policy approved by the board of disclosure controls and procedures are including the disclosures required by directors that addresses its approach for maintained. The chief financial officer this appendix. determining the disclosures it makes.

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 46 within the group (a) that are fully consolidated; (b) that are deconsolidated and deducted; (c) for which the regulatory capital requirement is deducted; and (d) 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 of capital deficiencies 47 in all subsidiaries and the name(s) of such subsidiaries.

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; 48 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.49 (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; ∑ Residential mortgage exposures; ∑ Qualifying revolving exposures; ∑ Other retail exposures; ∑ Securitization exposures; and ∑ Equity exposures: ∑ Equity exposures subject to simple risk weight approach; and ∑ Equity exposures subject to internal models approach. (c) Risk-weighted assets for market risk as calculated under [the market risk rule]: 50 ∑ 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: 51

some of them may be included in public financial 46 Entities include securities, insurance and other 48 Representing 50% of the amount, if any, by reports (for example, in Management’s Discussion financial subsidiaries, commercial subsidiaries which total expected credit losses as calculated and Analysis included in SEC filings) or other (where permitted), significant minority equity within the IRB framework exceed eligible credit regulatory reports. The savings association must investments in insurance, financial and commercial reserves, which must be deducted from Tier 1 provide a summary table on its public Website that entities. capital. 49 Including 50% of the amount, if any, by which specifically indicates where all the disclosures may 47 A capital deficiency is the amount by which total expected credit losses as calculated within the be found (for example, regulatory report schedules, actual regulatory capital is less than the minimum IRB framework exceed eligible credit reserves, page numbers in annual reports). regulatory capital requirements. which must be deducted from Tier 2 capital.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00126 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55955

TABLE 11.3.—CAPITAL ADEQUACY—Continued ∑ 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 savings The structure and organization of processes for monitoring the continuing association must describe its risk the relevant risk management function; effectiveness of hedges/mitigants.

TABLE 11.4.52—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 applicable; • Discussion of the savings association’s credit risk management policy. Quantitative Disclosures ...... (b) Total gross credit risk exposures,53 and average gross credit risk exposures, over the period broken down by major types of credit exposure.54 (c) Geographic 55 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;56 • 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.57 (h) Reconciliation of changes in the allowance for loan and lease losses.58

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; 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; and • Retail subcategories: residential mortgage exposures; • 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; • The definitions, methods and data for estimation and validation of PD, ELGD, LGD, and EAD, including assumptions employed in the derivation of these variables.59 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: 60 • Total EAD; 61 • Exposure-weighted average ELGD and LGD (percentage); • Exposure weighted-average capital requirement (K); and

50 Risk-weighted assets determined under [the balance sheet commitments, and other non- 58 The reconciliation should include the market risk rule] are to be disclosed only for the derivative off-balance sheet exposures, (b) debt following: A description of the allowance; the approaches used. securities, and (c) OTC derivatives. opening balance of the allowance; charge-offs taken 51 Total risk-weighted assets should also be 55 Geographical areas may comprise individual against the allowance during the period; amounts disclosed. countries, groups of countries or regions within provided (or reversed) for estimated probable loan countries. A savings association might choose to 52 Table 4 does not include equity exposures. losses during the period; any other adjustments (for define the geographical areas based on the way the 53 That is, after accounting offsets in accordance company’s portfolio is geographically managed. The example, exchange rate differences, business with US GAAP (for example, FASB Interpretations criteria used to allocate the loans to geographical combinations, acquisitions and disposals of 39 and 41) and without taking into account the areas must be specified. subsidiaries), including transfers between effects of credit risk mitigation techniques, for 56 A savings association is encouraged also to allowances; and the closing balance of the example collateral and netting. provide an analysis of the aging of past-due loans. allowance. Charge-offs and recoveries that have 54 For example, banks could apply a breakdown 57 The portion of general allowance that is not been recorded directly to the income statement similar to that used for accounting purposes. Such allocated to a geographical area should be disclosed should be disclosed separately. a breakdown might, for instance, be (a) loans, off- separately.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00127 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55956 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

TABLE 11.5.—CREDIT RISK: DISCLOSURES FOR PORTFOLIOS SUBJECT TO IRB RISK-BASED CAPITAL FORMULAS— Continued • 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. (e) Comparison of risk parameter estimates against actual outcomes over a longer period.62 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.63 Where appropriate, the savings association should further decompose this to provide analysis of PD, ELGD, LGD, and EAD out- comes against estimates provided in the quantitative risk assessment disclosures above.64

TABLE 11.6.—GENERAL DISCLOSURE FOR COUNTERPARTY CREDIT RISK-RELATED EXPOSURES

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 ∑ Discussions of the impact of the amount of collateral the bank would have to provide given 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.65 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 the distribution of current credit ex- posure by types of credit exposure.66 (c) Notional amount of purchased and sold credit derivatives, segregated between use for the institution’s own credit portfolio, as well as in its intermediation activities, including the distribution of the credit deriv- ative 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 MITIGATION67 68 69

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.

59 This disclosure does not require a detailed distribution of PD grades used for regulatory capital 64 A savings association should provide this description of the model in full—it should provide purposes. further decomposition where it will allow users the reader with a broad overview of the model 61 Outstanding loans and EAD on undrawn greater insight into the reliability of the estimates approach, describing definitions of the variables, commitments can be presented on a combined basis provided in the ‘‘quantitative disclosures: risk and methods for estimating and validating those for these disclosures. assessment.’’ In particular, it should provide this variables set out in the quantitative risk disclosures 62 These disclosures are a way of further information where there are material differences below. This should be done for each of the four informing the reader about the reliability of the between its estimates of PD, ELGD, LGD or EAD category/subcategories. The savings association information provided in the ‘‘quantitative compared to actual outcomes over the long run. The should disclose any significant differences in disclosures: risk assessment’’ over the long run. The savings association should also provide approach to estimating these variables within each disclosures are requirements from year-end 2010; in explanations for such differences. the meantime, early adoption is encouraged. The category/subcategories. 65 Net unsecured credit exposure is the cedit phased implementation is to allow a savings 60 The PD, ELGD, LGD and EAD disclosures in association sufficient time to build up a longer run exposure after considering both the benefits from Table 11.5(c) should reflect the effects of collateral, of data that will make these disclosures meaningful. legally enforceable netting agreements and qualifying master netting agreements, eligible 63 This regulation is not prescriptive about the collateral arrangements without taking into account guarantees and eligible credit derivatives as defined period used for this assessment. Upon haircuts for price volatility, liquidity, etc. in Part 1. Disclosure of each PD grade should implementation, it might be expected that a savings 66 This may include interest rate derivative include the exposure weighted-average PD for each association would provide these disclosures for as contracts, foreign exchange derivative contracts, grade. Where a savings association aggregates PD long run of data as possible—for example, if a equity derivative contracts, credit derivatives, grades PD for the purposes of disclosure, this savings association has 10 years of data, it might commodity or other derivative contracts, repo-style should be a representative breakdown of the choose to disclose the average default rates transactions, and eligible margin loans.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00128 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55957

TABLE 11.7.—CREDIT RISK MITIGATION67 68 69—Continued 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 and the risk-weighted asset amount asso- ciated with that exposure.

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 70 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 operation criteria in Section 41 (broken down into traditional/synthetic), by underlying exposure type.71,72,73 (e) For exposures securitized by the savings association in securitizations that meet the operational criteria in Section 41: ∑ Amount of securitized assets that are impaired/past due; and ∑ Losses recognized by the savings association during the current period 74 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 charges for these expo- sures broken down into a meaningful number of risk weight bands. Exposures that have been deducted from capital should be disclosed separately by type of underlying asset. (h) For securitizations subject to the early amortisation 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 investor’s 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 recognised gain or loss on sale by asset type.

TABLE 11.9.—OPERATIONAL RISK

Qualitative Disclosures ...... (a) The general qualitative disclosure requirement for disclosures 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.

67 At a minimum, a savings association must give 69 Counterparty credit risk-related exposures securitization exposure should be shown separately the disclosures in Table 11.7 in relation to credit disclosed pursuant to Table 11.6 should be but need only be reported for the year of inception. risk mitigation that has been recognized for the excluded from the credit risk mitgation disclosures 73 Where relevant, a savings association is purposes of reducing capital requirements under in Table 11.7. encouraged to differentiate between exposures this Appendix. Where relevant, savings associations 70 For example: Originator, investor, servicer, resulting from activities in which they act only as are encouraged to give further information about provider of credit enhancement, sponsor of asset mitigants that have not been recognized for that backed commercial paper facility, liquidity sponsors, and exposures that result from all other purpose. provider, swap provider. savings association securitization activities. 68 Credit derivatives that are treated, for the 71 Underlying exposure types may include, for 74 For example, charge-offs/allowances (if the purposes of this Appendix, as synthetic example, 1–4 family residential loans, from equity assets remain on the savings association’s balance securitization exposures should be excluded from lines, credit card receivables, and auto loans. sheet) or write-downs of I/O strips and other the credit risk mitigation disclosures and included 72 Securitization transactions in which the residual interests. within those relating to securitization. originating savings association does not retain any

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00129 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS 55958 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules

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 taken under other ob- jectives 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); 75 ∑ Total latent revaluation gains (losses); 76 and ∑ 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.77

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 disclosures value (or relevant measure used by man- agement) for upward and downward rate shocks according to management’s method for measuring in- terest rate risk for non-trading activities, broken down by currency (as appropriate).

* * * * * DEPARTMENT OF THE TREASURY Corporation, and Office of Thrift Dated: September 5, 2006. Supervision, Treasury. Office of the Comptroller of the John C. Dugan, ACTION: Joint notice of proposed Currency rulemaking. Comptroller of the Currency. 12 CFR Part 3 By order of the Board of Governors of the SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board of Federal Reserve System, September 11, 2006. [Docket No. 06–10] Governors of the Federal Reserve Jennifer J. Johnson, RIN 1557–AC99 System (Board), and the Federal Deposit Secretary of the Board. Insurance Corporation (FDIC) are Dated at Washington, DC, this 5th day of FEDERAL RESERVE SYSTEM proposing revisions to the market risk September, 2006. capital rule to enhance its risk 12 CFR Parts 208 and 225 By order of the Board of Directors. sensitivity and introduce requirements Federal Deposit Insurance Corporation. for public disclosure of certain [Regulations H and Y; Docket No. R–1266] qualitative and quantitative information Robert E. Feldman, about the market risk of a bank or bank Executive Secretary. FEDERAL DEPOSIT INSURANCE CORPORATION holding company. The Office of Thrift Dated: September 5, 2006. Supervision (OTS) currently does not apply a market risk capital rule to By the Office of Thrift Supervision. 12 CFR Part 325 savings associations and is proposing in John M. Reich, RIN 3064–AD10 this notice a market risk capital rule for Director. savings associations. The proposed rules [FR Doc. 06–7656 Filed 9–22–06] DEPARTMENT OF THE TREASURY for each agency are substantively BILLING CODES 4810–33–P, 6210–01–P, 6714–01–P, identical. 6720–01–P Office of Thrift Supervision DATES: Comments must be received on or before January 23, 2007. 12 CFR Part 566 ADDRESSES: Comments should be [Docket No. 2006–34] directed to: OCC: You should include OCC and RIN 1550–AC02 Docket Number 06–10 in your comment. Risk-Based Capital Standards: Market Risk 75 Unrealized gains (losses) recognized in the balance sheet but not through earnings. 76 AGENCIES: Office of the Comptroller of Unrealized gains (losses) not recognized either in the balance sheet or through earnings. the Currency, Treasury; Board of 77 This disclosure should include a breakdown of Governors of the Federal Reserve equities that are subject to the 0%, 20%, 100%, System; Federal Deposit Insurance 300%, and 400% risk weights, as applicable.

VerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00130 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2 sroberts on PROD1PC70 with PROPOSALS