[Federal Register Volume 71, Number 185 (Monday, September 25, 2006)]
[Proposed Rules]
[Pages 55830-55958]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-7656]



[[Page 55829]]

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Part II

Department of the Treasury



Office of the Comptroller of the Currency



Office of Thrift Supervision



12 CFR Part 3 and 566



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Federal Reserve System

12 CFR Parts 208 and 225



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Federal Deposit Insurance Corporation

12 CFR Part 325



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

Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / 
Proposed Rules

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 06-09]
RIN 1557-AC91

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R-1261]

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AC73

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Part 566

RIN 1550-AB56


Risk-Based Capital Standards: Advanced Capital Adequacy Framework

AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of 
Governors of the Federal Reserve System; Federal Deposit Insurance 
Corporation; and Office of Thrift Supervision, Treasury.

ACTION: Joint notice of proposed rulemaking.

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SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board 
of Governors of the Federal Reserve System (Board), the Federal Deposit 
Insurance Corporation (FDIC), and the Office of Thrift Supervision 
(OTS) (collectively, the agencies) are proposing a new risk-based 
capital adequacy framework that would require some and permit other 
qualifying banks \1\ to use an internal ratings-based approach to 
calculate regulatory credit risk capital requirements and advanced 
measurement approaches to calculate regulatory operational risk capital 
requirements. The proposed rule describes the qualifying criteria for 
banks required or seeking to operate under the proposed framework and 
the applicable risk-based capital requirements for banks that operate 
under the framework.
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    \1\ For simplicity, and unless otherwise indicated, this notice 
of proposed rulemaking (NPR) uses the term ``bank'' to include 
banks, savings associations, and bank holding companies (BHCs). The 
terms ``bank holding company'' and ``BHS'' refer only to bank 
holding companies regulated by the board and do not include savings 
and loan holding companies regulated by the OTS.

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DATES: Comments must be received on or before January 23, 2007.

ADDRESSES: Comments should be directed to:
    OCC: You should include OCC and Docket Number 06-09 in your 
comment. You may submit comments by any of the following methods:
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     OCC Web Site: http://www.occ.treas.gov. Click on ``Contact 
the OCC,'' scroll down and click on ``Comments on Proposed 
Regulations.''
     E-mail address: regs.comments@occ.treas.gov.
     Fax: (202) 874-4448.
     Mail: Office of the Comptroller of the Currency, 250 E 
Street, SW., Mail Stop 1-5, Washington, DC 20219.
     Hand Delivery/Courier: 250 E Street, SW., Attn: Public 
Information Room, Mail Stop 1-5, Washington, DC 20219.
    Instructions: All submissions received must include the agency name 
(OCC) and docket number or Regulatory Information Number (RIN) for this 
notice of proposed rulemaking. In general, OCC will enter all comments 
received into the docket without change, including any business or 
personal information that you provide. You may review comments and 
other related materials by any of the following methods:
     Viewing Comments Personally: You may personally inspect 
and photocopy comments at the OCC's Public Information Room, 250 E 
Street, SW., Washington, DC. You can make an appointment to inspect 
comments by calling (202) 874-5043.
    Board: You may submit comments, identified by Docket No. R-1261, by 
any of the following methods:
     Agency Web Site: http://www.federalreserve.gov. Follow the 
instructions for submitting comments at http://www.federalreserve.gov/
generalinfo/foia/ProposedRegs.cfm.
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     E-mail: regs.comments@federalreserve.gov. Include docket 
number in the subject line of the message.
     FAX: 202/452-3819 or 202/452-3102.
     Mail: Jennifer J. Johnson, Secretary, Board of Governors 
of the Federal Reserve System, 20th Street and Constitution Avenue, 
NW., Washington, DC 20551.
    All public comments are available from the Board's Web site at 
www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted, 
unless modified for technical reasons. Accordingly, your comments will 
not be edited to remove any identifying or contact information. Public 
comments may also be viewed electronically or in paper in Room MP-500 
of the Board's Martin Building (20th and C Streets, NW.) between 9 a.m. 
and 5 p.m. on weekdays.
    FDIC: You may submit comments, identified by RIN number, by any of 
the following methods:
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     Agency Web Site: http://www.fdic.gov/regulations/laws/
federal/propose.html.
     Mail: Robert E. Feldman, Executive Secretary, Attention: 
Comments, Federal Deposit Insurance Corporation, 550 17th Street, NW., 
Washington, DC 20429.
     Hand Delivery/Courier: Guard station at rear of the 550 
17th Street Building (located on F Street) on business days between 7 
a.m. and 5 p.m.
     E-mail: Comments@FDIC.gov.
     Public Inspection: Comments may be inspected at the FDIC 
Public Information Center, Room E-1002, 3502 Fairfax Drive, Arlington, 
VA 22226, between 9 a.m. and 5 p.m. on business days.
    Instructions: Submissions received must include the agency name and 
RIN for this rulemaking. Comments received will be posted without 
change to http://www.fdic.gov/regulations/laws/federal/propose.html 
including any personal information provided.
    OTS: You may submit comments, identified by No. 2006-33, by any of 
the following methods:
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     E-mail address: regs.comments@ots.treas.gov. Please 
include No. 2006-33 in the subject line of the message and include your 
name and telephone number in the message.
     Fax: (202) 906-6518.
     Mail: Regulation Comments, Chief Counsel's Office, Office 
of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552, 
Attention: No. 2006-33.
     Hand Delivery/Courier: Guard's Desk, East Lobby Entrance, 
1700 G Street, NW., from 9 a.m. to 4 p.m. on business days, Attention: 
Regulation Comments, Chief Counsel's Office, Attention: No. 2006-33.
    Instructions: All submissions received must include the agency name 
and

[[Page 55831]]

docket number or Regulatory Information Number (RIN) for this 
rulemaking. All comments received will be posted without change to the 
OTS Internet Site at http://www.ots.treas.gov/
pagehtml.cfm?catNumber=67&an=1, including any personal information 
provided.
    Docket: For access to the docket to read background documents or 
comments received, go to http://www.ots.treas.gov/
pagehtml.cfm?catNumber=67&an=1.
    In addition, you may inspect comments at the Public Reading Room, 
1700 G Street, NW., by appointment. To make an appointment for access, 
call (202) 906-5922, send an e-mail to public.info@ots.treas.gov, or 
send a facsimile transmission to (202) 906-7755. (Prior notice 
identifying the materials you will be requesting will assist us in 
serving you.) We schedule appointments on business days between 10 a.m. 
and 4 p.m. In most cases, appointments will be available the next 
business day following the date we receive a request.

FOR FURTHER INFORMATION CONTACT: 
    OCC: Roger Tufts, Senior Economic Advisor, Capital Policy (202-874-
4925) or Ron Shimabukuro, Special Counsel, Legislative and Regulatory 
Activities Division (202-874-5090). Office of the Comptroller of the 
Currency, 250 E Street, SW., Washington, DC 20219.
    Board: Barbara Bouchard, Deputy Associate Director (202-452-3072 or 
barbara.bouchard@frb.gov) or Anna Lee Hewko, Senior Supervisory 
Financial Analyst (202-530-6260 or anna.hewko@frb.gov), Division of 
Banking Supervision and Regulation; or Mark E. Van Der Weide, Senior 
Counsel (202-452-2263 or mark.vanderweide@frb.gov), Legal Division. For 
users of Telecommunications Device for the Deaf (``TDD'') only, contact 
202-263-4869.
    FDIC: Jason C. Cave, Associate Director, Capital Markets Branch, 
(202) 898-3548, Bobby R. Bean, Senior Quantitative Risk Analyst, 
Capital Markets Branch, (202) 898-3575, Kenton Fox, Senior Capital 
Markets Specialist, Capital Markets Branch, (202) 898-7119, Division of 
Supervision and Consumer Protection; or Michael B. Phillips, Counsel, 
(202) 898-3581, Supervision and Legislation Branch, Legal Division, 
Federal Deposit Insurance Corporation, 550 17th Street, NW., 
Washington, DC 20429.
    OTS: Michael D. Solomon, Director, Capital Policy, Supervision 
Policy (202) 906-5654; David W. Riley, Senior Analyst, Capital Policy 
(202) 906-6669; or Karen Osterloh, Special Counsel, Regulations and 
Legislation Division (202) 906-6639, Office of Thrift Supervision, 1700 
G Street, NW., Washington, DC 20552.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction
    A. Background
    B. Conceptual Overview
    1. The IRB Framework for Credit Risk
    2. The AMA for Operational Risk
    C. Overview of Proposed Rule
    D. Structure of Proposed Rule
    E. Quantitative Impact Study 4 and Overall Capital Objectives
    1. Quantitative Impact Study 4
    2. Overall Capital Objectives
    F. Competitive Considerations
II. Scope
    A. Core and Opt-In Banks
    B. U.S. Depository Institution Subsidiaries of Foreign Banks
    C. Reservation of Authority
III. Qualification
    A. The Qualification Process
    1. In General
    2. Parallel Run and Transitional Floor Periods
    B. Qualification Requirements
    1. Process and Systems Requirements
    2. Risk Rating and Segmentation Systems for Wholesale and Retail 
Exposures
    Wholesale exposures
    Retail exposures
    Definition of default
    Rating philosophy
    Rating and segmentation reviews and updates
    3. Quantification of Risk Parameters for Wholesale and Retail 
Exposures
    Probability of default (PD)
    Loss given default (LGD) and expected loss given default (ELGD)
    Exposure at default (EAD)
    General quantification principles
    4. Optional Approaches That Require Prior Supervisory Approval
    5. Operational Risk
    Operational risk data and assessment system
    Operational risk quantification system
    6. Data Management and Maintenance
    7. Control and Oversight Mechanisms
    Validation
    Internal audit
    Stress testing
    8. Documentation
    C. Ongoing Qualification
IV. Calculation of Tier 1 Capital and Total Qualifying Capital
V. Calculation of Risk-Weighted Assets
    A. Categorization of Exposures
    1. Wholesale Exposures
    2. Retail Exposures
    3. Securitization Exposures
    4. Equity Exposures
    5. Boundary Between Operational Risk and Other Risks
    6. Boundary Between the Proposed Rule and the Market Risk 
Amendment
    B. Risk-Weighted Assets for General Credit Risk (Wholesale 
Exposures, Retail Exposures, On-Balance Sheet Assets That Are Not 
Defined by Exposure Category, and Immaterial Credit Exposures)
    1. Phase 1--Categorization of Exposures
    2. Phase 2--Assignment of Wholesale Obligors and Exposures to 
Rating Grades and Retail Exposures to Segments
    Purchased wholesale receivables
    Wholesale lease residuals
    3. Phase 3--Assignment of Risk Parameters to Wholesale Obligors 
and Exposures and Retail Segments
    4. Phase 4--Calculation of Risk-Weighted Assets
    5. Statutory Provisions on the Regulatory Capital Treatment of 
Certain Mortgage Loans
    C. Credit Risk Mitigation Techniques
    1. Collateral
    2. EAD for Counterparty Credit Risk
    EAD for repo-style transactions and eligible margin loans
    Collateral haircut approach
    Standard supervisory haircuts
    Own estimates of haircuts
    Simple VaR methodology
    3. EAD for OTC Derivative Contracts
    Current exposure methodology
    4. Internal Models Methodology
    Maturity under the internal models methodology
    Collateral agreements under the internal models methodology
    Internal estimate of alpha
    Alternative models
    5. Guarantees and Credit Derivatives That Cover Wholesale 
Exposures
    Eligible guarantees and eligible credit derivatives
    PD substitution approach
    LGD adjustment approach
    Maturity mismatch haircut
    Restructuring haircut
    Currency mismatch haircut
    Example
    Multiple credit risk mitigants
    Double default treatment
    6. Guarantees and Credit Derivatives That Cover Retail Exposures
    D. Unsettled Securities, Foreign Exchange, and Commodity 
Transactions
    E. Securitization Exposures
    1. Hierarchy of Approaches
    Exceptions to the general hierarchy of approaches
    Servicer cash advances
    Amount of a securitization exposure
    Implicit support
    Operational requirements for traditional securitizations
    Clean-up calls
    2. Ratings-Based Approach (RBA)
    3. Internal Assessment Approach (IAA)
    4. Supervisory Formula Approach (SFA)
    General requirements
    Inputs to the SFA formula
    5. Eligible Disruption Liquidity Facilities
    6. Credit Risk Mitigation for Securitization Exposures
    7. Synthetic Securitizations
    Background
    Operational requirements for synthetic securitizations
    First-loss tranches
    Mezzanine tranches
    Super-senior tranches
    8. Nth-to-Default Credit Derivatives

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    9. Early Amortization Provisions
    Background
    Controlled early amortization
    Noncontrolled early amortization
    F. Equity Exposures
    1. Introduction and Exposure Measurement
    Hedge transactions
    Measures of hedge effectiveness
    2. Simple Risk-Weight Approach (SRWA)
    Non-significant equity exposures
    3. Internal Models Approach (IMA)
    IMA qualification
    Risk-weighted assets under the IMA
    4. Equity Exposures to Investment Funds
    Full look-through approach
    Simple modified look-through approach
    Alternative modified look-through approach
VI. Operational Risk
VII. Disclosure
    1. Overview
    Comments on ANPR
    2. General Requirements
    Frequency/timeliness
    Location of disclosures and audit/certification requirements
    Proprietary and confidential information
    3. Summary of Specific Public Disclosure Requirements
    4. Regulatory Reporting

I. Introduction

A. Background

    On August 4, 2003, the agencies issued an advance notice of 
proposed rulemaking (ANPR) (68 FR 45900) that sought public comment on 
a new risk-based regulatory capital framework based on the Basel 
Committee on Banking Supervision (BCBS)\2\ April 2003 consultative 
paper entitled `` New Basel Capital Accord'' (Proposed New Accord). The 
Proposed New Accord set forth a ``three pillar'' framework encompassing 
risk-based capital requirements for credit risk, market risk, and 
operational risk (Pillar 1); supervisory review of capital adequacy 
(Pillar 2); and market discipline through enhanced public disclosures 
(Pillar 3). The Proposed New Accord incorporated several methodologies 
for determining a bank's risk-based capital requirements for credit, 
market, and operational risk.\3\
    The ANPR sought comment on selected regulatory capital approaches 
contained in the Proposed New Accord that the agencies believe are 
appropriate for large, internationally active U.S. banks. These 
approaches include the internal ratings-based (IRB) approach for credit 
risk and the advanced measurement approaches (AMA) for operational risk 
(together, the advanced approaches). The IRB framework uses risk 
parameters determined by a bank's internal systems in the calculation 
of the bank's credit risk capital requirements. The AMA relies on a 
bank's internal estimates of its operational risks to generate an 
operational risk capital requirement for the bank. The ANPR included a 
number of questions highlighting various issues for the industry's 
consideration. The agencies received approximately 100 public comments 
on the ANPR from banks, trade associations, supervisory authorities, 
and other interested parties. These comments addressed the agencies' 
specific questions as well as a range of other issues. Commenters 
generally encouraged further development of the framework, and most 
supported the overall direction of the ANPR. Commenters did, however, 
raise a number of conceptual and technical issues that they believed 
required additional consideration.
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    \2\ The BCBS is a committee of banking supervisory authorities, 
which was established by the central bank governors of the G-10 
countries in 1975. It consists of senior representatives of bank 
supervisory authorities and central banks from Belgium, Canada, 
France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, 
Sweden, Switzerland, the United Kingdom, and the United States.
    \3\ The BCBS developed the Proposed New Accord to modernize its 
first capital Accord, which was endorsed by the G-10 governors in 
1988 and implemented by the agencies in the United States in 1989. 
The BCBS's 1988 Accord is described in a document entitled 
``International Convergence of Capital Measurement and Capital 
Standards.'' This document and other documents issued by the BCBS 
are available through the Bank for International Settlements Web 
site at http://www.bis.org. The agencies' implementing regulations 
are available at 12 CFR part 3, Appendices A and B (national banks); 
12 CFR part 208, Appendices A and E (state member banks); 12 CFR 
part 225, Appendixes A and E (bank holding companies); 12 CFR part 
325, Appendices A and C (state nonmember banks); and 12 CFR part 567 
(savings associations).
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    Since the issuance of the ANPR, the agencies have worked 
domestically and with other BCBS member countries to modify the 
methodologies in the Proposed New Accord to reflect comments received 
during the international consultation process and the U.S. ANPR comment 
process. In June 2004, the BCBS issued a document entitled 
``International Convergence of Capital Measurement and Capital 
Standards: A Revised Framework'' (New Accord or Basel II). The New 
Accord recognizes developments in financial products, incorporates 
advances in risk measurement and management practices, and assesses 
capital requirements that are generally more sensitive to risk. It is 
intended for use by individual countries as the basis for national 
consultation and implementation. Accordingly, the agencies are issuing 
this proposed rule to implement the New Accord for banks in the United 
States.

B. Conceptual Overview

    The framework outlined in this proposal (IRB framework) is intended 
to produce risk-based capital requirements that are more risk-sensitive 
than the existing risk-based capital rules of the agencies (general 
risk-based capital rules). The proposed framework seeks to build on 
improvements to risk assessment approaches that a number of large banks 
have adopted over the last decade. In particular, the proposed 
framework requires banks to assign risk parameters to exposures and 
provides specific risk-based capital formulas that would be used to 
transform these risk parameters into risk-based capital requirements.
    The proposed framework is based on the ``value-at-risk'' (VaR) 
approach to measuring credit risk and operational risk. VaR modeling 
techniques for measuring risk have been the subject of economic 
research and are used by large banks. The proposed framework has 
benefited significantly from comments on the ANPR, as well as 
consultations organized in conjunction with the BCBS's development of 
the New Accord. Because bank risk measurement practices are both 
continually evolving and subject to model and other errors, the 
proposed framework should be viewed less as an effort to produce a 
statistically precise measurement of risk, and more as an effort to 
improve the risk sensitivity of the risk-based capital requirements for 
banks.
    The proposed framework's conceptual foundation is based on the view 
that risk can be quantified through the assessment of specific 
characteristics of the probability distribution of potential losses 
over a given time horizon. This approach assumes that a suitable 
estimate of that probability distribution, or at least of the specific 
characteristics to be measured, can be produced. Figure 1 illustrates 
some of the key concepts associated with the proposed framework. The 
figure shows a probability distribution of potential losses associated 
with some time horizon (for example, one year). It could reflect, for 
example, credit losses, operational losses, or other types of losses.

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[GRAPHIC] [TIFF OMITTED] TP25SE06.075

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

[[Page 55834]]

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

    \7\ See Explanatory Note, section 5.3.
---------------------------------------------------------------------------

    Another important conceptual element of the IRB framework concerns 
the treatment of EL. The ANPR generally would have required banks to 
hold capital against the measured amount of UL plus EL over a one-year 
horizon, except in the limited instance of credit card exposures where 
future

[[Page 55835]]

margin income (FMI) was allowed to offset EL. The ANPR treatment also 
would have maintained the existing definition of regulatory capital, 
which includes the allowance for loan and lease losses (ALLL) in tier 2 
capital up to a limit equal to 1.25 percent of risk-weighted assets. 
The ANPR requested comment on the proposed treatment of EL. Many 
commenters on the ANPR objected to this treatment on conceptual 
grounds, arguing that capital is not the appropriate mechanism for 
covering EL. In response to this feedback, the agencies sought and 
obtained changes to the BCBS's proposals in this area.
    The agencies supported the BCBS's proposal, announced in October 
2003, to remove ECL (as defined below) from the risk-weighted assets 
calculation. This NPR, consistent with the New Accord, removes ECL from 
the risk-weighted assets calculation but requires a bank to compare its 
ECL to its eligible credit reserves (as defined below). If a bank's ECL 
exceeds its eligible credit reserves, the bank must deduct the excess 
ECL amount 50 percent from tier 1 capital and 50 percent from tier 2 
capital. If a bank's eligible credit reserves exceed its ECL, the bank 
would be able to include the excess eligible credit reserves amount in 
tier 2 capital, up to 0.6 percent of the bank's credit risk-weighted 
assets. This treatment is intended to maintain a capital incentive to 
reserve prudently and seeks to ensure that ECL over a one-year horizon 
is covered either by reserves or capital. This treatment also 
recognizes that prudent reserving that considers probable losses over 
the life of a loan may result in a bank holding reserves in excess of 
ECL measured with a one-year horizon. The BCBS calibrated the proposed 
0.6 percent limit on inclusion of excess reserves in tier 2 capital to 
be approximately as restrictive as the existing cap on the inclusion of 
ALLL under the general risk-based capital rules, based on data obtained 
in the BCBS's Third Quantitative Impact Study (QIS-3).\8\ Question 3: 
The agencies seek comment and supporting data on the appropriateness of 
this limit.
---------------------------------------------------------------------------

    \8\ BCBS, ``QIS 3: Third Quantitative Impact Study,'' May 2003.
---------------------------------------------------------------------------

    The agencies are aware that certain banks believe that FMI should 
be eligible to cover ECL for the purposes of such a calculation, while 
other banks have asserted that, for certain business lines, prudential 
reserving practices do not involve setting reserves at levels 
consistent with ECL over a horizon as long as one year. The agencies 
nevertheless believe that the proposed approach is appropriate because 
banks should receive risk-based capital benefits only for the most 
highly reliable ECL offsets.
    The combined impact of these changes in the treatment of ECL and 
reserves will depend on the reserving practices of individual banks. 
Nevertheless, if other factors are equal, the removal of ECL from the 
calculation of risk-weighted assets will result in a lower amount of 
risk-weighted assets than the proposals in the ANPR. However, the 
impact on risk-based capital ratios should be partially offset by 
related changes to the numerators of the risk-based capital ratios--
specifically, (i) the ALLL will be allowed in tier 2 capital up to 
certain limits only to the extent that it and certain other reserves 
exceed ECL, and (ii) if ECL exceeds reserves, the reserve shortfall 
must be deducted 50 percent from tier 1 capital and 50 percent from 
tier 2 capital.
    Using data from QIS-3, the BCBS conducted an analysis of the risk-
based capital requirements that would be generated under the New 
Accord, taking into account the aggregate effect of ECL-related changes 
to both the numerator and the denominator of the risk-based capital 
ratios. The BCBS concluded that to offset these changes relative to the 
credit risk-based capital requirements of the Proposed New Accord, it 
might be necessary under the New Accord to apply a ``scaling factor'' 
(multiplier) to credit risk-weighted assets. The BCBS, in the New 
Accord, indicated that the best estimate of the scaling factor using 
QIS-3 data adjusted for the EL-UL decisions was 1.06. The BCBS noted 
that a final determination of any scaling factor would be reconsidered 
prior to full implementation of the new framework. The agencies are 
proposing a multiplier of 1.06 at this time, consistent with the New 
Accord.
    The agencies note that a 1.06 multiplier should be viewed as a 
placeholder. The BCBS is expected to revisit the determination of a 
scaling factor based on the results of the latest international QIS 
(QIS-5, which was not conducted in the United States).\9\ The agencies 
will consider the BCBS's determination, as well as other factors 
including the most recent QIS conducted in the United States (QIS-4, 
which is described below),\10\ in determining a multiplier for the 
final rule. As the agencies gain more experience with the proposed 
advanced approaches, the agencies will revisit the scaling factor along 
with other calibration issues identified during the parallel run and 
transitional floor periods (described below) and make changes to the 
rule as necessary. While a scaling factor is one way to ensure that 
regulatory capital is maintained at a certain level, particularly in 
the short- to medium-term, the agencies also may address calibration 
issues through modifications to the underlying IRB risk-based capital 
formulas.
---------------------------------------------------------------------------

    \9\ See http://www.bis.org/bcbs/qis/qis5.htm.
    \10\ See ``Summary Findings of the Fourth Quantitative Impact 
Study,'' February 24, 2006.
---------------------------------------------------------------------------

2. The AMA for Operational Risk
    The proposed rule also includes the AMA for determining risk-based 
capital requirements for operational risk. Under the proposed rule, 
operational risk is defined as the risk of loss resulting from 
inadequate or failed internal processes, people, and systems or from 
external events. This definition of operational risk includes legal 
risk--which is the risk of loss (including litigation costs, 
settlements, and regulatory fines) resulting from the failure of the 
bank to comply with laws, regulations, prudent ethical standards, and 
contractual obligations in any aspect of the bank's business--but 
excludes strategic and reputational risks.
    Under the AMA, a bank would use its internal operational risk 
management systems and processes to assess its exposure to operational 
risk. Given the complexities involved in measuring operational risk, 
the AMA provides banks with substantial flexibility and, therefore, 
does not require a bank to use specific methodologies or distributional 
assumptions. Nevertheless, a bank using the AMA must demonstrate to the 
satisfaction of its primary Federal supervisor that its systems for 
managing and measuring operational risk meet established standards, 
including producing an estimate of operational risk exposure that meets 
a 1-year, 99.9th percentile soundness standard. A bank's estimate of 
operational risk exposure includes both expected operational loss (EOL) 
and unexpected operational loss (UOL) and forms the basis of the bank's 
risk-based capital requirement for operational risk.
    The AMA allows a bank to base its risk-based capital requirement 
for operational risk on UOL alone if the bank can demonstrate to the 
satisfaction of its primary Federal supervisor that the bank has 
eligible operational risk offsets, such as certain operational risk 
reserves, that equal or exceed the bank's EOL. To the extent that 
eligible operational risk offsets are less than EOL, the bank's risk-
based capital requirement for operational risk must incorporate the 
shortfall.

[[Page 55836]]

C. Overview of Proposed Rule

    The proposed rule maintains the general risk-based capital rules' 
minimum tier 1 risk-based capital ratio of 4.0 percent and total risk-
based capital ratio of 8.0 percent. The components of tier 1 and total 
capital are also generally the same, with a few adjustments described 
in more detail below. The primary difference between the general risk-
based capital rules and the proposed rule is the methodologies used for 
calculating risk-weighted assets. Banks applying the proposed rule 
generally would use their internal risk measurement systems to 
calculate the inputs for determining the risk-weighted asset amounts 
for (i) general credit risk (including wholesale and retail exposures); 
(ii) securitization exposures; (iii) equity exposures; and (iv) 
operational risk. In certain cases, however, external ratings or 
supervisory risk weights would be used to determine risk-weighted asset 
amounts. Each of these areas is discussed below.
    Banks using the proposed rule also would be subject to supervisory 
review of their capital adequacy (Pillar 2) and certain public 
disclosure requirements to foster transparency and market discipline 
(Pillar 3). In addition, each bank using the advanced approaches would 
continue to be subject to the tier 1 leverage ratio requirement, and 
each depository institution (DI) (as defined in section 3 of the 
Federal Deposit Insurance Act (12 U.S.C. 1813)) using the advanced 
approaches would continue to be subject to the prompt corrective action 
(PCA) thresholds. Those banks subject to the MRA also would continue to 
be subject to the MRA.
    Under the proposed rule, a bank must identify whether each of its 
on- and off-balance sheet exposures is a wholesale, retail, 
securitization, or equity exposure. Assets that are not defined by any 
exposure category (and certain immaterial portfolios of exposures) 
generally would be assigned risk-weighted asset amounts equal to their 
carrying value (for on-balance sheet exposures) or notional amount (for 
off-balance sheet exposures).
    Wholesale exposures under the proposed rule include most credit 
exposures to companies and governmental entities. For each wholesale 
exposure, a bank would assign five quantitative risk parameters: PD 
(which is stated as a percentage and measures the likelihood that an 
obligor will default over a 1-year horizon); ELGD (which is stated as a 
percentage and is an estimate of the economic loss rate if a default 
occurs); LGD (which is stated as a percentage and is an estimate of the 
economic loss rate if a default occurs during economic downturn 
conditions); EAD (which is measured in dollars and is an estimate of 
the amount that would be owed to the bank at the time of default); and 
M (which is measured in years and reflects the effective remaining 
maturity of the exposure). Banks would be able to factor into their 
risk parameter estimates the risk mitigating impact of collateral, 
credit derivatives, and guarantees that meet certain criteria. Banks 
would input the risk parameters for each wholesale exposure into an IRB 
risk-based capital formula to determine the risk-based capital 
requirement for the exposure.
    Retail exposures under the proposed rule include most credit 
exposures to individuals and small businesses that are managed as part 
of a segment of exposures with similar risk characteristics, not on an 
individual-exposure basis. A bank would classify each of its retail 
exposures into one of three retail subcategories--residential mortgage 
exposures, qualifying revolving exposures (QREs) (for example, credit 
cards and overdraft lines), and other retail exposures. Within these 
three subcategories, the bank would group exposures into segments with 
similar risk characteristics. The bank would then assign the risk 
parameters PD, ELGD, LGD, and EAD to each retail segment. The bank 
would be able to take into account the risk mitigating impact of 
collateral and guarantees in the segmentation process and in the 
assignment of risk parameters to retail segments. Like wholesale 
exposures, the risk parameters for each retail segment would be used as 
inputs into an IRB risk-based capital formula to determine the risk-
based capital requirement for the segment. Question 4: The agencies 
seek comment on the use of a segment-based approach rather than an 
exposure-by-exposure approach for retail exposures.
    For securitization exposures, the bank would apply one of three 
general approaches, subject to various conditions and qualifying 
criteria: the Ratings-Based Approach (RBA), which uses external ratings 
to risk-weight exposures; an Internal Assessment Approach (IAA), which 
uses internal ratings to risk-weight exposures to asset-backed 
commercial paper programs (ABCP programs); or the Supervisory Formula 
Approach (SFA). Securitization exposures in the form of gain-on-sale or 
credit-enhancing interest-only strips (CEIOs)\11\ and securitization 
exposures that do not qualify for the RBA, the IAA, or the SFA would be 
deducted from regulatory capital.
---------------------------------------------------------------------------

    \11\ A CEIO is an on-balance-sheet asset that (i) represents the 
contractual right to receive some or all of the interest and no more 
than a minimal amount of principal due on the underlying exposures 
of a securitization and (ii) exposes the holder to credit risk 
directly or indirectly associated with the underlying exposures that 
exceeds its pro rata claim on the underlying exposures whether 
through subordination provisions or other credit-enhancement 
techniques.
---------------------------------------------------------------------------

    Banks would be able to use an internal models approach (IMA) for 
determining risk-based capital requirements for equity exposures, 
subject to certain qualifying criteria and floors. If a bank does not 
have a qualifying internal model for equity exposures, or chooses not 
to use such a model, the bank must apply a simple risk weight approach 
(SRWA) in which publicly traded equity exposures would have a 300 
percent risk weight and non-publicly traded equity exposures would have 
a 400 percent risk weight. Under both the IMA and the SRWA, equity 
exposures to certain entities or made pursuant to certain statutory 
authorities would be subject to a 0 to 100 percent risk weight.
    Banks would have to develop qualifying AMA systems to determine 
risk-based capital requirements for operational risk. Under the AMA, a 
bank would use its own methodology to identify operational loss events, 
measure its exposure to operational risk, and assess a risk-based 
capital requirement for operational risk.
    Under the proposed rule, a bank would calculate its risk-based 
capital ratios by first converting any dollar risk-based capital 
requirements for exposures produced by the IRB risk-based capital 
formulas into risk-weighted asset amounts by multiplying the capital 
requirements by 12.5 (the inverse of the overall 8.0 percent risk-based 
capital requirement). After determining the risk-weighted asset amounts 
for credit risk and operational risk, a bank would sum these amounts 
and then subtract any allocated transfer risk reserves and excess 
eligible credit reserves not included in tier 2 capital (defined below) 
to determine total risk-weighted assets. The bank would then calculate 
its risk-based capital ratios by dividing its tier 1 capital and total 
qualifying capital by the total risk-weighted assets amount.
    The proposed rule contains specific public disclosure requirements 
to provide important information to market participants on the capital 
structure, risk exposures, risk assessment processes, and, hence, the

[[Page 55837]]

capital adequacy of a bank. The public disclosure requirements would 
apply only to the DI or bank holding company representing the top 
consolidated level of the banking group that is subject to the advanced 
approaches. In addition, the agencies are also publishing today 
proposals to require certain disclosures from subsidiary DIs in the 
banking group through the supervisory reporting process. The agencies 
believe that the reporting of key risk parameter estimates for each DI 
applying the advanced approaches will provide the primary Federal 
supervisor of the DI and other relevant supervisors with important data 
for assessing the reasonableness and accuracy of the institution's 
calculation of its risk-based capital requirements under this proposal 
and the adequacy of the institution's capital in relation to its risks. 
Some of the proposed supervisory reports would be publicly available 
(for example, on the Call Report or Thrift Financial Report), and 
others would be confidential disclosures to the agencies to augment the 
supervisory process.

D. Structure of Proposed Rule

    The agencies are considering implementing a comprehensive 
regulatory framework for the advanced approaches in which each agency 
would have an advanced approaches regulation or appendix that sets 
forth (i) the elements of tier 1 and tier 2 capital and associated 
adjustments to the risk-based capital ratio numerator, (ii) the 
qualification requirements for using the advanced approaches, and (iii) 
the details of the advanced approaches. For proposal purposes, the 
agencies are issuing a single proposed regulatory text for comment. 
Unless otherwise indicated, the term ``bank'' in the regulatory text 
includes banks, savings associations, and bank holding companies 
(BHCs). The term ``[AGENCY]'' in the regulatory text refers to the 
primary Federal supervisor of the bank applying the rule. Areas where 
the regulatory text would differ by agency--for example, provisions 
that would only apply to savings associations or to BHCs--are generally 
indicated in appropriate places.
    In this proposed rule, the agencies are not restating the elements 
of tier 1 and tier 2 capital, which would generally remain the same as 
under the general risk-based capital rules. Adjustments to the risk-
based capital ratio numerators specific to banks applying the advanced 
approaches are in part II of the proposed rule and explained in greater 
detail in section IV of this preamble. The OCC, Board, and FDIC also 
are proposing to incorporate their existing market risk rules by cross-
reference and are proposing modifications to the market risk rules in a 
separate NPR issued concurrently.\12\ The OTS is proposing its own 
market risk rule, including the proposed modifications, as a part of 
that separate NPR. In addition, the agencies may need to make 
additional conforming amendments to certain of their regulations that 
use tier 1 or total qualifying capital or the risk-based capital ratios 
for various purposes.
---------------------------------------------------------------------------

    \12\ See elsewhere in today's issue of the Federal Register.
---------------------------------------------------------------------------

    The proposed rule is structured in eight broad parts. Part I 
identifies criteria for determining which banks are subject to the 
rule, provides key definitions, and sets forth the minimum risk-based 
capital ratios. Part II describes the adjustments to the numerator of 
the risk-based capital ratios for banks using the advanced approaches. 
Part III describes the qualification process and provides qualification 
requirements for obtaining supervisory approval for use of the advanced 
approaches. This part incorporates critical elements of supervisory 
oversight of capital adequacy (Pillar 2).
    Parts IV through VII address the calculation of risk-weighted 
assets. Part IV provides the risk-weighted assets calculation 
methodologies for wholesale and retail exposures; on-balance-sheet 
assets that do not meet the regulatory definition of a wholesale, 
retail, securitization, or equity exposure; and certain immaterial 
portfolios of credit exposures. This part also describes the risk-based 
capital treatment for over-the-counter (OTC) derivative contracts, 
repo-style transactions, and eligible margin loans. In addition, this 
part describes the methodology for reflecting eligible credit risk 
mitigation techniques in risk-weighted assets for wholesale and retail 
exposures. Furthermore, this part sets forth the risk-based capital 
requirements for failed and unsettled securities, commodities, and 
foreign exchange transactions.
    Part V identifies operating criteria for recognizing risk 
transference in the securitization context and outlines the approaches 
for calculating risk-weighted assets for securitization exposures. Part 
VI describes the approaches for calculating risk-weighted assets for 
equity exposures. Part VII describes the calculation of risk-weighted 
assets for operational risk. Finally, Part VIII provides public 
disclosure requirements for banks employing the advanced approaches 
(Pillar 3).
    The structure of the preamble generally follows the structure of 
the proposed regulatory text. Definitions, however, are discussed in 
the portions of the preamble where they are most relevant.

E. Quantitative Impact Study 4 and Overall Capital Objectives

1. Quantitative Impact Study 4
    After the BCBS published the New Accord, the agencies conducted the 
additional quantitative impact study referenced above, QIS-4, in the 
fall and winter of 2004-2005, to better understand the potential impact 
of the proposed framework on the risk-based capital requirements for 
individual U.S. banks and U.S. banks as a whole. The results showed a 
substantial dollar-weighted average decline and variation in risk-based 
capital requirements across the 26 participating U.S. banks and their 
portfolios.\13\ In an April 2005 press release,\14\ the agencies 
expressed their concern about the magnitude of the drop in QIS-4 risk-
based capital requirements and the dispersion of those requirements and 
decided to undertake further analysis.
---------------------------------------------------------------------------

    \13\ Since neither an NPR and associated supervisory guidance 
nor final regulations implementing a Basel II-based framework had 
been issued in the United States at the time of data collection, all 
QIS-4 results relating to the U.S. implementation of Basel II are 
based on the description of the framework contained in the QIS-4 
instructions. These instructions differed from the framework issued 
by the BCBS in June 2004 in several respects. For example, the QIS-4 
articulation of the Basel II framework does not include the 1.06 
scaling factor. The QIS-4 instructions are available at http://
www.ffiec.gov/qis4.
    \14\ See ``Banking Agencies to Perform Additional Analysis 
Before Issuing Notice of Proposed Rulemaking Related to Basel II,'' 
Apr. 29, 2005.
---------------------------------------------------------------------------

    The QIS-4 analysis indicated a dollar-weighted average reduction of 
15.5 percent in risk-based capital requirements at participating banks 
when moving from the current Basel I-based framework to a Basel II-
based framework.\15\ Table A provides a numerical summary of the QIS-4 
results, in total and by portfolio, aggregated across all QIS-4 
participants.\16\ The first column shows

[[Page 55838]]

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

    \15\ The Basel II framework on which QIS-4 is based uses a UL-
only approach (even though EL requirements were included in QIS-4). 
But the current Basel I risk-based capital requirements use a UL+EL 
approach. Therefore, in order to compare the Basel II results from 
QIS-4 with the current Basel I requirements, the EL requirements 
from QIS-4 had to be added to the UL capital requirements from QIS-
4.
    \16\ In the table, ``Minimum required capital'' (MRC) refers to 
the total risk-based capital requirement before incorporating the 
impact of reserves. ``Effective MRC'' is equal to MRC adjusted for 
the impact of reserves. As noted above, under the Basel II 
framework, a shortfall in reserves generally increases the total 
risk-based capital requirement and a surplus in reserves generally 
reduces the total risk-based capital requirement, though not with 
equal impact.
[GRAPHIC] [TIFF OMITTED] TP25SE06.076

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

[[Page 55839]]

determined that this dispersion in capital requirements not only 
reflected differences in actual risk or portfolio composition, but also 
reflected differences in the banks' estimated risk parameters for 
similar exposures.
    Although concerns with dispersion might be remedied to some degree 
with refinements to internal bank risk measurement and management 
systems and through the rulemaking process, the agencies also note that 
some of the dispersion encountered in the QIS-4 exercise is a 
reflection of the flexibility in methods to quantify the risk 
parameters that may be allowed under implementation of the proposed 
framework.
    The agencies intend to conduct other analyses of the impact of the 
Basel II framework during both the parallel run and transitional floor 
periods. These analyses will look at both the impact of the Basel II 
framework and the preparedness of banks to compute risk-based capital 
requirements in a manner consistent with the Basel II framework.
2. Overall Capital Objectives
    The ANPR stated: ``The Agencies do not expect the implementation of 
the New Accord to result in a significant decrease in aggregate capital 
requirements for the U.S. banking system. Individual banking 
organizations may, however, face increases or decreases in their 
minimum risk-based capital requirements because the New Accord is more 
risk sensitive than the 1988 Accord and the Agencies' existing risk-
based capital rules (general risk-based capital rules).'' \17\ The ANPR 
was in this respect consistent with statements made by the BCBS in its 
series of Basel II consultative papers and its final text of the New 
Accord, in which the BCBS stated as an objective broad maintenance of 
the overall level of risk-based capital requirements while allowing 
some incentives for banks to adopt the advanced approaches.
---------------------------------------------------------------------------

    \17\ 68 FR 45900, 45902 (Aug. 4, 2003).
---------------------------------------------------------------------------

    The agencies remain committed to these objectives. Were the QIS-4 
results just described produced under an up-and-running risk-based 
capital regime, the risk-based capital requirements generated under the 
framework would not meet the objectives described in the ANPR, and thus 
would be considered unacceptable.
    When considering QIS-4 results and their implications, it is 
important to recognize that banking organizations participated in QIS-4 
on a best-efforts basis. The agencies had not qualified any of the 
participants to use the Basel II framework and had not conducted any 
formal supervisory review of their progress toward meeting the Basel II 
qualification requirements. In addition, the risk measurement and 
management systems of the QIS-4 participants, as indicated by the QIS-4 
exercise, did not yet meet the Basel II qualification requirements 
outlined in this proposed rule.
    As banks work with their supervisors to refine their risk 
measurement and management systems, it will become easier to determine 
the actual quantitative impact of the advanced approaches. The agencies 
have decided, therefore, not to recalibrate the framework at the 
present time based on QIS-4 results, but to await further experience 
with more fully developed bank risk measurement and management systems.
    If there is a material reduction in aggregate minimum regulatory 
capital requirements upon implementation of Basel II-based rules, the 
agencies will propose regulatory changes or adjustments during the 
transitional floor periods. In this context, materiality will depend on 
a number of factors, including the size, source, and nature of any 
reduction; the risk profiles of banks authorized to use Basel II-based 
rules; and other considerations relevant to the maintenance of a safe 
and sound banking system. In any event, the agencies will view a 10 
percent or greater decline in aggregate minimum required risk-based 
capital (without reference to the effects of the transitional floors 
described in a later section of this preamble), compared to minimum 
required risk-based capital as determined under the existing rules, as 
a material reduction warranting modifications to the supervisory risk 
functions or other aspects of this framework.
    The agencies are, in short, identifying a numerical benchmark for 
evaluating and responding to capital outcomes during the parallel run 
and transitional floor periods that do not comport with the overall 
capital objectives outlined in the ANPR. At the end of the transitional 
floor periods, the agencies would re-evaluate the consistency of the 
framework, as (possibly) revised during the transitional floor periods, 
with the capital goals outlined in the ANPR and with the maintenance of 
broad competitive parity between banks adopting the framework and other 
banks, and would be prepared to make further changes to the framework 
if warranted. Question 5: The agencies seek comment on this approach to 
ensuring that overall capital objectives are achieved.
    The agencies also noted above that tier 1 capital requirements 
reported in QIS-4 declined substantially more than did total capital 
requirements. The agencies have long placed special emphasis on the 
importance of tier 1 capital in maintaining bank safety and soundness 
because of its ability to absorb losses on a going concern basis. The 
agencies will continue to monitor the trend in tier 1 capital 
requirements during the parallel run and transitional floor periods and 
will take appropriate action if reductions in tier 1 capital 
requirements are inconsistent with the agencies' overall capital goals.
    Similar to the attention the agencies will give to overall risk-
based capital requirements for the U.S. banking system, the agencies 
will carefully consider during the transitional floor periods whether 
dispersion in risk-based capital results across banks and portfolios 
appropriately reflects differences in risk. A conclusion by the 
agencies that dispersion in risk-based capital requirements does not 
appropriately reflect differences in risk could be another possible 
basis for proposing regulatory adjustments or refinements during the 
transitional floor periods.
    It should also be noted that given the bifurcated regulatory 
capital framework that would result from the adoption of this rule, 
issues related to overall capital may be inextricably linked to the 
competitive issues discussed elsewhere in this document. The agencies 
indicated in the ANPR that if the competitive effects of differential 
capital requirements were deemed significant, ``the Agencies would need 
to consider potential ways to address those effects while continuing to 
seek the objectives of the current proposal. Alternatives could 
potentially include modifications to the proposed approaches, as well 
as fundamentally different approaches.'' \18\ In this regard, the 
agencies view the parallel run and transitional floor periods as a 
trial of the new framework under controlled conditions. While the 
agencies hope and expect that regulatory changes proposed during those 
years would be in the nature of adjustments made within the framework 
described in this proposed rule, more fundamental changes cannot be 
ruled out if warranted based on future experience or comments received 
on this proposal.
---------------------------------------------------------------------------

    \18\ 68 FR 45900, 45905 (August 4, 2003).
---------------------------------------------------------------------------

    The agencies reiterate that, especially in light of the QIS-4 
results, retention of the tier 1 leverage ratio and other existing 
prudential safeguards (for example, PCA) is critical for the

[[Page 55840]]

preservation of a safe and sound regulatory capital framework. In 
particular, the leverage ratio is a straightforward and tangible 
measure of solvency and serves as a needed complement to the risk-
sensitive Basel II framework based on internal bank inputs.

F. Competitive Considerations

    A fundamental objective of the New Accord is to strengthen the 
soundness and stability of the international banking system while 
maintaining sufficient consistency in capital adequacy regulation to 
ensure that the New Accord will not be a significant source of 
competitive inequity among internationally active banks. The agencies 
support this objective and believe that it is crucial to promote 
continual advancement of the risk measurement and management practices 
of large and internationally active banks. For this reason, the 
agencies propose to implement only the advanced approaches of the New 
Accord because these approaches utilize the most sophisticated and 
risk-sensitive risk measurement and management techniques.
    While all banks should work to enhance their risk management 
practices, the advanced approaches and the systems required to support 
their use may not be appropriate for many banks from a cost-benefit 
point of view. For these banks, the agencies believe that, with some 
modifications, the general risk-based capital rules are a reasonable 
alternative. As discussed in section E.2. above, this proposal's 
bifurcated approach to risk-based capital requirements raises difficult 
issues and inextricably links competitive considerations with overall 
capital issues. One such issue relates to concerns about competitive 
inequities between U.S. banks operating under different regulatory 
capital regimes. The ANPR cited this concern, and a number of 
commenters expressed their belief that in some portfolios competitive 
inequities would be worsened under the proposed bifurcated framework. 
These commenters expressed the concern that the Proposed New Accord 
might place community banks operating under the general risk-based 
capital rules at a competitive disadvantage to banks applying the 
advanced approaches because the IRB framework would likely result in 
lower risk-based capital requirements on some types of exposures, such 
as residential mortgage exposures, other retail exposures, and small 
business loans.
    Some commenters asserted that the application of lower risk-based 
capital requirements under the Proposed New Accord would create a 
competitive disadvantage for banks operating under the general risk-
based capital rules, which in turn may adversely affect their asset 
quality and cost of capital. Other commenters suggested that if the 
advanced approaches in the Proposed New Accord are implemented, the 
agencies should consider revising their general risk-based capital 
rules to enhance risk sensitivity and to mitigate potential competitive 
inequities associated with the bifurcated system.
    The agencies recognize that the industry has concerns with the 
potential competitive inequities associated with a bifurcated risk-
based capital framework. The agencies reaffirm their intention, 
expressed in the ANPR, to address competitive issues while continuing 
to pursue the objectives of the current proposal. In addition to the 
QIS-4 analysis discussed above, the agencies have also researched 
discrete topics to further understand where competitive pressures might 
arise. As part of their effort to develop a bifurcated risk-based 
capital framework that minimizes competitive inequities and is not 
disruptive to the banking sector, the agencies issued an Advance Notice 
of Proposed Rulemaking (Basel IA ANPR) considering various 
modifications to the general risk-based capital rules to improve risk 
sensitivity and to reduce potential competitive disparities between 
Basel II banks and non-Basel II banks.\19\ The comment period for the 
Basel IA ANPR ended on January 18, 2006, and the agencies intend to 
consider all comments and issue for public comment a more fully 
developed risk-based capital proposal for non-Basel II banks. The 
comment period for the non-Basel II proposal is expected to overlap 
that of this proposal, allowing commenters to analyze the effects of 
the two proposals concurrently.
---------------------------------------------------------------------------

    \19\ See 70 FR 61068 (Oct. 20, 2005).
---------------------------------------------------------------------------

    In addition, some commenters expressed concern about competitive 
inequities arising from differences in implementation and application 
of the New Accord by supervisory authorities in different countries. In 
particular, some commenters expressed concern about the different 
implementation timetables of various jurisdictions, and differences in 
the scope of application in various jurisdictions or in the range of 
approaches that different jurisdictions will allow. The BCBS has 
established an Accord Implementation Group, comprised of supervisors 
from member countries, whose primary objectives are to work through 
implementation issues, maintain a constructive dialogue about 
implementation processes, and harmonize approaches as much as possible 
within the range of national discretion embedded in the New Accord.
    While supervisory judgment will play a critical role in the 
evaluation of risk measurement and management practices at individual 
banks, supervisors are committed to developing protocols and 
information-sharing arrangements that should minimize burdens on banks 
operating in multiple countries and ensure that supervisory authorities 
are implementing the New Accord as consistently as possible. The New 
Accord identifies numerous areas where national discretion is 
encouraged. This design was intended to enable national supervisors to 
implement the methodology, or combination of methodologies, most 
appropriate for banks in their jurisdictions. Disparate implementation 
decisions are expected, particularly during the transition years. Over 
time, the agencies expect that industry and supervisory practices 
likely will converge in many areas, thus mitigating differences across 
countries. Competitive considerations, both internationally and 
domestically, will be monitored and discussed by the agencies on an 
ongoing basis. With regard to implementation timing concerns, the 
agencies believe that the transitional arrangements described in 
section III.A. of this preamble below provide a prudent and reasonable 
framework for moving to the advanced approaches. Where international 
implementation differences affect an individual bank, the agencies 
expect to work with the bank and appropriate national supervisory 
authorities for the bank to ensure that implementation proceeds as 
smoothly as possible. Question 6: The agencies seek comment on all 
potential competitive aspects of this proposal and on any specific 
aspects of the proposal that might raise competitive concerns for any 
bank or group of banks.

II. Scope

    The agencies have identified three groups of banks: (i) Large or 
internationally active banks that would be required to adopt the 
advanced approaches in the proposed rule (core banks); (ii) banks that 
voluntarily decide to adopt the advanced approaches (opt-in banks); and 
(iii) banks that do not adopt the advanced approaches (general banks). 
Each core and opt-in bank would be required to meet certain 
qualification requirements to the satisfaction of its primary Federal 
supervisor, in consultation with other

[[Page 55841]]

relevant supervisors, before the bank may use the advanced approaches 
for risk-based capital purposes.
    Pillar I of the New Accord requires all banks subject to the New 
Accord to calculate capital requirements for exposure to both credit 
risk and operational risk. The New Accord provides a bank three 
approaches to calculate its credit risk capital requirement and three 
approaches to calculate its operational risk capital requirement. 
Outside the United States, countries that are replacing Basel I with 
the New Accord generally have required all banks to comply with the New 
Accord, but have provided banks the option of choosing among the New 
Accord's various approaches for calculating credit risk and operational 
risk capital requirements.\20\ For banks in the United States, the NPR, 
like the ANPR, takes a different approach. It would not subject all 
U.S. banks to the New Accord, but instead focuses on only the largest 
and most internationally active banks. Due to the size and complexity 
of these banks, the NPR would require core banks to comply with the 
most advanced approaches for calculating credit and operational risk 
capital requirements `` that is, the IRB and the AMA. In addition, the 
NPR would allow other U.S. banks to ``opt in'' to Basel II-based rules, 
but, as with core banks, the only Basel II-based rules available to 
U.S. ``opt-in'' banks would be the New Accord's most advanced 
approaches.
    Question 7: The agencies request comment on whether U.S. banks 
subject to the advanced approaches in the proposed rule (that is, core 
banks and opt-in banks) should be permitted to use other credit and 
operational risk approaches similar to those provided under the New 
Accord. With respect to the credit risk capital requirement, the 
agencies request comment on whether banks should be provided the option 
of using a U.S. version of the so-called ``standardized approach'' of 
the New Accord and on the appropriate length of time for such an 
option.
---------------------------------------------------------------------------

    \20\ Despite the options provided in national legislation and 
rules, most non-U.S. banks comparable in size and complexity to U.S. 
core banks are adopting some form of the advanced approaches. For 
example, based on currently available information, the vast majority 
of large, internationally-active banks based outside of the United 
States plan to employ an internal ratings-based approach in the 
calculation of credit risk capital requirements.
---------------------------------------------------------------------------

A. Core and Opt-In Banks

    A DI is a core bank if it meets either of two independent threshold 
criteria: (i) Consolidated total assets of $250 billion or more, as 
reported on the most recent year-end regulatory reports; or (ii) 
consolidated total on-balance sheet foreign exposure of $10 billion or 
more at the most recent year-end. To determine total on-balance sheet 
foreign exposure, a bank would sum its adjusted cross-border claims, 
local country claims, and cross-border revaluation gains (calculated in 
accordance with the Federal Financial Institutions Examination Council 
(FFIEC) Country Exposure Report (FFIEC 009)). Adjusted cross-border 
claims would equal total cross-border claims less claims with the head 
office/guarantor located in another country, plus redistributed 
guaranteed amounts to the country of head office/guarantor. A DI also 
is a core bank if it is a subsidiary of another DI or BHC that uses the 
advanced approaches.
    Under the proposed rule, a U.S.-chartered BHC \21\ is a core bank 
if the BHC has: (i) Consolidated total assets (excluding assets held by 
an insurance underwriting subsidiary) of $250 billion or more, as 
reported on the most recent year-end regulatory reports; (ii) 
consolidated total on-balance sheet foreign exposure of $10 billion or 
more at the most recent year-end; or (iii) a subsidiary DI that is a 
core bank or opt-in bank. Currently 11 top-tier banking organizations 
meet these criteria. The agencies note that, using this approach to 
define whether a BHC is a core bank, it is possible that no single DI 
under a BHC would meet the threshold criteria, but that all of the 
BHC's subsidiary DIs would be core banks.
---------------------------------------------------------------------------

    \21\ OTS does not currently impose any explicit capital 
requirements on savings and loan holding companies and does not 
propose to apply the Basel II proposal to these holding companies.
---------------------------------------------------------------------------

    The proposed BHC consolidated asset threshold is different from the 
threshold in the ANPR, which applied to the total consolidated DI 
assets of a BHC. The proposed shift to total consolidated assets 
(excluding assets held by an insurance underwriting subsidiary) 
recognizes that BHCs can hold similar assets within and outside of DIs 
and reduces potential incentives to structure BHC assets and activities 
to arbitrage capital regulations. The proposed rule excludes assets 
held in an insurance underwriting subsidiary of a BHC because the New 
Accord was not designed to address insurance company exposures. 
Question 8A: The Board seeks comment on the proposed BHC consolidated 
non-insurance assets threshold relative to the consolidated DI assets 
threshold in the ANPR.
    A bank that is subject to the proposed rule either as a core bank 
or as an opt-in bank would be required to apply the rule unless its 
primary Federal supervisor determines in writing that application of 
the rule is not appropriate in light of the bank's asset size, level of 
complexity, risk profile, or scope of operations. Question 8B: The 
agencies seek comment on the proposed scope of application. In 
particular, the agencies seek comment on the regulatory burden of a 
framework that requires the advanced approaches to be implemented by 
each subsidiary DI of a BHC or bank that uses the advanced approaches.

B. U.S. DI Subsidiaries of Foreign Banks

    Any U.S.-chartered DI that is a subsidiary of a foreign banking 
organization is subject to the U.S. regulatory capital requirements 
applied to domestically-owned U.S. DIs. Thus, if the U.S. DI subsidiary 
of a foreign banking organization meets any of the threshold criteria, 
it would be a core bank and would be subject to the advanced 
approaches. If it does not meet any of the criteria, the U.S. DI may 
remain a general bank or may opt-in to the advanced approaches, subject 
to the same qualification process and requirements as a domestically-
owned U.S. DI. A top-tier U.S. BHC, and its subsidiary DIs, that is 
owned by a foreign banking organization also would be subject to the 
same threshold levels for core bank determination as would a top-tier 
BHC that is not owned by a foreign banking organization. A U.S. BHC 
that meets the conditions in Federal Reserve SR letter 01-01\22\ and is 
a core bank would not be required to meet the minimum capital ratios in 
the Board's capital adequacy guidelines, although it would be required 
to adopt the advanced approaches, compute and report its capital ratios 
in accordance with the advanced approaches, and make the required 
public and regulatory disclosures.
---------------------------------------------------------------------------

    \22\ SR 01-01, ``Application of the Board's Capital Adequacy 
Guidelines to Bank Holding Companies Owned by Foreign Banking 
Organizations,'' January 5, 2001.
---------------------------------------------------------------------------

    A DI subsidiary of such a U.S. BHC would be a core bank and would 
be required to adopt the advanced approaches (unless specifically 
exempted from the advanced approaches by its primary Federal 
supervisor) and meet the minimum capital ratio requirements. In 
addition, the Board retains its supervisory authority to require any 
BHC, including a U.S. BHC owned or controlled by a foreign banking 
organization that is or is treated as a financial holding company 
(FHC), to maintain capital levels above

[[Page 55842]]

the regulatory minimums. Question 9: The agencies seek comment on the 
application of the proposed rule to DI subsidiaries of a U.S. BHC that 
meets the conditions in Federal Reserve SR letter 01-01 and on the 
principle of national treatment in this context.

C. Reservation of Authority

    The proposed rule would restate the authority of a bank's primary 
Federal supervisor to require the bank to hold an overall amount of 
capital greater than would otherwise be required under the rule if the 
agency determines that the bank's risk-based capital requirements under 
the rule are not commensurate with the bank's credit, market, 
operational, or other risks. In addition, the agencies anticipate that 
there may be instances when the proposed rule generates a risk-weighted 
asset amount for specific exposures that is not commensurate with the 
risks posed by such exposures. In these cases, under the proposed rule, 
the bank's primary Federal supervisor would retain the authority to 
require the bank to use a different risk-weighted asset amount for the 
exposures or to use different risk parameters (for wholesale or retail 
exposures) or model assumptions (for modeled equity or securitization 
exposures) than those required in the proposed rule when calculating 
the risk-weighted asset amount for those exposures. Similarly, the 
proposed rule would provide authority for a bank's primary Federal 
supervisor to require the bank to assign a different risk-weighted 
asset amount for operational risk, to change elements of its 
operational risk analytical framework (including distributional and 
dependence assumptions), or to make other changes to the bank's 
operational risk management processes, data and assessment systems, or 
quantification systems if the supervisor finds that the risk-weighted 
asset amount for operational risk produced by the bank under the rule 
is not commensurate with the operational risks of the bank. Any agency 
that exercises this reservation of authority would notify each of the 
other agencies of its determination.

III. Qualification

A. The Qualification Process

1. In General
    Supervisory qualification to use the advanced approaches is a 
continuous and iterative process that begins when a bank's board of 
directors adopts an implementation plan and continues as the bank 
operates under the advanced approaches. Before a bank may use the 
advanced approaches for risk-based capital purposes, it must develop 
and adopt a written implementation plan, establish and maintain a 
comprehensive and sound planning and governance process to oversee the 
implementation efforts described in the plan, demonstrate to its 
primary Federal supervisor that it meets the qualification requirements 
in section 22 of the proposed rule, and complete a satisfactory 
``parallel run'' (discussed below). A bank's primary Federal supervisor 
would be responsible, after consultation with other relevant 
supervisors, for evaluating the bank's initial and ongoing compliance 
with the qualification requirements for the advanced approaches.
    The agencies will jointly issue supervisory guidance describing 
agency expectations for wholesale, retail, securitization, and equity 
exposures, as well as for operational risk.\23\ The agencies recognize 
that a consistent and transparent process to oversee implementation of 
the advanced approaches is crucial, and will consult with each other on 
significant issues raised during the implementation process.
---------------------------------------------------------------------------

    \23\ The agencies have issued for public comment draft 
supervisory guidance on corporate and retail exposures and 
operational risk. See 68 FR 45949 (Aug. 4, 2003); 69 FR 62748 (Oct. 
27, 2004).
---------------------------------------------------------------------------

    Under the proposed rule, a bank preparing to implement the advanced 
approaches must adopt a written implementation plan, approved by its 
board of directors, describing in detail how the bank complies, or 
intends to comply, with the qualification requirements. A core bank 
must adopt a plan no later than six months after it meets a threshold 
criterion in section 1(b)(1) of the proposed rule. If a bank meets a 
threshold criterion on the effective date of the final rule, the bank 
would have to adopt a plan within six months of the effective date. 
Banks that do not meet a threshold criterion, but are nearing any 
criterion by direct growth or merger, would be expected to engage in 
ongoing dialogue with their primary Federal supervisor regarding 
implementation strategies to ensure their readiness to adopt the 
advanced approaches when a threshold criterion is reached. An opt-in 
bank may adopt an implementation plan at any time, but must adopt an 
implementation plan and notify its primary Federal supervisor in 
writing at least twelve months before it proposes to begin the first 
floor period (as discussed later in this section of the preamble).
    In developing an implementation plan, a bank must assess its 
current state of readiness relative to the qualification requirements 
in this proposed rule and related supervisory guidance. This assessment 
would include a gap analysis that identifies where additional work is 
needed and a remediation or action plan that clearly sets forth how the 
bank intends to fill the gaps it has identified. The implementation 
plan must comprehensively address the qualification requirements for 
the bank and each of its consolidated subsidiaries (U.S. and foreign-
based) with respect to all portfolios and exposures of the bank and 
each of its consolidated subsidiaries. The implementation plan must 
justify and support any proposed temporary or permanent exclusion of a 
business line, portfolio, or exposure from the advanced approaches. The 
business lines, portfolios, and exposures that the bank proposes to 
exclude from the advanced approaches must be, in the aggregate, 
immaterial to the bank. The implementation plan must include objective, 
measurable milestones (including delivery dates and a date when the 
bank's implementation of the advanced approaches will be fully 
operational). For core banks, the implementation plan must include an 
explicit first floor period start date that is no later than 36 months 
after the later of the effective date of the rule or the date the bank 
meets at least one of the threshold criteria.\24\ Further, the 
implementation plan must describe the resources that the bank has 
budgeted and are available to implement the plan.
---------------------------------------------------------------------------

    \24\ The bank's primary Federal supervisor may extend the bank's 
first floor period start date.
---------------------------------------------------------------------------

    During implementation of the advanced approaches, a bank would work 
closely with its primary Federal supervisor to ensure that its risk 
measurement and management systems are fully functional and reliable 
and are able to generate risk parameter estimates that can be used to 
calculate the risk-based capital ratios correctly under the advanced 
approaches. The implementation plan, including the gap analysis and 
action plan, will provide a basis for ongoing supervisory dialogue and 
review during this period. The primary Federal supervisor will assess a 
bank's progress relative to its implementation plan. To the extent that 
adjustments to target dates are needed, these adjustments would be made 
subject to the ongoing supervisory discussion between the bank and its 
primary Federal supervisor.
2. Parallel Run and Transitional Floor Periods
    Once a bank has adopted its implementation plan, it must complete

[[Page 55843]]

a satisfactory parallel run before it may use the advanced approaches 
to calculate its risk-based capital requirements. A satisfactory 
parallel run is a period of at least four consecutive calendar quarters 
during which the bank complies with all of the qualification 
requirements to the satisfaction of its primary Federal supervisor. 
During this period, the bank would continue to be subject to the 
general risk-based capital rules but would simultaneously calculate its 
risk-based capital ratios under the advanced approaches. During the 
parallel run period, a bank would report its risk-based capital ratios 
under both the general risk-based capital rules and the advanced 
approaches to its primary Federal supervisor through the supervisory 
process on a quarterly basis. The agencies will share this information 
with each other for calibration and other analytical purposes.
    A bank's primary Federal supervisor would notify the bank of the 
date when it may begin to use the advanced approaches for risk-based 
capital purposes. A bank would not be permitted to begin using the 
advanced approaches for risk-based capital purposes until its primary 
Federal supervisor is satisfied that the bank fully complies with the 
qualification requirements, the bank has satisfactorily completed a 
parallel run, and the bank has an adequate process to ensure ongoing 
compliance with the qualification requirements.
    To provide for a smooth transition to the advanced approaches, the 
proposed rule would impose temporary limits on the amount by which a 
bank's risk-based capital requirements could decline over a period of 
at least three years (that is, at least four consecutive calendar 
quarters in each of the three transitional floor periods). Based on its 
assessment of the bank's ongoing compliance with the qualification 
requirements, a bank's primary Federal supervisor would determine when 
the bank is ready to move from one transitional floor period to the 
next period and, after the full transition has been completed, to move 
to stand-alone use of the advanced approaches. Table B sets forth the 
proposed transitional floor periods for banks moving to the advanced 
approaches:

                      Table B.--Transitional Floors
------------------------------------------------------------------------
                                                           Transitional
                Transitional floor period                      floor
                                                            percentage
------------------------------------------------------------------------
First floor period......................................              95
Second floor period.....................................              90
Third floor period......................................              85
------------------------------------------------------------------------

    During the transitional floor periods, a bank would calculate its 
risk-weighted assets under the general risk-based capital rules. Next, 
the bank would multiply this risk-weighted assets amount by the 
appropriate floor percentage in the table above. This product would be 
the bank's ``floor-adjusted'' risk-weighted assets. Third, the bank 
would calculate its tier 1 and total risk-based capital ratios using 
the definitions of tier 1 and tier 2 capital (and associated deductions 
and adjustments) in the general risk-based capital rules for the 
numerator values and floor-adjusted risk-weighted assets for the 
denominator values. These ratios would be referred to as the ``floor-
adjusted risk-based capital ratios.''
    The bank also would calculate its tier 1 and total risk-based 
capital ratios using the definitions and rules in this proposed rule. 
These ratios would be referred to as the ``advanced approaches risk-
based capital ratios.'' In addition, the bank would calculate a tier 1 
leverage ratio using tier 1 capital as defined in this proposed rule 
for the numerator of the ratio.
    During a bank's transitional floor periods, the bank would report 
all five regulatory capital ratios described above--two floor-adjusted 
risk-based capital ratios, two advanced approaches risk-based capital 
ratios, and one leverage ratio. To determine its applicable capital 
category for PCA purposes and for all other regulatory and supervisory 
purposes, a bank's risk-based capital ratios during the transitional 
floor periods would be set equal to the lower of the respective floor-
adjusted risk-based capital ratio and the advanced approaches risk-
based capital ratio. During the transitional floor periods, a bank's 
tier 1 capital and tier 2 capital for all non-risk-based-capital 
supervisory and regulatory purposes (for example, lending limits and 
Regulation W quantitative limits) would be the bank's tier 1 capital 
and tier 2 capital as calculated under the advanced approaches.
    Thus, for example, in order to be well capitalized under PCA, a 
bank would have to have a floor-adjusted tier 1 risk-based capital 
ratio and an advanced approaches tier 1 risk-based capital ratio of 6 
percent or greater, a floor-adjusted total risk-based capital ratio and 
an advanced approaches total risk-based capital ratio of 10 percent or 
greater, and a tier 1 leverage ratio of 5 percent or greater (with tier 
1 capital calculated under the advanced approaches). Although the PCA 
rules do not apply to BHCs, a BHC would be required to report all five 
of these regulatory capital ratios and would have to meet applicable 
supervisory and regulatory requirements using the lower of the 
respective floor-adjusted risk-based capital ratio and the advanced 
approaches risk-based capital ratio.
    After a bank completes its transitional floor periods and its 
primary Federal supervisor determines the bank may begin using the 
advanced approaches with no further transitional floor, the bank would 
use its tier 1 and total risk-based capital ratios as calculated under 
the advanced approaches and its tier 1 leverage ratio calculated using 
the advanced approaches definition of tier 1 capital for PCA and all 
other supervisory and regulatory purposes.
    The transitional floor calculations described above are linked to 
the general risk-based capital rules. As noted above, the agencies 
issued the Basel IA ANPR outlining possible modifications to those 
rules and are developing an NPR in this regard. The agencies are still 
considering the extent and nature of these modifications to the general 
risk-based capital rules and the scope of application of these 
modifications, including for banks that transition to the advanced 
approaches. The agencies expect banks that meet the threshold criteria 
in section 1(b)(1) of the proposed rule (that is, core banks) as of the 
effective date of the rule, and banks that opt-in pursuant to section 
1(b)(2) at the earliest possible date, will use the general risk-based 
capital rules in place immediately before the rule becomes effective 
both during the parallel run and as a basis for the transitional floor 
calculations. Other changes to the general risk-based capital rules 
(outside the scope of the changes outlined in the Basel IA ANPR) may be 
considered by the agencies, as appropriate. Question 10: The agencies 
seek comment on this approach, including the transitional floor 
thresholds and transition period, and on how and to what extent future 
modifications to the general risk-based capital rules should be 
incorporated into the transitional floor calculations for advanced 
approaches banks.
    Banks' computation of risk-based capital requirements under both 
the general risk-based capital rules and the advanced approaches will 
help the agencies assess the impact of the advanced approaches on 
overall capital requirements, including whether the change in capital 
requirements relative to the general risk-based capital rules is 
consistent with the agencies' overall capital objectives. Question 11: 
The agencies seek comment on what other information should be 
considered in deciding whether those overall capital goals have been 
achieved.

[[Page 55844]]

    The agencies are proposing to make 2008 the first possible year for 
a bank to conduct its parallel run and 2009-2011 the first possible 
years for the three transitional floor periods. Question 12: The 
agencies seek comment on this proposed timetable for implementing the 
advanced approaches in the United States.

B. Qualification Requirements

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

[[Page 55845]]

exposures cover most credit exposures of banks.
    To differentiate among degrees of credit risk, a bank must be able 
to make meaningful and consistent distinctions among credit exposures 
along two dimensions--default risk and loss severity in the event of a 
default. In addition, a bank must be able to assign wholesale obligors 
to rating grades that approximately reflect likelihood of default and 
must be able to assign wholesale exposures to rating grades (or ELGD 
and LGD estimates) that approximately reflect the loss severity 
expected in the event of default. As discussed below, the proposed rule 
requires banks to treat wholesale exposures differently from retail 
exposures when differentiating among degrees of credit risk.
    Wholesale exposures. For wholesale exposures, a bank must have an 
internal risk rating system that indicates the likelihood of default of 
each individual obligor and may use an internal risk rating system that 
indicates the economic loss rate upon default of each individual 
exposure.\25\ A bank would assign an internal risk rating to each 
wholesale obligor, which should reflect the obligor's PD--that is, its 
long-run average one-year default rate over a reasonable mix of 
economic conditions. PD is defined in more detail below.
---------------------------------------------------------------------------

    \25\ As explained below, a bank that chooses not to use an 
internal risk rating system for ELGD and LGD for a wholesale 
exposure must directly assign an ELGD and LGD estimate to the 
wholesale exposure.
---------------------------------------------------------------------------

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

[[Page 55846]]

supervisor that its system assigns accurate and reliable PD, ELGD, and 
LGD estimates for each retail segment on a consistent basis.
    Definition of default. In the ANPR, the agencies proposed to define 
default for a wholesale exposure as either or both of the following 
events: (i) The bank determines that the borrower is unlikely to pay 
its obligations to the bank in full, without recourse to actions by the 
bank such as the realization of collateral; or (ii) the borrower is 
more than 90 days past due on principal or interest on any material 
obligation to the bank.
    A number of commenters encouraged the agencies to use a definition 
of default that conforms more closely to that used by bank risk 
managers. Many of these commenters recommended that the agencies define 
default as the entry into non-accrual status for wholesale exposures 
and the number of days past due for retail exposures, or as the entry 
into charge-off status for wholesale and retail exposures. The agencies 
have amended the ANPR definitions of default to respond to these 
concerns and recognize that the definition of default in this proposed 
rule is different from the definitions that are being implemented in 
other jurisdictions.
    Under the proposed rule's definition of default, a bank's wholesale 
obligor would be in default if, for any credit exposure of the bank to 
the obligor, the bank has (i) placed the exposure on non-accrual status 
consistent with the Call Report Instructions or the Thrift Financial 
Report and the Thrift Financial Report Instruction Manual; (ii) taken a 
full or partial charge-off or write-down on the exposure due to the 
distressed financial condition of the obligor; or (iii) incurred a 
credit-related loss of 5 percent or more of the exposure's initial 
carrying value in connection with the sale of the exposure or the 
transfer of the exposure to the held-for-sale, available-for-sale, 
trading account, or other reporting category. Under the proposed 
definition, a wholesale exposure to an obligor remains in default until 
the bank has reasonable assurance of repayment and performance for all 
contractual principal and interest payments on all exposures of the 
bank to the obligor (other than exposures that have been fully written-
down or charged-off). The agencies would expect a bank to employ 
standards for determining whether it has a reasonable assurance of 
repayment and performance that are similar to those for determining 
whether to restore a loan from non-accrual to accrual status.
    When a bank sells a set of wholesale exposures, the bank must 
examine the sale prices of the individual exposures contained in the 
set and evaluate whether a credit loss of 5 percent or more of the 
exposure's initial carrying value has occurred on any given exposure. 
Write-downs of securities that are not credit-related (for example, a 
write-down that is due to a change in market interest rates) would not 
be a default event.
    Question 14: The agencies seek comment on this proposed definition 
of default and on how well it captures substantially all of the 
circumstances under which a bank could experience a material credit-
related economic loss on a wholesale exposure. In particular, the 
agencies seek comment on the appropriateness of the 5 percent credit 
loss threshold for exposures sold or transferred between reporting 
categories. The agencies also seek commenters' views on specific issues 
raised by applying different definitions of default in multiple 
national jurisdictions and on ways to minimize potential regulatory 
burden, including use of the definition of default in the New Accord, 
keeping in mind that national bank supervisory authorities must adopt 
default definitions that are appropriate in light of national banking 
practices and conditions.
    In response to comments on the ANPR, the agencies propose to define 
default for retail exposures according to the timeframes for loss 
classification that banks generally use for internal purposes and that 
are embodied in the FFIEC's Uniform Retail Credit Classification and 
Account Management Policy.\26\ Specifically, revolving retail exposures 
and residential mortgages would be in default at 180 days past due; 
other retail exposures would be in default at 120 days past due. In 
addition, a retail exposure would be in default if the bank has taken a 
full or partial charge-off or write-down of principal on the exposure 
for credit-related reasons. Such an exposure would remain in default 
until the bank has reasonable assurance of repayment and performance 
for all contractual principal and interest payments on the exposure.
---------------------------------------------------------------------------

    \26\ FFIEC, ``Uniform Retail Credit Classification and Account 
Management Policy,'' 65 FR 36903 (June 12, 2000).
---------------------------------------------------------------------------

    The proposed definition of default for retail exposures differs 
from the proposed definition for the wholesale portfolio in several 
important respects. First, the proposed retail default definition 
applies on an exposure-by-exposure basis (rather than, as is the case 
for wholesale exposures, on an obligor-by-obligor basis). In other 
words, default on one retail exposure would not require a bank to treat 
all other obligations of the same obligor to the bank as defaulted. 
This difference reflects the fact that banks generally manage retail 
credit risk based on segments of similar exposures rather than through 
the assignment of ratings to particular obligors. In addition, it is 
quite common for retail borrowers that default on some of their 
obligations to continue payment on others.
    Second, the retail definition of default, unlike the wholesale 
definition of default, does not include exposures placed on non-accrual 
status. The agencies recognize that retail non-accrual practices vary 
considerably among banks. Accordingly, the agencies have determined 
that removing non-accrual from the retail definition of default would 
promote greater consistency among banks in the treatment of retail 
exposures.
    In addition, the retail definition of default, unlike the wholesale 
definition of default, does not explicitly state that an exposure is in 
default if a bank incurs credit-related losses of 5 percent or more in 
connection with the sale of the exposure. Because of the large number 
of diverse retail exposures that banks usually sell in a single 
transaction, banks typically do not allocate the sales price of a pool 
of retail exposures in such a way as to enable the bank to calculate 
the premium or discount on individual retail exposures. Although the 
proposed rule's definition of retail default does not explicitly 
include credit-related losses in connection with loan sales, the 
agencies would expect banks to assess carefully the impact of retail 
exposure sales in quantifying the risk parameters calculated by the 
bank for its retained retail exposures.
    Rating philosophy. A bank must explain to its primary Federal 
supervisor its rating philosophy--that is, how the bank's wholesale 
obligor rating assignments are affected by the bank's choice of the 
range of economic, business, and industry conditions that are 
considered in the obligor rating process. The philosophical basis of a 
bank's ratings system is important because, when combined with the 
credit quality of individual obligors, it will determine the frequency 
of obligor rating changes in a changing economic environment. Rating 
systems that rate obligors based on their ability to perform over a 
wide range of economic, business, and industry conditions, sometimes 
described as ``through-the-cycle'' systems, would tend to have ratings 
that migrate more slowly as conditions change. Banks that rate

[[Page 55847]]

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

[[Page 55848]]

    The LGD of some exposures may be substantially higher during 
economic downturn conditions than during other periods, while for other 
types of exposures it may not. Accordingly, the proposed rule requires 
banks to use an LGD estimate that reflects economic downturn conditions 
for purposes of calculating the risk-based capital requirements for 
wholesale exposures and retail segments; however, the LGD of an 
exposure may never be less than the exposure's ELGD. More specifically, 
banks must produce for each wholesale exposure (or downturn loss 
severity rating grade) and retail segment an estimate of the economic 
loss per dollar of EAD that the bank would expect to incur if default 
were to occur within a one-year horizon during economic downturn 
conditions. The estimate of LGD can be thought of as the ELGD plus an 
increase if appropriate to reflect the impact of economic downturn 
conditions.
    For the purpose of defining economic downturn conditions, the 
proposed rule identifies two wholesale exposure subcategories--high-
volatility commercial real estate (HVCRE) wholesale exposures and non-
HVCRE wholesale exposures (that is, all wholesale exposures that are 
not HVCRE exposures)--and three retail exposure subcategories--
residential mortgage exposures, QREs, and other retail exposures. The 
proposed rule defines economic downturn conditions with respect to an 
exposure as those conditions in which the aggregate default rates for 
the exposure's entire wholesale or retail subcategory held by the bank 
(or subdivision of such subcategory selected by the bank) in the 
exposure's national jurisdiction (or subdivision of such jurisdiction 
selected by the bank) are significantly higher than average.
    Under this approach, a bank with a geographical or industry sector 
concentration in a subcategory of exposures may find that information 
relating to a downturn in that geographical region or industry sector 
may be more relevant for the bank than a general downturn affecting 
many regions or industries. At this time, however, the proposed rule 
does not require a bank with a geographical, industry sector, or other 
concentration to subdivide exposure subcategories or national 
jurisdictions to reflect such concentrations; rather, the proposed rule 
allows banks to subdivide exposure subcategories or national 
jurisdictions as they deem appropriate given the exposures held by the 
bank. The agencies understand that downturns in particular geographical 
subdivisions of national jurisdictions or in particular industrial 
sectors may result in significantly increased loss rates in material 
subdivisions of a bank's exposures in an exposure subcategory. Question 
15: In light of the possibility of significantly increased loss rates 
at the subdivision level due to downturn conditions in the subdivision, 
the agencies seek comment on whether to require banks to determine 
economic downturn conditions at a more granular level than an entire 
wholesale or retail exposure subcategory in a national jurisdiction.
    The proposed rule provides banks two methods of generating LGD 
estimates for wholesale and retail exposures. First, a bank may use its 
own estimates of LGD for a subcategory of exposures if the bank has 
prior written approval from its primary Federal supervisor to use 
internal estimates for that subcategory of exposures. In approving a 
bank's use of internal estimates of LGD, a bank's primary Federal 
supervisor will consider whether the bank's internal estimates of LGD 
are reliable and sufficiently reflective of economic downturn 
conditions. The supervisor will also consider whether the bank has 
rigorous and well-documented policies and procedures for identifying 
economic downturn conditions for the exposure subcategory, identifying 
material adverse correlations between the relevant drivers of default 
rates and loss rates given default, and incorporating identified 
correlations into internal LGD estimates. If a bank has supervisory 
approval to use its own estimates of LGD for an exposure subcategory, 
it must use its own estimates of LGD for all exposures within that 
subcategory.
    As noted above, the LGD of an exposure or segment may never be less 
than the ELGD of that exposure or segment. The proposed rule defines 
the ELGD of a wholesale exposure as the bank's empirically-based best 
estimate of the default-weighted average economic loss per dollar of 
EAD the bank expects to incur in the event that the obligor of the 
exposure (or a typical obligor in the loss severity grade assigned by 
the bank to the exposure) defaults within a one-year horizon.\27\ For a 
segment of retail exposures, ELGD is the bank's empirically-based best 
estimate of the default-weighted average economic loss per dollar of 
EAD the bank expects to incur on exposures in the segment that default 
within a one-year horizon. ELGD estimates must incorporate a mix of 
economic conditions (including economic downturn conditions). For 
example, given appropriate data, the ELGD could be estimated by 
calculating the default-weighted average economic loss per dollar of 
EAD given default for exposures in a particular loss severity grade or 
segment observed over a complete credit cycle.
---------------------------------------------------------------------------

    \27\ Under the proposal, ELGD is not the statistical expected 
value of LGD.
---------------------------------------------------------------------------

    As an alternative to internal estimates of LGD, the proposed rule 
provides a supervisory mapping function for converting ELGD into LGD 
for risk-based capital purposes. Although the agencies encourage banks 
to develop internal LGD estimates, the agencies are aware that it may 
be difficult at this time and in the near future for banks to produce 
internal estimates of LGD that are sufficient for risk-based capital 
purposes because LGD data for important portfolios may be sparse, and 
there is very limited industry experience with incorporating downturn 
conditions into LGD estimates. Accordingly, under the proposed rule, a 
bank that does not qualify for use of its own estimates of LGD for a 
subcategory of exposures must instead compute LGD by applying a 
supervisory mapping function to its internal estimates of ELGD for such 
exposures. The bank would adjust its ELGDs upward to LGDs using the 
linear supervisory mapping function: LGD = 0.08 + 0.92 x ELGD. Under 
this mapping function, for example, an ELGD of 0 percent is converted 
to an LGD of 8 percent, an ELGD of 20 percent is converted to an LGD of 
26.4 percent, and an ELGD of 50 percent is converted to an LGD of 54 
percent. A bank would not have to apply the supervisory mapping 
function to repo-style transactions, eligible margin loans, and OTC 
derivative contracts (defined below in section V.C. of the preamble). 
For these exposures, the agencies believe that the difference between a 
bank's estimate of LGD and its estimate of ELGD is likely to be small. 
Instead a bank would set LGD equal to ELGD for these exposures.
    As noted, the proposed rule would permit a bank to use the 
supervisory mapping function to translate ELGDs to LGDs and would only 
permit a bank to use its own estimates of LGD for an exposure 
subcategory if the bank has received prior written approval from its 
primary Federal supervisor. The agencies also are considering whether 
to require every bank, as a condition to qualifying for use of the 
advanced approaches, to be able to produce credible and reliable 
internal estimates of LGD for all its wholesale and retail exposures. 
Under this stricter approach, a bank that is unable to demonstrate to

[[Page 55849]]

its primary Federal supervisor that it could produce credible and 
reliable internal estimates of LGD would not be permitted to use the 
advanced approaches.
    Question 16: The agencies seek comment on and supporting empirical 
analysis of (i) the proposed rule's definitions of LGD and ELGD; (ii) 
the proposed rule's overall approach to LGD estimation; (iii) the 
appropriateness of requiring a bank to produce credible and reliable 
internal estimates of LGD for all its wholesale and retail exposures as 
a precondition for using the advanced approaches; (iv) the 
appropriateness of requiring all banks to use a supervisory mapping 
function, rather than internal estimates, for estimating LGDs, due to 
limited data availability and lack of industry experience with 
incorporating economic downturn conditions in LGD estimates; (v) the 
appropriateness of the proposed supervisory mapping function for 
translating ELGD into LGD for all portfolios of exposures and possible 
alternative supervisory mapping functions; (vi) exposures for which no 
mapping function would be appropriate; and (vii) exposures for which a 
more lenient (that is, producing a lower LGD for a given ELGD) or more 
strict (that is, producing a higher LGD for a given ELGD) mapping 
function may be appropriate (for example, residential mortgage 
exposures and HVCRE exposures).
    The agencies are concerned that some approaches to ELGD or LGD 
quantification could produce estimates that are pro-cyclical, 
particularly if these estimates are based on economic indicators, such 
as frequently updated loan-to-value (LTV) ratios, that are highly 
sensitive to current economic conditions. Question 17: The agencies 
seek comment on the extent to which ELGD or LGD estimates under the 
proposed rule would be pro-cyclical, particularly for longer-term 
secured exposures. The agencies also seek comment on alternative 
approaches to measuring ELGDs or LGDs that would address concerns 
regarding potential pro-cyclicality without imposing undue burden on 
banks.
    This proposed rule incorporates comments on the ANPR suggesting a 
need to better accommodate certain credit products, most prominently 
asset-based lending programs, whose structures typically result in a 
bank recovering substantial amounts of the exposure prior to the 
default date--for example, through paydowns of outstanding principal. 
The agencies believe that actions taken prior to default to mitigate 
losses are an important component of a bank's overall credit risk 
management, and that such actions should be reflected in ELGD and LGD 
when banks can quantify their effectiveness in a reliable manner. In 
the proposed rule, this is achieved by measuring ELGD and LGD relative 
to the exposure's EAD (defined in the next section) as opposed to the 
amount actually owed at default.\28\
---------------------------------------------------------------------------

    \28\ To illustrate, suppose that for a particular asset-based 
lending exposure, the EAD equaled $100 and that for every $1 owed by 
the obligor at the time of default, the bank's recovery would be 
$0.40. Furthermore, suppose that in the event of default, within a 
one-year horizon, pre-default paydowns of $20 would reduce the 
exposure amount to $80 at the time of default. In this case, the 
bank's economic loss rate measured relative to the amount owed at 
default (60%) would exceed the economic loss rate measured relative 
to EAD (48% = 60% x ($100 - $20)/$100), because the former does not 
reflect fully the impact of the pre-default paydowns.
---------------------------------------------------------------------------

    In practice, the agencies would expect methods for estimating ELGD 
and LGD, and the way those methods reflect changes in exposure during 
the period prior to default, to be consistent with other aspects of the 
proposed rule. For example, a default horizon that is longer than one 
year could result in lower estimates of economic loss due to greater 
contractual amortization prior to default, or a greater likelihood that 
covenants would enable a bank to accelerate paydowns of principal as 
the condition of an obligor deteriorates, but such long horizons could 
be inconsistent with the one-year default horizon incorporated in other 
aspects of this proposed rule, such as the quantification of PD.
    The agencies intend to limit recognition of the impact on ELGD and 
LGD of pre-default paydowns to certain types of exposures where the 
pattern is common, measurable, and especially significant, as with 
various types of asset-based lending. In addition, not all paydowns 
during the period prior to default warrant recognition as part of the 
recovery process. For example, a pre-default reduction in the 
outstanding amount on one exposure may simply reflect a refinancing by 
the obligor with the bank, with no reduction in the bank's total 
exposure to the obligor. Question 18: The agencies seek comment on the 
feasibility of recognizing such pre-default changes in exposure in a 
way that is consistent with the safety and soundness objectives of this 
proposed rule. The agencies also seek comment on appropriate 
restrictions to place on any such recognition to ensure that the 
results are not counter to the objectives of this proposal to ensure 
adequate capital within a more risk-sensitive capital framework. In 
addition, the agencies seek comment on whether, for wholesale 
exposures, allowing ELGD and LGD to reflect anticipated future 
contractual paydowns prior to default may be inconsistent with the 
proposed rule's imposition of a one-year floor on M (for certain types 
of exposures) or may lead to some double-counting of the risk-
mitigating benefits of shorter maturities for exposures not subject to 
this floor.
    Exposure at default (EAD). Except as noted below, EAD for the on-
balance- sheet component of a wholesale or retail exposure means (i) 
the bank's carrying value for the exposure (including net accrued but 
unpaid interest and fees) \29\ less any allocated transfer risk reserve 
for the exposure, if the exposure is held-to-maturity or for trading; 
or (ii) the bank's carrying value for the exposure (including net 
accrued but unpaid interest and fees) less any allocated transfer risk 
reserve for the exposure and any unrealized gains on the exposure, plus 
any unrealized losses on the exposure, if the exposure is available for 
sale. For the off-balance-sheet component of a wholesale or retail 
exposure (other than an OTC derivative contract, repo-style 
transaction, or eligible margin loan) in the form of a loan commitment 
or line of credit, EAD means the bank's best estimate of net additions 
to the outstanding amount owed the bank, including estimated future 
additional draws of principal and accrued but unpaid interest and fees, 
that are likely to occur over the remaining life of the exposure 
assuming the exposure were to go into default. This estimate of net 
additions must reflect what would be expected during a period of 
economic downturn conditions. For the off-balance-sheet component of a 
wholesale or retail exposure other than an OTC derivative contract, 
repo-style transaction, eligible margin loan, loan commitment, or line 
of credit issued by a bank, EAD means the notional amount of the 
exposure.
---------------------------------------------------------------------------

    \29\ ``Net accrued but unpaid interest and fees'' are accrued 
but unpaid interest and fees net of any amount expensed by the bank 
as uncollectable.
---------------------------------------------------------------------------

    For a segment of retail exposures, EAD is the sum of the EADs for 
each individual exposure in the segment. For wholesale or retail 
exposures in which only the drawn balance has been securitized, the 
bank must reflect its share of the exposures' undrawn balances in EAD. 
The undrawn balances of exposures for which the drawn balances have 
been securitized must be allocated between the seller's and investors' 
interests on a pro rata basis, based on the proportions of the seller's 
and investors' shares of the securitized drawn balances. For example, 
if the

[[Page 55850]]

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

[[Page 55851]]

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

[[Page 55852]]

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

[[Page 55853]]

measure heightens the need to ensure that dependence within units of 
measure is suitably reflected in the operational risk exposure 
estimate.
    In addition, the bank's process for estimating dependence should 
provide for ongoing monitoring, recognizing that dependence estimates 
can change. The agencies expect that a bank's approach for developing 
explicit and objective dependence determinations will improve over 
time. As such, the bank should develop a process for assessing 
incremental improvements to the approach (for example, through out-of-
sample testing).
    A bank must review and update (as appropriate) its operational risk 
quantification system whenever the bank becomes aware of information 
that may have a material effect on the bank's estimate of operational 
risk exposure, but no less frequently than annually.
    As described above, the agencies expect a bank using the AMA to 
demonstrate that its systems for managing and measuring operational 
risk meet established standards, including producing an estimate of 
operational risk exposure at the 99.9 percent confidence level. 
However, the agencies recognize that, in limited circumstances, there 
may not be sufficient data available for a bank to generate a credible 
estimate of its own operational risk exposure at the 99.9 percent 
confidence level. In these limited circumstances, a bank may propose 
use of an alternative operational risk quantification system to that 
specified in section 22(h)(3)(i) of the proposed rule, subject to 
approval by the bank's primary Federal supervisor. The alternative 
approach is not available at the BHC level.
    The agencies are not prescribing specific estimation methodologies 
under this approach and expect use of an alternative approach to occur 
on a very limited basis. A bank proposing to use an alternative 
operational risk quantification system must submit a proposal to its 
primary Federal supervisor. In evaluating a bank's proposal, the bank's 
primary Federal supervisor will review the bank's justification for 
requesting use of an alternative approach in light of the bank's size, 
complexity, and risk profile. The bank's primary Federal supervisor 
will also consider whether the proposed approach results in capital 
levels that are commensurate with the bank's operational risk profile, 
is sensitive to changes in the bank's risk profile, can be supported 
empirically, and allows the bank's board of directors to fulfill its 
fiduciary responsibilities to ensure that the bank is adequately 
capitalized. Furthermore, the agencies expect a bank using an 
alternative operational risk quantification system to adhere to the 
qualification requirements outlined in the proposed rule, including 
establishment and use of operational risk management processes and data 
and assessment systems.
    A bank proposing an alternative approach to operational risk based 
on an allocation methodology should be aware of certain limitations 
associated with use of such an approach. Specifically, the agencies 
will not accept an allocation of operational risk capital requirements 
that includes non-DI entities or the benefits of diversification across 
entities. The exclusion of allocations that include non-DIs is in 
recognition that, unlike the cross-guarantee provision of the Federal 
Deposit Insurance Act, which provides that a DI is liable for any 
losses incurred by the FDIC in connection with the failure of a 
commonly controlled DI, there are no statutory provisions requiring 
cross-guarantees between a DI and its non-DI affiliates.\30\ 
Furthermore, depositors and creditors of a DI generally have no legal 
recourse to capital funds that are not held by the DI or its affiliate 
DIs.
---------------------------------------------------------------------------

    \30\ 12 U.S.C. 1815(e).
---------------------------------------------------------------------------

6. Data Management and Maintenance
    A bank must have data management and maintenance systems that 
adequately support all aspects of the bank's advanced IRB systems, 
operational risk management processes, operational risk data and 
assessment systems, operational risk quantification systems, and, to 
the extent the bank uses the following systems, the internal models 
methodology to counterparty credit risk, double default excessive 
correlation detection process, IMA to equity exposures, and IAA to 
securitization exposures to ABCP programs (collectively, advanced 
systems). The bank's data management and maintenance systems must 
ensure the timely and accurate reporting of risk-based capital 
requirements. Specifically, a bank must retain sufficient data elements 
to permit monitoring, validation, and refinement of the bank's advanced 
systems. A bank's data management and maintenance systems should 
generally support the proposed rule's qualification requirements 
relating to quantification, validation, and control and oversight 
mechanisms, as well as the bank's broader risk management and reporting 
needs. The precise data elements to be collected would be dictated by 
the features and methodologies of the risk measurement and management 
systems employed by the bank. To meet the significant data management 
challenges presented by the quantification, validation, and control and 
oversight requirements of the advanced approaches, a bank must store 
its data in an electronic format that allows timely retrieval for 
analysis, reporting, and disclosure purposes.
7. Control and Oversight Mechanisms
    The consequences of an inaccurate or unreliable advanced system can 
be significant, particularly on the calculation of risk-based capital 
requirements. Accordingly, bank senior management would be responsible 
for ensuring that all advanced system components function effectively 
and are in compliance with the qualification requirements of the 
advanced approaches. Moreover, the bank's board of directors (or a 
designated committee of the board) must evaluate at least annually the 
effectiveness of, and approve, the bank's advanced systems.
    To support senior management's and the board of directors' 
oversight responsibilities, a bank must have an effective system of 
controls and oversight that ensures ongoing compliance with the 
qualification requirements and maintains the integrity, reliability, 
and accuracy of the bank's advanced systems. Banks would have 
flexibility in how they achieve integrity in their risk management 
systems. They would, however, be expected to follow standard control 
principles in their systems such as checks and balances, separation of 
duties, appropriateness of incentives, and data integrity assurance, 
including that of information purchased from third parties. Moreover, 
the oversight process should be sufficiently independent of the 
advanced systems' development, implementation, and operation to ensure 
the integrity of the component systems. The objective of risk 
management system oversight is to ensure that the various systems used 
in determining risk-based capital requirements are operating as 
intended. The oversight process should draw conclusions on the 
soundness of the components of the risk management system, identify 
errors and flaws, and recommend corrective action as appropriate.
    Validation. A bank must validate its advanced systems on an ongoing 
basis. Validation is the set of activities designed to give the 
greatest possible assurances of accuracy of the advanced systems. 
Validation includes three broad components: (i) Evaluation of the 
conceptual soundness of the advanced

[[Page 55854]]

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

[[Page 55855]]

benefits of double default treatment. Under the proposed rule, changes 
in borrower credit quality will lead to changes in risk-based capital 
requirements. Because credit quality changes typically reflect changing 
economic conditions, risk-based capital requirements may also vary with 
the economic cycle. During an economic downturn, risk-based capital 
requirements would increase if wholesale obligors or retail exposures 
migrate toward lower credit quality ratings or segments.
    Supervisors expect that banks will manage their regulatory capital 
position so that they remain at least adequately capitalized during all 
phases of the economic cycle. A bank that is able to credibly estimate 
regulatory capital levels during a downturn can be more confident of 
appropriately managing regulatory capital. Stress testing analysis 
consists of identifying a stress scenario and then translating the 
scenario into its effect on the levels of key performance measures, 
including regulatory capital ratios.
    Banks should use a range of plausible but severe scenarios and 
methods when stress testing to manage regulatory capital. Scenarios 
could be historical, hypothetical, or model-based. Key variables 
specified in a scenario could include, for example, interest rates, 
transition matrices (ratings and score-band segments), asset values, 
credit spreads, market liquidity, economic growth rates, inflation 
rates, exchange rates, or unemployment rates. A bank may choose to have 
scenarios apply to an entire portfolio, or it may identify scenarios 
specific to various sub-portfolios. The severity of the stress 
scenarios should be consistent with the periodic economic downturns 
experienced in the bank's market areas. Such scenarios may be less 
severe than those used for other purposes, such as testing a bank's 
solvency.
    The scope of stress testing analysis should be broad and include 
all material portfolios. The time horizon of the analysis should be 
consistent with the specifics of the scenario and should be long enough 
to measure the material effects of the scenario on key performance 
measures. For example, if a scenario such as a historical recession has 
material income and segment or ratings migration effects over two 
years, the appropriate time horizon is at least two years.
8. Documentation
    A bank must document adequately all material aspects of its 
advanced systems, including but not limited to the internal risk rating 
and segmentation systems, risk parameter quantification processes, 
model design, assumptions, and validation results. The guiding 
principle governing documentation is that it should support the 
requirements for the quantification, validation, and control and 
oversight mechanisms as well as the bank's broader risk management and 
reporting needs. Documentation is also critical to the supervisory 
oversight process.
    The bank should document the rationale for all material assumptions 
underpinning its chosen analytical frameworks, including the choice of 
inputs, distributional assumptions, and weighting of quantitative and 
qualitative elements. The bank also should document and justify any 
subsequent changes to these assumptions.

C. Ongoing Qualification

    An advanced approaches bank must meet the qualification 
requirements on an ongoing basis. Banks are expected to improve their 
advanced systems as they improve data gathering capabilities and as 
industry practice evolves. To facilitate the supervisory oversight of 
such systems changes, a bank must notify its primary Federal supervisor 
when it makes a change to its advanced systems that results in a 
material change in the bank's risk-weighted asset amount for an 
exposure type, or when the bank makes any significant change to its 
modeling assumptions.
    Due to the advanced approaches' rigorous systems requirements, a 
core or opt-in bank that merges with or acquires another company that 
does not calculate risk-based capital requirements using the advanced 
approaches might not be able to use the advanced approaches immediately 
for the merged or acquired company's exposures. Therefore, the proposed 
rule would permit a core or opt-in bank to use the general risk-based 
capital rules to compute the risk-weighted assets and associated 
capital for the merged or acquired company's exposures for up to 24 
months following the calendar quarter during which the merger or 
acquisition consummates.
    Any ALLL associated with the acquired company's exposures may be 
included in the acquiring bank's tier 2 capital up to 1.25 percent of 
the acquired company's risk-weighted assets. Such ALLL would be 
excluded from the acquiring bank's eligible credit reserves. The risk-
weighted assets of the acquired company would not be included in the 
acquiring bank's credit-risk-weighted assets but would be included in 
the acquiring bank's total risk-weighted assets. Any amount of the 
acquired company's ALLL that was eliminated in accounting for the 
acquisition would not be included in the acquiring bank's regulatory 
capital. An acquiring bank using the general risk-based capital rules 
for acquired exposures would be required to disclose publicly the 
amounts of risk-weighted assets and qualifying capital calculated under 
the general risk-based capital rules with respect to the acquired 
company and under the proposed rule for the acquiring bank.
    Similarly, due to the substantial infrastructure requirements of 
the proposed rule, a core or opt-in bank that merges with or acquires 
another core or opt-in bank might not be able to apply its own version 
of the advanced approaches immediately to the acquired bank's 
exposures. Accordingly, the proposed rule permits a core or opt-in bank 
that merges with or acquires another core or opt-in bank to use the 
acquired bank's advanced approaches to determine the risk-weighted 
asset amounts for, and deductions from capital associated with, the 
acquired bank's exposures for up to 24 months following the calendar 
quarter during which the merger or acquisition consummates.
    In all mergers and acquisitions involving a core or opt-in bank, 
the acquiring bank must submit an implementation plan for using 
advanced approaches for the merged or acquired company to its primary 
Federal supervisor within 30 days of consummating the merger or 
acquisition. A bank's primary Federal supervisor may extend the 
transition period for mergers or acquisitions for up to an additional 
12 months. The primary Federal supervisor of the bank will monitor the 
merger or acquisition to determine whether the application of the 
general risk-based capital rules by the acquired company produces 
appropriate risk weights for the assets of the acquired company in 
light of the overall risk profile of the combined bank.
    Question 20: The agencies seek comment on the appropriateness of 
the 24-month and 30-day time frames for addressing the merger and 
acquisition transition situations advanced approaches banks may face.
    If a bank that uses the advanced approaches to calculate its risk-
based capital requirements falls out of compliance with the 
qualification requirements, the bank must establish a plan satisfactory 
to its primary Federal supervisor to return to compliance with the 
qualification requirements. Such a bank also must disclose to the 
public its failure to comply with the qualification requirements 
promptly after receiving notice of non-compliance from its

[[Page 55856]]

primary Federal supervisor. If the bank's primary Federal supervisor 
determines that the bank's risk-based capital requirements are not 
commensurate with the bank's credit, market, operational, or other 
risks, it may require the bank to calculate its risk-based capital 
requirements using the general risk-based capital rules or a modified 
form of the advanced approaches (for example, with fixed supervisory 
risk parameters).

IV. Calculation of Tier 1 Capital and Total Qualifying Capital

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

[[Page 55857]]

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

[[Page 55858]]

approach does not fully capture the risk in insurance underwriting 
subsidiaries at the consolidated BHC level and, thus, has proposed the 
consolidation and deduction approach described above. Question 23: The 
Board seeks comment on this proposed treatment and in particular on how 
a minimum insurance regulatory capital proxy for tier 1 deduction 
purposes should be determined for insurance underwriting subsidiaries 
that are not subject to U.S. functional regulation.
    A March 10, 2005, final rule issued by the Board defined restricted 
core capital elements for BHCs and generally limited restricted core 
capital elements for internationally active banking organizations to 15 
percent of the sum of all core capital elements net of goodwill less 
any associated deferred tax liability.\38\ Restricted core capital 
elements are defined as qualifying cumulative perpetual preferred stock 
(and related surplus), minority interest related to qualifying 
cumulative perpetual preferred stock directly issued by a consolidated 
DI or foreign bank subsidiary, minority interest related to qualifying 
common or qualifying perpetual preferred stock issued by a consolidated 
subsidiary that is neither a DI nor a foreign bank, and qualifying 
trust preferred securities. The final rule defined an internationally 
active banking organization to be a BHC that (i) as of its most recent 
year-end FR Y-9C reports total consolidated assets equal to $250 
billion or more or (ii) on a consolidated basis, reports total on-
balance sheet foreign exposure of $10 billion or more in its filing of 
the most recent year-end FFIEC 009 Country Exposure Report. The Board 
intends to change the definition of an internationally active banking 
organization in the Board's capital adequacy guidelines for BHCs to 
make it consistent with the definition of a core bank. This change 
would be less restrictive on BHCs because the BHC threshold in this 
proposed rule uses total consolidated assets excluding insurance rather 
than total consolidated assets including insurance.
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    \38\ 70 FR 11827 (Mar. 10, 2005). The final rule also allowed 
internationally active banking organizations to include restricted 
core capital elements in their tier 1 capital up to 25 percent of 
the sum of all core capital elements net of goodwill less associated 
deferred tax liability so long as any amounts of restricted core 
capital elements in excess of the 15 percent limit were in the form 
of mandatory convertible preferred securities.
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V. Calculation of Risk-Weighted Assets

    A bank's total risk-weighted assets would be the sum of its credit 
risk-weighted assets and risk-weighted assets for operational risk, 
minus the sum of its excess eligible credit reserves (that is, its 
eligible credit reserves in excess of its total ECL) not included in 
tier 2 capital and allocated transfer risk reserves.

A. Categorization of Exposures

    To calculate credit risk-weighted assets, a bank must group its 
exposures into four general categories: wholesale, retail, 
securitization, and equity. It must also identify assets not included 
in an exposure category and any non-material portfolios of exposures to 
which the bank elects not to apply the IRB framework. In order to 
exclude a portfolio from the IRB framework, a bank must demonstrate to 
the satisfaction of its primary Federal supervisor that the portfolio 
(when combined with all other portfolios of exposures that the bank 
seeks to exclude from the IRB framework) is not material to the bank.
1. Wholesale Exposures
    The proposed rule defines a wholesale exposure as a credit exposure 
to a company, individual, sovereign or governmental entity (other than 
a securitization exposure, retail exposure, or equity exposure).\39\ 
The term ``company'' is broadly defined to mean a corporation, 
partnership, limited liability company, depository institution, 
business trust, SPE, association, or similar organization. Examples of 
a wholesale exposure include: (i) A non-tranched guarantee issued by a 
bank on behalf of a company; \40\ (ii) a repo-style transaction entered 
into by a bank with a company and any other transaction in which a bank 
posts collateral to a company and faces counterparty credit risk; (iii) 
an exposure that the bank treats as a covered position under the MRA 
for which there is a counterparty credit risk charge in section 32 of 
the proposed rule; (iv) a sale of corporate loans by a bank to a third 
party in which the bank retains full recourse; (v) an OTC derivative 
contract entered into by a bank with a company; (vi) an exposure to an 
individual that is not managed by the bank as part of a segment of 
exposures with homogeneous risk characteristics; and (vii) a commercial 
lease.
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    \39\ The proposed rule excludes from the definition of a 
wholesale exposure certain pre-sold one-to-four family residential 
construction loans and certain multifamily residential loans. The 
treatment of such loans is discussed below in section V.B.5. of the 
preamble.
    \40\ As described below, tranched guarantees (like most 
transactions that involve a tranching of credit risk) generally 
would be securitization exposures under this proposal. The proposal 
defines a guarantee broadly to include almost any transaction (other 
than a credit derivative executed under standard industry credit 
derivative documentation) that involves the transfer of the credit 
risk of an exposure from one party to another party. This definition 
of guarantee generally would include, for example, a credit spread 
option under which a bank has agreed to make payments to its 
counterparty in the event of an increase in the credit spread 
associated with a particular reference obligation issued by a 
company.
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    The agencies are proposing two subcategories of wholesale 
exposures--HVCRE exposures and non-HVCRE exposures. Under the proposed 
rule, HVCRE exposures would be subject to a separate IRB risk-based 
capital formula that would produce a higher risk-based capital 
requirement for a given set of risk parameters than the IRB risk-based 
capital formula for non-HVCRE wholesale exposures. An HVCRE exposure is 
defined as a credit facility that finances or has financed the 
acquisition, development, or construction of real property, excluding 
facilities used to finance (i) one- to four-family residential 
properties or (ii) commercial real estate projects where: (A) The 
exposure's LTV ratio is less than or equal to the applicable maximum 
supervisory LTV ratio in the real estate lending standards of the 
agencies; \41\ (B) the borrower has contributed capital to the project 
in the form of cash or unencumbered readily marketable assets (or has 
paid development expenses out-of-pocket) of at least 15 percent of the 
real estate's appraised ``as completed'' value; and (C) the borrower 
contributed the amount of capital required before the bank advances 
funds under the credit facility, and the capital contributed by the 
borrower or internally generated by the project is contractually 
required to remain in the project throughout the life of the project.
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    \41\ 12 CFR part 34, Subpart D (OCC); 12 CFR part 208, Appendix 
C (Board); 12 CFR part 365, Subpart D (FDIC); and 12 CFR 560.100-
560.101 (OTS).
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    Once an exposure is determined to be HVCRE, it would remain an 
HVCRE exposure until paid in full, sold, or converted to permanent 
financing. After considering comments received on the ANPR, the 
agencies are proposing to retain a separate IRB risk-based capital 
formula for HVCRE exposures in recognition of the high levels of 
systematic risk inherent in some of these exposures. The agencies 
believe that the revised definition of HVCRE in the proposed rule 
appropriately identifies exposures that are particularly susceptible to 
systematic risk. Question 24: The agencies seek comment on how to 
strike the appropriate balance between the enhanced risk sensitivity 
and marginally higher risk-based capital

[[Page 55859]]

requirements obtained by separating HVCRE exposures from other 
wholesale exposures and the additional complexity the separation 
entails.
    The New Accord identifies five sub-classes of specialized lending 
for which the primary source of repayment of the obligation is the 
income generated by the financed asset(s) rather than the independent 
capacity of a broader commercial enterprise. The sub-classes are 
project finance, object finance, commodities finance, income-producing 
real estate, and HVCRE. The New Accord provides a methodology to 
accommodate banks that cannot meet the requirements for the estimation 
of PD for these exposure types. The sophisticated banks that would 
apply the advanced approaches in the United States should be able to 
estimate risk parameters for specialized lending exposures, and 
therefore the agencies are not proposing a separate treatment for 
specialized lending beyond the separate IRB risk-based capital formula 
for HVCRE exposures specified in the New Accord.
    In contrast to the New Accord, the agencies are not including in 
this proposed rule an adjustment that would result in a lower risk 
weight for a loan to a small- and medium-size enterprise (SME) that has 
the same risk parameter values as a loan to a larger firm. The agencies 
are not aware of compelling evidence that smaller firms with the same 
PD and LGD as larger firms are subject to less systematic risk. 
Question 25: The agencies request comment and supporting evidence on 
the consistency of the proposed treatment with the underlying riskiness 
of SME portfolios. Further, the agencies request comment on any 
competitive issues that this aspect of the proposed rule may cause for 
U.S. banks.
2. Retail Exposures
    Under the proposed rule, a retail exposure would generally include 
exposures (other than securitization exposures or equity exposures) to 
an individual or small business that are managed as part of a segment 
of similar exposures, that is, not on an individual-exposure basis. 
Under the proposed rule, there are three subcategories of retail 
exposure: (i) Residential mortgage exposures; (ii) QREs; and (iii) 
other retail exposures. The agencies propose generally to define 
residential mortgage exposure as an exposure that is primarily secured 
by a first or subsequent lien on one-to-four-family residential 
property.\42\ This includes both term loans and revolving home equity 
lines of credit (HELOCs). An exposure primarily secured by a first or 
subsequent lien on residential property that is not one-to-four family 
would also be included as a residential mortgage exposure as long as 
the exposure has both an original and current outstanding amount of no 
more than $1 million. There would be no upper limit on the size of an 
exposure that is secured by one-to-four-family residential properties. 
To be a residential mortgage exposure, the bank must manage the 
exposure as part of a segment of exposures with homogeneous risk 
characteristics. Residential mortgage loans that are managed on an 
individual basis, rather than managed as part of a segment, would be 
categorized as wholesale exposures.
---------------------------------------------------------------------------

    \42\ The proposed rule excludes from the definition of a 
residential mortgage exposure certain pre-sold one-to-four family 
residential construction loans and certain multi-family residential 
loans. The treatment of such loans is discussed below in section 
V.B.5. of the preamble.
---------------------------------------------------------------------------

    QREs would be defined as exposures to individuals that are (i) 
revolving, unsecured, and unconditionally cancelable by the bank to the 
fullest extent permitted by Federal law; (ii) have a maximum exposure 
amount (drawn plus undrawn) of up to $100,000; and (iii) are managed as 
part of a segment with homogeneous risk characteristics. In practice, 
QREs typically would include exposures where customers' outstanding 
borrowings are permitted to fluctuate based on their decisions to 
borrow and repay, up to a limit established by the bank. Most credit 
card exposures to individuals and overdraft lines on individual 
checking accounts would be QREs.
    The category of other retail exposures would include two types of 
exposures. First, all exposures to individuals for non-business 
purposes (other than residential mortgage exposures and QREs) that are 
managed as part of a segment of similar exposures would be other retail 
exposures. Such exposures may include personal term loans, margin 
loans, auto loans and leases, credit card accounts with credit lines 
above $100,000, and student loans. The agencies are not proposing an 
upper limit on the size of these types of retail exposures to 
individuals. Second, exposures to individuals or companies for business 
purposes (other than residential mortgage exposures and QREs), up to a 
single-borrower exposure threshold of $1 million, that are managed as 
part of a segment of similar exposures would be other retail exposures. 
For the purpose of assessing exposure to a single borrower, the bank 
would aggregate all business exposures to a particular legal entity and 
its affiliates that are consolidated under GAAP. If that legal entity 
is a natural person, any consumer loans (for example, personal credit 
card loans or mortgage loans) to that borrower would not be part of the 
aggregate. A bank could distinguish a consumer loan from a business 
loan by the loan department through which the loan is made. Exposures 
to a borrower for business purposes primarily secured by residential 
property would count toward the $1 million single-borrower other retail 
business exposure threshold.\43\
---------------------------------------------------------------------------

    \43\ The proposed rule excludes from the definition of an other 
retail exposure certain pre-sold one-to-four family residential 
construction loans and certain multi-family residential loans. The 
treatment of such loans is discussed below in section V.B.5. of the 
preamble.
---------------------------------------------------------------------------

    The residual value portion of a retail lease exposure is excluded 
from the definition of an other retail exposure. A bank would assign 
the residual value portion of a retail lease exposure a risk-weighted 
asset amount equal to its residual value as described in section 31 of 
the proposed rule.
3. Securitization Exposures
    The proposed rule defines a securitization exposure as an on-
balance sheet or off-balance sheet credit exposure that arises from a 
traditional or synthetic securitization. A traditional securitization 
is a transaction in which (i) all or a portion of the credit risk of 
one or more underlying exposures is transferred to one or more third 
parties other than through the use of credit derivatives or guarantees; 
(ii) the credit risk associated with the underlying exposures has been 
separated into at least two tranches reflecting different levels of 
seniority; (iii) performance of the securitization exposures depends on 
the performance of the underlying exposures; and (iv) all or 
substantially all of the underlying exposures are financial exposures. 
Examples of financial exposures are loans, commitments, receivables, 
asset-backed securities, mortgage-backed securities, corporate bonds, 
equity securities, or credit derivatives. For purposes of the proposed 
rule, mortgage-backed pass-through securities guaranteed by Fannie Mae 
or Freddie Mac (whether or not issued out of a structure that tranches 
credit risk) also would be securitization exposures.\44\
---------------------------------------------------------------------------

    \44\ In addition, margin loans and other credit exposures to 
personal investment companies, all or substantially all of whose 
assets are financial exposures, typically would meet the definition 
of a securitization exposure.

---------------------------------------------------------------------------

[[Page 55860]]

    A synthetic securitization is a transaction in which (i) all or a 
portion of the credit risk of one or more underlying exposures is 
transferred to one or more third parties through the use of one or more 
credit derivatives or guarantees (other than a guarantee that transfers 
only the credit risk of an individual retail exposure); (ii) the credit 
risk associated with the underlying exposures has been separated into 
at least two tranches reflecting different levels of seniority; (iii) 
performance of the securitization exposures depends on the performance 
of the underlying exposures; and (iv) all or substantially all of the 
underlying exposures are financial exposures. Accordingly, the proposed 
definition of a securitization exposure would include tranched cover or 
guarantee arrangements--that is, arrangements in which an entity 
transfers a portion of the credit risk of an underlying exposure to one 
or more other guarantors or credit derivative providers but also 
retains a portion of the credit risk, where the risk transferred and 
the risk retained are of different seniority levels.\45\
---------------------------------------------------------------------------

    \45\ If a bank purchases an asset-backed security issued by a 
securitization SPE and purchases a credit derivative to protect 
itself from credit losses associated with the asset-backed security, 
the purchase of the credit derivative by the investing bank does not 
turn the traditional securitization into a synthetic securitization. 
Instead, under the proposal, the investing bank would be viewed as 
having purchased a traditional securitization exposure and would 
reflect the CRM benefits of the credit derivative through the 
securitization CRM rules described later in the preamble and in 
section 46 of the proposed rule.
---------------------------------------------------------------------------

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

[[Page 55861]]

when a purchase was intended, would be treated as operational losses.
    The agencies generally propose to treat losses that are related to 
both operational risk and credit risk as credit losses for purposes of 
calculating risk-based capital requirements. For example, where a loan 
defaults (credit risk) and the bank discovers that the collateral for 
the loan was not properly secured (operational risk), the bank's 
resulting loss would be attributed to credit risk (not operational 
risk). This general separation between credit and operational risk is 
supported by current U.S. accounting standards for the treatment of 
credit risk.
    The proposed exception to this standard is retail credit card fraud 
losses. More specifically, retail credit card losses arising from non-
contractual, third party-initiated fraud (for example, identity theft) 
are to be treated as external fraud operational losses under this 
proposed rule. All other third party-initiated losses are to be treated 
as credit losses. Based on discussions with the industry, this 
distinction is consistent with prevailing practice in the credit card 
industry, with banks commonly considering these losses to be 
operational losses and treating them as such for risk management 
purposes.
    Question 27: The agencies seek commenters' perspectives on other 
loss types for which the boundary between credit and operational risk 
should be evaluated further (for example, with respect to losses on 
HELOCs).
6. Boundary Between the Proposed Rule and the Market Risk Amendment 
(MRA)
    Positions currently subject to the MRA include all positions 
classified as trading consistent with GAAP. The New Accord sets forth 
additional criteria for positions to be eligible for application of the 
MRA. The agencies propose to incorporate these additional criteria into 
the MRA through a separate notice of proposed rulemaking concurrently 
published in the Federal Register. Advanced approaches banks subject to 
the MRA would use the MRA as amended for trading exposures eligible for 
application of the MRA. Advanced approaches banks not subject to the 
MRA would use this proposed rule for all of their exposures. Question 
28: The agencies generally seek comment on the proposed treatment of 
the boundaries between credit, operational, and market risk.

B. Risk-Weighted Assets for General Credit Risk (Wholesale Exposures, 
Retail Exposures, On-Balance Sheet Assets That Are Not Defined by 
Exposure Category, and Immaterial Credit Portfolios)

    Under the proposed rule, the wholesale and retail risk-weighted 
assets calculation consists of four phases: (1) Categorization of 
exposures; (2) assignment of wholesale exposures to rating grades and 
segmentation of retail exposures; (3) assignment of risk parameters to 
wholesale obligors and exposures and segments of retail exposures; and 
(4) calculation of risk-weighted asset amounts. Phase 1 involves the 
categorization of a bank's exposures into four general categories--
wholesale exposures, retail exposures, securitization exposures, and 
equity exposures. Phase 1 also involves the further classification of 
retail exposures into subcategories and identifying certain wholesale 
exposures that receive a specific treatment within the wholesale 
framework. Phase 2 involves the assignment of wholesale obligors and 
exposures to rating grades and the segmentation of retail exposures. 
Phase 3 requires the bank to assign a PD, ELGD, LGD, EAD, and M to each 
wholesale exposure and a PD, ELGD, LGD, and EAD to each segment of 
retail exposures. In phase 4, the bank calculates the risk-weighted 
asset amount (i) for each wholesale exposure and segment of retail 
exposures by inserting the risk parameter estimates into the 
appropriate IRB risk-based capital formula and multiplying the 
formula's dollar risk-based capital requirement output by 12.5; and 
(ii) for on-balance sheet assets that are not included in one of the 
defined exposure categories and for certain immaterial portfolios of 
exposures by multiplying the carrying value or notional amount of the 
exposures by a 100 percent risk weight.
1. Phase 1--Categorization of Exposures
    In phase 1, a bank must determine which of its exposures fall into 
each of the four principal IRB exposure categories--wholesale 
exposures, retail exposures, securitization exposures, and equity 
exposures. In addition, a bank must identify within the wholesale 
exposure category certain exposures that receive a special treatment 
under the wholesale framework. These exposures include HVCRE exposures, 
sovereign exposures, eligible purchased wholesale receivables, eligible 
margin loans, repo-style transactions, OTC derivative contracts, 
unsettled transactions, and eligible guarantees and eligible credit 
derivatives that are used as credit risk mitigants.
    The treatment of HVCRE exposures and eligible purchased wholesale 
receivables is discussed below in this section. The treatment of 
eligible margin loans, repo-style transactions, OTC derivative 
contracts, and eligible guarantees and eligible credit derivatives that 
are credit risk mitigants is discussed in section V.C. of the preamble. 
In addition, sovereign exposures and exposures to or directly and 
unconditionally guaranteed by the Bank for International Settlements, 
the International Monetary Fund, the European Commission, the European 
Central Bank, and multi-lateral development banks \46\ are exempt from 
the 0.03 percent floor on PD discussed in the next section.
---------------------------------------------------------------------------

    \46\ Multi-lateral development bank is defined as any multi-
lateral lending institution or regional development bank in which 
the U.S. government is a shareholder or contributing member. These 
institutions currently are the International Bank for Reconstruction 
and Development, the International Finance Corporation, the Inter-
American Development Bank, the Asian Development Bank, the African 
Development Bank, and the European Bank for Reconstruction and 
Development.
---------------------------------------------------------------------------

    In phase 1, a bank also must subcategorize its retail exposures as 
residential mortgage exposures, QREs, or other retail exposures. In 
addition, a bank must identify any on-balance sheet asset that does not 
meet the definition of a wholesale, retail, securitization, or equity 
exposure, as well as any non-material portfolio of exposures to which 
it chooses, subject to supervisory review, not to apply the IRB risk-
based capital formulas.
2. Phase 2 Assignment of Wholesale Obligors and Exposures to Rating 
Grades and Retail Exposures to Segments
    In phase 2, a bank must assign each wholesale obligor to a single 
rating grade (for purposes of assigning an estimated PD) and may assign 
each wholesale exposure to loss severity rating grades (for purposes of 
assigning an estimated ELGD and LGD). A bank that elects not use a loss 
severity rating grade system for a wholesale exposure will directly 
assign ELGD and LGD to the wholesale exposure in phase 3. As a part of 
the process of assigning wholesale obligors to rating grades, a bank 
must identify which of its wholesale obligors are in default.
    In addition, a bank must divide its retail exposures within each 
retail subcategory into segments that have homogeneous risk 
characteristics.\47\

[[Page 55862]]

Segmentation is the grouping of exposures within each subcategory 
according to the predominant risk characteristics of the borrower (for 
example, credit score, debt-to-income ratio, and delinquency) and the 
exposure (for example, product type and LTV ratio). In general, retail 
segments should not cross national jurisdictions. A bank would have 
substantial flexibility to use the retail portfolio segmentation it 
believes is most appropriate for its activities, subject to the 
following broad principles:
---------------------------------------------------------------------------

    \47\ A bank must segment defaulted retail exposures separately 
from non-defaulted retail exposures and, if the bank determines the 
EAD for eligible margin loans using the approach in section 32(a) of 
the proposed rule, it must segment retail eligible margin loans for 
which the bank uses this approach separately from other retail 
exposures.
---------------------------------------------------------------------------

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

[[Page 55863]]

3. Phase 3--Assignment of Risk Parameters to Wholesale Obligors and 
Exposures and Retail Segments
    In phase 3, a bank would associate a PD with each wholesale obligor 
rating grade; associate an ELGD or LGD with each wholesale loss 
severity rating grade or assign an ELGD and LGD to each wholesale 
exposure; assign an EAD and M to each wholesale exposure; and assign a 
PD, ELGD, LGD, and EAD to each segment of retail exposures. The 
quantification phase can generally be divided into four steps--
obtaining historical reference data, estimating the risk parameters for 
the reference data, mapping the historical reference data to the bank's 
current exposures, and determining the risk parameters for the bank's 
current exposures.
    A bank should base its estimation of the values assigned to PD, 
ELGD, LGD, and EAD \48\ on historical reference data that are a 
reasonable proxy for the bank's current exposures and that provide 
meaningful predictions of the performance of such exposures. A 
``reference data set'' consists of a set of exposures to defaulted 
wholesale obligors and defaulted retail exposures (in the case of ELGD, 
LGD, and EAD estimation) or to both defaulted and non-defaulted 
wholesale obligors and retail exposures (in the case of PD estimation).
---------------------------------------------------------------------------

    \48\ EAD for repo-style transactions, eligible margin loans, and 
OTC derivatives is calculated as described in section 32 of the 
proposed rule.
---------------------------------------------------------------------------

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

[[Page 55864]]

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

[[Page 55865]]

exposures and retail segments, the bank would calculate the dollar 
risk-based capital requirement for each wholesale exposure to a non-
defaulted obligor or segment of non-defaulted retail exposures (except 
eligible guarantees and eligible credit derivatives that hedge another 
wholesale exposure and exposures to which the bank is applying the 
double default treatment in section 34 of the proposed rule) by 
inserting the risk parameters for the wholesale obligor and exposure or 
retail segment into the appropriate IRB risk-based capital formula 
specified in Table C and multiplying the output of the formula (K) by 
the EAD of the exposure or segment. Eligible guarantees and eligible 
credit derivatives that are hedges of a wholesale exposure would be 
reflected in the risk-weighted assets amount of the hedged exposure (i) 
through adjustments made to the risk parameters of the hedged exposure 
under the PD substitution or LGD adjustment approach in section 33 of 
the proposed rule or (ii) through a separate double default risk-based 
capital requirement formula in section 34 of the proposed rule.
[GRAPHIC] [TIFF OMITTED] TP25SE06.077

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

[[Page 55866]]

dollar risk-based capital requirement for the exposure is K for the 
exposure (as determined in Table C immediately before the obligor 
became defaulted), multiplied by the EAD of the exposure. The reason 
for this comparison is to ensure that a bank does not receive a 
regulatory capital benefit as a result of the exposure moving from non-
defaulted to defaulted status.
    The proposed rule provides a simpler approach for segments of 
defaulted retail exposures. The dollar risk-based capital requirement 
for a segment of defaulted retail exposures equals 0.08 multiplied by 
the EAD of the segment. The agencies are proposing this uniform 8 
percent risk-based capital requirement for defaulted retail exposures 
to ease implementation burden on banks and in light of accounting and 
other supervisory policies in the retail context that would help 
prevent the sum of a bank's ECL and risk-based capital requirement for 
a retail exposure from declining at the time of default.
    To convert the dollar risk-based capital requirements to a risk-
weighted asset amount, the bank would sum the dollar risk-based capital 
requirements for all wholesale exposures to defaulted obligors and 
segments of defaulted retail exposures and multiply the sum by 12.5.
    A bank could assign a risk-weighted asset amount of zero to cash 
owned and held in all offices of the bank or in transit, and for gold 
bullion held in the bank's own vaults or held in another bank's vaults 
on an allocated basis, to the extent it is offset by gold bullion 
liabilities. On-balance-sheet assets that do not meet the definition of 
a wholesale, retail, securitization, or equity exposure--for example, 
property, plant, and equipment and mortgage servicing rights--and 
portfolios of exposures that the bank has demonstrated to its primary 
Federal supervisor's satisfaction are, when combined with all other 
portfolios of exposures that the bank seeks to treat as immaterial for 
risk-based capital purposes, not material to the bank generally would 
be assigned risk-weighted asset amounts equal to their carrying value 
(for on-balance-sheet exposures) or notional amount (for off-balance-
sheet exposures). For this purpose, the notional amount of an OTC 
derivative contract that is not a credit derivative is the EAD of the 
derivative as calculated in section 32 of the proposed rule.
    Total wholesale and retail risk-weighted assets would be the sum of 
risk-weighted assets for wholesale exposures to non-defaulted obligors 
and segments of non-defaulted retail exposures, wholesale exposures to 
defaulted obligors and segments of defaulted retail exposures, assets 
not included in an exposure category, non-material portfolios of 
exposures, and unsettled transactions minus the amounts deducted from 
capital pursuant to the general risk-based capital rules (excluding 
those deductions reversed in section 12 of the proposed rule).
5. Statutory Provisions on the Regulatory Capital Treatment of Certain 
Mortgage Loans
    The general risk-based capital rules assign 50 and 100 percent risk 
weights to certain one- to four-family residential pre-sold 
construction loans and multifamily residential loans.\49\ The agencies 
adopted these provisions as a result of the Resolution Trust 
Corporation Refinancing, Restructuring, and Improvement Act of 1991 
(RTCRRI Act).\50\ The RTCRRI Act mandates that each agency provide in 
its capital regulations (i) a 50 percent risk weight for certain one- 
to four-family residential pre-sold construction loans and multifamily 
residential loans that meet specific statutory criteria set forth in 
the Act and any other underwriting criteria imposed by the agencies; 
and (ii) a 100 percent risk weight for one- to four-family residential 
pre-sold construction loans for residences for which the purchase 
contract is cancelled.\51\
---------------------------------------------------------------------------

    \49\ See 12 CFR part 3, Appendix A, section 3(a)(3)(iii) 
(national banks); 12 CFR part 208, Appendix A, section III.C.3. 
(state member banks); 12 CFR part 225, Appendix A, section III.C.3. 
(bank holding companies); 12 CFR part 325, Appendix A, section 
II.C.a. (state nonmember banks); 12 CFR 567.6(a)(1)(iii) and (iv) 
(savings associations).
    \50\ See sections 618(a) and (b) of the RTCRRI Act. The first 
class includes loans for the construction of a residence consisting 
of 1- to 4-family dwelling units that have been pre-sold under firm 
contracts to purchasers who have obtained firm commitments for 
permanent qualifying mortgages and have made substantial earnest 
money deposits. The second class includes loans that are secured by 
a first lien on a residence consisting of more than 4 dwelling units 
if the loan meets certain criteria outlined in the RTCRRI Act.
    \51\ See sections 618(a) and (b) of the RTCRRI Act.
---------------------------------------------------------------------------

    When Congress enacted the RTCRRI Act in 1991, the agencies' risk-
based capital rules reflected the Basel I framework. Consequently, the 
risk weight treatment for certain categories of mortgage loans in the 
RTCRRI Act assumes a risk weight bucketing approach, instead of the 
more risk-sensitive IRB approach in the Basel II framework.
    For purposes of this proposed rule implementing the Basel II IRB 
approach, the agencies are proposing that the three types of 
residential mortgage loans addressed by the RTCRRI Act should continue 
to receive the risk weights provided in the Act. Specifically, 
consistent with the general risk-based capital rules, the proposed rule 
requires a bank to use the following risk weights (instead of the risk 
weights that would otherwise be produced under the IRB risk-based 
capital formulas): (i) A 50 percent risk weight for one- to four-family 
residential construction loans if the residences have been pre-sold 
under firm contracts to purchasers who have obtained firm commitments 
for permanent qualifying mortgages and have made substantial earnest 
money deposits, and the loans meet the other underwriting 
characteristics established by the agencies in the general risk-based 
capital rules; \52\ (ii) a 50 percent risk weight for multifamily 
residential loans that meet certain statutory loan-to-value, debt-to-
income, amortization, and performance requirements, and meet the other 
underwriting characteristics established by the agencies in the general 
risk-based capital rules; \53\ and (iii) a 100 percent risk weight for 
one- to four-family residential pre-sold construction loans for a 
residence for which the purchase contract is canceled.\54\ Mortgage 
loans that do not meet the relevant criteria do not qualify for the 
statutory risk weights and will be risk-weighted according to the IRB 
risk-based capital formulas.
---------------------------------------------------------------------------

    \52\ See section 618(a)(1)((B) of the RTCRRI Act.
    \53\ See section 618(b)(1)(B) of the RTCRRI Act.
    \54\ See section 618(a)(2) of the RTCRRI Act.
---------------------------------------------------------------------------

    The agencies understand that there is a tension between the 
statutory risk weights provided by the RTCRRI Act and the more risk-
sensitive IRB approaches to risk-based capital that are contained in 
this proposed rule. Question 32: The agencies seek comment on whether 
the agencies should impose the following underwriting criteria as 
additional requirements for a Basel II bank to qualify for the 
statutory 50 percent risk weight for a particular mortgage loan: (i) 
That the bank has an IRB risk measurement and management system in 
place that assesses the PD and LGD of prospective residential mortgage 
exposures; and (ii) that the bank's IRB system generates a 50 percent 
risk weight for the loan under the IRB risk-based capital formulas. The 
agencies note that a capital-related provision of the Federal Deposit 
Insurance Corporation Improvement Act of 1991 (FDICIA), enacted by 
Congress just four days after its adoption of the RTCRRI Act, directs 
each agency to revise its risk-based capital standards for DIs to 
ensure that those standards ``reflect the

[[Page 55867]]

actual performance and expected risk of loss of multifamily 
mortgages.'' \55\
---------------------------------------------------------------------------

    \55\ Section 305(b)(1)(B) of FDICIA (12 U.S.C. 1828 notes).
---------------------------------------------------------------------------

    Question 33: The agencies seek comment on all aspects of the 
proposed treatment of one- to four-family residential pre-sold 
construction loans and multifamily residential loans.

C. Credit Risk Mitigation (CRM) Techniques

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

[[Page 55868]]



                                                     Table D
----------------------------------------------------------------------------------------------------------------
                                                                                            Models approach
                                                             Current     Collateral  ---------------------------
                                                            exposure       haircut     Simple VaR     Internal
                                                           methodology    approach        \56\         models
                                                                                       methodology   methodology
----------------------------------------------------------------------------------------------------------------
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 determining EAD for counterparty 
credit risk and recognizing collateral mitigating that risk, the 
proposed rule allows banks to take into account only financial 
collateral, which, by definition, does not include debt securities that 
have an external rating lower than one rating category below investment 
grade. The agencies invite comment on the extent to which lower-rated 
debt securities or other securities that do not meet the definition of 
financial collateral are used in these transactions and on the CRM 
value of such securities.
---------------------------------------------------------------------------

    \56\ Only repo-style transactions and eligible margin loans 
subject to a single-product qualifying master netting agreement are 
eligible for the simple VaR methodology.
    \57\ In conjunction with the current exposure methodology.
---------------------------------------------------------------------------

    EAD for repo-style transactions and eligible margin loans. Under 
the proposal, a bank could recognize the risk mitigating effect of 
financial collateral that secures a repo-style transaction, eligible 
margin loan, or single-product group of such transactions with a single 
counterparty subject to a qualifying master netting agreement (netting 
set) through an adjustment to EAD rather than ELGD and LGD. The bank 
may use a collateral haircut approach or one of two models approaches: 
a simple VaR methodology (for single-product netting sets of repo-style 
transactions or eligible margin loans) or an internal models 
methodology. Figure 2 illustrates the methodologies available for 
calculating EAD and LGD for eligible margin loans and repo-style 
transactions.
    The proposed rule defines repo-style transaction as a repurchase or 
reverse repurchase transaction, or a securities borrowing or securities 
lending transaction (including a transaction in which the bank acts as 
agent for a customer and indemnifies the customer against loss), 
provided that:
    (i) The transaction is based solely on liquid and readily 
marketable securities or cash;
    (ii) The transaction is marked to market daily and subject to daily 
margin maintenance requirements;
    (iii) The transaction is executed under an agreement that provides 
the bank the right to accelerate, terminate, and close-out the 
transaction on a net basis and to liquidate or set off collateral 
promptly upon an event of default (including upon an event of 
bankruptcy, insolvency, or similar proceeding) of the counterparty, 
provided that, in any such case, any exercise of rights under the 
agreement will not be stayed or avoided under applicable law in the 
relevant jurisdictions; \58\ and
---------------------------------------------------------------------------

    \58\ This requirement is met where all transactions under the 
agreement are (i) executed under U.S. law and (ii) constitute 
``securities contracts'' or ``repurchase agreements'' under section 
555 or 559, respectively, of the Bankruptcy Code (11 U.S.C. 555 or 
559), qualified financial contracts under section 11(e)(8) of the 
Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or netting 
contracts between or among financial institutions under sections 
401-407 of the Federal Deposit Insurance Corporation Improvement Act 
of 1991 (12 U.S.C. 4401-4407) or the Federal Reserve Board's 
Regulation EE (12 CFR part 231).

---------------------------------------------------------------------------

[[Page 55869]]

[GRAPHIC] [TIFF OMITTED] TP25SE06.078

    (iv) The bank has conducted and documented sufficient legal review 
to conclude with a well-founded basis that the agreement meets the 
requirements of paragraph (iii) of this definition and is legal, valid, 
binding, and enforceable under applicable law in the relevant 
jurisdictions.
    Question 35: The agencies recognize that criterion (iii) above may 
pose challenges for certain transactions that would not be eligible for 
certain exemptions from bankruptcy or receivership laws because the 
counterparty--for example, a sovereign entity or a pension fund--is not 
subject to such laws. The agencies seek comment on ways this criterion 
could be crafted to accommodate such transactions when justified on 
prudential grounds, while ensuring that the requirements in criterion 
(iii) are met for transactions that are eligible for those exemptions.
    The proposed rule defines an eligible margin loan as an extension 
of credit where:
    (i) The credit extension is collateralized exclusively by debt or 
equity securities that are liquid and readily marketable;
    (ii) The collateral is marked to market daily and the transaction 
is subject to daily margin maintenance requirements;
    (iii) The extension of credit is conducted under an agreement that 
provides the bank the right to accelerate and terminate the extension 
of credit and to liquidate or set off collateral promptly upon an event 
of default (including upon an event of bankruptcy, insolvency, or 
similar proceeding) of the counterparty, provided that, in any such 
case, any exercise of rights under the agreement will not be stayed or 
avoided under applicable law in the relevant jurisdictions;\59\ and
---------------------------------------------------------------------------

    \59\ This requirement is met under the circumstances described 
in the previous footnote.
---------------------------------------------------------------------------

    (iv) The bank has conducted and documented sufficient legal review 
to conclude with a well-founded basis that the agreement meets the 
requirements of paragraph (iii) of this definition and is legal, valid, 
binding, and enforceable under applicable law in the relevant 
jurisdictions.
    The proposed rule describes various ways that a bank may recognize 
the risk mitigating impact of financial collateral. The proposed rule 
defines financial collateral as collateral in the form of any of the 
following instruments in which the bank has a perfected, first priority 
security interest or the legal equivalent thereof: (i) Cash on deposit 
with the bank (including cash held for the bank by a third-party 
custodian or trustee); (ii) gold bullion; (iii) long-term debt 
securities that have an applicable external rating of one category 
below investment grade or higher (for example, at least BB-); (iv) 
short-term debt instruments that have an applicable external rating of 
at least investment grade (for example, at least A-3); (v) equity 
securities that are publicly traded; (vi) convertible bonds that are 
publicly traded; and (vii) mutual fund shares for which a share price 
is publicly quoted daily and money market mutual fund shares. Question 
36: The agencies seek comment on the appropriateness of requiring that 
a bank have a perfected, first priority security interest, or the legal 
equivalent thereof, in the definition of financial collateral.
    The proposed rule defines an external rating as a credit rating 
assigned by a nationally recognized statistical rating organization 
(NRSRO) to an exposure that fully reflects the entire amount of credit 
risk the holder of the exposure has with regard to all payments owed to 
it under the exposure. For example, if a holder is owed principal and 
interest on an exposure, the external rating must

[[Page 55870]]

fully reflect the credit risk associated with timely repayment of 
principal and interest. Moreover, the external rating must be published 
in an accessible form and must be included in the transition matrices 
made publicly available by the NRSRO that summarize the historical 
performance of positions it has rated.\60\ Under the proposed rule, an 
exposure's applicable external rating is the lowest external rating 
assigned to the exposure by any NRSRO.
---------------------------------------------------------------------------

    \60\ Banks should take particular care with these requirements 
where the financial collateral is in the form of a securitization 
exposure.
---------------------------------------------------------------------------

    Collateral haircut approach. Under the collateral haircut approach, 
a bank would set EAD equal to the sum of three quantities: (i) The 
value of the exposure less the value of the collateral; (ii) the 
absolute value of the net position in a given security (where the net 
position in a given security equals the sum of the current market 
values of the particular security the bank has lent, sold subject to 
repurchase, or posted as collateral to the counterparty minus the sum 
of the current market values of that same security the bank has 
borrowed, purchased subject to resale, or taken as collateral from the 
counterparty) multiplied by the market price volatility haircut 
appropriate to that security; and (iii) the sum of the absolute values 
of the net position of both cash and securities in each currency that 
is different from the settlement currency multiplied by the haircut 
appropriate to each currency mismatch. To determine the appropriate 
haircuts, a bank could choose to use standard supervisory haircuts or 
its own estimates of haircuts. For purposes of the collateral haircut 
approach, a given security would include, for example, all securities 
with a single Committee on Uniform Securities Identification Procedures 
(CUSIP) number and would not include securities with different CUSIP 
numbers, even if issued by the same issuer with the same maturity date. 
Question 37: The agencies recognize that this is a conservative 
approach and seek comment on other approaches to consider in 
determining a given security for purposes of the collateral haircut 
approach.

Standard Supervisory Haircuts

    If a bank chooses to use standard supervisory haircuts, it would 
use an 8 percent haircut for each currency mismatch and the haircut 
appropriate to each security in table E below. These haircuts are based 
on the 10-business-day holding period for eligible margin loans and may 
be multiplied by the square root of \1/2\ to convert the standard 
supervisory haircuts to the 5-business-day minimum holding period for 
repo-style transactions. A bank must adjust the standard supervisory 
haircuts upward on the basis of a holding period longer than 10 
business days for eligible margin loans or 5 business days for repo-
style transactions where and as appropriate to take into account the 
illiquidity of an instrument.

                         Table E.--Standard Supervisory Market Price Volatility Haircuts
----------------------------------------------------------------------------------------------------------------
                                                                               Issuers exempt
  Applicable external rating grade    Residual maturity for debt securities    from the 3 b.p.    Other issuers
    category for debt securities                                                    floor
----------------------------------------------------------------------------------------------------------------
Two highest investment grade rating  <=1 year...............................              .005               .01
 categories for long-term ratings/   >1 year, <=5 years.....................               .02               .04
 highest investment grade rating     >5 years...............................               .04               .08
 category for short-term ratings.
----------------------------------------------------------------------------------------------------------------
Two lowest investment grade rating   <=1 year...............................               .01               .02
 categories for both short- and      >1 year, <=5 years.....................               .03               .06
 long-term ratings.                  >5 years...............................               .06               .12
----------------------------------------------------------------------------------------------------------------
One rating category below            All....................................               .15               .25
 investment grade.
----------------------------------------------------------------------------------------------------------------
Main index equities \61\ (including                             .15
 convertible bonds) and gold.
----------------------------------------------------------------------------------------------------------------
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 deposit0issued by
 the bank).
----------------------------------------------------------------------------------------------------------------

    As an example, assume a bank that uses standard supervisory 
haircuts has extended an eligible margin loan of $100 that is 
collateralized by 5-year U.S. Treasury notes with a market value of 
$100. The value of the exposure less the value of the collateral would 
be zero, and the net position in the security ($100) times the 
supervisory haircut (.02) would be $2. There is no currency mismatch. 
Therefore, the EAD of the exposure would be $0 + $2 = $2.
---------------------------------------------------------------------------

    \61\ The proposed rule defines a ``main index'' as the S&P 500 
Index, the FTSE All-World Index, and any other index for which the 
bank demonstrates to the satisfaction of its primary Federal 
supervisor that the equities represented in the index have 
comparable liquidity, depth of market, and size of bid-ask spreads 
as equities in the S&P 500 Index and the FTSE All-World Index.
---------------------------------------------------------------------------

    Own estimates of haircuts. With the prior written approval of the 
bank's primary Federal supervisor, a bank may calculate security type 
and currency mismatch haircuts using its own internal estimates of 
market price volatility and foreign exchange volatility. The bank's 
primary Federal supervisor would base approval to use internally 
estimated haircuts on the satisfaction of certain minimum qualitative 
and quantitative standards. These standards include: (i) The bank must 
use a 99th percentile one-tailed confidence interval and a minimum 5-
business-day holding period for repo-style transactions and a minimum 
10-business-day holding period for all other transactions; (ii) the 
bank must adjust holding periods upward where and as appropriate to 
take into account the illiquidity of an instrument; (iii) the bank must 
select a historical observation period for calculating haircuts of at 
least one year; and (iv) the bank must update its data sets and 
recompute haircuts no less frequently than quarterly and must update 
its data sets and recompute haircuts whenever market prices change 
materially. A bank must estimate

[[Page 55871]]

individually the volatilities of the exposure, the collateral, and 
foreign exchange rates, and may not take into account the correlations 
between them.
    A bank that uses internally estimated haircuts would have to adhere 
to the following rules. The bank may calculate internally estimated 
haircuts for categories of debt securities that have an applicable 
external rating of at least investment grade. The haircut for a 
category of securities would have to be representative of the internal 
volatility estimates for securities in that category that the bank has 
actually lent, sold subject to repurchase, posted as collateral, 
borrowed, purchased subject to resale, or taken as collateral. In 
determining relevant categories, the bank would have to take into 
account (i) the type of issuer of the security; (ii) the applicable 
external rating of the security; (iii) the maturity of the security; 
and (iv) the interest rate sensitivity of the security. A bank would 
calculate a separate internally estimated haircut for each individual 
debt security that has an applicable external rating below investment 
grade and for each individual equity security. In addition, a bank 
would internally estimate a separate currency mismatch haircut for each 
individual mismatch between each net position in a currency that is 
different from the settlement currency.
    When a bank calculates an internally estimated haircut on a 
TN-day holding period, which is different from the minimum 
holding period for the transaction type, the applicable haircut 
(HM) must be calculated using the following square root of 
time formula:
[GRAPHIC] [TIFF OMITTED] TP25SE06.039

Where:

(i) TM = 5 for repo-style transactions and 10 for 
eligible margin loans;
(ii) TN = holding period used by the bank to derive 
HN; and
(iii) HN = haircut based on the holding period 
TN.

    Simple VaR methodology. As noted above, a bank may use one of two 
internal models approaches to recognize the risk mitigating effects of 
financial collateral that secures a repo-style transaction or eligible 
margin loan. This section of the preamble describes the simple VaR 
methodology; a later section of the preamble describes the internal 
models methodology (which also may be used to determine the EAD for OTC 
derivative contracts).
    With the prior written approval of its primary Federal supervisor, 
a bank may estimate EAD for repo-style transactions and eligible margin 
loans subject to a single product qualifying master netting agreement 
using a VaR model. Under the simple VaR methodology, a bank's EAD for 
the transactions subject to such a netting agreement would be equal to 
the value of the exposures minus the value of the collateral plus a 
VaR-based estimate of the potential future exposure (PFE), that is, the 
maximum exposure expected to occur on a future date with a high level 
of confidence. The value of the exposures is the sum of the current 
market values of all securities and cash the bank has lent, sold 
subject to repurchase, or posted as collateral to a counterparty under 
the netting set. The value of the collateral is the sum of the current 
market values of all securities and cash the bank has borrowed, 
purchased subject to resale, or taken as collateral from a counterparty 
under the netting set.
    The VaR model must estimate the bank's 99th percentile, one-tailed 
confidence interval for an increase in the value of the exposures minus 
the value of the collateral ([Sigma]E - [Sigma]C) over a 5-business-day 
holding period for repo-style transactions or over a 10-business-day 
holding period for eligible margin loans using a minimum one-year 
historical observation period of price data representing the 
instruments that the bank has lent, sold subject to repurchase, posted 
as collateral, borrowed, purchased subject to resale, or taken as 
collateral.
    The qualifying requirements for the use of a VaR model are less 
stringent than the qualification requirements for the internal models 
methodology described below. The main ongoing qualification requirement 
for using a VaR model is that the bank must validate its VaR model by 
establishing and maintaining a rigorous and regular backtesting regime.
3. EAD for OTC Derivative Contracts
    A bank may use either the current exposure methodology or the 
internal models methodology to determine the EAD for OTC derivative 
contracts. An OTC derivative contract is defined as a derivative 
contract that is not traded on an exchange that requires the daily 
receipt and payment of cash-variation margin. A derivative contract is 
defined to include interest rate derivative contracts, exchange rate 
derivative contracts, equity derivative contracts, commodity derivative 
contracts, credit derivatives, and any other instrument that poses 
similar counterparty credit risks. The proposed rule also would define 
derivative contracts to include unsettled securities, commodities, and 
foreign exchange trades with a contractual settlement or delivery lag 
that is longer than the normal settlement period (which the proposed 
rule defines as the lesser of the market standard for the particular 
instrument or 5 business days). This would include, for example, agency 
mortgage-backed securities transactions conducted in the To-Be-
Announced market.
    Figure 3 illustrates the treatment of OTC derivative contracts.

[[Page 55872]]

[GRAPHIC] [TIFF OMITTED] TP25SE06.079

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

[[Page 55873]]

agencies believe it is no longer appropriate given the evolution of the 
product. The computation of the PFE of multiple OTC derivative 
contracts subject to a qualifying master netting agreement would not 
change from the general risk-based capital rules.
---------------------------------------------------------------------------

    \62\ The counterparty credit risk of a credit derivative that is 
used to hedge the credit risk of an exposure subject to an IRB 
credit risk capital requirement is captured in the IRB treatment of 
the hedged exposure, as detailed in sections 33 and 34 of the 
proposed rule.
---------------------------------------------------------------------------

    If an OTC derivative contract is collateralized by financial 
collateral, a bank would first determine an unsecured EAD as described 
above and in section 32(b) of the proposed rule. To take into account 
the risk-reducing effects of the financial collateral, the bank may 
either adjust the ELGD and LGD of the contract or, if the transaction 
is subject to daily marking-to-market and remargining, adjust the EAD 
of the contract using the collateral haircut approach for repo-style 
transactions and eligible margin loans described above and in section 
32(a) of the proposed rule.
    Under part VI of the proposed rule, a bank must treat an equity 
derivative contract as an equity exposure and compute a risk-weighted 
asset amount for that exposure. If the bank is using the internal 
models approach for its equity exposures, it also must compute a risk-
weighted asset amount for its counterparty credit risk exposure on the 
equity derivative contract. However, if the bank is using the simple 
risk weight approach for its equity exposures, it may choose not to 
hold risk-based capital against the counterparty credit risk of the 
equity derivative contract. Likewise, a bank that purchases a credit 
derivative that is recognized under section 33 or 34 of the proposed 
rule as a credit risk mitigant for an exposure that is not a covered 
position under the MRA does not have to compute a separate counterparty 
credit risk capital requirement for the credit derivative. If a bank 
chooses not to hold risk-based capital against the counterparty credit 
risk of such equity or credit derivative contracts, it must do so 
consistently for all such equity derivative contracts or for all such 
credit derivative contracts. Further, where the contracts are subject 
to a qualifying master netting agreement, the bank must either include 
them all or exclude them all from any measure used to determine 
counterparty credit risk exposure to all relevant counterparties for 
risk-based capital purposes.
    Where a bank provides protection through a credit derivative that 
is not treated as a covered position under the MRA, it must treat the 
credit derivative as a wholesale exposure to the reference obligor and 
compute a risk-weighted asset amount for the credit derivative under 
section 31 of the proposed rule. The bank need not compute a 
counterparty credit risk capital requirement for the credit derivative, 
so long as it does so consistently for all such credit derivatives and 
either includes all or excludes all such credit derivatives that are 
subject to a master netting contract from any measure used to determine 
counterparty credit risk exposure to all relevant counterparties for 
risk-based capital purposes. Where the bank provides protection through 
a credit derivative treated as a covered position under the MRA, it 
must compute a counterparty credit risk capital requirement under 
section 32 of the proposed rule.
4. Internal Models Methodology
    This proposed rule includes an internal models methodology for the 
calculation of EAD for transactions with counterparty credit exposure, 
namely, OTC derivatives, eligible margin loans, and repo-style 
transactions. The internal models methodology requires a risk model 
that captures counterparty credit risk and estimates EAD at the level 
of a ``netting set.'' A netting set is a group of transactions with a 
single counterparty that are subject to a qualifying master netting 
agreement. A transaction not subject to a qualifying master netting 
agreement is considered to be its own netting set and EAD must be 
calculated for each such transaction individually. A bank may use the 
internal models methodology for OTC derivatives (collateralized or 
uncollateralized) and single-product netting sets thereof, for eligible 
margin loans and single-product netting sets thereof, or for repo-style 
transactions and single-product netting sets thereof. A bank that uses 
the internal models methodology for a particular transaction type (that 
is, OTC derivative contracts, eligible margin loans, or repo-style 
transactions) must use the internal models methodology for all 
transactions in that transaction type. However, a bank may choose 
whether or not to use the internal models methodology for each 
transaction type.
    A bank also may use the internal models methodology for OTC 
derivatives, eligible margin loans, and repo-style transactions subject 
to a qualifying cross-product master netting agreement if (i) the bank 
effectively integrates the risk mitigating effects of cross-product 
netting into its risk management and other information technology 
systems; and (ii) the bank obtains the prior written approval of its 
primary Federal supervisor.
    A qualifying cross-product master netting agreement is defined as a 
qualifying master netting agreement that provides for termination and 
close-out netting across multiple types of financial transactions or 
qualifying master netting agreements in the event of a counterparty's 
default, provided that:
    (i) The underlying financial transactions are OTC derivative 
contracts, eligible margin loans, or repo-style transactions; and
    (ii) The bank obtains a written legal opinion verifying the 
validity and enforceability of the netting agreement under applicable 
law of the relevant jurisdictions if the counterparty fails to perform 
upon an event of default, including upon an event of bankruptcy, 
insolvency, or similar proceeding.
    Banks use several measures to manage their exposure to counterparty 
credit risk including PFE, expected exposure (EE), and expected 
positive exposure (EPE). PFE is the maximum exposure estimated to occur 
on a future date at a high level of statistical confidence. Banks often 
use PFE when measuring counterparty credit risk exposure against 
counterparty credit limits. EE is the probability-weighted average 
exposure to a counterparty estimated to exist at any specified future 
date, whereas EPE is the time-weighted average of individual expected 
exposures estimated for a given forecasting horizon (one year in the 
proposed rule). Banks typically compute EPE, EE, and PFE using a common 
stochastic model.
    A paper published by the BCBS in July 2005 titled ``The Application 
of Basel II to Trading Activities and the Treatment of Double Default 
Effects'' notes that EPE is an appropriate EAD measure for determining 
risk-based capital requirements for counterparty credit risk because 
transactions with counterparty credit risk ``are given the same 
standing as loans with the goal of reducing the capital treatment's 
influence on a firm's decision to extend an on-balance sheet loan 
rather than engage in an economically equivalent transaction that 
involves exposure to counterparty credit risk.''\63\ An adjustment to 
EPE, called effective EPE and described below, is used in the 
calculation of EAD under the internal models methodology. EAD is 
calculated as a multiple of effective EPE.
---------------------------------------------------------------------------

    \63\ BCBS, ``The Application of Basel II to Trading Activities 
and the Treatment of Double Default Effects,'' July 2005, ] 15.
---------------------------------------------------------------------------

    To address the concern that EE and EPE may not capture risk arising 
from the replacement of existing short-term positions over the one year 
horizon used for capital requirements (that is, rollover risk) or may 
underestimate the exposures of eligible margin loans, repo-style 
transactions, and OTC derivatives

[[Page 55874]]

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

[[Page 55875]]

[GRAPHIC] [TIFF OMITTED] TP25SE06.040

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

[[Page 55876]]

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

[[Page 55877]]

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

[[Page 55878]]

    (iv) T = lesser of 5 or effective residual maturity of the hedged 
exposure, expressed in years.
    Restructuring haircut. An originating bank that seeks to recognize 
an eligible credit derivative that does not include a distressed 
restructuring as a credit event that triggers payment under the 
derivative would have to reduce the recognition of the credit 
derivative by 40 percent. A distressed restructuring is a restructuring 
of the hedged exposure involving forgiveness or postponement of 
principal, interest, or fees that results in a charge-off, specific 
provision, or other similar debit to the profit and loss account.
    In other words, the protection amount of the credit derivative 
adjusted for lack of restructuring credit event (and maturity mismatch, 
if applicable) would be: Pr = Pm x 0.60, where:
    (i) Pr = protection amount of the credit derivative, adjusted for 
lack of restructuring credit event (and maturity mismatch, if 
applicable); and
    (ii) Pm = effective notional amount of the credit derivative 
(adjusted for maturity mismatch, if applicable).
    Currency mismatch haircut. Where the eligible guarantee or eligible 
credit derivative is denominated in a currency different from that in 
which any hedged exposure is denominated, the protection amount of the 
guarantee or credit derivative adjusted for currency mismatch (and 
maturity mismatch and lack of restructuring credit event, if 
applicable) would be: Pc = Pr x (1-Hfx), where:
    (i) Pc = protection amount of the guarantee or credit derivative, 
adjusted for currency mismatch (and maturity mismatch and lack of 
restructuring credit event, if applicable);
    (ii) Pr = effective notional amount of the guarantee or credit 
derivative (adjusted for maturity mismatch and lack of restructuring 
credit event, if applicable); and
    (iii) Hfx = haircut appropriate for the currency mismatch between 
the guarantee or credit derivative and the hedged exposure.
    A bank may use a standard supervisory haircut of 8 percent for Hfx 
(based on a 10-business day holding period and daily marking-to-market 
and remargining). Alternatively, a bank may use internally estimated 
haircuts for Hfx based on a 10-business day holding period and daily 
marking-to-market and remargining if the bank qualifies to use the own-
estimates haircuts in paragraph (a)(2)(iii) of section 32, the simple 
VaR methodology in paragraph (a)(3) of section 32, or the internal 
models methodology in paragraph (c) of section 32 of the proposed rule. 
The bank must scale these haircuts up using a square root of time 
formula if the bank revalues the guarantee or credit derivative less 
frequently than once every 10 business days.

    Example.  Assume that a bank holds a five-year $100 corporate 
exposure, purchases a $100 credit derivative to mitigate its credit 
risk on the exposure, and chooses to use the PD substitution 
approach. The unsecured ELGD and LGD of the corporate exposure are 
20 and 30 percent, respectively; the ELGD and LGD of the credit 
derivative are 75 and 80 percent, respectively. The credit 
derivative is an eligible credit derivative, has the bank's exposure 
as its reference exposure, has a three-year maturity, immediate cash 
payout on default, no restructuring provision, and no currency 
mismatch with the bank's hedged exposure. The effective notional 
amount and initial protection amount of the credit derivative would 
be $100. The maturity mismatch would reduce the protection amount to 
$100 x (3-.25)/(5-.25) or $57.89. The haircut for lack of 
restructuring would reduce the protection amount to $57.89 x 0.6 or 
$34.74. So the bank would treat the $100 corporate exposure as two 
exposures: (i) An exposure of $34.74 with the PD of the protection 
provider, an ELGD of 20 percent, an LGD of 30 percent, and an M of 
5; and (ii) an exposure of $65.26 with the PD of the obligor, an 
ELGD of 20 percent, an LGD of 30 percent, and an M of 5.

    Multiple credit risk mitigants. The New Accord provides that if 
multiple credit risk mitigants (for example, two eligible guarantees) 
cover a single exposure, a bank must disaggregate the exposure into 
portions covered by each credit risk mitigant (for example, the portion 
covered by each guarantee) and must calculate separately the risk-based 
capital requirement of each portion.\64\ The New Accord also indicates 
that when credit risk mitigants provided by a single protection 
provider have differing maturities, they should be subdivided into 
separate layers of protection.\65\ Question 41: The agencies are 
interested in the views of commenters as to whether and how the 
agencies should address these and other similar situations in which 
multiple credit risk mitigants cover a single exposure.
---------------------------------------------------------------------------

    \64\ New Accord, ] 206.
    \65\ Id.
---------------------------------------------------------------------------

    Double default treatment. As noted above, the proposed rule 
contains a separate risk-based capital methodology for hedged exposures 
eligible for double default treatment. To be eligible for double 
default treatment, a hedged exposure must be fully covered or covered 
on a pro rata basis (that is, there must be no tranching of credit 
risk) by an uncollateralized single-reference-obligor credit derivative 
or guarantee (or certain nth-to-default credit derivatives) provided by 
an eligible double default guarantor (as defined below). Moreover, the 
hedged exposure must be a wholesale exposure other than a sovereign 
exposure.\66\ In addition, the obligor of the hedged exposure must not 
be an eligible double default guarantor, an affiliate of an eligible 
double default guarantor, or an affiliate of the guarantor.
---------------------------------------------------------------------------

    \66\ The New Accord permits certain retail small business 
exposures to be eligible for double default treatment. Under this 
proposal, however, a bank must effectively desegment a retail small 
business exposure (thus rendering it a wholesale exposure) to make 
it eligible for double default treatment.
---------------------------------------------------------------------------

    The proposed rule defines eligible double default guarantor to 
include a depository institution (as defined in section 3 of the 
Federal Deposit Insurance Act (12 U.S.C. 1813)); a bank holding company 
(as defined in section 2 of the Bank Holding Company Act (12 U.S.C. 
1841)); a savings and loan holding company (as defined in 12 U.S.C. 
1467a) provided all or substantially all of the holding company's 
activities are permissible for a financial holding company under 12 
U.S.C. 1843(k)); a securities broker or dealer registered (under the 
Securities Exchange Act of 1934) with the Securities and Exchange 
Commission (SEC); an insurance company in the business of providing 
credit protection (such as a monoline bond insurer or re-insurer) that 
is subject to supervision by a state insurance regulator; a foreign 
bank (as defined in section 211.2 of the Federal Reserve Board's 
Regulation K (12 CFR 211.2)); a non-U.S. securities firm; or a non-U.S. 
based insurance company in the business of providing credit protection. 
To be an eligible double default guarantor, the entity must (i) have a 
bank-assigned PD that, at the time the guarantor issued the guarantee 
or credit derivative, was equal to or lower than the PD associated with 
a long-term external rating of at least the third highest investment 
grade rating category; and (ii) have a current bank-assigned PD that is 
equal to or lower than the PD associated with a long-term external 
rating of at least investment grade. In addition, a non-U.S. based 
bank, securities firm, or insurance company may qualify as an eligible 
double default guarantor only if the firm is subject to consolidated 
supervision and regulation comparable to that imposed on U.S. 
depository institutions, securities firms, or insurance companies (as 
the case may be) or has issued and outstanding an unsecured long-term 
debt security without credit enhancement that has a long-term 
applicable external rating in one of the

[[Page 55879]]

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

[[Page 55880]]

Accordingly, for this limited set of traditional guarantees of retail 
exposures by high credit quality guarantors, a bank would be allowed to 
recognize the benefit of the guarantee when estimating ELGD and LGD, 
but not when estimating PD. Question 42: The agencies seek comment on 
this alternative approach's definition of eligible retail guarantee and 
treatment for eligible retail guarantees, and on whether the agencies 
should provide similar treatment for any other forms of wholesale 
credit insurance or guarantees on retail exposures, such as student 
loans, if the agencies adopt this approach.
    This alternative approach would provide a different treatment for 
non-eligible retail guarantees. In short, within the retail framework, 
a bank would not be able to recognize non-eligible retail guarantees 
when estimating PD, ELGD, and LGD for any segment of retail exposures. 
In other words, a bank would be required to estimate PD, ELGD, and LGD 
for segments containing retail exposures with non-eligible guarantees 
as if the exposures were not guaranteed. However, a bank would be 
permitted to recognize non-eligible retail guarantees provided by a 
wholesale guarantor by treating the hedged retail exposure as a direct 
exposure to the guarantor and applying the appropriate wholesale IRB 
risk-based capital formula. In other words, for retail exposures 
covered by non-eligible retail guarantees, a bank would be permitted to 
reflect the guarantee by ``desegmenting'' the retail exposures (which 
effectively would convert the retail exposures into wholesale 
exposures) and then applying the rules set forth above for guarantees 
that cover wholesale exposures. Thus, under this approach, a bank would 
not be allowed to recognize either double default or double recovery 
effects for non-eligible retail guarantees.
    The agencies understand that this approach to non-eligible retail 
guarantees, while addressing the prudential concerns of the agencies, 
is conservative and may not harmonize with banks' internal risk 
measurement and management practices in this area. Question 43: The 
agencies seek comment on the types of non-eligible retail guarantees 
banks obtain and the extent to which banks obtain credit risk 
mitigation in the form of non-eligible retail guarantees.
    A second alternative that the agencies are considering for purposes 
of the final rule would permit a bank to recognize the credit risk 
mitigation benefits of all eligible guarantees (whether eligible retail 
guarantees or not) that cover retail exposures by adjusting its 
estimates of ELGD and LGD for the relevant segments, but would subject 
a bank's risk-based capital requirement for a segment of retail 
exposures that are covered by one or more non-eligible retail 
guarantees to a floor. Under this second alternative, the agencies 
could impose a floor on risk-based capital requirements of between 2 
percent and 6 percent on such a segment of retail exposures.
    Question 44: The agencies seek comment on both of these alternative 
approaches to guarantees that cover retail exposures. The agencies also 
invite comment on other possible prudential treatments for such 
guarantees.

D. Unsettled Securities, Foreign Exchange, and Commodity Transactions

    Section 35 of the proposed rule sets forth the risk-based capital 
requirements for unsettled and failed securities, foreign exchange, and 
commodities transactions. Certain transaction types are excluded from 
the scope of this section, including:
    (i) Transactions accepted by a qualifying central counterparty that 
are subject to daily marking-to-market and daily receipt and payment of 
variation margin (which do not have a risk-based capital 
requirement);\67\
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    \67\ The agencies consider a qualifying central counterparty to 
be the functional equivalent of an exchange, and have long exempted 
exchange-traded contracts from risk-based capital requirements. 
Transactions rejected by a qualifying central counterparty (because, 
for example, of a discrepancy in the details of the transaction such 
as in quantity, price, or in the underlying security, between the 
buyer and seller) potentially give rise to risk exposure to either 
party.
---------------------------------------------------------------------------

    (ii) Repo-style transactions (the risk-based capital requirements 
of which are determined under sections 31 and 32 of the proposed rule);
    (iii) One-way cash payments on OTC derivative contracts (the risk-
based capital requirements of which are determined under sections 31 
and 32 of the proposed rule); and
    (iv) Transactions with a contractual settlement period that is 
longer than the normal settlement period (defined below), which 
transactions are treated as OTC derivative contracts and assessed a 
risk-based capital requirement under sections 31 and 32 of the proposed 
rule. The proposed rule also provides that, in the case of a system-
wide failure of a settlement or clearing system, the bank's primary 
Federal supervisor may waive risk-based capital requirements for 
unsettled and failed transactions until the situation is rectified.
    The proposed rule contains separate treatments for delivery-versus-
payment (DvP) and payment-versus-payment (PvP) transactions with a 
normal settlement period, on the one hand, and non-DvP/non-PvP 
transactions with a normal settlement period, on the other hand. The 
proposed rule provides the following definitions of a DvP transaction, 
a PvP transaction, and a normal settlement period. A DvP transaction is 
a securities or commodities transaction in which the buyer is obligated 
to make payment only if the seller has made delivery of the securities 
or commodities and the seller is obligated to deliver the securities or 
commodities only if the buyer has made payment. A PvP transaction is a 
foreign exchange transaction in which each counterparty is obligated to 
make a final transfer of one or more currencies only if the other 
counterparty has made a final transfer of one or more currencies. A 
transaction has a normal settlement period if the contractual 
settlement period for the transaction is equal to or less than the 
market standard for the instrument underlying the transaction and equal 
to or less than five business days.
    A bank must hold risk-based capital against a DvP or PvP 
transaction with a normal settlement period if the bank's counterparty 
has not made delivery or payment within five business days after the 
settlement date. The bank must determine its risk-weighted asset amount 
for such a transaction by multiplying the positive current exposure of 
the transaction for the bank by the appropriate risk weight in Table F. 
The positive current exposure of a transaction of a bank is the 
difference between the transaction value at the agreed settlement price 
and the current market price of the transaction, if the difference 
results in a credit exposure of the bank to the counterparty.

      Table F.--Risk Weights for Unsettled DvP and PvP Transactions
------------------------------------------------------------------------
                                                          Risk weight to
                                                           be applied to
  Number of business days after contractual settlement       positive
                          date                                current
                                                             exposure
                                                             (percent)
------------------------------------------------------------------------
From 5 to 15............................................             100
From 16 to 30...........................................             625
From 31 to 45...........................................           937.5
46 or more..............................................           1,250
------------------------------------------------------------------------

    A bank must hold risk-based capital against any non-DvP/non-PvP 
transaction with a normal settlement period if the bank has delivered 
cash, securities, commodities, or currencies to its counterparty but 
has not received its

[[Page 55881]]

corresponding deliverables by the end of the same business day. The 
bank must continue to hold risk-based capital against the transaction 
until the bank has received its corresponding deliverables. From the 
business day after the bank has made its delivery until five business 
days after the counterparty delivery is due, the bank must calculate 
its risk-based capital requirement for the transaction by treating the 
current market value of the deliverables owed to the bank as a 
wholesale exposure.
    A bank may assign an internal obligor rating to a counterparty for 
which it is not otherwise required under the proposed rule to assign an 
obligor rating on the basis of the applicable external rating of any 
outstanding senior unsecured long-term debt security without credit 
enhancement issued by the counterparty. A bank may estimate loss 
severity ratings or ELGD and LGD for the exposure, or may use a 45 
percent ELGD and LGD for the exposure provided the bank uses the 45 
percent ELGD and LGD for all such exposures. Alternatively, a bank may 
use a 100 percent risk weight for the exposure as long as the bank uses 
this risk weight for all such exposures.
    If, in a non-DvP/non-PvP transaction with a normal settlement 
period, the bank has not received its deliverables by the fifth 
business day after counterparty delivery was due, the bank must deduct 
the current market value of the deliverables owed to the bank 50 
percent from tier 1 capital and 50 percent from tier 2 capital.
    The total risk-weighted asset amount for unsettled transactions 
equals the sum of the risk-weighted asset amount for each DvP and PvP 
transaction with a normal settlement period and the risk-weighted asset 
amount for each non-DvP/non-PvP transaction with a normal settlement 
period.

E. Securitization Exposures

    This section describes the framework for calculating risk-based 
capital requirements for securitization exposures under the proposed 
rule (the securitization framework). In contrast to the proposed 
framework for wholesale and retail exposures, the proposed 
securitization framework does not permit a bank to rely on its internal 
assessments of the risk parameters of a securitization exposure.\68\ 
For securitization exposures, which typically are tranched exposures to 
a pool of underlying exposures, such assessments would require implicit 
or explicit estimates of correlations among the losses on the 
underlying exposures and estimates of the credit risk consequences of 
tranching. Such correlation and tranching effects are difficult to 
estimate and validate in an objective manner and on a going-forward 
basis. Instead, the proposed securitization framework relies 
principally on two sources of information, where available, to 
determine risk-based capital requirements: (i) An assessment of the 
securitization exposure's credit risk made by an NRSRO; or (ii) the 
risk-based capital requirement for the underlying exposures as if the 
exposures had not been securitized (along with certain other objective 
information about the securitization exposure, such as the size and 
relative seniority of the exposure).
---------------------------------------------------------------------------

    \68\ Although the Internal Assessment Approach described below 
does allow a bank to use an internal-ratings-based approach to 
determine its risk-based capital requirement for an exposure to an 
ABCP program, banks are required to follow NRSRO rating criteria and 
therefore are required implicitly to use the NRSRO's determination 
of the correlation of the underlying exposures in the ABCP program.
---------------------------------------------------------------------------

    A bank must use the securitization framework for exposures to any 
transaction that involves the tranching of credit risk (with the 
exception of a tranched guarantee that applies only to an individual 
retail exposure), regardless of the number of underlying exposures in 
the transaction.\69\ A single, unified approach to dealing with the 
tranching of credit risk is important to create a level playing field 
across the securitization, credit derivatives, and other financial 
markets. The agencies believe that basing the applicability of the 
proposed securitization framework on the presence of some minimum 
number of underlying exposures would complicate the proposed rule 
without any material improvement in risk sensitivity. The proposed 
securitization framework is designed specifically to deal with tranched 
exposures to credit risk, and the principal risk-based capital 
approaches of the proposed securitization framework take into account 
the effective number of underlying exposures.
---------------------------------------------------------------------------

    \69\ As noted above, mortgage-backed pass-through securities 
guaranteed by Fannie Mae or Freddie Mac are also securitization 
exposures.
---------------------------------------------------------------------------

1. Hierarchy of Approaches
    The proposed securitization framework contains three general 
approaches for determining the risk-based capital requirement for a 
securitization exposure: A Ratings-Based Approach (RBA), an Internal 
Assessment Approach (IAA), and a Supervisory Formula Approach (SFA). 
Under the proposed rule, banks generally must apply the following 
hierarchy of approaches to determine the risk-based capital requirement 
for a securitization exposure.
    First, a bank must deduct from tier 1 capital any after-tax gain-
on-sale resulting from a securitization and must deduct from total 
capital any portion of a CEIO that does not constitute a gain-on-sale, 
as described in section 42(c) of the proposed rule. Second, a bank must 
apply the RBA to a securitization exposure if the exposure qualifies 
for the RBA. As a general matter, an exposure qualifies for the RBA if 
the exposure has an external rating from an NRSRO or has an inferred 
rating (that is, the exposure is senior to another securitization 
exposure in the transaction that has an external rating from an NRSRO). 
For example, a bank generally must use the RBA approach to determine 
the risk-based capital requirement for an asset-backed security that 
has an applicable external rating of AA+ from an NRSRO and for another 
tranche of the same securitization that is unrated but senior in all 
respects to the asset-backed security that was rated. In this example, 
the senior unrated tranche would be treated as if it were rated AA+.
    If a securitization exposure does not qualify for the RBA but is an 
exposure to an ABCP program--such as a credit enhancement or liquidity 
facility--the bank may apply the IAA (if the bank, the exposure, and 
the ABCP program qualify for the IAA) or the SFA (if the bank and the 
exposure qualify for the SFA) to the exposure. As a general matter, a 
bank would qualify for use of the IAA if the bank establishes and 
maintains an internal risk rating system for exposures to ABCP programs 
that has been approved by the bank's primary Federal supervisor. 
Alternatively, a bank may use the SFA if the bank is able to calculate 
a set of risk factors relating to the securitization, including the 
risk-based capital requirement for the underlying exposures as if they 
were held directly by the bank. A bank that chooses to use the IAA must 
use the IAA for all exposures that qualify for the IAA.
    If a securitization exposure is not a gain-on-sale or a CEIO, does 
not qualify for the RBA and is not an exposure to an ABCP program, the 
bank may apply the SFA to the exposure if the bank is able to calculate 
the SFA risk factors for the securitization. In many cases an 
originating bank would use the SFA to determine its risk-based capital 
requirements for retained securitization exposures. If a securitization 
exposure is not a gain-on-sale or a CEIO and does not qualify for the 
RBA, the IAA, or the SFA, the bank must deduct the exposure

[[Page 55882]]

from total capital. Total risk-weighted assets for securitization 
exposures would be the sum of risk-weighted assets calculated under the 
RBA, IAA, and SFA, plus any risk-weighted asset amounts calculated 
under the early amortization provisions in section 47 of the proposed 
rule.
    Numerous commenters criticized the complexity of the ANPR's 
treatment of approaches to securitization exposures and the different 
treatment accorded to originating banks versus investing banks. As 
discussed elsewhere in this section, the agencies have responded to 
these comments by eliminating most of the differences in treatment for 
originating banks and investing banks and by eliminating the 
``Alternative RBA'' from the hierarchy of approaches. As discussed in 
more detail below, there is one difference in treatment between 
originating and investing banks in the RBA, consistent with the general 
risk-based capital rules.
    Some commenters expressed dissatisfaction that the ANPR required 
banks to use the RBA to assess risk-based capital requirements against 
a securitization exposure with an external or inferred rating. These 
commenters argued that banks should be allowed to choose between the 
RBA and the SFA when both approaches are available. The agencies have 
not altered the proposed securitization framework to provide this 
element of choice to banks because the agencies believe it would likely 
create a means for regulatory capital arbitrage.
    Exceptions to the general hierarchy of approaches. Under the 
proposed securitization framework, unless one or more of the underlying 
exposures does not meet the definition of a wholesale, retail, 
securitization, or equity exposure, the total risk-based capital 
requirement for all securitization exposures held by a single bank 
associated with a single securitization (including any regulatory 
capital requirement that relates to an early amortization provision, 
but excluding any capital requirements that relate to the bank's gain-
on-sale or CEIOs associated with the securitization) cannot exceed the 
sum of (i) the bank's total risk-based capital requirement for the 
underlying exposures as if the bank directly held the underlying 
exposures; and (ii) the bank's total ECL for the underlying exposures. 
The ECL of the underlying exposures is included in this calculation 
because if the bank held the underlying exposures on its balance sheet, 
the bank would have had to estimate the ECL of the exposures and hold 
reserves or capital against the ECL. This cap ensures that a bank's 
effective risk-based capital requirement for exposure to a pool of 
underlying exposures generally would not be greater than the applicable 
risk-based capital requirement if the underlying exposures were held 
directly by the bank, taking into consideration the agencies' safety 
and soundness concerns with respect to CEIOs.
    This proposed maximum risk-based capital requirement would be 
different from the general risk-based capital rules. Under the general 
risk-based capital rules, banks generally are required to hold a dollar 
in capital for every dollar in residual interest, regardless of the 
effective risk-based capital requirement on the underlying exposures. 
The agencies adopted this dollar-for-dollar capital treatment for a 
residual interest to recognize that in many instances the relative size 
of the residual interest retained by the originating bank reveals 
market information about the quality of the underlying exposures and 
transaction structure that may not have been captured under the general 
risk-based capital rules. Given the significantly heightened risk 
sensitivity of the IRB framework, the agencies believe that the 
proposed maximum risk-based capital requirement in the proposed 
securitization framework is more appropriate.
    In addition, the proposed rule would address various situations 
involving overlapping exposures. Consistent with the general risk-based 
capital rules, if a bank has multiple securitization exposures to an 
ABCP program that provide duplicative coverage of the underlying 
exposures of the program (such as when a bank provides a program-wide 
credit enhancement and multiple pool-specific liquidity facilities to 
an ABCP program), the bank is not required to hold duplicative risk-
based capital against the overlapping position. Instead, the bank would 
apply to the overlapping position the applicable risk-based capital 
treatment under the securitization framework that results in the 
highest capital requirement. If different banks have overlapping 
exposures to an ABCP program, however, each bank must hold capital 
against the entire maximum amount of its exposure. Although duplication 
of capital requirements will not occur for individual banks, some 
systemic duplication may occur where multiple banks have overlapping 
exposures to the same ABCP program.
    The proposed rule also addresses overlapping exposures that arise 
when a bank holds a securitization exposure in the form of a mortgage-
backed security or participation certificate that results from a 
mortgage loan swap with recourse. In these situations, a bank must 
determine a risk-based capital requirement for two separate exposures--
the retained recourse obligation on the swapped loans and the 
percentage of the mortgage-backed security or participation certificate 
that is not covered by the recourse obligation. The total risk-based 
capital requirement is capped at the risk-based capital requirement for 
the underlying exposures as if they were held directly on the bank's 
balance sheet.
    The proposed rule also addresses the risk-based capital treatment 
of a securitization of non-IRB assets. Specifically, if a bank has a 
securitization exposure and any underlying exposure of the 
securitization is not a wholesale, retail, securitization or equity 
exposure, the bank must (i) apply the RBA if the securitization 
exposure qualifies for the RBA and is not gain-on-sale or a CEIO; or 
(ii) otherwise, deduct the exposure from total capital. Music concert 
and film receivables are examples of types of assets that are not 
wholesale, retail, securitization, or equity exposures.
    The proposed rule contains several additional exceptions to the 
general hierarchy. For example, in light of the substantial volatility 
in asset value related to prepayment risk and interest rate risk 
associated with interest-only mortgage-backed securities, the proposed 
rule provides that the risk weight for such a security may not be less 
than 100 percent. In addition, the proposed rule follows the general 
risk-based capital rules by allowing a sponsoring bank that qualifies 
as a primary beneficiary and must consolidate an ABCP program as a 
variable interest entity under GAAP to exclude the consolidated ABCP 
program assets from risk-weighted assets. In such cases, the bank would 
hold risk-based capital only against any securitization exposures of 
the bank to the ABCP program.\70\ Moreover, the proposed rule follows 
the general risk-based capital rules and a Federal statute \71\ by 
including a special set of more lenient rules for the transfer of small 
business loans and leases with recourse by well-capitalized depository 
institutions.\72\
---------------------------------------------------------------------------

    \70\ See Financial Accounting Standards Board, Interpretation 
No. 46: Consolidation of Certain Variable Interest Entities (Jan. 
2003).
    \71\ See 12 U.S.C. 1835, which places a cap on the risk-based 
capital requirement applicable to a well-capitalized depository 
institution that transfers small business loans with recourse.
    \72\ The proposed rule does not expressly state that the 
agencies may permit adequately capitalized banks to use the small 
business recourse rule on a case-by-case basis because the agencies 
may do this under the general reservation of authority contained in 
section 1 of the rule.

---------------------------------------------------------------------------

[[Page 55883]]

    Servicer cash advances. A traditional securitization typically 
employs a servicing bank that--on a day-to-day basis--collects 
principal, interest, and other payments from the underlying exposures 
of the securitization and forwards such payments to the securitization 
SPE or to investors in the securitization. Such servicing banks often 
provide to the securitization a credit facility under which the 
servicing bank may advance cash to ensure an uninterrupted flow of 
payments to investors in the securitization (including advances made to 
cover foreclosure costs or other expenses to facilitate the timely 
collection of the underlying exposures). These servicer cash advance 
facilities are securitization exposures, and a servicing bank must 
determine its risk-based capital requirement for the funded portion of 
any such facility by using the proposed securitization framework.
    Consistent with the general risk-based capital rules with respect 
to residential mortgage servicer cash advances, however, a servicing 
bank would not be required to hold risk-based capital against the 
undrawn portion of an ``eligible'' servicer cash advance facility. 
Under the proposed rule, an eligible servicer cash advance facility is 
a servicer cash advance facility in which (i) the servicer is entitled 
to full reimbursement of advances (except that a servicer may be 
obligated to make non-reimburseable advances if any such advance with 
respect to any underlying exposure is limited to an insignificant 
amount of the outstanding principal balance of the underlying 
exposure); (ii) the servicer's right to reimbursement is senior in 
right of payment to all other claims on the cash flows from the 
underlying exposures of the securitization; and (iii) the servicer has 
no legal obligation to, and does not, make advances to the 
securitization if the servicer concludes the advances are unlikely to 
be repaid. If these conditions are not satisfied, a bank that provides 
a servicer cash advance facility must determine its risk-based capital 
requirement for the undrawn portion of the facility in the same manner 
as the bank would determine its risk-based capital requirement for any 
other undrawn securitization exposure.
    Amount of a securitization exposure. For all of the securitization 
approaches, the amount of an on-balance sheet securitization exposure 
is the bank's carrying value, if the exposure is held-to-maturity or 
for trading, or the bank's carrying value minus any unrealized gains 
and plus any unrealized losses on the exposure, if the exposure is 
available for sale. The amount of an off-balance sheet securitization 
exposure is the notional amount of the exposure. For a commitment, such 
as a liquidity facility extended to an ABCP program, the notional 
amount may be reduced to the maximum potential amount that the bank 
currently would be required to fund under the arrangement's 
documentation (that is, the amount that could be drawn given the assets 
held by the program). For an OTC derivative contract that is not a 
credit derivative, the notional amount is the EAD of the derivative 
contract (as calculated in section 32).
    Implicit support. The proposed rule also sets forth the regulatory 
capital consequences if a bank provides support to a securitization in 
excess of the bank's predetermined contractual obligation to provide 
credit support to the securitization. First, consistent with the 
general risk-based capital rules,\73\ a bank that provides such 
implicit support must hold regulatory capital against all of the 
underlying exposures associated with the securitization as if the 
exposures had not been securitized, and must deduct from tier 1 capital 
any after-tax gain-on-sale resulting from the securitization. Second, 
the bank must disclose publicly (i) that it has provided implicit 
support to the securitization, and (ii) the regulatory capital impact 
to the bank of providing the implicit support. The bank's primary 
Federal supervisor also may require the bank to hold regulatory capital 
against all the underlying exposures associated with some or all the 
bank's other securitizations as if the exposures had not been 
securitized, and to deduct from tier 1 capital any after-tax gain-on-
sale resulting from such securitizations.
---------------------------------------------------------------------------

    \73\ Interagency Guidance on Implicit Recourse in Asset 
Securitizations, May 23, 2002.
---------------------------------------------------------------------------

    Operational requirements for traditional securitizations. In a 
traditional securitization, an originating bank typically transfers a 
portion of the credit risk of exposures to third parties by selling 
them to an SPE. Banks engaging in a traditional securitization may 
exclude the underlying exposures from the calculation of risk-weighted 
assets only if each of the following conditions is met: (i) The 
transfer is a sale under GAAP; (ii) the originating bank transfers to 
third parties credit risk associated with the underlying exposures; and 
(iii) any clean-up calls relating to the securitization are eligible 
clean-up calls (as discussed below).
    Originating banks that meet these conditions must hold regulatory 
capital against any securitization exposures they retain in connection 
with the securitization. Originating banks that fail to meet these 
conditions must hold regulatory capital against the transferred 
exposures as if they had not been securitized and must deduct from tier 
1 capital any gain-on-sale resulting from the transaction.
    Clean-up calls. For purposes of these operational requirements, a 
clean-up call is a contractual provision that permits a servicer to 
call securitization exposures (for example, asset-backed securities) 
before the stated (or contractual) maturity or call date. In the case 
of a traditional securitization, a clean-up call is generally 
accomplished by repurchasing the remaining securitization exposures 
once the amount of underlying exposures or outstanding securitization 
exposures has fallen below a specified level. In the case of a 
synthetic securitization, the clean-up call may take the form of a 
clause that extinguishes the credit protection once the amount of 
underlying exposures has fallen below a specified level.
    To satisfy the operational requirements for securitizations--and, 
therefore, to enable an originating bank to exclude the underlying 
exposures from the calculation of its risk-based capital requirements--
any clean-up call associated with a securitization must be an eligible 
clean-up call. An eligible clean-up call is a clean-up call that:
    (i) Is exercisable solely at the discretion of the servicer;
    (ii) Is not structured to avoid allocating losses to securitization 
exposures held by investors or otherwise structured to provide credit 
enhancement to the securitization (for example, to purchase non-
performing underlying exposures); and
    (iii) (A) For a traditional securitization, is only exercisable 
when 10 percent or less of the principal amount of the underlying 
exposures or securitization exposures (determined as of the inception 
of the securitization) is outstanding.
    (B) For a synthetic securitization, is only exercisable when 10 
percent or less of the principal amount of the reference portfolio of 
underlying exposures (determined as of the inception of the 
securitization) is outstanding.
    Over the last several years, the agencies have published a 
significant amount of supervisory guidance to assist banks with 
assessing the extent to which they have transferred credit risk and, 
consequently, may recognize any reduction in required regulatory 
capital as a result of a securitization or other

[[Page 55884]]

form of credit risk transfer.\74\ In general, the agencies would expect 
banks to continue to use this guidance, most of which remains 
applicable to the securitization framework. Banks are encouraged to 
consult with their primary Federal supervisor about transactions that 
require additional guidance.
---------------------------------------------------------------------------

    \74\ See, e.g., OCC Bulletin 99-46 (Dec. 14, 1999) (OCC); FDIC 
Financial Institution Letter 109-99 (Dec. 13, 1999) (FDIC); SR 
Letter 99-37 (Dec. 13, 1999) (Board); CEO Ltr. 99-119 (Dec. 14, 
1999) (OTS).
---------------------------------------------------------------------------

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

[[Page 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
                                                               senior           non-senior      Risk weights for
    Applicable rating (illustrative rating example)        securitization     securitization     securitization
                                                          exposures backed   exposures backed   exposures backed
                                                         by granular pools  by granular pools   by non-granular
                                                             (percent)          (percent)       pools (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                    10                 18                 35
 (for example, A+).....................................
Third-highest investment grade (for example, A)........                 12                 20  .................
Third-highest investment grade--negative designation                    20                 35  .................
 (for example, A-).....................................
----------------------------------------------------------------------------------------------------------------
Lowest investment grade--positive designation (for                      35                   50
 example, BBB+)........................................
----------------------------------------------------------------------------------------------------------------
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 Table H when the 
securitization exposure's external rating represents a short-term 
credit rating or its inferred rating is based on a short-term credit 
rating. A bank must apply the decision rules outlined in the previous 
paragraph to determine which column of Table H 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
                                                               senior           non-senior      Risk weights for
    Applicable rating (illustrative rating example)        securitization     securitization     securitization
                                                          exposures backed   exposures backed   exposures backed
                                                         by granular pools  by granular pools   by non-granular
                                                             (percent)          (percent)       pools (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 increase as rating grades 
decline. Under column 2 of Table G, for example, the risk weights range 
from 12 percent for exposures with the highest investment grade rating 
to 650 percent for exposures rated one category below investment grade 
with a negative designation. This pattern of risk weights is broadly 
consistent with analyses employing standard credit risk models and a 
range of assumptions regarding correlation effects and the types of 
exposures being securitized.\75\ These analyses imply that, compared 
with a corporate bond having a given level of stand-alone credit risk 
(for example, as measured by its expected loss rate), a securitization 
tranche having the same level of stand-alone credit risk--but backed by 
a reasonably granular and diversified pool--will tend to exhibit more 
systematic risk.\76\ This effect is most pronounced for below-
investment-grade tranches and is the primary reason why the RBA risk-
weights increase rapidly as ratings deteriorate over this range--much 
more rapidly than for similarly rated corporate bonds.
---------------------------------------------------------------------------

    \75\ See Vladislav Peretyatkin and William Perraudin, ``Capital 
for Asset-Backed Securities,'' Bank of England, February 2003.
    \76\ See, e.g., Michael Pykhtin and Ashish Dev, ``Credit Risk in 
Asset Securitizations: An Analytical Model,'' Risk (May 2002) S16-
S20.
---------------------------------------------------------------------------

    Under the RBA, a securitization exposure that has an investment 
grade rating and has fewer than six effective underlying exposures 
generally receives a higher risk weight than a similarly rated 
securitization exposure with six or more effective underlying 
exposures. The agencies have designed the risk weights in this manner 
to discourage a bank from engaging in regulatory capital arbitrage by 
securitizing very high-quality wholesale exposures (that is, wholesale 
exposures with a low PD and LGD), obtaining external ratings on the 
securitization exposures issued by the securitization, and retaining 
essentially all the credit risk of the pool of underlying exposures.
    Consistent with the ANPR, the proposed rule requires a bank to 
deduct from regulatory capital any securitization exposure with an 
external or inferred rating below one category below investment grade 
for long-term ratings or below investment grade for short-term ratings. 
Several commenters

[[Page 55886]]

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

[[Page 55887]]

capital treatment for bank exposures to ABCP programs.
    To use the IAA, a bank must receive prior written approval from its 
primary Federal supervisor. To receive such approval, the bank would 
have to demonstrate that its internal credit assessment process 
satisfies all the following criteria. The bank's internal credit 
assessments of securitization exposures to ABCP programs must be based 
on publicly available rating criteria used by an NRSRO for evaluating 
the credit risk of the underlying exposures. The bank's internal credit 
assessments of securitization exposures used for regulatory capital 
purposes must be consistent with those used in the bank's internal risk 
management process, capital adequacy assessment process, and management 
information reporting systems.
    In addition, the bank's internal credit assessment process must 
have sufficient granularity to identify gradations of risk. Each of the 
bank's internal credit assessment categories must correspond to an 
external credit rating of an NRSRO. The proposed rule also requires 
that the bank's internal credit assessment process, particularly the 
stress test factors for determining credit enhancement requirements, be 
at least as conservative as the most conservative of the publicly 
available rating criteria of the NRSROs that have provided external 
credit ratings to the commercial paper issued by the ABCP program.
    Moreover, the bank must have an effective system of controls and 
oversight that ensures compliance with these operational requirements 
and maintains the integrity of the internal credit assessments. The 
bank must review and update each internal credit assessment whenever 
new material information is available, but no less frequently than 
annually. The bank must also validate its internal credit assessment 
process on an ongoing basis, but not less frequently than annually.
    To use the IAA on a specific exposure to an ABCP program, the 
program must exhibit the following characteristics:
    (i) All the commercial paper issued by the ABCP program must have 
an external rating.
    (ii) The ABCP program must have robust credit and investment 
guidelines (that is, underwriting standards).
    (iii) The ABCP program must perform a detailed credit analysis of 
the asset sellers' risk profiles.
    (iv) The ABCP program's underwriting policy must establish minimum 
asset eligibility criteria that include a prohibition of the purchase 
of assets that are significantly past due or defaulted, as well as 
limitations on concentrations to an individual obligor or geographic 
area and the tenor of the assets to be purchased.
    (v) The aggregate estimate of loss on an asset pool that the ABCP 
program is considering purchasing must consider all sources of 
potential risk, such as credit and dilution risk.
    (vi) The ABCP program must incorporate structural features into 
each purchase of assets to mitigate potential credit deterioration of 
the underlying exposures. Such features may include wind-down triggers 
specific to a pool of underlying exposures.
4. Supervisory Formula Approach (SFA)
    General requirements. Under the SFA, a bank would determine the 
risk-weighted asset amount for a securitization exposure by multiplying 
the SFA risk-based capital requirement for the exposure (as determined 
by the supervisory formula set forth below) by 12.5. If the SFA risk 
weight for a securitization exposure is 1,250 percent or greater, 
however, the bank must deduct the exposure from total capital rather 
than risk weight the exposure. Deduction is consistent with the 
treatment of other high-risk securitization exposures, such as CEIOs.
    The SFA capital requirement for a securitization exposure depends 
on the following seven inputs:
    (i) The amount of the underlying exposures (UE);
    (ii) The securitization exposure's proportion of the tranche in 
which it resides (TP);
    (iii) The sum of the risk-based capital requirement and ECL for the 
underlying exposures as if they were held directly on the bank's 
balance sheet divided by the amount of the underlying exposures 
(KIRB);
    (iv) The tranche's credit enhancement level (L);
    (v) The tranche's thickness (T);
    (vi) The securitization's effective number of underlying exposures 
(N); and
    (vii) The securitization's exposure-weighted average loss given 
default (EWALGD).
    A bank may only use the SFA to determine its risk-based capital 
requirement for a securitization exposure if the bank can calculate 
each of these seven inputs on an ongoing basis. In particular, if a 
bank cannot compute KIRB because the bank cannot compute the 
risk-based capital requirement for all underlying exposures, the bank 
may not use the SFA to compute its risk-based capital requirement for 
the securitization exposure. In those cases, the bank would deduct the 
exposure from regulatory capital.
    The SFA capital requirement for a securitization exposure is UE 
multiplied by TP multiplied by the greater of (i) 0.0056 * T; or (ii) 
S[L+T]-S[L], where:
[GRAPHIC] [TIFF OMITTED] TP25SE06.041

[GRAPHIC] [TIFF OMITTED] TP25SE06.042

[GRAPHIC] [TIFF OMITTED] TP25SE06.043

[GRAPHIC] [TIFF OMITTED] TP25SE06.044


[[Page 55888]]


[GRAPHIC] [TIFF OMITTED] TP25SE06.045

[GRAPHIC] [TIFF OMITTED] TP25SE06.046

[GRAPHIC] [TIFF OMITTED] TP25SE06.047

[GRAPHIC] [TIFF OMITTED] TP25SE06.048

[GRAPHIC] [TIFF OMITTED] TP25SE06.049

[GRAPHIC] [TIFF OMITTED] TP25SE06.050

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

[[Page 55889]]

influence on the SFA capital requirement.
---------------------------------------------------------------------------

    \77\ The conceptual basis for specification of K[x] is developed 
in Michael B. Gordy and David Jones, ``Random Tranches,'' Risk. 
(Mar. 2003) 78-83.
    \78\ See Michael Pykhtin and Ashish Dev, ``Coarse-grained 
CDOs,'' Risk (Jan. 2003) 113-116.
---------------------------------------------------------------------------

    Inputs to the SFA formula. The proposed rule provides the following 
definitions of the seven inputs into the SFA formula.
    (i) Amount of the underlying exposures (UE). This input (measured 
in dollars) is the EAD of any underlying wholesale and retail exposures 
plus the amount of any underlying exposures that are securitization 
exposures (as defined in section 42(e) of the proposed rule) plus the 
adjusted carrying value of any underlying equity exposures (as defined 
in section 51(b) of the proposed rule). UE also would include any 
funded spread accounts, cash collateral accounts, and other similar 
funded credit enhancements.
    (ii) Tranche percentage (TP). TP is the ratio of (i) the amount of 
the bank's securitization exposure to (ii) the amount of the 
securitization tranche that contains the bank's securitization 
exposure.
    (iii) KIRB. KIRB is the ratio of (i) the 
risk-based capital requirement for the underlying exposures plus the 
ECL of the underlying exposures (all as determined as if the underlying 
exposures were directly held by the bank) to (ii) UE. The definition of 
KIRB includes the ECL of the underlying exposures in the 
numerator because if the bank held the underlying exposures on its 
balance sheet, the bank also would hold reserves against the exposures.
    The calculation of KIRB must reflect the effects of any 
credit risk mitigant applied to the underlying exposures (either to an 
individual underlying exposure, a group of underlying exposures, or to 
the entire pool of underlying exposures). In addition, all assets 
related to the securitization are to be treated as underlying exposures 
for purposes of the SFA, including assets in a reserve account (such as 
a cash collateral account).
    (iv) Credit enhancement level (L). L is the ratio of (i) the amount 
of all securitization exposures subordinated to the securitization 
tranche that contains the bank's securitization exposure to (ii) UE. 
Banks must determine L before considering the effects of any tranche-
specific credit enhancements (such as third-party guarantees that 
benefit only a single tranche). Any after-tax gain-on-sale or CEIOs 
associated with the securitization may not be included in L.
    Any reserve account funded by accumulated cash flows from the 
underlying exposures that is subordinated to the tranche that contains 
the bank's securitization exposure may be included in the numerator and 
denominator of L to the extent cash has accumulated in the account. 
Unfunded reserve accounts (that is, reserve accounts that are to be 
funded from future cash flows from the underlying exposures) may not be 
included in the calculation of L.
    In some cases, the purchase price of receivables will reflect a 
discount that provides credit enhancement (for example, first loss 
protection) for all or certain tranches. When this arises, L should be 
calculated inclusive of this discount if the discount provides credit 
enhancement for the securitization exposure.
    (v) Thickness of tranche (T). T is the ratio of (i) the size of the 
tranche that contains the bank's securitization exposure to (ii) UE.
    (vi) Effective number of exposures (N). As a general matter, the 
effective number of exposures would be calculated as follows:
[GRAPHIC] [TIFF OMITTED] TP25SE06.051

where EADi represents the EAD associated with the 
ith instrument in the pool of underlying exposures. For 
purposes of computing N, multiple exposures to one obligor must be 
treated as a single underlying exposure. In the case of a re-
securitization (that is, a securitization in which some or all of the 
underlying exposures are themselves securitization exposures), a bank 
must treat each underlying securitization exposure as a single exposure 
and must not look through to the exposures that secure the underlying 
securitization exposures. The agencies recognize that this simple and 
conservative approach to re-securitizations may result in the 
differential treatment of economically similar securitization 
exposures. Question 49: The agencies seek comment on suggested 
alternative approaches for determining the N of a re-securitization.
    N represents the granularity of a pool of underlying exposures 
using an ``effective'' number of exposures concept rather than a 
``gross'' number of exposures concept to appropriately assess the 
diversification of pools that have individual underlying exposures of 
different sizes. An approach that simply counts the gross number of 
underlying exposures in a pool treats all exposures in the pool 
equally. This simplifying assumption could radically overestimate the 
granularity of a pool with numerous small exposures and one very large 
exposure. The effective exposure approach captures the notion that the 
risk profile of such an unbalanced pool is more like a pool of several 
medium-sized exposures than like a pool of a large number of equally 
sized small exposures.
    For example, suppose Pool A contains four loans with EADs of $100 
each. Under the formula set forth above, N for Pool A would be four, 
precisely equal to the actual number of exposures. Suppose Pool B also 
contains four loans: One loan with an EAD of $100 and three loans with 
an EAD of $1. Although both pools contain four loans, Pool B is much 
less diverse and granular than Pool A because Pool B is dominated by 
the presence of a single $100 loan. Intuitively, therefore, N for Pool 
B should be closer to one than to four. Under the formula in the rule, 
N for Pool B is calculated as follows:
[GRAPHIC] [TIFF OMITTED] TP25SE06.052

    (vii) Exposure-weighted average loss given default (EWALGD). The 
EWALGD is calculated as:
[GRAPHIC] [TIFF OMITTED] TP25SE06.053

where LGDi represents the average LGD associated with all 
exposures to the ith obligor. In the case of a re-
securitization, an LGD of 100 percent must be assumed for any 
underlying exposure that is itself a securitization exposure.
    Under certain conditions, a bank may employ the following 
simplifications to the SFA. First, for securitizations all of whose 
underlying exposures are retail exposures, a bank may set h = 0 and v = 
0. In addition, if the share of a securitization corresponding to the 
largest underlying exposure (C1) is no more than 0.03 (or 3 
percent of the underlying exposures), then for purposes of the SFA the 
bank may set EWALGD=0.50 and N equal to the following amount:

[[Page 55890]]

[GRAPHIC] [TIFF OMITTED] TP25SE06.054

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

Where the collateral is a basket of different asset types or a basket 
of assets denominated in different currencies, the haircut on the 
basket will be
[GRAPHIC] [TIFF OMITTED] TP25SE06.055

where ai is the current market value of the asset in the 
basket divided by the current market value of all assets in the basket 
and Hi is the haircut applicable to that asset.
    With the prior written approval of its primary Federal supervisor, 
a bank may calculate haircuts using its own internal estimates of 
market price volatility and foreign exchange volatility, subject to the 
requirements for use of own-estimates haircuts contained in section 32 
of the proposed rule. Banks that use own-estimates haircuts for 
collateralized securitization exposures must assume a minimum holding 
period (TM) for securitization exposures of 65 business 
days.
    A bank that does not qualify for and use own-estimates haircuts 
must use the collateral type haircuts (Hs) in Table 3 of this preamble 
and must use a currency mismatch haircut (Hfx) of 8 percent if the 
exposure and the collateral are denominated in different currencies. To 
reflect the longer-term nature of securitization exposures as compared 
to eligible margin loans and OTC derivative contracts, however, these 
standard supervisory haircuts (which are based on a 10-business-day 
holding period and daily marking-to-

[[Page 55891]]

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

[[Page 55892]]

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

[[Page 55893]]

tranche has defaulted or become a loss. A simplified treatment is 
available to banks that purchase and provide such credit protection. A 
bank that obtains credit protection on a group of underlying exposures 
through a first-to-default credit derivative must determine its risk-
based capital requirement for the underlying exposures as if the bank 
had synthetically securitized only the underlying exposure with the 
lowest capital requirement (K) (as calculated under Table 2 of the 
proposed rule) and had obtained no credit risk mitigant on the other 
(higher capital requirement) underlying exposures. If the bank 
purchases credit protection on a group of underlying exposures through 
an nth-to-default credit derivative (other than a first-to-default 
credit derivative), it may only recognize the credit protection for 
risk-based capital purposes either if it has obtained credit protection 
on the same underlying exposures in the form of first-through-(n-1)-to-
default credit derivatives, or if n-1 of the underlying exposures have 
already defaulted. In such a case, the bank would again determine its 
risk-based capital requirement for the underlying exposures as if the 
bank had only synthetically securitized the n-1 underlying exposures 
with the lowest capital requirement (K) (as calculated under Table 2 of 
the proposed rule) and had obtained no credit risk mitigant on the 
other underlying exposures.
    A bank that provides credit protection on a group of underlying 
exposures through a first-to-default credit derivative must determine 
its risk-weighted asset amount for the derivative by applying the RBA 
(if the derivative qualifies for the RBA) or, if the derivative does 
not qualify for the RBA, by setting its risk-weighted asset amount for 
the derivative equal to the product of (i) the protection amount of the 
derivative; (ii) 12.5; and (iii) the sum of the risk-based capital 
requirements (K) of the individual underlying exposures (as calculated 
under Table 2 of the proposed rule), up to a maximum of 100 percent. If 
a bank provides credit protection on a group of underlying exposures 
through an nth-to-default credit derivative (other than a first-to-
default credit derivative), the bank must determine its risk-weighted 
asset amount for the derivative by applying the RBA (if the derivative 
qualifies for the RBA) or, if the derivative does not qualify for the 
RBA, by setting the risk-weighted asset amount for the derivative equal 
to the product of (i) the protection amount of the derivative; (ii) 
12.5; and (iii) the sum of the risk-based capital requirements (K) of 
the individual underlying exposures (as calculated under Table 2 of the 
proposed rule and excluding the n-1 underlying exposures with the 
lowest risk-based capital requirements), up to a maximum of 100 
percent.
    For example, a bank provides credit protection in the form of a 
second-to-default credit derivative on a basket of five reference 
exposures. The derivative is unrated and the protection amount of the 
derivative is $100. The risk-based capital requirements of the 
underlying exposures are 2.5 percent, 5.0 percent, 10.0 percent, 15.0 
percent, and 20 percent. The risk-weighted asset amount of the 
derivative would be $100 x 12.5 x (.05 + .10 + .15 + .20) or $625. If 
the derivative were externally rated in the lowest investment grade 
rating category with a positive designation, the risk-weighted asset 
amount would be $100 x 0.50 or $50.
9. Early Amortization Provisions
    Background. Many securitizations of revolving credit facilities 
(for example, credit card receivables) contain provisions that require 
the securitization to be wound down and investors to be repaid if the 
excess spread falls below a certain threshold.\79\ This decrease in 
excess spread may, in some cases, be caused by deterioration in the 
credit quality of the underlying exposures. An early amortization event 
can increase a bank's capital needs if new draws on the revolving 
credit facilities would need to be financed by the bank using on-
balance sheet sources of funding. The payment allocations used to 
distribute principal and finance charge collections during the 
amortization phase of these transactions also can expose a bank to 
greater risk of loss than in other securitization transactions. To 
address the risks that early amortization of a securitization poses to 
originating banks, the agencies propose the capital treatment described 
below.
---------------------------------------------------------------------------

    \79\ The proposed rule defines excess spread for a period as 
gross finance charge collections (including market interchange fees) 
and other income received by the SPE over the period minus interest 
paid to holders of securitization exposures, servicing fees, charge-
offs, and other senior trust similar expenses of the SPE over the 
period, all divided by the principal balance of the underlying 
exposures at the end of the period.
---------------------------------------------------------------------------

    The proposed rule would define an early amortization provision as a 
provision in a securitization's governing documentation that, when 
triggered, causes investors in the securitization exposures to be 
repaid before the original stated maturity of the securitization 
exposure, unless the provision is solely triggered by events not 
related to the performance of the underlying exposures or the 
originating bank (such as material changes in tax laws or regulations). 
Under the proposed rule, an originating bank must generally hold 
regulatory capital against the sum of the originating bank's interest 
and the investors' interest arising from a revolving securitization 
that contains an early amortization provision. An originating bank must 
compute its capital requirement for its interest using the hierarchy of 
approaches for securitization exposures as described above. The 
originating bank's risk-weighted asset amount with respect to the 
investors' interest in the securitization is equal to the product of 
the following four quantities: (i) The EAD associated with the 
investors' interest; (ii) the appropriate conversion factor (CF) as 
determined below; (iii) KIRB; and (iv) 12.5.
    Under the proposed rule, as noted above, a bank is not required to 
hold regulatory capital against the investors' interest if early 
amortization is solely triggered by events not related to the 
performance of the underlying exposures or the originating bank, such 
as material changes in tax laws or regulation. Under the New Accord, a 
bank is also not required to hold regulatory capital against the 
investors' interest if (i) the securitization has a replenishment 
structure in which the individual underlying exposures do not revolve 
and the early amortization ends the ability of the originating bank to 
add new underlying exposures to the securitization; (ii) the 
securitization involves revolving assets and contains early 
amortization features that mimic term structures (that is, where the 
risk of the underlying exposures does not return to the originating 
bank); or (iii) investors in the securitization remain fully exposed to 
future draws by borrowers on the underlying exposures even after the 
occurrence of early amortization. Question 51: The agencies seek 
comment on the appropriateness of these additional exemptions in the 
U.S. markets for revolving securitizations.
    Under the proposed rule, the investors' interest with respect to a 
revolving securitization captures both the drawn balances and undrawn 
lines of the underlying exposures that are allocated to the investors 
in the securitization. The EAD associated with the investors' interest 
is equal to the EAD of the underlying exposures multiplied by the ratio 
of the total amount of securitization exposures issued by the SPE to 
investors; divided by the outstanding principal amount of underlying 
exposures.

[[Page 55894]]

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

           Table I.--Controlled Early Amortization Provisions
------------------------------------------------------------------------
                                       Uncommitted          Committed
------------------------------------------------------------------------
Retail Credit Lines............  3-month average excess  90% CF.
                                  spread Conversion
                                  Factor (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 for all other revolving 
underlying exposures (that is, committed exposures and non-retail 
exposures) in securitizations containing a controlled early 
amortization provision. The CFs for uncommitted revolving retail credit 
lines are much lower than for committed retail credit lines or for non-
retail credit lines because of the demonstrated ability of banks to 
monitor and, when appropriate, to curtail promptly uncommitted retail 
credit lines for customers of deteriorating credit quality. Such 
account management tools are unavailable for committed lines, and banks 
may be less proactive about using such tools in the case of uncommitted 
non-retail credit lines owing to lender liability concerns and the 
prominence of broad-based, longer-term customer relationships.
    Question 54: The agencies seek comment on and supporting empirical 
analysis of the appropriateness of a more simple alternative approach 
that would impose at all times a flat CF on the entire investors' 
interest of a revolving securitization with a controlled early 
amortization provision, and on what an appropriate level of such a CF 
would be (for example, 10 or 20 percent).
    Noncontrolled early amortization. To calculate the appropriate CF 
for securitizations of uncommitted revolving retail exposures that 
contain a noncontrolled early amortization provision, a bank must 
perform the excess spread calculations described in the controlled 
early amortization section above and then apply the CFs in Table J.

         Table J.--Non-Controlled Early Amortization Provisions
------------------------------------------------------------------------
                                       Uncommitted          Committed
------------------------------------------------------------------------
Retail Credit Lines............  3-month average excess  100% CF.
                                  spread Conversion
                                  Factor (CF).

[[Page 55895]]

 
                                 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 all other revolving underlying 
exposures (that is, committed exposures and nonretail exposures) in 
securitizations containing a noncontrolled early amortization 
provision. In other words, no risk transference would be recognized for 
these transactions; an originating bank's IRB capital requirement would 
be the same as if the underlying exposures had not been securitized.
    In circumstances where a securitization contains a mix of retail 
and nonretail exposures or a mix of committed and uncommitted 
exposures, a bank may take a pro rata approach to determining the risk-
based capital requirement for the securitization's early amortization 
provision. If a pro rata approach is not feasible, a bank must treat 
the securitization as a securitization of nonretail exposures if a 
single underlying exposure is a nonretail exposure and must treat the 
securitization as a securitization of committed exposures if a single 
underlying exposure is a committed exposure.

F. Equity Exposures

1. Introduction and Exposure Measurement
    This section describes the proposed rule's risk-based capital 
treatment for equity exposures. Under the proposed rule, a bank would 
have the option to use either a simple risk-weight approach (SRWA) or 
an internal models approach (IMA) for equity exposures that are not 
exposures to an investment fund. A bank would use a look-through 
approach for equity exposures to an investment fund. Under the SRWA, a 
bank would generally assign a 300 percent risk weight to publicly 
traded equity exposures and a 400 percent risk weight to non-publicly 
traded equity exposures. Certain equity exposures to sovereigns, 
multilateral institutions, and public sector enterprises would have a 
risk weight of 0 percent, 20 percent, or 100 percent; and certain 
community development equity exposures, hedged equity exposures, and, 
up to certain limits, non-significant equity exposures would receive a 
100 percent risk weight.
    Alternatively, a bank that meets certain minimum quantitative and 
qualitative requirements on an ongoing basis and obtains the prior 
written approval of its primary Federal supervisor could use the IMA to 
determine its risk-based capital requirement for all modeled equity 
exposures. A bank that qualifies to use the IMA may apply the IMA to 
its publicly traded and non-publicly traded equity exposures, or may 
choose to apply the IMA only to its publicly traded equity exposures. 
However, if the bank applies the IMA to its publicly traded equity 
exposures, it must apply the IMA to all such exposures. Similarly, if a 
bank applies the IMA to both publicly traded and non-publicly traded 
equity exposures, it must apply the IMA to all such exposures. If a 
bank does not qualify to use the IMA, or elects not to use the IMA, to 
compute its risk-based capital requirements for equity exposures, the 
bank must apply the SRWA to assign risk weights to its equity 
exposures.
    The proposed rule defines a publicly traded equity exposure as an 
equity exposure traded on (i) any exchange registered with the SEC as a 
national securities exchange under section 6 of the Securities Exchange 
Act of 1934 (15 U.S.C. 78f) or (ii) any non-U.S.-based securities 
exchange that is registered with, or approved by, a national securities 
regulatory authority, provided that there is a liquid, two-way market 
for the exposure (that is, there are enough bona fide offers to buy and 
sell so that a sales price reasonably related to the last sales price 
or current bona fide competitive bid and offer quotations can be 
determined promptly and a trade can be settled at such a price within 
five business days). Question 55: The agencies seek comment on this 
definition.
    A bank using either the IMA or the SRWA must determine the adjusted 
carrying value for each equity exposure. The proposed rule defines the 
adjusted carrying value of an equity exposure as:
    (i) For the on-balance sheet component of an equity exposure, the 
bank's carrying value of the exposure reduced by any unrealized gains 
on the exposure that are reflected in such carrying value but excluded 
from the bank's tier 1 and tier 2 capital; \80\ and
---------------------------------------------------------------------------

    \80\ The potential downward adjustment to the carrying value of 
an equity exposure reflects the fact that 100 percent of the 
unrealized gains on available-for-sale equity exposures are included 
in carrying value but only up to 45 percent of any such unrealized 
gains are included in regulatory capital.
---------------------------------------------------------------------------

    (ii) For the off-balance sheet component of an equity exposure, the 
effective notional principal amount of the exposure, the size of which 
is equivalent to a hypothetical on-balance sheet position in the 
underlying equity instrument that would evidence the same change in 
fair value (measured in dollars) for a given small change in the price 
of the underlying equity instrument, minus the adjusted carrying value 
of the on-balance sheet component of the exposure as calculated in (i).
    The agencies created the definition of the effective notional 
principal amount of the off-balance sheet portion of an equity exposure 
to provide a uniform method for banks to measure the on-balance sheet 
equivalent of an off-balance sheet exposure. For example, if the value 
of a derivative contract referencing the common stock of company X 
changes the same amount as the value of 150 shares of common stock of 
company X, for a small (for example, 1 percent) change in the value of 
the common stock of company X, the effective notional principal amount 
of the derivative contract is the current value of 150 shares of common 
stock of company X regardless of the number of shares the derivative 
contract

[[Page 55896]]

references. The adjusted carrying value of the off-balance sheet 
component of the derivative is the current value of 150 shares of 
common stock of company X minus the adjusted carrying value of any on-
balance sheet amount associated with the derivative. Question 56: The 
agencies seek comment on the approach to adjusted carrying value for 
the off-balance sheet component of equity exposures and on alternative 
approaches that may better capture the market risk of such exposures.
    Hedge transactions. For purposes of determining risk-weighted 
assets under both the SRWA and the IMA, a bank may identify hedge 
pairs, which the proposed rule defines as two equity exposures that 
form an effective hedge so long as each equity exposure is publicly 
traded or has a return that is primarily based on a publicly traded 
equity exposure. A bank may risk weight only the effective and 
ineffective portions of a hedge pair rather than the entire adjusted 
carrying value of each exposure that makes up the pair. Two equity 
exposures form an effective hedge if the exposures either have the same 
remaining maturity or each has a remaining maturity of at least three 
months; the hedge relationship is formally documented in a prospective 
manner (that is, before the bank acquires at least one of the equity 
exposures); the documentation specifies the measure of effectiveness 
(E) the bank will use for the hedge relationship throughout the life of 
the transaction; and the hedge relationship has an E greater than or 
equal to 0.8. A bank must measure E at least quarterly and must use one 
of three alternative measures of E--the dollar-offset method, the 
variability-reduction method, or the regression method.
    It is possible that only part of a bank's exposure to a particular 
equity instrument would be part of a hedge pair. For example, assume a 
bank has an equity exposure A with a $300 adjusted carrying value and 
chooses to hedge a portion of that exposure with an equity exposure B 
with an adjusted carrying value of $100. Also assume that the 
combination of equity exposure B and $100 of the adjusted carrying 
value of equity exposure A form an effective hedge with an E of 0.8. In 
this situation the bank would treat $100 of equity exposure A and $100 
of equity exposure B as a hedge pair, and the remaining $200 of its 
equity exposure A as a separate, stand-alone position.
    The effective portion of a hedge pair is E multiplied by the 
greater of the adjusted carrying values of the equity exposures forming 
a hedge pair, whereas the ineffective portion is (1-E) multiplied by 
the greater of the adjusted carrying values of the equity exposures 
forming a hedge pair. In the above example, the effective portion of 
the hedge pair would be 0.8 x $100 = $80 and the ineffective portion of 
the hedge pair would be (1 - 0.8) x $100 = $20.
    Measures of hedge effectiveness. Under the dollar-offset method of 
measuring effectiveness, the bank must determine the ratio of the 
cumulative sum of the periodic changes in the value of one equity 
exposure to the cumulative sum of the periodic changes in the value of 
the other equity exposure, termed the ratio of value change (RVC). If 
the changes in the values of the two exposures perfectly offset each 
other, the RVC will be -1. If RVC is positive, implying that the values 
of the two equity exposures moved in the same direction, the hedge is 
not effective and E = 0. If RVC is negative and greater than or equal 
to -1 (that is, between zero and -1), then E equals the absolute value 
of RVC. If RVC is negative and less than -1, then E equals 2 plus RVC.
    The variability-reduction method of measuring effectiveness 
compares changes in the value of the combined position of the two 
equity exposures in the hedge pair (labeled X) to changes in the value 
of one exposure as though that one exposure were not hedged (labeled 
A). This measure of E expresses the time-series variability in X as a 
proportion of the variability of A. As the variability described by the 
numerator becomes small relative to the variability described by the 
denominator, the measure of effectiveness improves, but is bounded from 
above by a value of 1. E can be computed as:
[GRAPHIC] [TIFF OMITTED] TP25SE06.057

    Xt = At - Bt
    A = the value at time t of the one exposure in a hedge pair, and
    Bt = the value at time t of the other exposure in a 
hedge pair.
    The value of t will range from zero to T, where T is the length of 
the observation period for the values of A and B, and is comprised of 
shorter values each labeled t.
    The regression method of measuring effectiveness is based on a 
regression in which the change in value of one exposure in a hedge pair 
is the dependent variable and the change in value of the other exposure 
in a hedge pair is the independent variable. E equals the coefficient 
of determination of this regression, which is the proportion of the 
variation in the dependent variable explained by variation in the 
independent variable. The closer the relationship between the values of 
the two exposures, the higher E will be.
2. Simple Risk-Weight Approach (SRWA)
    Under the SRWA in section 52 of the proposed rule, a bank would 
determine the risk-weighted asset amount for each equity exposure, 
other than an equity exposure to an investment fund, by multiplying the 
adjusted carrying value of the equity exposure, or the effective 
portion and ineffective portion of a hedge pair as described below, by 
the lowest applicable risk weight in Table K. A bank would determine 
the risk-weighted asset amount for an equity exposure to an investment 
fund as set forth below (and in section 54 of the proposed rule). Use 
of the SRWA would be most appropriate when a bank's equity holdings are 
principally composed of non-traded instruments.
    If a bank exclusively uses the SRWA for its equity exposures, the 
bank's aggregate risk-weighted asset amount for its equity exposures 
(other than equity exposures to investment funds) would be equal to the 
sum of the risk-weighted asset amounts for each of the bank's 
individual equity exposures.

                                 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.

[[Page 55897]]

 
                                   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 bank may apply a 100 percent 
risk weight to non-significant equity exposures, which the proposed 
rule defines as equity exposures to the extent that the aggregate 
adjusted carrying value of the exposures does not exceed 10 percent of 
the bank's tier 1 capital plus tier 2 capital. To compute the aggregate 
adjusted carrying value of a bank's equity exposures for determining 
non-significance, the bank may exclude (i) equity exposures that 
receive less than a 300 percent risk weight under the SRWA (other than 
equity exposures determined to be non-significant), (ii) the equity 
exposure in a hedge pair with the smaller adjusted carrying value, and 
(iii) a proportion of each equity exposure to an investment fund equal 
to the proportion of the assets of the investment fund that are not 
equity exposures. If a bank does not know the actual holdings of the 
investment fund, the bank may calculate the proportion of the assets of 
the fund that are not equity exposures based on the terms of the 
prospectus, partnership agreement, or similar contract that defines the 
fund's permissible investments. If the sum of the investment limits for 
all exposure classes\81\ within the fund exceeds 100 percent, the bank 
must assume that the investment fund invests to the maximum extent 
possible in equity exposures.
---------------------------------------------------------------------------

    \81\ The proposed rule generally defines these exposures as 
exposures that would qualify as community development investments 
under 12 U.S.C. 24(Eleventh), excluding equity exposures to an 
unconsolidated small business investment company and equity 
exposures held through a consolidated small business investment 
company described in section 302 of the Small Business Investment 
Act of 1958 (15 U.S.C. 682). For savings associations, community 
development investments would be defined to mean equity investments 
that are designed primarily to promote community welfare, including 
the welfare of low- and moderate-income communities or families, 
such as by providing services or jobs, and excluding equity 
exposures to an unconsolidated small business investment company and 
equity exposures held through a consolidated small business 
investment company described in section 302 of the Small Business 
Investment Act of 1958 (15 U.S.C. 682).
---------------------------------------------------------------------------

    When determining which of a bank's equity exposures qualify for a 
100 percent risk weight based on non-significance, a bank must first 
include equity exposures to unconsolidated small business investment 
companies or held through consolidated small business investment 
companies described in section 302 of the Small Business Investment Act 
of 1958 (15 U.S.C. 682) and then must include publicly traded equity 
exposures (including those held indirectly through investment funds) 
and then must include non-publicly traded equity exposures (including 
those held indirectly through investment funds).
3. Internal Models Approach (IMA)
    The IMA is designed to provide banks with a more sophisticated and 
risk-sensitive mechanism for calculating risk-based capital 
requirements for equity exposures. To qualify to use the IMA, a bank 
must receive prior written approval from its primary Federal 
supervisor. To receive such approval, the bank must demonstrate to its 
primary Federal supervisor's satisfaction that the bank meets the 
following quantitative and qualitative criteria.
    IMA qualification. First, the bank must have a model that (i) 
assesses the potential decline in value of its modeled equity 
exposures; (ii) is commensurate with the size, complexity, and 
composition of the bank's modeled equity exposures; and (iii) 
adequately captures both general market risk and idiosyncratic risks. 
Second, the bank's model must produce an estimate of potential losses 
for its modeled equity exposures that is no less than the estimate of 
potential losses produced by a VaR methodology employing a 99.0 percent 
one-tailed confidence interval of the distribution of quarterly returns 
for a benchmark portfolio of equity exposures comparable to the bank's 
modeled equity exposures using a long-term sample period.
    In addition, the number of risk factors and exposures in the sample 
and the data period used for quantification in the bank's model and 
benchmarking exercise must be sufficient to provide confidence in the 
accuracy and robustness of the bank's estimates. The bank's model and 
benchmarking exercise also must incorporate data that are relevant in 
representing the risk profile of the bank's modeled equity exposures, 
and must include data from at least one equity market cycle containing 
adverse market movements relevant to the risk profile of the bank's 
modeled equity exposures. If the bank's model uses a scenario 
methodology, the bank must demonstrate that the model produces a 
conservative estimate of potential losses on the bank's modeled equity 
exposures over a relevant long-term market cycle. If the bank employs 
risk factor models, the bank must demonstrate through empirical 
analysis the appropriateness of the risk factors used.
    The agencies also would require that daily market prices be 
available for all modeled equity exposures, either direct holdings or 
proxies. Finally, the bank must be able to demonstrate, using 
theoretical arguments and empirical evidence, that any proxies used in 
the modeling process are comparable to the bank's modeled equity 
exposures and that the bank has made appropriate adjustments for 
differences. The bank must derive any proxies for its modeled equity 
exposures or benchmark portfolio using historical market data that are 
relevant to the bank's modeled equity exposures or benchmark portfolio 
(or, where not, must use appropriately adjusted data), and such proxies 
must be robust estimates of the risk of the bank's modeled equity 
exposures.
    In evaluating a bank's internal model for equity exposures, the 
bank's primary Federal supervisor would consider, among other factors, 
(i) the nature of the bank's equity exposures, including the number and 
types of equity exposures (for example, publicly traded, non-publicly 
traded, long, short); (ii) the risk characteristics and makeup of the 
bank's equity exposures, including the extent to which publicly 
available price information is obtainable on the exposures; and (iii) 
the level and degree of concentration of, and correlations among, the 
bank's equity exposures. Banks with equity portfolios containing equity 
exposures with values that are highly nonlinear in nature (for example, 
equity derivatives or convertibles) would have to employ an internal 
model designed to appropriately capture the risks associated with these 
instruments.
    The agencies do not intend to dictate the form or operational 
details of a bank's internal model for equity

[[Page 55898]]

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

[[Page 55899]]

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

VI. Operational Risk

    This section describes features of the AMA framework for 
determining the risk-based capital requirement for operational risk. 
The proposed framework remains fundamentally similar to that described 
in the ANPR. Under this framework, a bank meeting the AMA qualifying 
criteria would use

[[Page 55900]]

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

[[Page 55901]]

risk exposure minus eligible operational risk offsets (if any). If a 
bank qualifies to use operational risk mitigants and has qualifying 
operational risk mitigants, the bank's dollar risk-based capital 
requirement for operational risk would be the greater of: (i) The 
bank's operational risk exposure adjusted for qualifying operational 
risk mitigants minus eligible operational risk offsets (if any); and 
(ii) 0.8 multiplied by the difference between the bank's operational 
risk exposure and its eligible operational risk offsets (if any). The 
dollar risk-based capital requirement for operational risk would be 
multiplied by 12.5 to convert it into an equivalent risk-weighted asset 
amount. The resulting amount would be added to the comparable amount 
for credit risk in calculating the institution's risk-based capital 
denominator.

VII. Disclosure

1. Overview

    The agencies have long supported meaningful public disclosure by 
banks with the objective of improving market discipline. The agencies 
recognize the importance of market discipline in encouraging sound risk 
management practices and fostering financial stability.
    Pillar 3 of the New Accord, market discipline, complements the 
minimum capital requirements and the supervisory review process by 
encouraging market discipline through enhanced and meaningful public 
disclosure. These proposed public disclosure requirements are intended 
to allow market participants to assess key information about an 
institution's risk profile and its associated level of capital.
    The agencies view public disclosure as an important complement to 
the advanced approaches to calculating minimum regulatory risk-based 
capital requirements, which will be heavily based on internal systems 
and methodologies. With enhanced transparency of the advanced 
approaches, investors can better evaluate a bank's capital structure, 
risk exposures, and capital adequacy. With sufficient and relevant 
information, market participants can better evaluate a bank's risk 
management performance, earnings potential and financial strength.
    Improvements in public disclosures come not only from regulatory 
standards, but also through efforts by bank management to improve 
communications to public shareholders and other market participants. In 
this regard, improvements to risk management processes and internal 
reporting systems provide opportunities to significantly improve public 
disclosures over time. Accordingly, the agencies strongly encourage the 
management of each bank to regularly review its public disclosures and 
enhance these disclosures, where appropriate, to clearly identify all 
significant risk exposures --whether on-or off-balance sheet--and their 
effects on the bank's financial condition and performance, cash flow, 
and earnings potential.
    Comments on ANPR. Some commenters to the ANPR indicated that the 
proposed disclosures were burdensome, excessive, and overly 
prescriptive. Other commenters believed that the information provided 
in the disclosures would not be comparable across banks because each 
bank will use distinct internal methodologies to generate the 
disclosures. These commenters also expressed concern that some 
disclosures could be misinterpreted or misunderstood by the public.
    The agencies believe, however, the required disclosures would 
enable market participants to gain key insights regarding a bank's 
capital structure, risk exposures, risk assessment processes, and 
ultimately, the capital adequacy of the institution. Some of the 
proposed disclosure requirements will be new disclosures for banks. 
Nonetheless, the agencies believe that a significant amount of the 
proposed disclosure requirements are already required by or consistent 
with existing GAAP, SEC disclosure requirements, or regulatory 
reporting requirements for banks.

2. General Requirements

    The public disclosure requirements would apply to the top-tier 
legal entity that is a core or opt-in bank within a consolidated 
banking group (that is, the top-tier BHC or DI that is a core or opt-in 
bank). In general, DIs that are a subsidiary of a BHC or another DI 
would not be subject to the disclosure requirements \82\ except that 
every DI must disclose total and tier 1 capital ratios and their 
components, similar to current requirements. If a DI is not a 
subsidiary of a BHC or another DI that must make the full set of 
disclosures, the DI must make these disclosures.
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    \82\ The bank regulatory reports and Thrift Financial Reports 
will be revised to collect some additional Basel II-related 
information, as described below in the regulatory reporting section.
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    The risks to which a bank is exposed and the techniques that it 
uses to identify, measure, monitor, and control those risks are 
important factors that market participants consider in their assessment 
of the institution. Accordingly, each bank that is subject to the 
disclosure requirements must have a formal disclosure policy approved 
by the board of directors that addresses the institution's approach for 
determining the disclosures it should make. The policy should address 
the associated internal controls and disclosure controls and 
procedures. The board of directors and senior management would be 
expected to ensure that appropriate verification of the disclosures 
takes place and that effective internal controls and disclosure 
controls and procedures are maintained.
    A bank should decide which disclosures are relevant for it based on 
the materiality concept. Information would be regarded as material if 
its omission or misstatement could change or influence the assessment 
or decision of a user relying on that information for the purpose of 
making investment decisions.
    To the extent applicable, a bank would be able to fulfill its 
disclosure requirements under this proposed rule by relying on 
disclosures made in accordance with accounting standards or SEC 
mandates that are very similar to the disclosure requirements in this 
proposed rule. In these situations, a bank would explain material 
differences between the accounting or other disclosure and the 
disclosures required under this proposed rule.
    Frequency/timeliness. Consistent with longstanding requirements in 
the United States for robust quarterly disclosures in financial and 
regulatory reports, and considering the potential for rapid changes in 
risk profiles, the agencies would require that quantitative disclosures 
be made quarterly. However, qualitative disclosures that provide a 
general summary of a bank's risk management objectives and policies, 
reporting system, and definitions may be disclosed annually, provided 
any significant changes to these are disclosed in the interim. The 
disclosures must be timely, that is, must be made no later than the 
reporting deadlines for regulatory reports (for example, FR Y-9C) and 
financial reports (for example, SEC Forms 10-Q and 10-K). When these 
deadlines differ, the later deadline would be used.
    In some cases, management may determine that a significant change 
has occurred, such that the most recent reported amounts do not reflect 
the bank's capital adequacy and risk profile. In those cases, banks 
should disclose the general nature of these changes and briefly 
describe how they are likely to

[[Page 55902]]

affect public disclosures going forward. These interim disclosures 
should be made as soon as practicable after the determination that a 
significant change has occurred.
    Location of disclosures and audit/certification requirements. The 
disclosures would have to be publicly available (for example, included 
on a public Web site) for each of the last three years (that is, twelve 
quarters) or such shorter time period since the bank entered its first 
floor period. Except as discussed below, management would have some 
discretion to determine the appropriate medium and location of the 
disclosures required by this proposed rule. Furthermore, banks would 
have flexibility in formatting their public disclosures, that is, the 
agencies are not specifying a fixed format for these disclosures.
    Management would be encouraged to provide all of the required 
disclosures in one place on the entity's public Web site. The public 
Web site address would be reported in a regulatory report (for example, 
the FR Y-9C).\83\
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    \83\ Alternatively, banks would be permitted to provide the 
disclosures in more than one place, as some of them may be included 
in public financial reports (for example, in Management's Discussion 
and Analysis included in SEC filings) or other regulatory reports 
(for example, FR Y-9C Reports). The agencies would require such 
banks to provide a summary table on their public Web site that 
specifically indicates where all the disclosures may be found (for 
example, regulatory report schedules, page numbers in annual 
reports).
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    Disclosure of tier 1 and total capital ratios must be provided in 
the footnotes to the year-end audited financial statements.\84\ 
Accordingly, these disclosures must be tested by external auditors as 
part of the financial statement audit. Disclosures that are not 
included in the footnotes to the audited financial statements would not 
be required to be subject to external audit reports for financial 
statements or internal control reports from management and the external 
auditor. However, due to the importance of reliable disclosures, the 
agencies would require the chief financial officer to certify that the 
disclosures required by the proposed rule are appropriate and that the 
board of directors and senior management are responsible for 
establishing and maintaining an effective internal control structure 
over financial reporting, including the information required by this 
proposed rule.
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    \84\ These ratios are required to be disclosed in the footnotes 
to the audited financial statements pursuant to existing GAAP 
requirements in Chapter 17 of the ``AICPA Audit and Accounting Guide 
for Depository and Lending Institutions: Banks, Savings 
institutions, Credit unions, Finance companies and Mortgage 
companies.''
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    Proprietary and confidential information. The agencies believe that 
the proposed requirements strike an appropriate balance between the 
need for meaningful disclosure and the protection of proprietary and 
confidential information.\85\ Accordingly, the agencies believe that 
banks would be able to provide all of these disclosures without 
revealing proprietary and confidential information. However, in rare 
cases, disclosure of certain items of information required in the 
proposed rule may prejudice seriously the position of a bank by making 
public information that is either proprietary or confidential in 
nature. In such cases, a reporting bank may request confidential 
treatment for the information if the bank believes that disclosure of 
specific commercial or financial information in the report would likely 
result in substantial harm to its competitive position, or that 
disclosure of the submitted information would result in unwarranted 
invasion of personal privacy.
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    \85\ Proprietary information encompasses information that, if 
shared with competitors, would render a bank's investment in these 
products/systems less valuable, and, hence, could undermine its 
competitive position. Information about customers is often 
confidential, in that it is provided under the terms of a legal 
agreement or counterparty relationship.
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    Question 61: The agencies seek commenters' views on all of the 
elements proposed to be captured through the public disclosure 
requirements. In particular, the agencies seek comment on the extent to 
which the proposed disclosures balance providing market participants 
with sufficient information to appropriately assess the capital 
strength of individual institutions, fostering comparability from bank 
to bank, and reducing burden on the banks that are reporting the 
information.

3. Summary of Specific Public Disclosure Requirements

    The public disclosure requirements are comprised of 11 tables that 
provide important information to market participants on the scope of 
application, capital, risk exposures, risk assessment processes, and, 
hence, the capital adequacy of the institution. Again, the agencies 
note that the substantive content of the tables is the focus of the 
disclosure requirements, not the tables themselves. The table numbers 
below refer to the table numbers in the proposed rule.
    Table 11.1 disclosures, Scope of Application, include a description 
of the level in the organization to which the disclosures apply and an 
outline of any differences in consolidation for accounting and 
regulatory capital purposes, as well as a description of any 
restrictions on the transfer of funds and capital within the 
organization. These disclosures provide the basic context underlying 
regulatory capital calculations.
    Table 11.2 disclosures, Capital Structure, provide information on 
various components of regulatory capital available to absorb losses and 
allow for an evaluation of the quality of the capital available to 
absorb losses within the bank.
    Table 11.3 disclosures, Capital Adequacy, provide information about 
how a bank assesses the adequacy of its capital and require that the 
bank disclose its minimum capital requirements for significant risk 
areas and portfolios. The table also requires disclosure of the 
regulatory capital ratios of the consolidated group and each DI 
subsidiary. Such disclosures provide insight into the overall adequacy 
of capital based on the risk profile of the organization.
    Tables 11.4, 11.5, and 11.7 disclosures, Credit Risk, provide 
market participants with insight into different types and 
concentrations of credit risk to which the bank is exposed and the 
techniques the bank uses to measure, monitor, and mitigate those risks. 
These disclosures are intended to enable market participants to assess 
the credit risk exposures under the IRB framework, without revealing 
proprietary information or duplicating the supervisor's fundamental 
review of the bank's IRB framework. Table 11.6 provides the disclosure 
requirements related to credit exposures from derivatives. This table 
was added as a supplement to the public disclosures initially in the 
New Accord as a result of the BCBS's additional efforts to address 
certain exposures arising from trading activities. See the July 2005 
BCBS publication entitled ``The Application of Basel II to Trading 
Activities and the Treatment of Double Default Effects.''
    Table 11.8 disclosures, Securitization, provide information to 
market participants on the amount of credit risk transferred and 
retained by the organization through securitization transactions and 
the types of products securitized by the organization. These 
disclosures provide users a better understanding of how securitization 
transactions impact the credit risk of the bank.

[[Page 55903]]

    Table 11.9 disclosures, Operational Risk, provide insight into the 
bank's application of the AMA for operational risk and what internal 
and external factors are considered in determining the amount of 
capital allocated to operational risk.
    Table 11.10 disclosures, Equities, provide market participants with 
an understanding of the types of equity securities held by the bank and 
how they are valued. The table also provides information on the capital 
allocated to different equity products and the amount of unrealized 
gains and losses.
    Table 11.11 disclosures, Interest Rate Risk in Non-Trading 
Activities, provide information about the potential risk of loss that 
may result from changes in interest rates and how the bank measures 
such risk.

4. Regulatory Reporting

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

[[Page 55904]]

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

[[Page 55905]]

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

[[Page 55906]]

extent feasible, a quantification of those costs; and
     An assessment, including the underlying analysis, of costs 
and benefits of potentially effective and reasonably feasible 
alternatives to the planned regulation, identified by the agencies or 
the public (including improving the current regulation and reasonably 
viable nonregulatory actions), and an explanation why the planned 
regulatory action is preferable to the identified potential 
alternatives.

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

[[Page 55907]]

to take further steps to mitigate operational risk.
    8. Enhanced supervisory feedback: Although U.S. banking 
organizations have long been subject to close supervision, aspects of 
all three pillars of the proposed rule aim to enhance supervisory 
feedback from Federal banking agencies to managers of banks and 
thrifts. Enhanced feedback could further strengthen the safety and 
soundness of the banking system.
    9. Incorporates market discipline into the regulatory framework: 
The proposed rule seeks to introduce market discipline directly into 
the regulatory framework by requiring specific disclosures relating to 
risk measurement and risk management. Market discipline could 
complement regulatory supervision to bolster safety and soundness.
    10. Preserves the benefits of international consistency and 
coordination achieved with the 1988 Basel Accord: An important 
objective of the 1988 Accord was competitive consistency of capital 
requirements for banking organizations competing in global markets. 
Basel II continues to pursue this objective. Because achieving this 
objective depends on the consistency of implementation in the United 
States and abroad, the Basel Committee has established an Accord 
Implementation Group to promote consistency in the implementation of 
Basel II.
    11. Ability to opt in offers long-term flexibility to nonmandatory 
banking organizations: The proposed U.S. implementation of Basel II 
allows banking organizations outside of the mandatory group to 
individually judge when the benefits they expect to realize from 
adopting the advanced approaches outweigh their costs. Even though the 
cost and complexity of adopting the advanced approaches may present 
nonmandatory organizations with a substantial hurdle to opting in at 
present, the potential long-term benefits of allowing nonmandatory 
organizations to partake in the benefits described above may be 
similarly substantial.
    B. Costs of the Proposed Rule.
    Because banking organizations are constantly developing programs 
and systems to improve how they measure and manage risk, it is 
difficult to distinguish between expenditures explicitly caused by 
adoption of the proposed rule and costs that would have occurred 
irrespective of any new regulation. In an effort to identify how much 
banking organizations expect to spend to comply with the U.S. 
implementation of Basel II, the Federal banking agencies included 
several questions related to compliance costs in QIS-4.\87\
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    \87\ For more information on QIS-4, see Office of the 
Comptroller of the Currency, Board of Governors of the Federal 
Reserve System, Federal Deposit Insurance Corporation, and Office of 
Thrift Supervision, ``Summary Findings of the Fourth Quantitative 
Impact Study,'' February 2006, available online at http://
www.occ.treas.gov/ftp/release/2006-23a.pdf.
---------------------------------------------------------------------------

    1. Overall Costs: According to the 19 out of 26 QIS-4 questionnaire 
respondents that provided estimates of their implementation costs, 
organizations will spend roughly $42 million on average to adapt to 
capital requirements implementing Basel II. Not all of these 
respondents are likely mandatory organizations. Counting just the 
likely mandatory organizations, the average is approximately $46 
million, so there is little difference between organizations that meet 
a mandatory threshold and those that do not. Aggregating estimated 
expenditures from all 19 respondents indicates that these organizations 
will spend a total of $791 million over several years to implement the 
proposed rule. Estimated costs for nine respondents meeting one of the 
mandatory thresholds come to $412 million.
    2. Estimate of costs specific to the proposal: Ten QIS-4 
respondents provided estimates of the portion of costs they would have 
incurred even if current capital rules remain in effect. Those ten 
indicated that they would have spent 45 percent on average, or roughly 
half of their Basel II expenditures on improving risk management 
anyway. This suggests that of the $42 million organizations expect to 
spend on implementation, approximately $21 million may represent 
expenditures each institution would have undertaken even without Basel 
II. Thus, pure implementation costs may be closer to roughly $395 
million for the 19 QIS-4 respondents.
    3. Ongoing costs: Seven QIS-4 respondents were able to estimate 
what their recurring costs might be under the proposed implementation 
of Basel II. On average, the seven organizations estimate that annual 
recurring expenses attributable to the proposed capital framework will 
be $2.4 million. Organizations indicated that the ongoing costs to 
maintain related technology reflect costs for increased personnel and 
system maintenance. The larger one-time expenditures primarily involve 
money for system development and software purchases.
    4. Implicit costs: In addition to explicit setup and recurring 
costs, banking organizations may also face implicit costs arising from 
the time and inconvenience of having to adapt to new capital 
regulations. At a minimum this involves the increased time and 
attention required of senior bank and thrift management to introduce 
new programs and procedures and the need to closely monitor the new 
activities during the inevitable rough patches when the proposed rule 
first takes effect.
    5. Government administrative costs: OCC expenditures fall into 
three broad categories: training, guidance, and supervision. Training 
includes expenses for AMA workshops, IRB workshops, and other training 
courses and seminars for examiners. Guidance expenses reflect 
expenditures on the development of IRB and AMA guidance. Supervision 
expenses reflect organization-specific supervisory activities related 
to the development and implementation of the Basel II framework. The 
largest OCC expenditures have been on the development of IRB and AMA 
policy guidance. The $4.6 million spent on guidance represents 65 
percent of the estimated total OCC Basel II-related expenditure of $7.1 
million through the 2005 fiscal year. In part, this large share 
reflects the absence of data for training and supervision costs for 
several years, but it also is indicative of the large guidance expenses 
in 2002 and 2003 when the Basel II framework was in development. To 
date, Basel II expenditures have not been a large part of overall OCC 
expenditures. The $3 million spent on Basel II in fiscal year 2005 
represents less than one percent of the OCC's $519 million budget for 
the year.
    6. Total cost: The OCC's estimate of the total cost of the proposed 
rule includes expenditures by banking organizations and the OCC from 
the present through 2011, the final year of the transition period. 
Combining expenditures by mandatory banking organizations and the OCC 
provides a present value estimate of $545.9 million for the total cost 
of the proposed rule.
    7. Procyclicality: Procyclicality refers to the possibility that 
banking organizations may reduce lending during economic downturns and 
increase lending during economic expansions as a consequence of minimum 
capital requirements. There is some concern that the risk-sensitivity 
of the IRB approach may cause capital requirements for credit risk to 
increase during an economic downturn. Although procyclicality may be 
inherent in banking to some extent, elements of the advanced approaches 
could reduce inherent procyclicality. Risk management and information 
systems may provide bank managers with more

[[Page 55908]]

forward-looking information about risk that would allow them to adjust 
portfolios gradually and with more foresight as the economic outlook 
changes over the business cycle. Regulatory stress-testing requirements 
included in the proposal also will help ensure that institutions 
anticipate cyclicality in capital requirements to the greatest extent 
possible, reducing the potential economic impact of changes in capital 
requirements.
    III. Competition Among Providers of Financial Services
    One potential concern with any regulatory change is the possibility 
that it might create a competitive advantage for some organizations 
relative to others, a possibility that certainly applies to a change 
with the scope of this proposed rule. However, measurement difficulties 
described in the preceding discussion of costs and benefits also extend 
to any consideration of the impact on competition. Despite the inherent 
difficulty of drawing definitive conclusions, this section considers 
various ways in which competitive effects might be manifest, as well as 
available evidence related to those potential effects.
    1. Explicit Capital for Operational Risk: Some have noted that the 
explicit computation of required capital for operational risk could 
lead to an increase in total minimum regulatory capital for U.S. 
``processing'' banks, generally defined as banking organizations that 
tend to engage in a variety of activities related to securities 
clearing, asset management, and custodial services. Some have suggested 
that the increase in required capital could place such firms at a 
competitive disadvantage relative to competitors that do not face a 
similar capital requirement. A careful analysis by Fontnouvelle et al 
\88\ considers the potential competitive impact of the explicit capital 
requirement for operational risk. Overall, the study concludes that 
competitive effects from an explicit operational risk capital 
requirement should be, at most, extremely modest.
---------------------------------------------------------------------------

    \88\ Patrick de Fontnouvelle, Victoria Garrity, Scott Chu, and 
Eric Rosengren, ``The Potential Impact of Explicit Operational Risk 
Capital Charges on Bank Processing Activities,'' Manuscript, Federal 
Reserve Bank of Boston, January 12, 2005. Available at http://
www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
---------------------------------------------------------------------------

    2. Residential Mortgage Lending: The issue of competitive effects 
has received substantial attention with respect to the residential 
mortgage market. The focus on the residential mortgage market stems 
from the size and importance of the market in the United States and the 
fact that the proposed rule may lead to substantial reductions in 
credit-risk capital for residential mortgages. To the extent that 
corresponding operational-risk capital requirements do not offset these 
credit-risk-related reductions, overall capital requirements for 
residential mortgages could decline under the proposed rule. Studies by 
Calem and Follain \89\ and Hancock, Lehnert, Passmore, and Sherlund 
\90\ suggest that banking organizations operating under capital rules 
based on Basel II may increase their holdings of residential mortgages. 
Calem and Follain argue that the increase would be significant and come 
at the expense of general organizations. Hancock et al. foresee a more 
modest increase in residential mortgage holdings at institutions 
operating under the new Basel II-based rules, and they see this 
increase primarily as a shift away from the large government sponsored 
mortgage enterprises.
---------------------------------------------------------------------------

    \89\ Paul S. Calem and James R. Follain, ``An Examination of How 
the Proposed Bifurcated Implementation of Basel II in the U.S. May 
Affect Competition Among Banking Organizations for Residential 
Mortgages,'' manuscript, January 14, 2005.
    \90\ Diana Hancock, Andreas Lehnert, Wayne Passmore, and Shane 
M. Sherlund, ``An Analysis of the Potential Competitive Impact of 
Basel II Capital Standards on U.S. Mortgage Rates and Mortgage 
Securitization'', Federal Reserve Board manuscript, April 2005. 
Available at http://www.federalreserve.gov/generalinfo/basel2/
whitepapers.htm.
---------------------------------------------------------------------------

    3. Small Business Lending: One potential avenue for competitive 
effects is small-business lending. Smaller banks--those that are less 
likely to adopt the advanced approaches to regulatory capital under the 
proposed rule--tend to rely more heavily on smaller loans within their 
commercial loan portfolios. To the extent that the proposed rule 
reduces required capital for such loans, general banking organizations 
not operating under the proposed rule might be placed at a competitive 
disadvantage. A study by Berger \91\ finds some potential for a 
relatively small competitive effect on smaller banks in small business 
lending. However, Berger concludes that the small business market for 
large banks is very different from the small business market for 
smaller banks. For instance, a ``small business'' at a larger banking 
organization is usually much larger than small businesses at community 
banking organizations.
---------------------------------------------------------------------------

    \91\ Allen N. Berger, ``Potential Competitive Effects of Basel 
II on Banks in SME Credit Markets in the United States,'' Federal 
Reserve Board Finance and Economics Discussion Series, 2004-12. 
Available at http://www.federalreserve.gov/generalinfo/basel2/
whitepapers.htm.
---------------------------------------------------------------------------

    4. Mergers and Acquisitions: Another concern related to potential 
changes in competitive conditions under the proposed rule is that 
bifurcation of capital standards might change the landscape with regard 
to mergers and acquisitions in banking and financial services. For 
example, banking organizations operating under the new Basel II-based 
capital requirements might be placed in a better position to acquire 
other banking organizations operating under the non-Basel II-based 
rules, possibly leading to an undesirable consolidation of the banking 
sector. Research by Hannan and Pilloff \92\ suggests that the proposed 
rule is unlikely to have a significant impact on merger and acquisition 
activity in banking.
---------------------------------------------------------------------------

    \92\ Timothy H. Hannan and Steven J. Pilloff, ``Will the 
Proposed Application of Basel II in the United States Encourage 
Increased Bank Merger Activity? Evidence from Past Merger 
Activity,'' Federal Reserve Board Finance and Economics Discussion 
Series, 2004-13. Available at http://www.federalreserve.gov/
generalinfo/basel2/whitepapers.htm.
---------------------------------------------------------------------------

    5. Credit Card Competition: The proposed U.S. implementation of 
Basel II might also affect competition in the credit card market. 
Overall capital requirements for credit card loans could increase under 
the proposed rule. This raises the possibility of a change in the 
competitive environment among banking organizations subject to the new 
Basel II-based capital rules, nonbank credit card issuers, and banking 
organizations not subject to the new Basel II-based capital rules. A 
study by Lang, Mester, and Vermilyea \93\ finds that implementation of 
a rule based on Basel II will not affect credit card competition at 
most community and regional banking organizations. The authors also 
suggest that higher capital requirements for credit cards may only pose 
a modest disadvantage to institutions that are subject to rules based 
on Basel II.
---------------------------------------------------------------------------

    \93\ William W. Lang, Loretta J. Mester, and Todd A. Vermilyea, 
``Potential Competitive Effects on U.S. Bank Credit Card Lending 
from the Proposed Bifurcated Application of Basel II,'' manuscript, 
December 2005. Available at http://www.federalreserve.gov/
generalinfo/basel2/whitepapers.htm.
---------------------------------------------------------------------------

    Overall, the evidence regarding the impact of the proposed rule on 
competitive equity is mixed. The body of recent economic research 
discussed in the body of this report does not reveal persuasive 
evidence of any sizeable competitive effects. Nonetheless, the Federal 
banking agencies recognize the need to closely monitor the competitive 
landscape subsequent to any regulatory change. In particular, the OCC 
and other Federal banking agencies will be alert

[[Page 55909]]

for early signs of competitive inequities that might result from this 
proposed rule. A multi-year transition period before full 
implementation of proposed rules based on Basel II should provide ample 
opportunity for the agencies to identify any emerging problems. To the 
extent that undesirable competitive inequities emerge, the agencies 
have the power to respond to them through many channels, including but 
not limited to suitable changes to the capital adequacy regulations.
    IV. Analysis of Baseline and Alternatives.
    Executive Order 12866 requires a comparison between the proposed 
rule, a baseline of what the world would look like without the proposed 
rule, and several reasonable alternatives to the proposed rule. In this 
regulatory impact analysis, we analyze two baselines and three 
alternatives to the proposed rule. We consider two baselines because of 
two very different outcomes that depend on the capital rules that other 
countries with internationally active banks might adopt absent the 
implementation of the Basel II framework in the United States.\94\ The 
first baseline considers the possibility that neither the United States 
nor these other countries adopt capital rules based on the Basel II 
framework. The second baseline analyzes the situation where the United 
States does not adopt the proposed rule, but the other countries with 
internationally active banking organizations do adopt Basel II.
---------------------------------------------------------------------------

    \94\ In addition to the United States, members of the Basel 
Committee on Banking Supervision considering Basel II are Belgium, 
Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, 
Spain, Sweden, Switzerland, and the United Kingdom.
---------------------------------------------------------------------------

    A. Presentation of Baselines and Alternatives.
    1. Baseline Scenario 1: Current capital standards based on the 1988 
Basel Accord continue to apply both here and abroad: Abandoning the 
Basel II framework in favor of current capital rules would eliminate 
essentially all of the benefits of the proposed rule described earlier. 
In place of these lost or diminished benefits, the only advantage of 
continuing to apply current capital rules to all banking organizations 
is that maintaining the status quo should alleviate concerns regarding 
competition among financial service providers. Although the effect of 
the proposed rule on competition is uncertain in our estimation, 
staying with current capital rules (or universally applying a revised 
rule that might emerge from the Basel IA ANPR) eliminates bifurcation 
and the explicit assignment of capital for operational risk. Concerns 
regarding competition usually center on these two characteristics of 
the proposed rule. While continuing to use current capital rules 
eliminates most of the benefits of adopting the proposed capital rule, 
it does not eliminate many costs associated with Basel II. Because 
Basel II costs are difficult to separate from the banking 
organization's ordinary development costs and ordinary supervisory 
costs at the agencies, dropping the proposal to implement Basel II 
would reduce but not eliminate many of these costs associated with the 
proposed rule.\95\
---------------------------------------------------------------------------

    \95\ Cost estimates for adopting a rule that might result from 
the Basel IA ANPR are not currently available.
---------------------------------------------------------------------------

    2. Baseline Scenario 2: Current capital standards based on the 1988 
Basel Accord continue to apply in the United States, but the rest of 
the world adopts the Basel II framework: Like the first baseline 
scenario, abandoning a framework based on Basel II in favor of current 
capital rules would eliminate essentially all of the benefits of the 
proposed rule described earlier. Like the first baseline scenario, the 
one advantage of this scenario is that there would be no bifurcation of 
capital rules within the United States. However, the emergence of 
different capital rules across national borders would at least 
partially offset this advantage. Thus, while concerns regarding 
competition among U.S. financial service providers might diminish in 
this scenario, concerns regarding cross-border competition would likely 
increase. Just as the first baseline scenario eliminated most of the 
benefits of adopting the proposed rule, the same holds true for the 
second baseline scenario with one important distinction. Because the 
United States would be operating under a set of capital rules different 
from the rest of the world, U.S. banking organizations that are 
internationally active may face higher costs because they will have to 
track and comply with more than one set of capital requirements.
    3. Alternative A: Permit U.S. banking organizations to choose among 
all three Basel II credit risk approaches: The principal benefit of 
Alternative A that the proposed rule does not achieve is the increased 
flexibility of the regulation for banking organizations that would be 
mandatory banking organizations under the proposed rule. Banking 
organizations that are not prepared for the adoption of the advanced 
IRB approach to credit risk under the proposed rule could choose to use 
the foundation IRB approach or even the standardized approach. How 
Alternative A might affect benefits depends entirely on how many 
banking organizations select each of the three available options. The 
most significant drawback to Alternative A is the increased cost of 
applying a new set of capital rules to all U.S. banking organizations. 
The vast majority of banking organizations in the United States would 
incur no direct costs from new capital rules under the proposed rule. 
Under Alternative A, direct costs would increase for every U.S. banking 
organization that would have continued with current capital rules under 
the proposed rule. Although it is not clear how high these costs might 
be, general banking organizations would face higher costs because they 
would be changing capital rules regardless of which option they choose 
under Alternative A.
    4. Alternative B: Permit U.S. banking organizations to choose among 
all three Basel II operational risk approaches: The operational risk 
approach that banking organizations ultimately selected would determine 
how the overall benefits of the new capital regulations would change 
under Alternative B. Just as Alternative A increases the flexibility of 
credit risk rules for mandatory banking organizations, Alternative B is 
more flexible with respect to operational risk. Because the 
Standardized Approach tries to be more sensitive to variations in 
operational risk than the Basic Indicator Approach and the AMA is more 
sensitive than the Standardized Approach, the effect of implementing 
Alternative B depends on how many banking organizations select the more 
risk sensitive approaches. As was the case with Alternative A, the most 
significant drawback to Alternative B is the increased cost of applying 
a new set of capital rules to all U.S. banking organizations. Under 
Alternative B, direct costs would increase for every U.S. banking 
organization that would have continued with current capital rules under 
the proposed rule. It is not clear how much it might cost banking 
organizations to adopt these capital measures for operational risk, but 
general banking organizations would face higher costs because they 
would be changing capital rules regardless of which option they choose 
under Alternative B.
    5. Alternative C: Use a different asset amount to determine a 
mandatory organization: The number of mandatory banking organizations 
decreases slowly as the size thresholds increase, and the number of 
banking organizations grows more quickly as the thresholds decrease. 
Under Alternative C, the framework of

[[Page 55910]]

the proposed rule would remain the same and only the number of 
mandatory banking organizations would change. Because the structure of 
the proposed implementation would remain intact, Alternative C would 
capture all of the benefits of the proposed rule. However, because 
these benefits derive from applying the proposed rule to individual 
banking organizations, changing the number of banking organizations 
affected by the rule will change the cumulative level of the benefits 
achieved. Generally, the benefits associated with the proposed rule 
will rise and fall with the number of mandatory banking organizations. 
Because Alternative C would change the number of mandatory banking 
organizations subject to the proposed rule, aggregate costs will also 
rise or fall with the number of mandatory banking organizations.
    B. Overall Comparison of the Proposed Rule with Baselines and 
Alternatives.
    The Basel II framework and its proposed U.S. implementation seek to 
incorporate risk measurement and risk management advances into capital 
requirements. On the basis of their analysis, the agencies believe that 
the benefits of the proposed rule are significant, durable, and hold 
the potential to increase with time. The offsetting costs of 
implementing the proposed rule are also significant, but appear to be 
largely because of considerable start-up costs. However, much of the 
apparent start-up costs reflect activities that the banking 
organizations would undertake as part of their ongoing efforts to 
improve the quality of their internal risk measurement and management, 
even in the absence of Basel II and this proposed rule. The advanced 
approaches seem to have fairly modest ongoing expenses. Against these 
costs, the significant benefits of Basel II suggest that the proposed 
rule offers an improvement over either of the two baseline scenarios.
    With regard to the three alternative approaches we consider, the 
proposed rule seems to offer an important degree of flexibility while 
significantly restricting the cost of the proposed rule by limiting its 
application to large, complex, internationally active banking 
organizations. Alternatives A and B introduce more flexibility from the 
perspective of the large mandatory banking organizations, but each is 
less flexible with respect to other banking organizations. Either 
Alternative A or B would compel these banking organizations to select a 
new set of capital rules and require them to undertake the time and 
expense of adjusting to these new rules. Alternative C would change the 
number of mandatory banking organizations. If the number of mandatory 
banking organizations increases, then the new rule would lose some of 
the flexibility the proposed rule achieves with the opt-in option. 
Furthermore, costs would increase as the new rule would compel more 
banking organizations to incur the expense of adopting the advanced 
approaches. Decreasing the number of mandatory banking organizations 
would decrease the aggregate social good of each benefit achieved with 
the proposed rule. The proposed rule seems to offer a better balance 
between costs and benefits than any of the three alternatives.
    OTS Executive Order 12866 Determination. OTS commented on the 
development of, and concurs with, OCC's RIA. Rather than replicate that 
analysis, OTS drafted an RIA incorporating OCC's analysis by reference 
and adding appropriate material reflecting the unique aspects of the 
thrift industry. The full text of OTS's RIA is available at the 
locations for viewing the OTS docket indicated in the ADDRESSES section 
above. OTS believes that its analysis meets the requirements of 
Executive Order 12866. The following discussion supplements OCC's 
summary of its RIA.
    The NPR would apply to approximately eight mandatory and potential 
opt-in savings associations representing approximately 46 percent of 
total thrift industry assets. Approximately 70 percent of the total 
assets in these eight institutions are concentrated in residential 
mortgage-related assets. By contrast, national banks tend to 
concentrate their assets in commercial loans and other kinds of non-
mortgage loans. Only about 35 percent of national bank's total assets 
are residential mortgage-related assets. As a result, the costs and 
benefits of the NPR for OTS-regulated savings associations will differ 
in important ways from OCC-regulated national banks. These differences 
are the focus of OTS's analysis.
    Benefits. Among the benefits of the NPR, OCC cites: (i) Better 
allocation of capital and reduced impact of moral hazard through 
reduction in the scope for regulatory arbitrage; (ii) improved signal 
quality of capital as an indicator of institution solvency; and (iii) 
more efficient use of required bank capital. From OTS's perspective, 
however, the NPR may not provide the degree of benefits anticipated by 
OCC from these sources.
    Because of the low credit risk associated with residential 
mortgage-related assets, OTS believes that the risk-insensitive 
leverage ratio, rather than the risk-based capital ratio, may be more 
binding on its institutions.\96\ As a result, these institutions may be 
required to hold more capital than would be required under proposed 
credit risk-based standards alone. Therefore, the NPR may cause these 
institutions to incur much the same implementation costs as banks with 
riskier assets, but with reduced benefits.
---------------------------------------------------------------------------

    \96\ The leverage ratio is the ratio of core capital to adjusted 
total assets. Under prompt corrective action requirements, savings 
associations must maintain a leverage ratio of at least five percent 
to be well capitalized and at least four percent to be adequately 
capitalized. Basel II will primarily affect the calculation of risk-
weighted assets, rather than the calculation of total assets and 
will have only a modest impact on the calculation of core capital. 
Thus, the proposed Basel II changes should not significantly affect 
the calculated leverage ratio and a savings association that is 
currently constrained by the leverage ratio would not significantly 
benefit from the Basel II changes.
---------------------------------------------------------------------------

    Costs. OTS adopts the OCC cost analysis with the following 
supplemental information on OTS's administrative costs. OTS did not 
incur a meaningful amount of direct expenditures until 2002 when it 
transitioned from a monitoring role to active involvement in Basel II. 
Thereafter, expenditures increased rapidly. The OTS expenditures fall 
into two broad categories: Policymaking expenses incurred in the 
development of the ANPR, this NPR, and related guidance; and 
supervision expenses that reflect institution-specific supervisory 
activities. OTS estimates that it incurred total expenses of $3,780,000 
for fiscal years 2002 through 2005, including $2,640,000 in 
policymaking expenses and $1,140,000 in supervision expenses. OTS 
anticipates that supervision expenses will continue to grow as a 
percentage of the total expense as it moves from policy development to 
implementation and training. To date, Basel II expenditures have not 
been a large part of overall expenditures.
    Competition. OTS agrees with OCC's analysis of competition among 
providers of financial services. OTS adds, however, that some 
institutions with low credit risk portfolios face an existing 
competitive disadvantage because they are bound by a non-risk-based 
capital requirement--the leverage ratio. Thus, the agencies regulate a 
class of institutions that currently receive fewer capital benefits 
from risk-based capital rules because they are bound by the risk-
insensitive leverage ratio. This anomaly will likely continue under the 
NPR.

[[Page 55911]]

    In addition, the results from QIS-3 and QIS-4 suggest that the 
largest reductions in regulatory credit-risk capital requirements from 
the application of revised rules would occur in the residential 
mortgage loan area. Thus, to the extent regulatory credit-risk capital 
requirements affect pricing of such loans, it is possible that core and 
opt-in institutions who are not constrained by the leverage ratio may 
experience an improvement in their competitive standing vis-[agrave]-
vis non-adopters and vis-[agrave]-vis adopters who are bound by the 
leverage ratio. Two research papers--one by Calem and Follain,\97\ and 
another by Hancock, Lenhert, Passmore, and Sherlund \98\ addressed this 
topic. The Calem and Follain paper argues that Basel II will 
significantly affect the competitive environment in mortgage lending; 
Hancock, et al. argue that it will not. Both papers are predicated, 
however, on the current capital regime for non-adopters. The agencies 
recently published an ANPR seeking comment on various modifications to 
the existing risk-based capital rules.\99\ These changes may reduce the 
competitive disparities between adopters and non-adopters of Basel II 
by reducing the competitive advantage of Basel II adopters.
---------------------------------------------------------------------------

    \97\ Paul S. Calem and James R. Follain, ``An Examination of How 
the Proposed Bifurcated Implementation of Basel II in the U.S. May 
Affect Competition Among Banking Organizations for Residential 
Mortgages,'' manuscript, January 14, 2005.
    \98\ Diana Hancock, Andreas Lenhert, Wayne Passmore, and Shane M 
Sherlund, ``An Analysis of the Competitive Impacts of Basel II 
Capital Standards on U.S. Mortgage Rates and Mortgage 
Securitization, March 7, 2005, Board of Governors of the Federal 
Reserve System, working paper.''
    \99\ 70 FR 61068 (Oct. 20, 2005).
---------------------------------------------------------------------------

    Further, residential mortgages are subject to substantial interest 
rate risk. The agencies will retain the authority to require additional 
capital to cover interest rate risk. If regulatory capital requirements 
affect asset pricing, a substantial regulatory capital interest rate 
risk component could mitigate any competitive advantages of the 
proposed rule. Moreover, the capital requirement for interest rate risk 
would be subject to interpretation by each agency. A consistent 
evaluation of interest rate risk by the supervisory agencies would 
present a level playing field among the adopters--an important 
consideration given the potential size of the capital requirement.
    OCC Unfunded Mandates Reform Act of 1995 Determination. The 
Unfunded Mandates Reform Act of 1995 (Pub. L. 104-4) (UMRA) requires 
cost-benefit and other analyses for a rule that would include any 
Federal mandate that may result in the expenditure by State, local, and 
tribal governments, in the aggregate, or by the private sector of $100 
million or more (adjusted annually for inflation) in any one year. The 
current inflation-adjusted expenditure threshold is $119.6 million. The 
requirements of the UMRA include assessing a rule's effects on future 
compliance costs; particular regions or State, local, or tribal 
governments; communities; segments of the private sector; productivity; 
economic growth; full employment; creation of productive jobs; and the 
international competitiveness of U.S. goods and services. The proposed 
rule qualifies as a significant regulatory action under the UMRA 
because its Federal mandates may result in the expenditure by the 
private sector of $119.6 million or more in any one year. As permitted 
by section 202(c) of the UMRA, the required analyses have been prepared 
in conjunction with the Executive Order 12866 analysis document titled 
Regulatory Impact Analysis for Risk-Based Capital Standards: Revised 
Capital Adequacy Guidelines. The analysis is available on the Internet 
at http://www.occ.treas.gov/law/basel.htm under the link of 
``Regulatory Impact Analysis for Risk-Based Capital Standards: Revised 
Capital Adequacy Guidelines (Basel II), Office of the Comptroller of 
the Currency, International and Economic Affairs (2006)''.
    OTS Unfunded Mandates Reform Act of 1995 Determination. The 
Unfunded Mandates Reform Act of 1995 (Pub. L. 104-4) (UMRA) requires 
cost-benefit and other analyses for a rule that would include any 
Federal mandate that may result in the expenditure by State, local, and 
tribal governments, in the aggregate, or by the private sector of $100 
million or more (adjusted annually for inflation) in any one year. The 
current inflation-adjusted expenditure threshold is $119.6 million. The 
requirements of the UMRA include assessing a rule's effects on future 
compliance costs; particular regions or State, local, or tribal 
governments; communities; segments of the private sector; productivity; 
economic growth; full employment; creation of productive jobs; and the 
international competitiveness of U.S. goods and services. The proposed 
rule qualifies as a significant regulatory action under the UMRA 
because its Federal mandates may result in the expenditure by the 
private sector of $119.6 or more in any one year. As permitted by 
section 202(c) of the UMRA, the required analyses have been prepared in 
conjunction with the Executive Order 12866 analysis document titled 
Regulatory Impact Analysis for Risk-Based Capital Standards: Revised 
Capital Adequacy Guidelines. The analysis is available at the locations 
for viewing the OTS docket indicated in the ADDRESSES section above.

Text of Common Appendix (All Agencies)

    The text of the agencies' common appendix appears below:
    [Appendix to Part----]--Capital Adequacy Guidelines for [Bank]s: 
\100\ Internal-Ratings-Based and Advanced Measurement Approaches

    \1\ For simplicity, and unless otherwise noted, this NPR uses 
the term [bank] to include banks, savings associations, and bank 
holding companies. [AGENCY] refers to the primary Federal supervisor 
of the bank applying the rule.
---------------------------------------------------------------------------

Part I General Provisions
    Section 1 Purpose, Applicability, and Reservation of Authority
    Section 2 Definitions
    Section 3 Minimum Risk-Based Capital Requirements
Part II Qualifying Capital
    Section 11 Additional Deductions
    Section 12 Deductions and Limitations Not Required
    Section 13 Eligible Credit Reserves
Part III Qualification
    Section 21 Qualification Process
    Section 22 Qualification Requirements
    Section 23 Ongoing Qualification
Part IV Risk-Weighted Assets for General Credit Risk
    Section 31 Mechanics for Calculating Total Wholesale and Retail 
Risk-Weighted Assets
    Section 32 Counterparty Credit Risk
    Section 33 Guarantees and Credit Derivatives: PD Substitution 
and LGD Adjustment Treatments
    Section 34 Guarantees and Credit Derivatives: Double Default 
Treatment
    Section 35 Risk-Based Capital Requirement for Unsettled 
Transactions
Part V Risk-Weighted Assets for Securitization Exposures
    Section 41 Operational Criteria for Recognizing the Transfer of 
Risk
    Section 42 Risk-Based Capital Requirement for Securitization 
Exposures
    Section 43 Ratings-Based Approach (RBA)
    Section 44 Internal Assessment Approach (IAA)
    Section 45 Supervisory Formula Approach (SFA)
    Section 46 Recognition of Credit Risk Mitigants for 
Securitization Exposures
    Section 47 Risk-Based Capital Requirement for Early Amortization 
Provisions
Part VI Risk-Weighted Assets for Equity Exposures
    Section 51 Introduction and Exposure Measurement
    Section 52 Simple Risk Weight Approach (SRWA)
    Section 53 Internal Models Approach (IMA)

[[Page 55912]]

    Section 54 Equity Exposures to Investment Funds
    Section 55 Equity Derivative Contracts
Part VII Risk-Weighted Assets for Operational Risk
    Section 61 Qualification Requirements for Incorporation of 
Operational Risk Mitigants
    Section 62 Mechanics of Risk-Weighted Asset Calculation
Part VIII Disclosure
    Section 71 Disclosure Requirements

Part I. General Provisions

Section 1. Purpose, Applicability, and Reservation of Authority

    (a) Purpose. This appendix establishes:
    (1) Minimum qualifying criteria for [bank]s using [bank]-specific 
internal risk measurement and management processes for calculating 
risk-based capital requirements;
    (2) Methodologies for such [bank]s to calculate their risk-based 
capital requirements; and
    (3) Public disclosure requirements for such [bank]s.
    (b) Applicability. (1) This appendix applies to a [bank] that:
    (i) Has consolidated total assets, as reported on the most recent 
year-end Consolidated Report of Condition and Income (Call Report) or 
Thrift Financial Report (TFR), equal to $250 billion or more;
    (ii) Has consolidated total on-balance sheet foreign exposure at 
the most recent year-end equal to $10 billion or more (where total on-
balance sheet foreign exposure equals total cross-border claims less 
claims with head office or guarantor located in another country plus 
redistributed guaranteed amounts to the country of head office or 
guarantor plus local country claims on local residents plus revaluation 
gains on foreign exchange and derivative products, calculated in 
accordance with the Federal Financial Institutions Examination Council 
(FFIEC) 009 Country Exposure Report);
    (iii) Is a subsidiary of a depository institution that uses 12 CFR 
part 3, Appendix C, 12 CFR part 208, Appendix F, 12 CFR part 325, 
Appendix D, or 12 CFR part 566, Appendix A, to calculate its risk-based 
capital requirements; or
    (iv) Is a subsidiary of a bank holding company (as defined in 12 
U.S.C. 1841) that uses 12 CFR part 225, Appendix F, to calculate its 
risk-based capital requirements.
    (2) Any [bank] may elect to use this appendix to calculate its 
risk-based capital requirements.
    (3) A [bank] that is subject to this appendix must use this 
appendix unless the [AGENCY] determines in writing that application of 
this appendix is not appropriate in light of the [bank]'s asset size, 
level of complexity, risk profile, or scope of operations. In making a 
determination under this paragraph, the [AGENCY] will apply notice and 
response procedures in the same manner and to the same extent as the 
notice and response procedures in 12 CFR 3.12 (for national banks), 12 
CFR 263.202 (for bank holding companies and state member banks), 12 CFR 
325.6(c) (for state nonmember banks), and 12 CFR 567.3(d) (for savings 
associations).
    (c) Reservation of authority--(1) Additional capital in the 
aggregate. The [AGENCY] may require a [bank] to hold an amount of 
capital greater than otherwise required under this appendix if the 
[AGENCY] determines that the [bank]'s risk-based capital requirement 
under this appendix is not commensurate with the [bank]'s credit, 
market, operational, or other risks. In making a determination under 
this paragraph, the [AGENCY] will apply notice and response procedures 
in the same manner and to the same extent as the notice and response 
procedures in 12 CFR 3.12 (for national banks), 12 CFR 263.202 (for 
bank holding companies and state member banks), 12 CFR 325.6(c) (for 
state nonmember banks), and 12 CFR 567.3(d) (for savings associations).
    (2) Specific risk-weighted asset amounts. (i) If the [AGENCY] 
determines that the risk-weighted asset amount calculated under this 
appendix by the [bank] for one or more exposures is not commensurate 
with the risks associated with those exposures, the [AGENCY] may 
require the [bank] to assign a different risk-weighted asset amount to 
the exposures, to assign different risk parameters to the exposures (if 
the exposures are wholesale or retail exposures), or to use different 
model assumptions for the exposures (if the exposures are equity 
exposures under the Internal Models Approach (IMA) or securitization 
exposures under the Internal Assessment Approach (IAA)), all as 
specified by the [AGENCY].
    (ii) If the [AGENCY] determines that the risk-weighted asset amount 
for operational risk produced by the [bank] under this appendix is not 
commensurate with the operational risks of the [bank], the [AGENCY] may 
require the [bank] to assign a different risk-weighted asset amount for 
operational risk, to change elements of its operational risk analytical 
framework, including distributional and dependence assumptions, or to 
make other changes to the [bank]'s operational risk management 
processes, data and assessment systems, or quantification systems, all 
as specified by the [AGENCY].
    (3) Other supervisory authority. Nothing in this appendix limits 
the authority of the [AGENCY] under any other provision of law or 
regulation to take supervisory or enforcement action, including action 
to address unsafe or unsound practices or conditions, deficient capital 
levels, or violations of law.

Section 2. Definitions

    Advanced internal ratings-based (IRB) systems means a [bank]'s 
internal risk rating and segmentation system; risk parameter 
quantification system; data management and maintenance system; and 
control, oversight, and validation system for credit risk of wholesale 
and retail exposures.
    Advanced systems means a [bank]'s advanced IRB systems, operational 
risk management processes, operational risk data and assessment 
systems, operational risk quantification systems, and, to the extent 
the [bank] uses the following systems, the counterparty credit risk 
model, double default excessive correlation detection process, IMA for 
equity exposures, and IAA for securitization exposures to ABCP 
programs.
    Affiliate with respect to a company means any company that 
controls, is controlled by, or is under common control with, the 
company. For purposes of this definition, a person or company controls 
a company if it:
    (1) Owns, controls, or holds with power to vote 25 percent or more 
of a class of voting securities of the company; or
    (2) Consolidates the company for financial reporting purposes.
    Applicable external rating means, with respect to an exposure, the 
lowest external rating assigned to the exposure by any NRSRO.
    Asset-backed commercial paper (ABCP) program means a program that 
primarily issues commercial paper that:
    (1) Has an external rating; and
    (2) Is backed by underlying exposures held in a bankruptcy-remote 
SPE.
    Asset-backed commercial paper (ABCP) program sponsor means a [bank] 
that:
    (1) Establishes an ABCP program;
    (2) Approves the sellers permitted to participate in an ABCP 
program;
    (3) Approves the exposures to be purchased by an ABCP program; or
    (4) Administers the ABCP program by monitoring the underlying 
exposures, underwriting or otherwise arranging for the placement of 
debt or other obligations issued by the program,

[[Page 55913]]

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

[[Page 55914]]

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

[[Page 55915]]

    (2) Non-U.S.-based entities. A foreign bank (as defined in section 
211.2 of the Federal Reserve Board's Regulation K (12 CFR 211.2)), a 
non-U.S. securities firm, or a non-U.S. based insurance company in the 
business of providing credit protection, if:
    (i) The [bank] demonstrates that the guarantor is subject to 
consolidated supervision and regulation comparable to that imposed on 
U.S. depository institutions, securities broker-dealers, or insurance 
companies (as the case may be) or has issued and outstanding an 
unsecured long-term debt security without credit enhancement that has a 
long-term applicable external rating in one of the three highest 
investment grade rating categories;
    (ii) At the time the guarantor issued the guarantee or credit 
derivative, the [bank] assigned a PD to the guarantor's rating grade 
that was equal to or lower than the PD associated with a long-term 
external rating in the third-highest investment grade rating category; 
and
    (iii) The [bank] currently assigns a PD to the guarantor's rating 
grade that is equal to or lower than the PD associated with a long-term 
external rating in the lowest investment grade rating category.
    Eligible guarantee means a guarantee that:
    (1) Is written and unconditional;
    (2) Covers all or a pro rata portion of all contractual payments of 
the obligor on the reference exposure;
    (3) Gives the beneficiary a direct claim against the protection 
provider;
    (4) Is non-cancelable by the protection provider for reasons other 
than the breach of the contract by the beneficiary;
    (5) Is legally enforceable against the protection provider in a 
jurisdiction where the protection provider has sufficient assets 
against which a judgment may be attached and enforced; and
    (6) Requires the protection provider to make payment to the 
beneficiary on the occurrence of a default (as defined in the 
guarantee) of the obligor on the reference exposure without first 
requiring the beneficiary to demand payment from the obligor.
    Eligible margin loan means an extension of credit where:
    (1) The extension of credit is collateralized exclusively by debt 
or equity securities that are liquid and readily marketable;
    (2) The collateral is marked to market daily, and the transaction 
is subject to daily margin maintenance requirements;
    (3) The extension of credit is conducted under an agreement that 
provides the [bank] the right to accelerate and terminate the extension 
of credit and to liquidate or set off collateral promptly upon an event 
of default (including upon an event of bankruptcy, insolvency, or 
similar proceeding) of the counterparty, provided that, in any such 
case, any exercise of rights under the agreement will not be stayed or 
avoided under applicable law in the relevant jurisdictions;\2\ and
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    \2\ This requirement is met where all transactions under the 
agreement are (i) executed under U.S. law and (ii) constitute 
``securities contracts'' or ``repurchase agreements'' under section 
555 or 559, respectively, of the Bankruptcy Code (11 U.S.C. 555), 
qualified financial contracts under section 11(e)(8) of the Federal 
Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or netting contracts 
between or among financial institutions under sections 401-407 of 
the Federal Deposit Insurance Corporation Improvement Act of 1991 
(12 U.S.C. 4401-4407) or the Federal Reserve Board's Regulation EE 
(12 CFR part 231).
---------------------------------------------------------------------------

    (4) The [bank] has conducted and documented sufficient legal review 
to conclude with a well-founded basis that the agreement meets the 
requirements of paragraph (3) of this definition and is legal, valid, 
binding, and enforceable under applicable law in the relevant 
jurisdictions.
    Eligible operational risk offsets means amounts, not to exceed 
expected operational loss, that:
    (1) Are generated by internal business practices to absorb highly 
predictable and reasonably stable operational losses, including 
reserves calculated consistent with GAAP; and
    (2) Are available to cover expected operational losses with a high 
degree of certainty over a one-year horizon.
    Eligible purchased wholesale receivable means a purchased wholesale 
receivable that:
    (1) The [bank] purchased from an unaffiliated seller and did not 
directly or indirectly originate;
    (2) Was generated on an arm's-length basis between the seller and 
the obligor;\3\
---------------------------------------------------------------------------

    \3\ Intercompany accounts receivable and receivables subject to 
contra-accounts between firms that buy and sell to each other do not 
satisfy this criterion.
---------------------------------------------------------------------------

    (3) Provides the [bank] with a claim on all proceeds from the 
receivable or a pro-rata interest in the proceeds from the receivable; 
and
    (4) Has an M of less than one year.
    Eligible securitization guarantor means:
    (1) A sovereign entity, the Bank for International Settlements, the 
International Monetary Fund, the European Central Bank, the European 
Commission, a Federal Home Loan Bank, Federal Agricultural Mortgage 
Corporation (Farmer Mac), a multi-lateral development bank, a 
depository institution, a bank holding company (as defined in section 2 
of the Bank Holding Company Act (12 U.S.C. 1841)), a savings and loan 
holding company (as defined in 12 U.S.C. 1467a) provided all or 
substantially all of the holding company's activities are permissible 
for a financial holding company under 12 U.S.C. 1843(k), a foreign bank 
(as defined in section 211.2 of the Federal Reserve Board's Regulation 
K (12 CFR 211.2)), or a securities firm;
    (2) Any other entity (other than an SPE) that has issued and 
outstanding an unsecured long-term debt security without credit 
enhancement that has a long-term applicable external rating in one of 
the three highest investment grade rating categories; or
    (3) Any other entity (other than an SPE) that has a PD assigned by 
the [bank] that is lower than or equal to the PD associated with a 
long-term external rating in the third highest investment grade rating 
category.
    Eligible servicer cash advance facility means a servicer cash 
advance facility in which:
    (1) The servicer is entitled to full reimbursement of advances, 
except that a servicer may be obligated to make non-reimbursable 
advances for a particular underlying exposure if any such advance is 
contractually limited to an insignificant amount of the outstanding 
principal balance of that exposure;
    (2) The servicer's right to reimbursement is senior in right of 
payment to all other claims on the cash flows from the underlying 
exposures of the securitization; and
    (3) The servicer has no legal obligation to, and does not, make 
advances to the securitization if the servicer concludes the advances 
are unlikely to be repaid.
    Equity derivative contract means an equity-linked swap, purchased 
equity-linked option, forward equity-linked contract, or any other 
instrument linked to equities that gives rise to similar counterparty 
credit risks.
    Equity exposure means:
    (1) A security or instrument (whether voting or non-voting) that 
represents a direct or indirect ownership interest in, and a residual 
claim on, the assets and income of a company, unless:
    (i) The issuing company is consolidated with the [bank] under GAAP;
    (ii) The [bank] is required to deduct the ownership interest from 
tier 1 or tier 2 capital under this appendix;
    (iii) The ownership interest is redeemable;
    (iv) The ownership interest incorporates a payment or other similar 
obligation on the part of the issuing

[[Page 55916]]

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

[[Page 55917]]

its share of the exposures' undrawn balances in EAD. Undrawn balances 
of exposures for which the drawn balances have been securitized must be 
allocated between the seller's and investors' interests on a pro rata 
basis, based on the proportions of the seller's and investors' shares 
of the securitized drawn balances.
    Exposure category means any of the wholesale, retail, 
securitization, or equity exposure categories.
    External operational loss event data means, with respect to a 
[bank], gross operational loss amounts, dates, recoveries, and relevant 
causal information for operational loss events occurring at 
organizations other than the [bank].
    External rating means a credit rating that is assigned by an NRSRO 
to an exposure, provided:
    (1) The credit rating fully reflects the entire amount of credit 
risk with regard to all payments owed to the holder of the exposure. If 
a holder is owed principal and interest on an exposure, the credit 
rating must fully reflect the credit risk associated with timely 
repayment of principal and interest. If a holder is owed only principal 
on an exposure, the credit rating must fully reflect only the credit 
risk associated with timely repayment of principal; and
    (2) The credit rating is published in an accessible form and is or 
will be included in the transition matrices made publicly available by 
the NRSRO that summarize the historical performance of positions rated 
by the NRSRO.
    Financial collateral means collateral:
    (1) In the form of:
    (i) Cash on deposit with the [bank] (including cash held for the 
[bank] by a third-party custodian or trustee);
    (ii) Gold bullion;
    (iii) Long-term debt securities that have an applicable external 
rating of one category below investment grade or higher;
    (iv) Short-term debt instruments that have an applicable external 
rating of at least investment grade;
    (v) Equity securities that are publicly traded;
    (vi) Convertible bonds that are publicly traded; or
    (vii) Money market mutual fund shares and other mutual fund shares 
if a price for the shares is publicly quoted daily; and
    (2) In which the [bank] has a perfected, first priority security 
interest or the legal equivalent thereof.
    GAAP means U.S. generally accepted accounting principles.
    Gain-on-sale means an increase in the equity capital (as reported 
on Schedule RC of the Call Report, schedule HC of the FR Y-9C Report, 
or Schedule SC of the Thrift Financial Report) of a [bank] that results 
from a securitization (other than an increase in equity capital that 
results from the [bank]'s receipt of cash in connection with the 
securitization).
    Guarantee means a financial guarantee, letter of credit, insurance, 
or other similar financial instrument (other than a credit derivative) 
that allows one party (beneficiary) to transfer the credit risk of one 
or more specific exposures (reference exposure) to another party 
(protection provider). See also eligible guarantee.
    High volatility commercial real estate (HVCRE) exposure means a 
credit facility that finances or has financed the acquisition, 
development, or construction (ADC) of real property, unless the 
facility finances:
    (1) One-to four-family residential properties; or
    (2) Commercial real estate projects in which:
    (i) The loan-to-value ratio is less than or equal to the applicable 
maximum supervisory loan-to-value ratio in the [AGENCY]'s real estate 
lending standards at 12 CFR part 34, Subpart D (OCC); 12 CFR part 208, 
Appendix C (Board); 12 CFR part 365, Subpart D (FDIC); and 12 CFR 
560.100-560.101 (OTS);
    (ii) The borrower has contributed capital to the project in the 
form of cash or unencumbered readily marketable assets (or has paid 
development expenses out-of-pocket) of at least 15 percent of the real 
estate's appraised ``as completed'' value; and
    (iii) The borrower contributed the amount of capital required by 
paragraph (2)(ii) of this definition before the [bank] advances funds 
under the credit facility, and the capital contributed by the borrower, 
or internally generated by the project, is contractually required to 
remain in the project throughout the life \4\ of the project.
---------------------------------------------------------------------------

    \4\ The life of a project concludes only when the credit 
facility is converted to permanent financing or is sold or paid in 
full. Permanent financing may be provided by the [bank] that 
provided the ADC facility as long as the permanent financing is 
subject to the [bank]'s underwriting criteria for long-term mortgage 
loans.
---------------------------------------------------------------------------

    Inferred rating. A securitization exposure has an inferred rating 
equal to the external rating referenced in paragraph (2)(i) of this 
definition if:
    (1) The securitization exposure does not have an external rating; 
and
    (2) Another securitization exposure issued by the same issuer and 
secured by the same underlying exposures:
    (i) Has an external rating;
    (ii) Is subordinated in all respects to the unrated securitization 
exposure;
    (iii) Does not benefit from any credit enhancement that is not 
available to the unrated securitization exposure; and
    (iv) Has an effective remaining maturity that is equal to or longer 
than that of the unrated securitization exposure.
    Interest rate derivative contract means a single-currency interest 
rate swap, basis swap, forward rate agreement, purchased interest rate 
option, when-issued securities, or any other instrument linked to 
interest rates that gives rise to similar counterparty credit risks.
    Internal operational loss event data means, with respect to a 
[bank], gross operational loss amounts, dates, recoveries, and relevant 
causal information for operational loss events occurring at the [bank].
    Investing [bank] means, with respect to a securitization, a [bank] 
that assumes the credit risk of a securitization exposure (other than 
an originating [bank] of the securitization). In the typical synthetic 
securitization, the investing [bank] sells credit protection on a pool 
of underlying exposures to the originating [bank].
    Investment fund means a company:
    (1) All or substantially all of the assets of which are financial 
assets; and
    (2) That has no material liabilities.
    Investors' interest EAD means, with respect to a securitization, 
the EAD of the underlying exposures multiplied by the ratio of:
    (1) The total amount of securitization exposures issued by the SPE 
to investors; divided by
    (2) The outstanding principal amount of underlying exposures.
    Loss given default (LGD) means:
    (1) For a wholesale exposure:
    (i) If the [bank] has received prior written approval from [AGENCY] 
to use internal estimates of LGD for the exposure's wholesale exposure 
subcategory, the greater of:
    (A) The [bank]'s ELGD for the exposure (or for the typical exposure 
in the loss severity grade assigned by the [bank] to the exposure); or
    (B) The [bank]'s empirically based best estimate of the economic 
loss, per dollar of EAD, the [bank] would expect to incur if the 
obligor (or a typical obligor in the loss severity grade assigned by 
the [bank] to the exposure) were to default within a one-year horizon 
during economic downturn conditions.
    (ii) If the [bank] has not received such prior approval,
    (A) For an exposure that is not a repo-style transaction, eligible 
margin loan, or OTC derivative contract, the sum of:
    (1) 0.08; and

[[Page 55918]]

    (2) 0.92 multiplied by the [bank]'s ELGD for the exposure (or for 
the typical exposure in the loss severity grade assigned by the [bank] 
to the exposure); or
    (B) For an exposure that is a repo-style transaction, eligible 
margin loan, or OTC derivative contract, the [bank]'s ELGD for the 
exposure (or for the typical exposure in the loss severity grade 
assigned by the [bank] to the exposure).
    (2) For a segment of retail exposures:
    (i) If the [bank] has received prior written approval from [AGENCY] 
to use internal estimates of LGD for the segment's retail exposure 
subcategory, the greater of:
    (A) The [bank]'s ELGD for the segment of exposures; or
    (B) The [bank]'s empirically based best estimate of the economic 
loss, per dollar of EAD, the [bank] would expect to incur on exposures 
in the segment that default within a one-year horizon during economic 
downturn conditions.
    (ii) If the [bank] has not received such prior approval,
    (A) For a segment of exposures that are not eligible margin loans, 
the sum of:
    (1) 0.08; and
    (2) 0.92 multiplied by the [bank]'s ELGD for the segment of 
exposures; or
    (B) For a segment of exposures that are eligible margin loans, the 
[bank]'s ELGD for the segment of exposures.
    (3) In approving a [bank]'s use of internal estimates of LGD for a 
wholesale or retail exposure subcategory, [AGENCY] will consider 
whether:
    (A) The [bank]'s internal estimates of LGD are reliable and 
sufficiently reflective of economic downturn conditions; and
    (B) The [bank] has rigorous and well-documented policies and 
procedures for identifying economic downturn conditions for the 
exposure subcategory, identifying material adverse correlations between 
the relevant drivers of default rates and loss rates given default, and 
incorporating identified correlations into internal LGD estimates.
    (4) The economic loss on an exposure in the event of default is all 
material credit-related losses on the exposure (including accrued but 
unpaid interest or fees, losses on the sale of collateral, direct 
workout costs, and an appropriate allocation of indirect workout 
costs). Where positive or negative cash flows on a wholesale exposure 
to a defaulted obligor or a defaulted retail exposure (including 
proceeds from the sale of collateral, workout costs, and draw-downs of 
unused credit lines) occur after the date of default, the economic loss 
must reflect the net present value of cash flows as of the default date 
using a discount rate appropriate to the risk of the defaulted 
exposure.
    Main index means the Standard & Poor's 500 Index, the FTSE All-
World Index, and any other index for which the [bank] can demonstrate 
to the satisfaction of [AGENCY] that the equities represented in the 
index have comparable liquidity, depth of market, and size of bid-ask 
spreads as equities in the Standard & Poor's 500 Index and FTSE All-
World Index.
    Multi-lateral development bank means any multi-lateral lending 
institution or regional development bank in which the U.S. government 
is a shareholder or contributing member.
    Nationally recognized statistical rating organization (NRSRO) means 
an entity recognized by the Division of Market Regulation (or any 
successor division) of the SEC as a nationally recognized statistical 
rating organization for various purposes, including the SEC's net 
capital requirements for securities broker-dealers.
    Netting set means a group of transactions with a single 
counterparty that are subject to a qualifying master netting agreement 
or qualifying cross-product master netting agreement. Each transaction 
that is not subject to such a master netting agreement is its own 
netting set.
    Nth-to-default credit derivative means a credit derivative that 
provides credit protection only for the nth-defaulting reference 
exposure in a group of reference exposures.
    Operational loss means a loss (excluding insurance or tax effects) 
resulting from an operational loss event. Operational loss includes all 
expenses associated with an operational loss event except for 
opportunity costs, forgone revenue, and costs related to risk 
management and control enhancements implemented to prevent future 
operational losses.
    Operational loss event means an event that results in loss and is 
associated with internal fraud; external fraud; \5\ employment 
practices and workplace safety; clients, products, and business 
practices; damage to physical assets; business disruption and system 
failures; or execution, delivery, and process management.
---------------------------------------------------------------------------

    \5\ Retail credit card losses arising from non-contractual, 
third-party initiated fraud (for example, identity theft) are 
external fraud operational losses. All other third-party initiated 
credit losses are to be treated as credit risk losses.
---------------------------------------------------------------------------

    Operational risk means the risk of loss resulting from inadequate 
or failed internal processes, people, and systems or from external 
events (including legal risk but excluding strategic and reputational 
risk).
    Operational risk exposure means the 99.9th percentile of the 
distribution of potential aggregate operational losses, as generated by 
the [bank]'s operational risk quantification system over a one-year 
horizon (and not incorporating eligible operational risk offsets or 
qualifying operational risk mitigants).
    Originating [bank], with respect to a securitization, means a 
[bank] that:
    (1) Directly or indirectly originated or securitized the underlying 
exposures included in the securitization; or
    (2) Serves as an ABCP program sponsor to the securitization.
    Other retail exposure means an exposure (other than a 
securitization exposure, an equity exposure, a residential mortgage 
exposure, an excluded mortgage exposure, a qualifying revolving 
exposure, or the residual value portion of a lease exposure) that is 
managed as part of a segment of exposures with homogeneous risk 
characteristics, not on an individual-exposure basis, and is either:
    (1) An exposure to an individual for non-business purposes; or
    (2) An exposure to an individual or company for business purposes 
if the [bank]'s consolidated business credit exposure to the individual 
or company is $1 million or less.
    Over-the-counter (OTC) derivative contract means a derivative 
contract that is not traded on an exchange that requires the daily 
receipt and payment of cash-variation margin.
    Parallel run period means a period of at least four consecutive 
quarters after adoption of the [bank]'s implementation plan and before 
the [bank]'s first floor period during which the [bank] complies with 
all the qualification requirements in section 22 to the satisfaction of 
the [AGENCY].
    Probability of default (PD) means:
    (1) For a wholesale exposure to a non-defaulted obligor, the 
[bank]'s empirically based best estimate of the long-run average of 
one-year default rates for the rating grade assigned by the [bank] to 
the obligor, capturing the average default experience for obligors in a 
rating grade over a mix of economic conditions (including economic 
downturn conditions) sufficient to provide a reasonable estimate of the 
average one-year default rate over the economic cycle for the rating 
grade.
    (2) For a segment of non-defaulted retail exposures for which 
seasoning effects are not material, or for a segment of non-defaulted 
retail exposures in a retail exposure subcategory for which seasoning 
effects are not material, the

[[Page 55919]]

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

    \6\ This requirement is met where all transactions under the 
agreement are (i) executed under U.S. law and (ii) constitute 
``securities contracts'' or ``repurchase agreements'' under section 
555 or 559, respectively, of the Bankruptcy Code (11 U.S.C. 555 or 
559), qualified financial contracts under section 11(e)(8) of the 
Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or netting 
contracts between or among financial institutions under sections 
401-407 of the Federal Deposit Insurance Corporation Improvement Act 
of 1991 (12 U.S.C. 4401-4407) or the Federal Reserve Board's 
Regulation EE (12 CFR part 231).
---------------------------------------------------------------------------

    (4) The [bank] has conducted and documented sufficient legal review 
to conclude with a well-founded basis that the agreement meets the 
requirements of paragraph (3) of this definition and is legal, valid, 
binding, and enforceable

[[Page 55920]]

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

[[Page 55921]]

    Value-at-Risk (VaR) means the estimate of the maximum amount that 
the value of one or more exposures could decline due to market price or 
rate movements during a fixed holding period within a stated confidence 
interval.
    Wholesale exposure means a credit exposure to a company, 
individual, sovereign, or governmental entity (other than a 
securitization exposure, retail exposure, excluded mortgage exposure, 
or equity exposure). Examples of a wholesale exposure include:
    (1) A non-tranched guarantee issued by a [bank] on behalf of a 
company;
    (2) A repo-style transaction entered into by a [bank] with a 
company and any other transaction in which a [bank] posts collateral to 
a company and faces counterparty credit risk;
    (3) An exposure that the [bank] treats as a covered position under 
[the market risk rule] for which there is a counterparty credit risk 
charge in section 32;
    (4) A sale of corporate loans by a [bank] to a third party in which 
the [bank] retains full recourse;
    (5) An OTC derivative contract entered into by a [bank] with a 
company;
    (6) An exposure to an individual that is not managed by the [bank] 
as part of a segment of exposures with homogeneous risk 
characteristics; and
    (7) A commercial lease.
    Wholesale exposure subcategory means the HVCRE or non-HVCRE 
wholesale exposure subcategory.

Section 3. Minimum Risk-Based Capital Requirements

    (a) Except as modified by paragraph (c) of this section or by 
section 23, each [bank] must meet a minimum ratio of:
    (1) Total qualifying capital to total risk-weighted assets of 8.0 
percent; and
    (2) Tier 1 capital to total risk-weighted assets of 4.0 percent.
    (b) Each [bank] must hold capital commensurate with the level and 
nature of all risks to which the [bank] is exposed.
    (c) When a [bank] subject to [the market risk rule] calculates its 
risk-based capital requirements under this appendix, the [bank] must 
also refer to [the market risk rule] for supplemental rules to 
calculate risk-based capital requirements adjusted for market risk.

Part II. Qualifying Capital

Section 11. Additional Deductions

    (a) General. A [bank] that uses this appendix must make the same 
deductions from its tier 1 capital and tier 2 capital required in [the 
general risk-based capital rules], except that:
    (1) A [bank] is not required to deduct certain equity investments 
and CEIOs (as explained in more detail in section 12); and
    (2) A [bank] also must make the deductions from capital required by 
paragraphs (b) and (c) of this section.
    (b) Deductions from tier 1 capital. A [bank] must deduct from tier 
1 capital any gain-on-sale associated with a securitization exposure as 
provided in paragraph (a) of section 41 and paragraphs (a)(1), (c), 
(g)(1), and (h)(1) of section 42.
    (c) Deductions from tier 1 and tier 2 capital. A [bank] must deduct 
the following exposures 50 percent from tier 1 capital and 50 percent 
from tier 2 capital. If the amount deductible from tier 2 capital 
exceeds the [bank]'s actual tier 2 capital, however, the [bank] must 
deduct the shortfall amount from tier 1 capital.
    (1) Credit-enhancing interest-only strips (CEIOs). In accordance 
with paragraphs (a)(1) and (c) of section 42, any CEIO that does not 
constitute gain-on-sale.
    (2) Non-qualifying securitization exposures. In accordance with 
paragraphs (a)(4) and (c) of section 42, any securitization exposure 
that does not qualify for the Ratings-Based Approach, Internal 
Assessment Approach, or the Supervisory Formula Approach under sections 
43, 44, and 45, respectively.
    (3) Securitizations of non-IRB exposures. In accordance with 
paragraphs (c) and (g)(3) of section 42, certain exposures to a 
securitization any underlying exposure of which is not a wholesale 
exposure, retail exposure, securitization exposure, or equity exposure.
    (4) Low-rated securitization exposures. In accordance with section 
43 and paragraph (c) of section 42, any securitization exposure that 
qualifies for and must be deducted under the Ratings-Based Approach.
    (5) High-risk securitization exposures subject to the Supervisory 
Formula Approach. In accordance with paragraph (b) of section 45 and 
paragraph (c) of section 42, any securitization exposure that qualifies 
for the Supervisory Formula Approach and has a risk weight equal to 
1,250 percent as calculated under the Supervisory Formula Approach.
    (6) Eligible credit reserves shortfall. In accordance with 
paragraph (a)(1) of section 13, any eligible credit reserves shortfall.
    (7) Certain failed capital markets transactions. In accordance with 
paragraph (e)(3) of section 35, the [bank]'s exposure on certain failed 
capital markets transactions.

Section 12. Deductions and Limitations Not Required

    (a) Deduction of CEIOs. A [bank] is not required to make the 
deductions from capital for CEIOs in 12 CFR part 3, Appendix A, Sec.  
2(c) (for national banks), 12 CFR part 208, Appendix A, Sec.  II.B.1.e. 
(for state member banks), 12 CFR part 225, Appendix A, Sec.  II.B.1.e. 
(for bank holding companies), 12 CFR part 325, Appendix A, Sec.  
II.B.5. (for state nonmember banks), and 12 CFR 567.5(a)(2)(iii) and 
567.12(e) (for savings associations).
    (b) Deduction of certain equity investments. A [bank] is not 
required to make the deductions from capital for nonfinancial equity 
investments in 12 CFR part 3, Appendix A, Sec.  2(c) (for national 
banks), 12 CFR part 208, Appendix A, Sec.  II.B.5. (for state member 
banks), 12 CFR part 225, Appendix A, Sec.  II.B.5. (for bank holding 
companies), and 12 CFR part 325, Appendix A, Sec.  II.B. (for state 
nonmember banks).

Section 13. Eligible Credit Reserves

    (a) Comparison of eligible credit reserves to expected credit 
losses--(1) Shortfall of eligible credit reserves. If a [bank]'s 
eligible credit reserves are less than the [bank]'s total expected 
credit losses, the [bank] must deduct the shortfall amount 50 percent 
from tier 1 capital and 50 percent from tier 2 capital. If the amount 
deductible from tier 2 capital exceeds the [bank]'s actual tier 2 
capital, the [bank] must deduct the excess amount from tier 1 capital.
    (2) Excess eligible credit reserves. If a [bank]'s eligible credit 
reserves exceed the [bank]'s total expected credit losses, the [bank] 
may include the excess amount in tier 2 capital to the extent that the 
excess amount does not exceed 0.6 percent of the [bank]'s credit-risk-
weighted assets.
    (b) Treatment of allowance for loan and lease losses. Regardless of 
any provision to the contrary in [general risk-based capital rules], 
ALLL is included in tier 2 capital only to the extent provided in 
paragraph (a)(2) of this section and paragraph (b) of section 23.

Part III. Qualification

Section 21. Qualification Process

    (a) Timing. (1) A [bank] that is described in paragraph (b)(1) of 
section 1 must adopt a written implementation plan no later than six 
months after the later of the effective date of this appendix or the 
date the [bank] meets a criterion in that section. The plan must 
incorporate an explicit first floor period

[[Page 55922]]

start date no later than 36 months after the later of the effective 
date of this appendix or the date the [bank] meets at least one 
criterion under paragraph (b)(1) of section 1. [AGENCY] may extend the 
first floor period start date.
    (2) A [bank] that elects to be subject to this appendix under 
paragraph (b)(2) of section 1 must adopt a written implementation plan 
and notify the [AGENCY] in writing of its intent at least 12 months 
before it proposes to begin its first floor period.
    (b) Implementation plan. The [bank]'s implementation plan must 
address in detail how the [bank] complies, or plans to comply, with the 
qualification requirements in section 22. The [bank] also must maintain 
a comprehensive and sound planning and governance process to oversee 
the implementation efforts described in the plan. At a minimum, the 
plan must:
    (1) Comprehensively address the qualification requirements in 
section 22 for the [bank] and each consolidated subsidiary (U.S. and 
foreign-based) of the [bank] with respect to all portfolios and 
exposures of the [bank] and each of its consolidated subsidiaries;
    (2) Justify and support any proposed temporary or permanent 
exclusion of business lines, portfolios, or exposures from application 
of the advanced approaches in this appendix (which business lines, 
portfolios, and exposures must be, in the aggregate, immaterial to the 
[bank]);
    (3) Include the [bank]'s self-assessment of:
    (i) The [bank]'s current status in meeting the qualification 
requirements in section 22; and
    (ii) The consistency of the [bank]'s current practices with the 
[AGENCY]'s supervisory guidance on the qualification requirements;
    (4) Based on the [bank]'s self-assessment, identify and describe 
the areas in which the [bank] proposes to undertake additional work to 
comply with the qualification requirements in section 22 or to improve 
the consistency of the [bank]'s current practices with the [AGENCY]'s 
supervisory guidance on the qualification requirements (gap analysis);
    (5) Describe what specific actions the [bank] will take to address 
the areas identified in the gap analysis required by paragraph (b)(4) 
of this section;
    (6) Identify objective, measurable milestones, including delivery 
dates and a date when the [bank]'s implementation of the methodologies 
described in this appendix will be fully operational;
    (7) Describe resources that have been budgeted and are available to 
implement the plan; and
    (8) Receive board of directors approval.
    (c) Parallel run. Before determining its risk-based capital 
requirements under this appendix and following adoption of the 
implementation plan, the [bank] must conduct a satisfactory parallel 
run. A satisfactory parallel run is a period of no less than four 
consecutive calendar quarters during which the [bank] complies with all 
of the qualification requirements in section 22 to the satisfaction of 
[AGENCY]. During the parallel run, the [bank] must report to the 
[AGENCY] on a calendar quarterly basis its risk-based capital ratios 
using [the general risk-based capital rules] and the risk-based capital 
requirements described in this appendix. During this period, the [bank] 
is subject to [the general risk-based capital rules].
    (d) Approval to calculate risk-based capital requirements under 
this appendix. The [AGENCY] will notify the [bank] of the date that the 
[bank] may begin its first floor period following a determination by 
the [AGENCY] that:
    (1) The [bank] fully complies with the qualification requirements 
in section 22;
    (2) The [bank] has conducted a satisfactory parallel run under 
paragraph (c) of this section; and
    (3) The [bank] has an adequate process to ensure ongoing compliance 
with the qualification requirements in section 22.
    (e) Transitional floor periods. Following a satisfactory parallel 
run, a [bank] is subject to three transitional floor periods.
    (1) Risk-based capital ratios during the transitional floor 
periods--(i) Tier 1 risk-based capital ratio. During a [bank]'s 
transitional floor periods, a [bank]'s tier 1 risk-based capital ratio 
is equal to the lower of:
    (A) The [bank]'s floor-adjusted tier 1 risk-based capital ratio; or
    (B) The [bank]'s advanced approaches tier 1 risk-based capital 
ratio.
    (ii) Total risk-based capital ratio. During a [bank]'s transitional 
floor periods, a [bank]'s total risk-based capital ratio is equal to 
the lower of:
    (A) The [bank]'s floor-adjusted total risk-based capital ratio; or
    (B) The [bank]'s advanced approaches total risk-based capital 
ratio.
    (2) Floor-adjusted risk-based capital ratios. (i) A [bank]'s floor-
adjusted tier 1 risk-based capital ratio during a transitional floor 
period is equal to the [bank]'s tier 1 capital as calculated under [the 
general risk-based capital rules], divided by the product of:
    (A) The [bank]'s total risk-weighted assets as calculated under 
[the general risk-based capital rules]; and
    (B) The appropriate transitional floor percentage in Table 1.
    (ii) A [bank]'s floor-adjusted total risk-based capital ratio 
during a transitional floor period is equal to the sum of the [bank]'s 
tier 1 and tier 2 capital as calculated under [the general risk-based 
capital rules], divided by the product of:
    (A) The [bank]'s total risk-weighted assets as calculated under 
[the general risk-based capital rules]; and
    (B) The appropriate transitional floor percentage in Table 1.
    (iii) A [bank] that meets the criteria in paragraph (b)(1) or 
(b)(2) of section 1 as of the effective date of this rule must use [the 
general risk-based capital rules] effective immediately before this 
rule became effective during the parallel run and as the basis for its 
transitional floors.

                      Table 1--Transitional Floors
------------------------------------------------------------------------
                                                 Transitional floor
         Transitional floor period                   percentage
------------------------------------------------------------------------
First floor period........................  95 percent
Second floor period.......................  90 percent
Third floor period........................  85 percent
------------------------------------------------------------------------

    (3) Advanced approaches risk-based capital ratios. (i) A [bank]'s 
advanced approaches tier 1 risk-based capital ratio equals the [bank]'s 
tier 1 risk-based capital ratio as calculated under this appendix 
(other than this section on transitional floor periods).
    (ii) A [bank]'s advanced approaches total risk-based capital ratio 
equals the [bank]'s total risk-based capital ratio as calculated under 
this appendix (other than this section on transitional floor periods).
    (4) Reporting. During the transitional floor periods, a [bank] must 
report to the [AGENCY] on a calendar quarterly basis both floor-
adjusted risk-based capital ratios and both advanced approaches risk-
based capital ratios.
    (5) Exiting a transitional floor period. A [bank] may not exit a 
transitional floor period until the [bank] has spent a minimum of four 
consecutive calendar quarters in the period and the [AGENCY] has 
determined that the [bank] may exit the floor period. The [AGENCY]'s 
determination will be based on an assessment of the [bank]'s ongoing 
compliance with the qualification requirements in section 22.

Section 22. Qualification Requirements

    (a) Process and systems requirements. (1) A [bank] must have a 
rigorous process for assessing its overall capital adequacy in relation 
to its risk profile

[[Page 55923]]

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

[[Page 55924]]

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

[[Page 55925]]

Section 23. Ongoing Qualification

    (a) Changes to advanced systems. A [bank] must meet all the 
qualification requirements in section 22 on an ongoing basis. A [bank] 
must notify the [AGENCY] when the [bank] makes any change to an 
advanced system that would result in a material change in the [bank]'s 
risk-weighted asset amount for an exposure type, or when the [bank] 
makes any significant change to its modeling assumptions.
    (b) Mergers and acquisitions--(1) Mergers and acquisitions of 
companies without advanced systems. If a [bank] merges with or acquires 
a company that does not calculate its risk-based capital requirements 
using advanced systems, the [bank] may use [the general risk-based 
capital rules] to determine the risk-weighted asset amounts for, and 
deductions from capital associated with, the merged or acquired 
company's exposures for up to 24 months after the calendar quarter 
during which the merger or acquisition consummates. [AGENCY] may extend 
this transition period for up to an additional 12 months. Within 30 
days of consummating the merger or acquisition, the [bank] must submit 
to [AGENCY] an implementation plan for using its advanced systems for 
the acquired company. During the period when [the general risk-based 
capital rules] apply to the merged or acquired company, any ALLL, net 
of allocated transfer risk reserves established pursuant to 12 U.S.C. 
3904, associated with the merged or acquired company's exposures may be 
included in the [bank]'s tier 2 capital up to 1.25 percent of the 
acquired company's risk-weighted assets. All general reserves of the 
merged or acquired company must be excluded from the [bank]'s eligible 
credit reserves. In addition, the risk-weighted assets of the merged or 
acquired company are not included in the [bank]'s credit-risk-weighted 
assets but are included in total risk-weighted assets. If a [bank] 
relies on this paragraph, the [bank] must disclose publicly the amounts 
of risk-weighted assets and qualifying capital calculated under this 
appendix for the acquiring [bank] and under [the general risk-based 
capital rules] for the acquired company.
    (2) Mergers and acquisitions of companies with advanced systems. If 
a [bank] merges with or acquires a company that calculates its risk-
based capital requirements using advanced systems, the acquiring [bank] 
may use the acquired company's advanced systems to determine the risk-
weighted asset amounts for, and deductions from capital associated 
with, the merged or acquired company's exposures for up to 24 months 
after the calendar quarter during which the acquisition or merger 
consummates. [AGENCY] may extend this transition period for up to an 
additional 12 months. Within 30 days of consummating the merger or 
acquisition, the [bank] must submit to [AGENCY] an implementation plan 
for using its advanced systems for the merged or acquired company.
    (c) Failure to comply with qualification requirements. If [AGENCY] 
determines that a [bank] that is subject to this appendix and has 
conducted a satisfactory parallel run fails to comply with the 
qualification requirements in section 22, [AGENCY] will notify the 
[bank] in writing of the [bank]'s failure to comply. The [bank] must 
establish a plan satisfactory to the [AGENCY] to return to compliance 
with the qualification requirements and must disclose to the public its 
failure to comply with the qualification requirements promptly after 
receiving notice from the [AGENCY]. In addition, if the [AGENCY] 
determines that the [bank]'s risk-based capital requirements are not 
commensurate with the [bank]'s credit, market, operational, or other 
risks, the [AGENCY] may require such a [bank] to calculate its risk-
based capital requirements:
    (1) Under [the general risk-based capital rules]; or
    (2) Under this appendix with any modifications provided by the 
[AGENCY].

Part IV. Risk-Weighted Assets for General Credit Risk

Section 31. Mechanics for Calculating Total Wholesale and Retail Risk-
Weighted Assets

    (a) Overview. A [bank] must calculate its total wholesale and 
retail risk-weighted asset amount in four distinct phases:
    (1) Phase 1--categorization of exposures;
    (2) Phase 2--assignment of wholesale obligors and exposures to 
rating grades and segmentation of retail exposures;
    (3) Phase 3--assignment of risk parameters to wholesale exposures 
and segments of retail exposures; and
    (4) Phase 4--calculation of risk-weighted asset amounts.
    (b) Phase 1--Categorization. The [bank] must determine which of its 
exposures are wholesale exposures, retail exposures, securitization 
exposures, or equity exposures. The [bank] must categorize each retail 
exposure as a residential mortgage exposure, a QRE, or an other retail 
exposure. The [bank] must identify which wholesale exposures are HVCRE 
exposures, sovereign exposures, OTC derivative contracts, repo-style 
transactions, eligible margin loans, eligible purchased wholesale 
receivables, unsettled transactions to which section 35 applies, and 
eligible guarantees or eligible credit derivatives that are used as 
credit risk mitigants. The [bank] must identify any on-balance sheet 
asset that does not meet the definition of a wholesale, retail, equity, 
or securitization exposure, as well as any non-material portfolio of 
exposures described in paragraph (e)(4) of this section.
    (c) Phase 2--Assignment of wholesale obligors and exposures to 
rating grades and retail exposures to segments--(1) Assignment of 
wholesale obligors and exposures to rating grades.
    (i) The [bank] must assign each obligor of a wholesale exposure to 
a single obligor rating grade and may assign each wholesale exposure to 
loss severity rating grades.
    (ii) The [bank] must identify which of its wholesale obligors are 
in default.
    (2) Segmentation of retail exposures. (i) The [bank] must group the 
retail exposures in each retail subcategory into segments that have 
homogeneous risk characteristics.
    (ii) The [bank] must identify which of its retail exposures are in 
default. The [bank] must segment defaulted retail exposures separately 
from non-defaulted retail exposures.
    (iii) If the [bank] determines the EAD for eligible margin loans 
using the approach in paragraph (a) of section 32, the [bank] must 
identify which of its retail exposures are eligible margin loans for 
which the [bank] uses this EAD approach and must segment such eligible 
margin loans separately from other retail exposures.
    (3) Eligible purchased wholesale receivables. A [bank] may group 
its eligible purchased wholesale receivables that, when consolidated by 
obligor, total less than $1 million into segments that have homogeneous 
risk characteristics. A [bank] must use the wholesale exposure formula 
in Table 2 in this section to determine the risk-based capital 
requirement for each segment of eligible purchased wholesale 
receivables.
    (d) Phase 3--Assignment of risk parameters to wholesale exposures 
and segments of retail exposures--(1) Quantification process. Subject 
to the limitations in this paragraph (d), the [bank] must:
    (i) Associate a PD with each wholesale obligor rating grade;
    (ii) Associate an ELGD or LGD, as appropriate, with each wholesale 
loss

[[Page 55926]]

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

    \7\ A [bank] may instead apply a 300 percent risk weight to the 
EAD of an eligible margin loan if the [bank] is not able to assign a 
rating grade to the obligor of the loan.

---------------------------------------------------------------------------

[[Page 55927]]

[GRAPHIC] [TIFF OMITTED] TP25SE06.080

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

[[Page 55928]]

(e)(2)(iii) of this section multiplied by 12.5.
    (3) Assets not included in a defined exposure category. A [bank] 
may assign a risk-weighted asset amount of zero to cash owned and held 
in all offices of the [bank] or in transit and for gold bullion held in 
the [bank]'s own vaults, or held in another [bank]'s vaults on an 
allocated basis, to the extent it is offset by gold bullion 
liabilities. The risk-weighted asset amount for the residual value of a 
retail lease exposure equals such residual value. The risk-weighted 
asset amount for an excluded mortgage exposure is determined under 12 
CFR part 3, Appendix A, section 3(a)(3)(iii) (for national banks), 12 
CFR part 208, Appendix A, section III.C.3. (for state member banks), 12 
CFR part 225, Appendix A, section III.C.3. (for bank holding 
companies), 12 CFR part 325, Appendix A, section II.C.a. (for state 
nonmember banks), and 12 CFR 567.6(a)(1)(iii) and (iv) (for savings 
associations). The risk-weighted asset amount for any other on-balance-
sheet asset that does not meet the definition of a wholesale, retail, 
securitization, or equity exposure equals the carrying value of the 
asset.
    (4) Non-material portfolios of exposures. The risk-weighted asset 
amount of a portfolio of exposures for which the [bank] has 
demonstrated to [AGENCY]'s satisfaction that the portfolio (when 
combined with all other portfolios of exposures that the [bank] seeks 
to treat under this paragraph) is not material to the [bank] is the sum 
of the carrying values of on-balance sheet exposures plus the notional 
amounts of off-balance sheet exposures in the portfolio. For purposes 
of this paragraph (e)(4), the notional amount of an OTC derivative 
contract that is not a credit derivative is the EAD of the derivative 
as calculated in section 32.

Section 32. Counterparty Credit Risk

    This section describes two methodologies--a collateral haircut 
approach and an internal models methodology--that a [bank] may use 
instead of an ELGD/LGD estimation methodology to recognize the benefits 
of financial collateral in mitigating the counterparty credit risk of 
repo-style transactions, eligible margin loans, and collateralized OTC 
derivative contracts, and single product netting sets of such 
transactions. A third methodology, the simple VaR methodology, is 
available for single product netting sets of repo-style transactions 
and eligible margin loans. This section also describes the methodology 
for calculating EAD for an OTC derivative contract or a set of OTC 
derivative contracts subject to a qualifying master netting agreement. 
A [bank] also may use the internal models methodology to estimate EAD 
for qualifying cross-product master netting agreements.
    A [bank] may use any combination of the three methodologies for 
collateral recognition; however, it must use the same methodology for 
similar exposures. A [bank] may use separate methodologies for agency 
securities lending transactions--that is, securities lending 
transactions in which the [bank], acting as agent for a customer, lends 
the customer's securities and indemnifies the customer against loss--
and all other repo-style transactions.
    (a) EAD for eligible margin loans and repo-style transactions--(1) 
General. A [bank] may recognize the credit risk mitigation benefits of 
financial collateral that secures an eligible margin loan, repo-style 
transaction, or single-product group of such transactions with a single 
counterparty subject to a qualifying master netting agreement (netting 
set) by factoring the collateral into its ELGD and LGD estimates for 
the exposure. Alternatively, a [bank] may estimate an unsecured ELGD 
and LGD for the exposure and determine the EAD of the exposure using:
    (i) The collateral haircut approach described in paragraph (a)(2) 
of this section;
    (ii) For netting sets only, the simple VaR methodology described in 
paragraph (a)(3) of this section; or
    (iii) The internal models methodology described in paragraph (c) of 
this section.
    (2) Collateral haircut approach--(i) EAD equation. A [bank] may 
determine EAD for an eligible margin loan, repo-style transaction, or 
netting set by setting EAD = max {0, [([Sigma]E - [Sigma]C) + 
[Sigma](Es x Hs) + (Efx x Hfx)]{time} , where:
    (A) [Sigma]E equals the value of the exposure (that is, the sum of 
the current market values of all securities and cash the [bank] has 
lent, sold subject to repurchase, or posted as collateral to the 
counterparty under the transaction (or netting set));
    (B) [Sigma]C equals the value of the collateral (that is, the sum 
of the current market values of all securities and cash the [bank] has 
borrowed, purchased subject to resale, or taken as collateral from the 
counterparty under the transaction (or netting set));
    (C) Es = absolute value of the net position in a given security 
(where the net position in a given security equals the sum of the 
current market values of the particular security the [bank] has lent, 
sold subject to repurchase, or posted as collateral to the counterparty 
minus the sum of the current market values of that same security the 
[bank] has borrowed, purchased subject to resale, or taken as 
collateral from the counterparty);
    (D) Hs = market price volatility haircut appropriate to the 
security referenced in Es;
    (E) Efx = absolute value of the net position of both cash and 
securities in a currency that is different from the settlement currency 
(where the net position in a given currency equals the sum of the 
current market values of any cash or securities in the currency the 
[bank] has lent, sold subject to repurchase, or posted as collateral to 
the counterparty minus the sum of the current market values of any cash 
or securities in the currency the [bank] has borrowed, purchased 
subject to resale, or taken as collateral from the counterparty); and
    (F) Hfx = haircut appropriate to the mismatch between the currency 
referenced in Efx and the settlement currency.
    (ii) Standard supervisory haircuts. (A) Under the ``standard 
supervisory haircuts'' approach:
    (1) A [bank] must use the haircuts for market price volatility (Hs) 
in Table 3, as adjusted in certain circumstances as provided in 
paragraph (a)(2)(ii)(A)(3) and (4) of this section;

                        Table 3.--Standard Supervisory Market Price Volatility Haircuts*
----------------------------------------------------------------------------------------------------------------
                                                                                  Issuers exempt
 Applicable external rating grade category for     Residual maturity for debt       from the 3     Other issuers
                debt securities                            securities               b.p. floor
----------------------------------------------------------------------------------------------------------------
Two highest investment grade rating categories  <=1 year........................            .005             .01
 for long-term ratings/highest investment       >1 year, <=5 years..............             .02             .04
 grade rating category for short-term ratings.  >5 years........................             .04             .08
----------------------------------------------------------------------------------------------------------------

[[Page 55929]]

 
Two lowest investment grade ratiing categories  <=1 year........................             .01             .02
 for both short- 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 issu0d by
 the [bank]).
----------------------------------------------------------------------------------------------------------------
*The market price volatility haircuts in Table 3 are based on a 10-business-day holding period.

    (2) For currency mismatches, a [bank] must use a haircut for 
foreign exchange rate volatility (Hfx) of 8 percent, as adjusted in 
certain circumstances as provided in paragraph (a)(2)(ii)(A)(3) and (4) 
of this section.
    (3) For repo-style transactions, a [bank] may multiply the 
supervisory haircuts provided in paragraphs (a)(2)(ii)(A)(1) and (2) by 
the square root of \1/2\ (which equals 0.707107).
    (4) A [bank] must adjust the supervisory haircuts upward on the 
basis of a holding period longer than 10 business days (for eligible 
margin loans) or 5 business days (for repo-style transactions) where 
and as appropriate to take into account the illiquidity of an 
instrument.
    (iii) Own estimates for haircuts. With the prior written approval 
of [AGENCY], a [bank] may calculate haircuts (Hs and Hfx) using its own 
internal estimates of the volatilities of market prices and foreign 
exchange rates.
    (A) To receive [AGENCY] approval to use internal estimates, a 
[bank] must satisfy the following minimum quantitative standards:
    (1) A [bank] must use a 99th percentile one-tailed confidence 
interval.
    (2) The minimum holding period for a repo-style transaction is 5 
business days and for an eligible margin loan is 10 business days. When 
a [bank] calculates an own-estimates haircut on a TN-day 
holding period, which is different from the minimum holding period for 
the transaction type, the applicable haircut (HM) is 
calculated using the following square root of time formula:
[GRAPHIC] [TIFF OMITTED] TP25SE06.058

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

[[Page 55930]]

    (i) [Sigma]E equals the value of the exposure (that is, the sum of 
the current market values of all securities and cash the [bank] has 
lent, sold subject to repurchase, or posted as collateral to the 
counterparty under the netting set);
    (ii) [Sigma]C equals the value of the collateral (that is, the sum 
of the current market values of all securities and cash the [bank] has 
borrowed, purchased subject to resale, or taken as collateral from the 
counterparty under the netting set); and
    (iii) PFE (potential future exposure) equals the [bank]'s 
empirically-based best estimate of the 99th percentile, one-tailed 
confidence interval for an increase in the value of ([Sigma]E - 
[Sigma]C) over a 5-business-day holding period for repo-style 
transactions or over a 10-business-day holding period for eligible 
margin loans using a minimum one-year historical observation period of 
price data representing the instruments that the [bank] has lent, sold 
subject to repurchase, posted as collateral, borrowed, purchased 
subject to resale, or taken as collateral. The [bank] must validate its 
VaR model, including by establishing and maintaining a rigorous and 
regular back-testing regime.
    (b) EAD for OTC derivative contracts. (1) A [bank] must determine 
the EAD for an OTC derivative contract that is not subject to a 
qualifying master netting agreement using the current exposure 
methodology in paragraph (b)(5) of this section or using the internal 
models methodology described in paragraph (c) of this section.
    (2) A [bank] must determine the EAD for multiple OTC derivative 
contracts that are subject to a qualifying master netting agreement 
using the current exposure methodology in paragraph (b)(6) of this 
section or using the internal models methodology described in paragraph 
(c) of this section.\8\
---------------------------------------------------------------------------

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

    (3) Counterparty credit risk for credit derivatives. 
Notwithstanding the above,
    (i) A [bank] that purchases a credit derivative that is recognized 
under section 33 or 34 as a credit risk mitigant for an exposure that 
is not a covered position under [the market risk rule] need not compute 
a separate counterparty credit risk capital requirement under this 
section so long as it does so consistently for all such credit 
derivatives and either includes all or excludes all such credit 
derivatives that are subject to a master netting contract from any 
measure used to determine counterparty credit risk exposure to all 
relevant counterparties for risk-based capital purposes.
    (ii) A [bank] that is the protection provider in a credit 
derivative must treat the credit derivative as a wholesale exposure to 
the reference obligor and need not compute a counterparty credit risk 
capital requirement for the credit derivative under this section, so 
long as it does so consistently for all such credit derivatives and 
either includes all or excludes all such credit derivatives that are 
subject to a master netting contract from any measure used to determine 
counterparty credit risk exposure to all relevant counterparties for 
risk-based capital purposes (unless the [bank] is treating the credit 
derivative as a covered position under [the market risk rule], in which 
case the [bank] must compute a supplemental counterparty credit risk 
capital requirement under this section).
    (4) Counterparty credit risk for equity derivatives. A [bank] must 
treat an equity derivative contract as an equity exposure and compute a 
risk-weighted asset amount for the equity derivative contract under 
part VI (unless the [bank] is treating the contract as a covered 
position under [the market risk rule]). In addition, if the [bank] is 
treating the contract as a covered position under [the market risk 
rule] and in certain other cases described in section 55, the [bank] 
must also calculate a risk-based capital requirement for the 
counterparty credit risk of an equity derivative contract under this 
part.
    (5) Single OTC derivative contract. Except as modified by paragraph 
(b)(7) of this section, the EAD for a single OTC derivative contract 
that is not subject to a qualifying master netting agreement is equal 
to the sum of the [bank]'s current credit exposure and potential future 
credit exposure on the derivative contract.
    (i) Current credit exposure. The current credit exposure for a 
single OTC derivative contract is the greater of the mark-to-market 
value of the derivative contract or zero.
    (ii) PFE. The PFE for a single OTC derivative contract, including 
an OTC derivative contract with a negative mark-to-market value, is 
calculated by multiplying the notional principal amount of the 
derivative contract by the appropriate conversion factor in Table 4. 
For purposes of calculating either the potential future credit exposure 
under this paragraph or the gross potential future credit exposure 
under paragraph (b)(6) of this section for exchange rate contracts and 
other similar contracts in which the notional principal amount is 
equivalent to the cash flows, notional principal amount is the net 
receipts to each party falling due on each value date in each currency. 
For any OTC derivative contract that does not fall within one of the 
specified categories in Table 4, the potential future credit exposure 
must be calculated using the ``other commodity'' conversion factors. 
[Bank]s must use an OTC derivative contract's effective notional 
principal amount (that is, its apparent or stated notional principal 
amount multiplied by any multiplier in the OTC derivative contract) 
rather than its apparent or stated notional principal amount in 
calculating potential future credit exposure. PFE of the protection 
provider of a credit derivative is capped at the net present value of 
the amount of unpaid premiums.

                                            Table 4.--Conversion Factor Matrix for OTC Derivative Contracts*
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                            Credit    Credit (non-
                                                                              Foreign    (investment   investment                 Precious
                    Remaining maturity**                       Interest      exchange       grade        grade        Equity       metals       Other
                                                                 rate        rate and     reference    reference                  (except     commodity
                                                                               gold      obligor)***    obligor)                   gold)
--------------------------------------------------------------------------------------------------------------------------------------------------------
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.

[[Page 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 contract
  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 investment grade.
  A [bank] must use column 5 of the table for all other credit derivatives.

    (6) Multiple OTC derivative contracts subject to a qualifying 
master netting agreement. Except as modified by paragraph (b)(7) of 
this section, the EAD for multiple OTC derivative contracts subject to 
a qualifying master netting agreement is equal to the sum of the net 
current credit exposure and the adjusted sum of the PFE exposure for 
all OTC derivative contracts subject to the qualifying master netting 
agreement.
    (i) Net current credit exposure. The net current credit exposure is 
the greater of:
    (A) The net sum of all positive and negative mark-to-market values 
of the individual OTC derivative contracts subject to the qualifying 
master netting agreement; or
    (B) zero.
    (ii) Adjusted sum of the PFE. The adjusted sum of the PFE is 
calculated as Anet = (0.4 x Agross) + (0.6 x NGR x Agross), where:
    (A) Anet = the adjusted sum of the PFE;
    (B) Agross = the gross PFE (that is, the sum of the PFE amounts (as 
determined under paragraph (b)(5)(ii) of this section) for each 
individual OTC derivative contract subject to the qualifying master 
netting agreement); and
    (C) NGR = the net to gross ratio (that is, the ratio of the net 
current credit exposure to the gross current credit exposure). In 
calculating the NGR, the gross current credit exposure equals the sum 
of the positive current credit exposures (as determined under paragraph 
(b)(5)(i) of this section) of all individual OTC derivative contracts 
subject to the qualifying master netting agreement.
    (7) Collateralized OTC derivative contracts. A [bank] may recognize 
the credit risk mitigation benefits of financial collateral that 
secures an OTC derivative contract or single-product set of OTC 
derivatives subject to a qualifying master netting agreement (netting 
set) by factoring the collateral into its ELGD and LGD estimates for 
the contract or netting set. Alternatively, a [bank] may recognize the 
credit risk mitigation benefits of financial collateral that secures 
such a contract or netting set that is marked to market on a daily 
basis and subject to a daily margin maintenance requirement by 
estimating an unsecured ELGD and LGD for the contract or netting set 
and adjusting the EAD calculated under paragraph (b)(5) or (b)(6) of 
this section using the collateral haircut approach in paragraph (a)(2) 
of this section. The [bank] must substitute the EAD calculated under 
paragraph (b)(5) or (b)(6) of this section for [Sigma]E in the equation 
in paragraph (a)(2)(i) of this section and must use a 10-business-day 
minimum holding period (TM = 10).
    (c) Internal models methodology. (1) With prior written approval 
from [AGENCY], a [bank] may use the internal models methodology in this 
paragraph (c) to determine EAD for counterparty credit risk for OTC 
derivative contracts (collateralized or uncollateralized) and single-
product netting sets thereof, for eligible margin loans and single-
product netting sets thereof, and for repo-style transactions and 
single-product netting sets thereof. A [bank] that uses the internal 
models methodology for a particular transaction type (OTC derivative 
contracts, eligible margin loans, or repo-style transactions) must use 
the internal models methodology for all transactions of that 
transaction type. A [bank] may choose to use the internal models 
methodology for one or two of these three types of exposures and not 
the other types. A [bank] may also use the internal models methodology 
for OTC derivative contracts, eligible margin loans, and repo-style 
transactions subject to a qualifying cross-product netting agreement 
if:
    (i) The [bank] effectively integrates the risk mitigating effects 
of cross-product netting into its risk management and other information 
technology systems; and
    (ii) The [bank] obtains the prior written approval of the [AGENCY].
    A [bank] that uses the internal models methodology for a type of 
exposures must receive approval from the [AGENCY] to cease using the 
methodology for that type of exposures or to make a material change to 
its internal model.
    (2) Under the internal models methodology, a [bank] uses an 
internal model to estimate the expected exposure (EE) for a netting set 
and then calculates EAD based on that EE.
    (i) The [bank] must use its internal model's probability 
distribution for changes in the market value of an exposure or netting 
set that are attributable to changes in market variables to determine 
EE. The [bank] may include financial collateral currently posted by the 
counterparty as collateral when calculating EE.
    (ii) Under the internal models methodology, EAD = [alpha] x 
effective EPE, or, subject to [AGENCY] approval as provided in 
paragraph (c)(7), a more conservative measure of EAD.
[GRAPHIC] [TIFF OMITTED] TP25SE06.081

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

[[Page 55932]]

    (i) The model must have the systems capability to estimate the 
expected exposure to the counterparty on a daily basis (but is not 
expected to estimate or report expected exposure on a daily basis).
    (ii) The model must estimate expected exposure at enough future 
dates to accurately reflect all the future cash flows of contracts in 
the netting set.
    (iii) The model must account for the possible non-normality of the 
exposure distribution, where appropriate.
    (iv) The [bank] must measure, monitor, and control current 
counterparty exposure and the exposure to the counterparty over the 
whole life of all contracts in the netting set.
    (v) The [bank] must measure and manage current exposures gross and 
net of collateral held, where appropriate. The [bank] must estimate 
expected exposures for OTC derivative contracts both with and without 
the effect of collateral agreements.
    (vi) The [bank] must have procedures to identify, monitor, and 
control specific wrong-way risk throughout the life of an exposure. 
Wrong-way risk in this context is the risk that future exposure to a 
counterparty will be high when the counterparty's probability of 
default is also high.
    (vii) The model must use current market data to compute current 
exposures. When estimating model parameters based on historical data, 
at least three years of historical data that cover a wide range of 
economic conditions must be used and must be updated quarterly or more 
frequently if market conditions warrant. The [bank] should consider 
using model parameters based on forward-looking measures such as 
implied volatilities, where appropriate.
    (viii) A [bank] must subject its internal model to an initial 
validation and annual model review process. The model review should 
consider whether the inputs and risk factors, as well as the model 
outputs, are appropriate.
    (4) Maturity. (i) If the remaining maturity of the exposure or the 
longest-dated contract in the netting set is greater than one year, the 
[bank] must set M for the exposure or netting set equal to the lower of 
5 years or M(EPE), where:
[GRAPHIC] [TIFF OMITTED] TP25SE06.059

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

[[Page 55933]]

credit risks measured at a 99.9 percent confidence level over a one-
year horizon. To receive approval, the [bank] must meet the following 
minimum standards to the satisfaction of [AGENCY]:
    (i) The [bank]'s own estimate of alpha must capture in the 
numerator the effects of:
    (A) The material sources of stochastic dependency of distributions 
of market values of transactions or portfolios of transactions across 
counterparties;
    (B) Volatilities and correlations of market risk factors used in 
the joint simulation, which must be related to the credit risk factor 
used in the simulation to reflect potential increases in volatility or 
correlation in an economic downturn, where appropriate; and
    (C) The granularity of exposures, that is, the effect of a 
concentration in the proportion of each counterparty's exposure that is 
driven by a particular risk factor.
    (ii) The [bank] must assess the potential model risk in its 
estimates of alpha.
    (iii) The [bank] must calculate the numerator and denominator of 
alpha in a consistent fashion with respect to modeling methodology, 
parameter specifications, and portfolio composition.
    (iv) The [bank] must review and adjust as appropriate its estimates 
of the numerator and denominator on at least a quarterly basis and more 
frequently when the composition of the portfolio varies over time.
    (7) Other measures of counterparty exposure. With prior written 
approval of [AGENCY], a [bank] may set EAD equal to a measure of 
counterparty credit risk exposure, such as peak EAD, that is more 
conservative than an alpha of 1.4 (or higher under the terms of 
paragraph (c)(2)(ii)(B)) times EPE for every counterparty whose EAD 
will be measured under the alternative measure of counterparty 
exposure. The [bank] must demonstrate the conservatism of the measure 
of counterparty credit risk exposure used for EAD.

Section 33. Guarantees and Credit Derivatives: PD Substitution and LGD 
Adjustment Treatments

    (a) Scope. (1) This section applies to wholesale exposures for 
which:
    (i) Credit risk is fully covered by an eligible guarantee or 
eligible credit derivative; and
    (ii) Credit risk is covered on a pro rata basis (that is, on a 
basis in which the [bank] and the protection provider share losses 
proportionately) by an eligible guarantee or eligible credit 
derivative.
    (2) Wholesale exposures on which there is a tranching of credit 
risk (reflecting at least two different levels of seniority) are 
securitization exposures subject to the securitization framework in 
part V.
    (3) A [bank] may elect to recognize the credit risk mitigation 
benefits of an eligible guarantee or eligible credit derivative 
covering an exposure described in paragraph (a)(1) of this section by 
using the PD substitution approach or the LGD adjustment approach in 
paragraph (c) of this section or using the double default treatment in 
section 34 (if the transaction qualifies for the double default 
treatment in section 34). A [bank]'s PD and LGD for the hedged exposure 
may not be lower than the PD and LGD floors described in paragraphs 
(d)(2) and (d)(3) of section 31.
    (4) A [bank] must use the same risk parameters for calculating ECL 
as it uses for calculating the risk-based capital requirement for the 
exposure.
    (b) Rules of recognition. (1) A [bank] may only recognize the 
credit risk mitigation benefits of eligible guarantees and eligible 
credit derivatives.
    (2) A [bank] may only recognize the credit risk mitigation benefits 
of an eligible credit derivative to hedge an exposure that is different 
from the credit derivative's reference exposure used for determining 
the derivative's cash settlement value, deliverable obligation, or 
occurrence of a credit event if:
    (i) The reference exposure ranks pari passu (that is, equally) with 
or is junior to the hedged exposure; and
    (ii) The reference exposure and the hedged exposure share the same 
obligor (that is, the same legal entity), and legally enforceable 
cross-default or cross-acceleration clauses are in place.
    (c) Risk parameters for hedged exposures--(1) PD substitution 
approach--(i) Full coverage. If an eligible guarantee or eligible 
credit derivative meets the conditions in paragraphs (a) and (b) of 
this section and the protection amount (P) of the guarantee or credit 
derivative is greater than or equal to the EAD of the hedged exposure, 
a [bank] may recognize the guarantee or credit derivative in 
determining the [bank]'s risk-based capital requirement for the hedged 
exposure by substituting the PD associated with the rating grade of the 
protection provider for the PD associated with the rating grade of the 
obligor in the risk-based capital formula in Table 2 and using the 
appropriate ELGD and LGD as described in paragraphs (c)(1)(iii) and 
(iv) of this section. If the [bank] determines that full substitution 
of the protection provider's PD leads to an inappropriate degree of 
risk mitigation, the [bank] may substitute a higher PD than that of the 
protection provider.
    (ii) Partial coverage. If an eligible guarantee or eligible credit 
derivative meets the conditions in paragraphs (a) and (b) of this 
section and the protection amount (P) of the guarantee or credit 
derivative is less than the EAD of the hedged exposure, the [bank] must 
treat the hedged exposure as two separate exposures (protected and 
unprotected) in order to recognize the credit risk mitigation benefit 
of the guarantee or credit derivative.
    (A) The [bank] must calculate its risk-based capital requirement 
for the protected exposure under section 31, where PD is the protection 
provider's PD, ELGD and LGD are determined under paragraphs (c)(1)(iii) 
and (iv) of this section, and EAD is P. If the [bank] determines that 
full substitution leads to an inappropriate degree of risk mitigation, 
the [bank] may use a higher PD than that of the protection provider.
    (B) The [bank] must calculate its risk-based capital requirement 
for the unprotected exposure under section 31, where PD is the 
obligor's PD, ELGD is the hedged exposure's ELGD (not adjusted to 
reflect the guarantee or credit derivative), LGD is the hedged 
exposure's LGD (not adjusted to reflect the guarantee or credit 
derivative), and EAD is the EAD of the original hedged exposure minus 
P.
    (C) The treatment in this paragraph (c)(1)(ii) is applicable when 
the credit risk of a wholesale exposure is covered on a pro rata basis 
or when an adjustment is made to the effective notional amount of the 
guarantee or credit derivative under paragraphs (d), (e), or (f) of 
this section.
    (iii) LGD of hedged exposures. The LGD of a hedged exposure under 
the PD substitution approach is equal to:
    (A) The lower of the LGD of the hedged exposure (not adjusted to 
reflect the guarantee or credit derivative) and the LGD of the 
guarantee or credit derivative, if the guarantee or credit derivative 
provides the [bank] with the option to receive immediate payout upon 
triggering the protection; or
    (B) The LGD of the guarantee or credit derivative, if the guarantee 
or credit derivative does not provide the [bank] with the option to 
receive immediate payout upon triggering the protection.
    (iv) ELGD of hedged exposures. The ELGD of a hedged exposure under 
the PD substitution approach is equal to the ELGD associated with the 
LGD determined under paragraph (c)(1)(iii) of this section.

[[Page 55934]]

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

[[Page 55935]]

Section 34. Guarantees and Credit Derivatives: Double Default Treatment

    (a) Eligibility and operational criteria for double default 
treatment. A [bank] may recognize the credit risk mitigation benefits 
of a guarantee or credit derivative covering an exposure described in 
paragraph (a)(1) of section 33 by applying the double default treatment 
in this section if all the following criteria are satisfied.
    (1) The hedged exposure is fully covered or covered on a pro rata 
basis by:
    (i) An eligible guarantee issued by an eligible double default 
guarantor; or
    (ii) An eligible credit derivative that meets the requirements of 
paragraph (b)(2) of section 33 and is issued by an eligible double 
default guarantor.
    (2) The guarantee or credit derivative is:
    (i) An uncollateralized guarantee or uncollateralized credit 
derivative (for example, a credit default swap) that provides 
protection with respect to a single reference obligor; or
    (ii) An nth-to-default credit derivative (subject to the 
requirements of paragraph (m) of section 42).
    (3) The hedged exposure is a wholesale exposure (other than a 
sovereign exposure).
    (4) The obligor of the hedged exposure is not:
    (i) An eligible double default guarantor or an affiliate of an 
eligible double default guarantor; or
    (ii) An affiliate of the guarantor.
    (5) The [bank] does not recognize any credit risk mitigation 
benefits of the guarantee or credit derivative for the hedged exposure 
other than through application of the double default treatment as 
provided in this section.
    (6) The [bank] has implemented a process (which has received the 
prior, written approval of the [AGENCY]) to detect excessive 
correlation between the creditworthiness of the obligor of the hedged 
exposure and the protection provider. If excessive correlation is 
present, the [bank] may not use the double default treatment for the 
hedged exposure.
    (b) Full coverage. If the transaction meets the criteria in 
paragraph (a) of this section and the protection amount (P) of the 
guarantee or credit derivative is at least equal to the EAD of the 
hedged exposure, the [bank] may determine its risk-weighted asset 
amount for the hedged exposure under paragraph (e) of this section.
    (c) Partial coverage. If the transaction meets the criteria in 
paragraph (a) of this section and the protection amount (P) of the 
guarantee or credit derivative is less than the EAD of the hedged 
exposure, the [bank] must treat the hedged exposure as two separate 
exposures (protected and unprotected) in order to recognize double 
default treatment on the protected portion of the exposure.
    (1) For the protected exposure, the [bank] must set EAD equal to P 
and calculate its risk-weighted asset amount as provided in paragraph 
(e) of this section.
    (2) For the unprotected exposure, the [bank] must set EAD equal to 
the EAD of the original exposure minus P and then calculate its risk-
weighted asset amount as provided in section 31.
    (d) Mismatches. For any hedged exposure to which a [bank] applies 
double default treatment, the [bank] must make applicable adjustments 
to the protection amount as required in paragraphs (d), (e), and (f) of 
section 33.
    (e) The double default dollar risk-based capital requirement. The 
dollar risk-based capital requirement for a hedged exposure to which a 
[bank] has applied double default treatment is KDD 
multiplied by the EAD of the exposure. KDD is calculated 
according to the following formula: KDD = Ko x 
(0.15 + 160 x PDg), where:
[GRAPHIC] [TIFF OMITTED] TP25SE06.060

    (2) PDg = PD of the protection provider.
    (3) PDo = PD of the obligor of the hedged exposure.
    (4) LGDg = (i) The lower of the LGD of the unhedged 
exposure and the LGD of the guarantee or credit derivative, if the 
guarantee or credit derivative provides the [bank] with the option to 
receive immediate payout on triggering the protection; or
    (ii) The LGD of the guarantee or credit derivative, if the 
guarantee or credit derivative does not provide the [bank] with the 
option to receive immediate payout on triggering the protection.
    (5) ELGDg = The ELGD associated with LGDg.
    (6) [rho]os (asset value correlation of the obligor) is 
calculated according to the appropriate formula for (R) provided in 
Table 2 in section 31, with PD equal to PDo.
    (7) b (maturity adjustment coefficient) is calculated according to 
the formula for b provided in Table 2 in section 31, with PD equal to 
the lesser of PDo and PDg.
    (8) M (maturity) is the effective maturity of the guarantee or 
credit derivative, which may not be less than one year or greater than 
five years.

Section 35. Risk-Based Capital Requirement for Unsettled Transactions

    (a) Definitions. For purposes of this section:
    (1) Delivery-versus-payment (DvP) transaction means a securities or 
commodities transaction in which the buyer is obligated to make payment 
only if the seller has made delivery of the securities or commodities 
and the seller is obligated to deliver the securities or commodities 
only if the buyer has made payment.
    (2) Payment-versus-payment (PvP) transaction means a foreign 
exchange transaction in which each counterparty is obligated to make a 
final transfer of one or more currencies only if the other counterparty 
has made a final transfer of one or more currencies.
    (3) Normal settlement period. A transaction has a normal settlement 
period if the contractual settlement period for the transaction is 
equal to or less than the market standard for the instrument underlying 
the transaction and equal to or less than 5 business days.
    (4) Positive current exposure. The positive current exposure of a 
[bank] for a transaction is the difference between the transaction 
value at the agreed settlement price and the current market price of 
the transaction, if the difference results in a credit exposure of the 
[bank] to the counterparty.
    (b) Scope. This section applies to all transactions involving 
securities, foreign exchange instruments, and commodities that have a 
risk of delayed settlement or delivery. This section does not apply to:
    (1) Transactions accepted by a qualifying central counterparty that 
are subject to daily marking-to-market and daily receipt and payment of 
variation margin;

[[Page 55936]]

    (2) Repo-style transactions (which are addressed in sections 31 and 
32); \9\
---------------------------------------------------------------------------

    \9\ Unsettled repo-style transactions are treated as repo-style 
transactions under sections 31 and 32.
---------------------------------------------------------------------------

    (3) One-way cash payments on OTC derivative contracts (which are 
addressed in sections 31 and 32); or
    (4) Transactions with a contractual settlement period that is 
longer than the normal settlement period (which are treated as OTC 
derivative contracts and addressed in sections 31 and 32).
    (c) System-wide failures. In the case of a system-wide failure of a 
settlement or clearing system, the [AGENCY] may waive risk-based 
capital requirements for unsettled and failed transactions until the 
situation is rectified.
    (d) Delivery-versus-payment (DvP) and payment-versus-payment (PvP) 
transactions. A [bank] must hold risk-based capital against any DvP or 
PvP transaction with a normal settlement period if the [bank]'s 
counterparty has not made delivery or payment within five business days 
after the settlement date. The [bank] must determine its risk-weighted 
asset amount for such a transaction by multiplying the positive current 
exposure of the transaction for the [bank] by the appropriate risk 
weight in Table 5.

      Table 5.--Risk Weights for Unsettled DvP and PvP Transactions
------------------------------------------------------------------------
                                                          Risk weight to
                                                           be applied to
  Number of business days after contractual settlement       positive
                          date                                current
                                                             exposure
                                                             (percent)
------------------------------------------------------------------------
From 5 to 15............................................             100
From 16 to 30...........................................             625
From 31 to 45...........................................           937.5
46 or more..............................................           1,250
------------------------------------------------------------------------

    (e) Non-DvP/non-PvP (non-delivery-versus-payment/non-payment-
versus-payment) transactions. (1) A [bank] must hold risk-based capital 
against any non-DvP/non-PvP transaction with a normal settlement period 
if the [bank] has delivered cash, securities, commodities, or 
currencies to its counterparty but has not received its corresponding 
deliverables by the end of the same business day. The [bank] must 
continue to hold risk-based capital against the transaction until the 
[bank] has received its corresponding deliverables.
    (2) From the business day after the [bank] has made its delivery 
until five business days after the counterparty delivery is due, the 
[bank] must calculate its risk-based capital requirement for the 
transaction by treating the current market value of the deliverables 
owed to the [bank] as a wholesale exposure.
    (i) A [bank] may assign an obligor rating to a counterparty for 
which it is not otherwise required under this rule to assign an obligor 
rating on the basis of the applicable external rating of any 
outstanding unsecured long-term debt security without credit 
enhancement issued by the counterparty.
    (ii) A [bank] may use a 45 percent ELGD and LGD for the transaction 
rather than estimating ELGD and LGD for the transaction provided the 
[bank] uses the 45 percent ELGD and LGD for all transactions described 
in paragraphs (e)(1) and (e)(2) of this section.
    (iii) A [bank] may use a 100 percent risk weight for the 
transaction provided the [bank] uses this risk weight for all 
transactions described in paragraphs (e)(1) and (e)(2) of this section.
    (3) If the [bank] has not received its deliverables by the fifth 
business day after counterparty delivery was due, the [bank] must 
deduct the current market value of the deliverables owed to the [bank] 
50 percent from tier 1 capital and 50 percent from tier 2 capital.
    (f) Total risk-weighted assets for unsettled transactions. Total 
risk-weighted assets for unsettled transactions is the sum of the risk-
weighted asset amounts of all DvP, PvP, and non-DvP/non-PvP 
transactions.

Part V. Risk-Weighted Assets for Securitization Exposures

Section 41. Operational Criteria for Recognizing the Transfer of Risk

    (a) Operational criteria for traditional securitizations. A [bank] 
that transfers exposures it has originated or purchased to an SPE or 
other third party in connection with a traditional securitization may 
exclude the exposures from the calculation of its risk-weighted assets 
only if each of the conditions in this paragraph (a) is satisfied. A 
[bank] that meets these conditions must hold risk-based capital against 
any securitization exposures it retains in connection with the 
securitization. A [bank] that fails to meet these conditions must hold 
risk-based capital against the transferred exposures as if they had not 
been securitized and must deduct from tier 1 capital any after-tax 
gain-on-sale resulting from the transaction. The conditions are:
    (1) The transfer is considered a sale under GAAP;
    (2) The [bank] has transferred to third parties credit risk 
associated with the underlying exposures; and
    (3) Any clean-up calls relating to the securitization are eligible 
clean-up calls.
    (b) Operational criteria for synthetic securitizations. For 
synthetic securitizations, a [bank] may recognize for risk-based 
capital purposes the use of a credit risk mitigant to hedge underlying 
exposures only if each of the conditions in this paragraph (b) is 
satisfied. A [bank] that fails to meet these conditions must hold risk-
based capital against the underlying exposures as if they had not been 
synthetically securitized. The conditions are:
    (1) The credit risk mitigant is financial collateral, an eligible 
credit derivative from an eligible securitization guarantor, or an 
eligible guarantee from an eligible securitization guarantor;
    (2) The [bank] transfers credit risk associated with the underlying 
exposures to third parties, and the terms and conditions in the credit 
risk mitigants employed do not include provisions that:
    (i) Allow for the termination of the credit protection due to 
deterioration in the credit quality of the underlying exposures;
    (ii) Require the [bank] to alter or replace the underlying 
exposures to improve the credit quality of the pool of underlying 
exposures;
    (iii) Increase the [bank]'s cost of credit protection in response 
to deterioration in the credit quality of the underlying exposures;
    (iv) Increase the yield payable to parties other than the [bank] in 
response to a deterioration in the credit quality of the underlying 
exposures; or
    (v) Provide for increases in a retained first loss position or 
credit enhancement provided by the [bank] after the inception of the 
securitization;
    (3) The [bank] obtains a well-reasoned opinion from legal counsel 
that confirms the enforceability of the credit risk mitigant in all 
relevant jurisdictions; and
    (4) Any clean-up calls relating to the securitization are eligible 
clean-up calls.

Section 42. Risk-Based Capital Requirement for Securitization Exposures

    (a) Hierarchy of approaches. Except as provided elsewhere in this 
section:
    (1) A [bank] must deduct from tier 1 capital any after-tax gain-on-
sale resulting from a securitization and must deduct from total capital 
in accordance with paragraph (c) of this section the portion of any 
CEIO that does not constitute gain-on-sale.
    (2) If a securitization exposure does not require deduction under 
paragraph (a)(1) of this section and qualifies for the Ratings-Based 
Approach in section 43, a [bank] must apply the Ratings-Based Approach 
to the exposure.

[[Page 55937]]

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

[[Page 55938]]

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

Section 43. Ratings-Based Approach (RBA)

    (a) Eligibility requirements for use of the RBA--(1) Originating 
[bank]. An originating [bank] must use the RBA to calculate its risk-
based capital requirement for a securitization exposure if the exposure 
has two or more external ratings or an inferred rating based on two or 
more external ratings (and may not use the RBA if the exposure has 
fewer than two external ratings or an inferred rating based on fewer 
than two external ratings).
    (2) Investing [bank]. An investing [bank] must use the RBA to 
calculate its risk-based capital requirement for a securitization 
exposure if the exposure has one or more external or inferred ratings 
(and may not use the RBA if the exposure has no external or inferred 
rating).
    (b) Ratings-based approach. (1) A [bank] must determine the risk-
weighted asset amount for a securitization exposure by multiplying the 
amount of the exposure (as defined in paragraph (e) of section 42) by 
the appropriate risk weight provided in the tables in this section.
    (2) The applicable rating of a securitization exposure that has 
more than one external or inferred rating is the lowest rating.
    (3) A [bank] must apply the risk weights in Table 6 when the 
securitization exposure's external or inferred rating represents a 
long-term credit rating, and must apply the risk weights in Table 7 
when the securitization exposure's external or inferred rating 
represents a short-term credit rating.
    (i) A [bank] must apply the risk weights in column 1 of Table 6 or 
7 to the securitization exposure if:
    (A) N (as calculated under paragraph (e)(6) of section 45) is 6 or 
more (for

[[Page 55939]]

purposes of this section 43 only, if the notional number of underlying 
exposures is 25 or more or if all of the underlying exposures are 
retail exposures, a [bank] may assume that N is 6 or more unless the 
[bank] knows or has reason to know that N is less than 6); and
    (B) The securitization exposure is a senior securitization 
exposure.
    (ii) A [bank] must apply the risk weights in column 3 of Table 6 or 
7 to the securitization exposure if N is less than 6, regardless of the 
seniority of the securitization exposure.
    (iii) Otherwise, a [bank] must apply the risk weights in column 2 
of Table 6 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
                                                               senior           non-senior      Risk weights for
    Applicable rating (illustrative rating example)        securitization     securitization     securitization
                                                          exposures backed   exposures backed   exposures backed
                                                         by granular pools  by granular pools   by non-granular
                                                              (percent)          (percent)      pools  (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                    10                 18                 35
 (for example, A+).....................................
Third-highest investment grade--(for example, A).......                 12                 20  .................
Third-highest investment grade-- negative designation                   20                 35  .................
 (for example, A-).....................................
                                                                           -------------------------------------
Lowest investment grade--positive designation (for                      35                   50
 example, BBB+)........................................
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
                                                               senior           non-senior      Risk weights for
    Applicable Rating (illustrative rating example)        securitization     securitization     securitization
                                                          exposures backed   exposures backed   exposures backed
                                                         by granular pools  by granular pools   by non-granular
                                                              (percent)          (percent)      pools  (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 Approach (IAA)

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

[[Page 55940]]

securitization exposures must be revised.
    (v) The [bank] must have an effective system of controls and 
oversight that ensures compliance with these operational requirements 
and maintains the integrity and accuracy of the internal credit 
assessments. The [bank] must have an internal audit function 
independent from the ABCP program business line and internal credit 
assessment process that assesses at least annually whether the controls 
over the internal credit assessment process function as intended.
    (vi) The [bank] must review and update each internal credit 
assessment whenever new material information is available, but no less 
frequently than annually.
    (vii) The [bank] must validate its internal credit assessment 
process on an ongoing basis and at least annually.
    (2) ABCP-program qualification criteria. An ABCP program qualifies 
for use of the IAA if the ABCP program meets the following criteria:
    (i) All commercial paper issued by the ABCP program must have an 
external rating.
    (ii) The ABCP program must have robust credit and investment 
guidelines (that is, underwriting standards).
    (iii) The ABCP program must perform a detailed credit analysis of 
the asset sellers' risk profiles.
    (iv) The ABCP program's underwriting policy must establish minimum 
asset eligibility criteria that include the prohibition of the purchase 
of assets that are significantly past due or defaulted, as well as 
limitations on concentration to individual obligor or geographic area 
and the tenor of the assets to be purchased.
    (v) The aggregate estimate of loss on an asset pool that the ABCP 
program is considering purchasing must consider all sources of 
potential risk, such as credit and dilution risk.
    (vi) The ABCP program must incorporate structural features into 
each purchase of assets to mitigate potential credit deterioration of 
the underlying exposures. Such features may include wind-down triggers 
specific to a pool of underlying exposures.
    (3) Exposure qualification criteria. A securitization exposure 
qualifies for use of the IAA if the [bank] initially rated the exposure 
at least the equivalent of investment grade.
    (b) Mechanics. A [bank] that elects to use the IAA to calculate the 
risk-based capital requirement for any securitization exposure must use 
the IAA to calculate the risk-based capital requirements for all 
securitization exposures that qualify for the IAA approach. Under the 
IAA, a [bank] must map its internal assessment of such a securitization 
exposure to an equivalent external rating from an NRSRO. Under the IAA, 
a [bank] must determine the risk-weighted asset amount for such a 
securitization exposure by multiplying the amount of the exposure (as 
defined in paragraph (e) of section 42) by the appropriate risk weight 
in the RBA tables in paragraph (b) of section 43.

Section 45. Supervisory Formula Approach (SFA)

    (a) Eligibility requirements. A [bank] may use the SFA to determine 
its risk-based capital requirement for a securitization exposure only 
if the [bank] can calculate on an ongoing basis each of the SFA 
parameters in paragraph (e) of this section.
    (b) Mechanics. Under the SFA, a [bank] must determine the risk-
weighted asset amount for a securitization exposure by multiplying the 
SFA risk-based capital requirement for the exposure (as determined in 
paragraph (c) of this section) by 12.5. If the SFA risk weight for a 
securitization exposure is 1,250 percent or greater, however, the 
[bank] must deduct the exposure from total capital under paragraph (c) 
of section 42 rather than risk weight the exposure. The SFA risk weight 
for a securitization exposure is equal to 1,250 percent multiplied by 
the ratio of the securitization exposure's SFA risk-based capital 
requirement to the amount of the securitization exposure (as defined in 
paragraph (e) of section 42).
    (c) The SFA risk-based capital requirement. The SFA risk-based 
capital requirement for a securitization exposure is UE multiplied by 
TP multiplied by the greater of:
    (1) 0.0056 * T; or
    (2) S[L+T] - S[L].
    (d) The supervisory formula:
    [GRAPHIC] [TIFF OMITTED] TP25SE06.061
    
    [GRAPHIC] [TIFF OMITTED] TP25SE06.062
    
    [GRAPHIC] [TIFF OMITTED] TP25SE06.063
    
    [GRAPHIC] [TIFF OMITTED] TP25SE06.064
    
    [GRAPHIC] [TIFF OMITTED] TP25SE06.065
    
    [GRAPHIC] [TIFF OMITTED] TP25SE06.066
    

[[Page 55941]]


[GRAPHIC] [TIFF OMITTED] TP25SE06.067

[GRAPHIC] [TIFF OMITTED] TP25SE06.068

[GRAPHIC] [TIFF OMITTED] TP25SE06.069

[GRAPHIC] [TIFF OMITTED] TP25SE06.070

    (11) In these expressions, [beta][Y; a, b] refers to the cumulative 
beta distribution with parameters a and b evaluated at Y. In the case 
where N = 1 and EWALGD = 100 percent, S[Y] in formula (1) must be 
calculated with K[Y] set equal to the product of KIRB and Y, 
and d set equal to 1-KIRB.
    (e) SFA Parameters--(1) Amount of the underlying exposures (UE). UE 
is the EAD of any underlying wholesale and retail exposures (including 
the amount of any funded spread accounts, cash collateral accounts, and 
other similar funded credit enhancements) plus the amount of any 
underlying exposures that are securitization exposures (as defined in 
paragraph (e) of section 42) plus the adjusted carrying value of any 
underlying equity exposures (as defined in paragraph (b) of section 
51).
    (2) Tranche percentage (TP). TP is the ratio of the amount of the 
[bank]'s securitization exposure to the amount of the tranche that 
contains the securitization exposure.
    (3) Capital requirement on underlying exposures (KIRB). 
(i) KIRB is the ratio of:
    (A) The sum of the risk-based capital requirements for the 
underlying exposures plus the expected credit losses of the underlying 
exposures (as determined under this appendix as if the underlying 
exposures were directly held by the [bank]); to
    (B) UE.
    (ii) The calculation of KIRB must reflect the effects of 
any credit risk mitigant applied to the underlying exposures (either to 
an individual underlying exposure, a group of underlying exposures, or 
to the entire pool of underlying exposures).
    (iii) All assets related to the securitization are treated as 
underlying exposures, including assets in a reserve account (such as a 
cash collateral account).
    (4) Credit enhancement level (L). (i) L is the ratio of:
    (A) The amount of all securitization exposures subordinated to the 
tranche that contains the [bank]'s securitization exposure; to (B) UE.
    (ii) [Bank]s must determine L before considering the effects of any 
tranche-specific credit enhancements.
    (iii) Any gain-on-sale or CEIO associated with the securitization 
may not be included in L.
    (iv) Any reserve account funded by accumulated cash flows from the 
underlying exposures that is subordinated to the tranche in question 
may be included in the numerator and denominator of L to the extent 
cash has accumulated in the account. Unfunded reserve accounts (that 
is, reserve accounts that are to be funded from future cash flows from 
the underlying exposures) may not be included in the calculation of L.
    (v) In some cases, the purchase price of receivables will reflect a 
discount that provides credit enhancement (for example, first loss 
protection) for all or certain tranches of the securitization. When 
this arises, L should be calculated inclusive of this discount if the 
discount provides credit enhancement for the securitization exposure.
    (5) Thickness of tranche (T). T is the ratio of:
    (i) The amount of the tranche that contains the [bank]'s 
securitization exposure; to
    (ii) UE.
    (6) Effective number of exposures (N). (i) Unless the [bank] elects 
to use the formula provided in paragraph (f),
[GRAPHIC] [TIFF OMITTED] TP25SE06.071

where EADi represents the EAD associated with the ith 
instrument in the pool of underlying exposures.
    (ii) Multiple exposures to one obligor must be treated as a single 
underlying exposure.
    (iii) In the case of a re-securitization (that is, a securitization 
in which some or all of the underlying exposures are themselves 
securitization exposures), the [bank] must treat each underlying 
exposure as a single underlying exposure and must not look through to 
the originally securitized underlying exposures.
    (7) Exposure-weighted average loss given default (EWALGD). EWALGD 
is calculated as:
[GRAPHIC] [TIFF OMITTED] TP25SE06.072

where LGDi represents the average LGD associated with all 
exposures to the ith obligor. In the case of a re-
securitization, an LGD of 100 percent must be assumed for the 
underlying exposures that are themselves securitization exposures.
    (f) Simplified method for computing N and EWALGD. (1) If all 
underlying exposures of a securitization are retail exposures, a [bank] 
may apply the SFA using the following simplifications:
    (i) h = 0; and
    (ii) v = 0.
    (2) Under the conditions in paragraphs (f)(3) and (f)(4), a [bank] 
may employ a simplified method for calculating N and EWALGD.
    (3) If C1 is no more than 0.03, a [bank] may set EWALGD 
= 0.50 and N equal to the following amount:

[[Page 55942]]

[GRAPHIC] [TIFF OMITTED] TP25SE06.073

Where:
(i) Cm is the ratio of the sum of the amounts of the `m' 
largest underlying exposures to UE; and
(ii) The level of m is to be selected by the [bank].

    (4) Alternatively, if only C1 is available and 
C1 is no more than 0.03, the [bank] may set EWALGD = 0.50 
and N = 1/C1.

Section 46. Recognition of Credit Risk Mitigants for Securitization 
Exposures

    (a) General. An originating [bank] that has obtained a credit risk 
mitigant to hedge its securitization exposure to a synthetic or 
traditional securitization that satisfies the operational criteria in 
section 41 may recognize the credit risk mitigant, but only as provided 
in this section. An investing [bank] that has obtained a credit risk 
mitigant to hedge a securitization exposure may recognize the credit 
risk mitigant, but only as provided in this section. A [bank] that has 
used the RBA in section 43 or the IAA in section 44 to calculate its 
risk-based capital requirement for a securitization exposure whose 
external or inferred rating (or equivalent internal rating under the 
IAA) reflects the benefits of a particular credit risk mitigant 
provided to the associated securitization or that supports some or all 
of the underlying exposures may not use the credit risk mitigation 
rules in this section to further reduce its risk-based capital 
requirement for the exposure to reflect that credit risk mitigant.
    (b) Collateral--(1) Rules of recognition. A [bank] may recognize 
financial collateral in determining the [bank]'s risk-based capital 
requirement for a securitization exposure as follows. The [bank]'s 
risk-based capital requirement for the collateralized securitization 
exposure is equal to the risk-based capital requirement for the 
securitization exposure as calculated under the RBA in section 43 or 
the SFA in section 45 multiplied by the ratio of adjusted exposure 
amount (E*) to original exposure amount (E), where:
    (i) E* = max {0, [E-C x (1-Hs-Hfx)]{time} ;
    (ii) E = the amount of the securitization exposure calculated under 
paragraph (e) of section 42;
    (iii) C = the current market value of the collateral;
    (iv) Hs = the haircut appropriate to the collateral type; and
    (v) Hfx = the haircut appropriate for any currency mismatch between 
the collateral and the exposure.
    (2) Mixed collateral. Where the collateral is a basket of different 
asset types or a basket of assets denominated in different currencies, 
the haircut on the basket will be
[GRAPHIC] [TIFF OMITTED] TP25SE06.081

where ai is the current market value of the asset in the 
basket divided by the current market value of all assets in the basket 
and Hi is the haircut applicable to that asset.
    (3) Standard supervisory haircuts. Unless a [bank] qualifies for 
use of and uses own-estimates haircuts in paragraph (b)(4) of this 
section:
    (i) A [bank] must use the collateral type haircuts (Hs) in Table 3;
    (ii) A [bank] must use a currency mismatch haircut (Hfx) of 8 
percent if the exposure and the collateral are denominated in different 
currencies;
    (iii) A [bank] must multiply the supervisory haircuts obtained in 
paragraphs (b)(3)(i) and (ii) by the square root of 6.5 (which equals 
2.549510); and
    (iv) A [bank] must adjust the supervisory haircuts upward on the 
basis of a holding period longer than 65 business days where and as 
appropriate to take into account the illiquidity of the collateral.
    (4) Own estimates for haircuts. With the prior written approval of 
the [AGENCY], a [bank] may calculate haircuts using its own internal 
estimates of market price volatility and foreign exchange volatility, 
subject to the provisions of paragraph (a)(2)(iii) of section 32. The 
minimum holding period (TM) for securitization exposures is 
65 business days.
    (c) Guarantees and credit derivatives--(1) Limitations on 
recognition. A [bank] may only recognize an eligible guarantee or 
eligible credit derivative provided by an eligible securitization 
guarantor in determining the [bank]'s risk-based capital requirement 
for a securitization exposure.
    (2) ECL for securitization exposures. When a [bank] recognizes an 
eligible guarantee or eligible credit derivative provided by an 
eligible securitization guarantor in determining the [bank]'s risk-
based capital requirement for a securitization exposure, the [bank] 
must also:
    (i) Calculate ECL for the exposure using the same risk parameters 
that it uses for calculating the risk-weighted asset amount of the 
exposure as described in paragraph (c)(3) of this section; and
    (ii) Add the exposure's ECL to the [bank]'s total ECL.
    (3) Rules of recognition. A [bank] may recognize an eligible 
guarantee or eligible credit derivative provided by an eligible 
securitization guarantor in determining the [bank]'s risk-based capital 
requirement for the securitization exposure as follows:
    (i) Full coverage. If the protection amount of the eligible 
guarantee or eligible credit derivative equals or exceeds the amount of 
the securitization exposure, then the [bank] may set the risk-weighted 
asset amount for the securitization exposure equal to the risk-weighted 
asset amount for a direct exposure to the eligible securitization 
guarantor (as determined in the wholesale risk weight function 
described in section 31), using the [bank]'s PD for the guarantor, the 
[bank]'s ELGD and LGD for the guarantee or credit derivative, and an 
EAD equal to the amount of the securitization exposure (as determined 
in paragraph (e) of section 42).
    (ii) Partial coverage. If the protection amount of the eligible 
guarantee or eligible credit derivative is less than the amount of the 
securitization exposure, then the [bank] may set the risk-weighted 
asset amount for the securitization exposure equal to the sum of:
    (A) Covered portion. The risk-weighted asset amount for a direct 
exposure to the eligible securitization guarantor (as determined in the 
wholesale risk weight function described in section 31), using the 
[bank]'s PD for the guarantor, the [bank]'s ELGD and LGD for the 
guarantee or credit derivative, and an EAD equal to the protection 
amount of the credit risk mitigant; and
    (B) Uncovered portion. (1) 1.0 minus (the protection amount of the 
eligible guarantee or eligible credit derivative divided by the amount 
of the securitization exposure); multiplied by
    (2) The risk-weighted asset amount for the securitization exposure 
without the credit risk mitigant (as determined in sections 42-45).

[[Page 55943]]

    (4) Mismatches. For any hedged securitization exposure, the [bank] 
must make applicable adjustments to the protection amount as required 
in paragraphs (d), (e), and (f) of section 33.

Section 47. Risk-Based Capital Requirement for Early Amortization 
Provisions

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

           Table 8.--Controlled Early Amortization Provisions
------------------------------------------------------------------------
                                       Uncommitted          Committed
------------------------------------------------------------------------
Retail Credit Lines............  3-month average excess  90% CF.
                                  spread Conversion
                                  Factor (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  100% CF.
                                  spread Conversion
                                  Factor (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 Equity Exposures

Section 51. Introduction and Exposure Measurement

    (a) General. To calculate its risk-weighted asset amounts for 
equity exposures that are not equity exposures to investment funds, a 
[bank] may apply either the Simple Risk Weight Approach (SRWA) in 
section 52 or, if it qualifies to do so, the Internal Models Approach 
(IMA) in section 53. A [bank] must use the look-through approaches in 
section 54 to calculate its risk-weighted asset amounts for equity 
exposures to investment funds.
    (b) Adjusted carrying value. For purposes of this part, the 
``adjusted carrying value'' of an equity exposure is:
    (1) For the on-balance sheet component of an equity exposure, the 
[bank]'s carrying value of the exposure reduced by any unrealized gains 
on the exposure that are reflected in such carrying value but excluded 
from the [bank]'s tier 1 and tier 2 capital; and
    (2) For the off-balance sheet component of an equity exposure, the 
effective notional principal amount of the exposure, the size of which 
is equivalent to a hypothetical on-balance sheet position in the 
underlying equity instrument that would evidence the same change in 
fair value (measured in dollars) for a given small change in the price 
of the underlying equity instrument, minus the adjusted carrying value 
of the on-balance sheet component of the exposure as calculated in 
paragraph (b)(1) of this section. 
---------------------------------------------------------------------------

    \10\ In securitizations that do not require excess spread to be 
trapped, or that specify trapping points based primarily on 
performance measures other than the three-month average excess 
spread, the excess spread trapping point is 4.5 percent.

---------------------------------------------------------------------------

[[Page 55944]]

Section 52. Simple Risk Weight Approach (SRWA)

    (a) In general. Under the SRWA, a [bank]'s aggregate risk-weighted 
asset amount for its equity exposures is equal to the sum of the risk-
weighted asset amounts for each of the [bank]'s individual equity 
exposures (other than equity exposures to an investment fund) as 
determined in this section and the risk-weighted asset amounts for each 
of the [bank]'s individual equity exposures to an investment fund as 
determined in section 54.
    (b) SRWA computation for individual equity exposures. A [bank] must 
determine the risk-weighted asset amount for an individual equity 
exposure (other than an equity exposure to an investment fund) by 
multiplying the adjusted carrying value of the equity exposure or the 
effective portion and ineffective portion of a hedge pair (as defined 
in paragraph (c) of this section) by the lowest applicable risk weight 
in this paragraph (b).
    (1) 0 percent risk weight equity exposures. An equity exposure to 
an entity whose credit exposures are exempt from the 0.03 percent PD 
floor in paragraph (d)(2) of section 31 is assigned a 0 percent risk 
weight.
    (2) 20 percent risk weight equity exposures. An equity exposure to 
a Federal Home Loan Bank or Farmer Mac that is not publicly traded and 
is held as a condition of membership in that entity is assigned a 20 
percent risk weight.
    (3) 100 percent risk weight equity exposures. The following equity 
exposures are assigned a 100 percent risk weight:
    (i) Community development equity exposures. An equity exposure that 
qualifies as a community development investment under 12 U.S.C. 
24(Eleventh), excluding equity exposures to an unconsolidated small 
business investment company and equity exposures held through a 
consolidated small business investment company described in section 302 
of the Small Business Investment Act of 1958 (15 U.S.C. 682).
    (ii) Certain equity exposures to a Federal Home Loan Bank and 
Farmer Mac. An equity exposure to a Federal Home Loan Bank or Farmer 
Mac that is not assigned a 20 percent risk weight.
    (iii) Effective portion of hedge pairs. The effective portion of a 
hedge pair.
    (iv) Non-significant equity exposures. Equity exposures to the 
extent that the aggregate adjusted carrying value of the exposures does 
not exceed 10 percent of the [bank]'s tier 1 capital plus tier 2 
capital.
    (A) To compute the aggregate adjusted carrying value of a [bank]'s 
equity exposures for purposes of this paragraph (b)(3)(iv), the [bank] 
may exclude equity exposures described in paragraphs (b)(1), (b)(2), 
and (b)(3)(i), (ii), and (iii) of this section, the equity exposure in 
a hedge pair with the smaller adjusted carrying value, and a proportion 
of each equity exposure to an investment fund equal to the proportion 
of the assets of the investment fund that are not equity exposures. If 
a [bank] does not know the actual holdings of the investment fund, the 
[bank] may calculate the proportion of the assets of the fund that are 
not equity exposures based on the terms of the prospectus, partnership 
agreement, or similar contract that defines the fund's permissible 
investments. If the sum of the investment limits for all exposure 
classes within the fund exceeds 100 percent, the [bank] must assume for 
purposes of this paragraph (b)(3)(iv) that the investment fund invests 
to the maximum extent possible in equity exposures.
    (B) When determining which of a [bank]'s equity exposures qualify 
for a 100 percent risk weight under this paragraph, a [bank] must first 
include equity exposures to unconsolidated small business investment 
companies or held through consolidated small business investment 
companies described in section 302 of the Small Business Investment Act 
of 1958 (15 U.S.C. 682) and then must include publicly traded equity 
exposures (including those held indirectly through investment funds) 
and then must include non-publicly traded equity exposures (including 
those held indirectly through investment funds).
    (4) 300 percent risk weight equity exposures. A publicly traded 
equity exposure (including the ineffective portion of a hedge pair) is 
assigned a 300 percent risk weight.
    (5) 400 percent risk weight equity exposures. An equity exposure 
that is not publicly traded is assigned a 400 percent risk weight.
    (c) Hedge transactions--(1) Hedge pair. A hedge pair is two equity 
exposures that form an effective hedge so long as each equity exposure 
is publicly traded or has a return that is primarily based on a 
publicly traded equity exposure.
    (2) Effective hedge. Two equity exposures form an effective hedge 
if the exposures either have the same remaining maturity or each have a 
remaining maturity of at least three months; the hedge relationship is 
formally documented in a prospective manner (that is, before the [bank] 
acquires at least one of the equity exposures); the documentation 
specifies the measure of effectiveness (E) the [bank] will use for the 
hedge relationship throughout the life of the transaction; and the 
hedge relationship has an E greater than or equal to 0.8. A [bank] must 
measure E at least quarterly and must use one of three alternative 
measures of E:
    (i) Under the dollar-offset method of measuring effectiveness, the 
[bank] must determine the ratio of value change (RVC), that is, the 
ratio of the cumulative sum of the periodic changes in value of one 
equity exposure to the cumulative sum of the periodic changes in the 
value of the other equity exposure. If RVC is positive, the hedge is 
not effective and E = 0. If RVC is negative and greater than or equal 
to -1 (that is, between zero and -1), then E equals the absolute value 
of RVC. If RVC is negative and less than -1, then E equals 2 plus RVC.
    (ii) Under the variability-reduction method of measuring 
effectiveness:
[GRAPHIC] [TIFF OMITTED] TP25SE06.074

    (A) Xt = At - Bt;
    (B) At the value at time t of one exposure in a hedge 
pair; and
    (C) Bt the value at time t of the other exposure in a 
hedge pair.
    (iii) Under the regression method of measuring effectiveness, E 
equals the coefficient of determination of a regression in which the 
change in value of one exposure in a hedge pair is the dependent 
variable and the change in value of the other exposure in a hedge pair 
is the independent variable.
    (3) The effective portion of a hedge pair is E multiplied by the 
greater of the adjusted carrying values of the equity exposures forming 
a hedge pair.
    (4) The ineffective portion of a hedge pair is (1-E) multiplied by 
the greater of the adjusted carrying values of the equity exposures 
forming a hedge pair.

Section 53. Internal Models Approach (IMA)

    This section describes the two ways that a [bank] may calculate its 
risk-weighted asset amount for equity exposures using the IMA. A [bank] 
may model publicly traded and non-publicly traded equity exposures (in 
accordance with paragraph (b) of this section) or model only publicly 
traded equity exposure (in accordance with paragraph (c) of this 
section).
    (a) Qualifying criteria. To qualify to use the IMA to calculate 
risk-based

[[Page 55945]]

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

Section 54. Equity Exposures to Investment Funds

    (a) Available approaches. A [bank] must determine the risk-weighted 
asset amount of an equity exposure to an investment fund under the Full 
Look-Through Approach in paragraph (b) of this section, the Simple 
Modified Look-Through Approach in paragraph (c) of this section, or the 
Alternative Modified Look-Through Approach in paragraph (d) of this 
section unless the exposure would meet the requirements for a community 
development equity exposure in paragraph (b)(3)(i) of section 52. The 
risk-weighted asset amount of such an equity exposure to an investment 
fund would be its adjusted carrying value. If an equity exposure to an 
investment fund is part of a hedge pair, a [bank] may use the 
ineffective portion of the hedge pair as determined under paragraph (c) 
of section 52 as the adjusted carrying value for the equity exposure to 
the investment fund.
    (b) Full look-through approach. A [bank] that is able to calculate 
a risk-weighted asset amount for each exposure held by the investment 
fund (as calculated under this appendix as if the exposures were held 
directly by the [bank]) may set the risk-weighted asset amount of the 
[bank]'s exposure to the fund equal to the greater of:
    (1) The product of:
    (i) The aggregate risk-weighted asset amounts of the exposures held 
by the fund (as calculated under this appendix) as if the exposures 
were held directly by the [bank]; and
    (ii) The [bank]'s proportional ownership share of the fund; or
    (2) 7 percent of the adjusted carrying value of the [bank]'s equity 
exposure to the fund.

[[Page 55946]]

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

   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
                                category; and exposures to, or
                                guaranteed by, depository institutions,
                                foreign banks (as defined in 12 CFR
                                211.2), or securities firms subject to
                                consolidated supervision and regulation
                                comparable to that imposed on U.S.
                                securities broker-dealers that are repo-
                                style transactions or bankers'
                                acceptances.
50 percent...................  Exposures with a long-term applicable
                                external rating in the third-highest
                                investment grade rating category or a
                                short-term applicable external rating in
                                the second-highest investment grade
                                rating category.
100 percent..................  Exposures with a long-term or short-term
                                applicable external rating in the lowest
                                investment grade rating category.
200 percent..................  Exposures with a long-term applicable
                                external rating one rating category
                                below investment grade.
300 percent..................  Publicly traded equity exposures.
400 percent..................  Non-publicly traded equity exposures;
                                exposures with a long-term applicable
                                external rating two rating categories or
                                more below investment grade; and
                                exposures without an external rating
                                (excluding publicly traded equity
                                exposures).
1,250 percent................  OTC derivative contracts and exposures
                                that must be deducted from regulatory
                                capital or receive a risk weight greater
                                than 400 percent under this appendix.
------------------------------------------------------------------------

    (d) Alternative Modified Look-Through Approach. Under this 
approach, a [bank] may assign the adjusted carrying value of an equity 
exposure to an investment fund on a pro rata basis to different risk 
weight categories in Table 10 according to the investment limits in the 
fund's prospectus, partnership agreement, or similar contract that 
defines the fund's permissible investments. If the sum of the 
investment limits for exposure classes within the fund exceeds 100 
percent, the [bank] must assume that the fund invests to the maximum 
extent permitted under its investment limits in the exposure class with 
the highest risk weight under Table 10, and continues to make 
investments in order of the exposure class with the next highest risk 
weight under Table 10 until the maximum total investment level is 
reached. If more than one exposure class applies to an exposure, the 
[bank] must use the highest applicable risk weight. A [bank] may not 
assign an equity exposure to an investment fund to an aggregate risk 
weight of less than 7 percent. A [bank] may exclude derivative 
contracts held by the fund that are used for hedging rather than 
speculative purposes and do not constitute a material portion of the 
fund's exposures.

Section 55. Equity Derivative Contracts

    Under the IMA, in addition to holding risk-based capital against an 
equity derivative contract under this part, a [bank] must hold risk-
based capital against the counterparty credit risk in the equity 
derivative contract by also treating the equity derivative contract as 
a wholesale exposure and computing a supplemental risk-weighted asset 
amount for the contract under part IV. Under the SRWA, a [bank] may 
choose not to hold risk-based capital against the counterparty credit 
risk of equity derivative contracts, as long as it does so for all such 
contracts. Where the equity derivative contracts are subject to a 
qualified master netting agreement, a [bank] using the SRWA must either 
include all or exclude all of the contracts from any measure used to 
determine counterparty credit risk exposure.

Part VII. Risk-Weighted Assets for Operational Risk

Section 61. Qualification Requirements for Incorporation of Operational 
Risk Mitigants

    (a) Qualification to use operational risk mitigants. A [bank] may 
adjust its estimate of operational risk exposure to reflect qualifying 
operational risk mitigants if:
    (1) The [bank]'s operational risk quantification system is able to 
generate an estimate of the [bank]'s operational risk exposure (which 
does not incorporate qualifying operational risk mitigants) and an 
estimate of the [bank]'s operational risk exposure adjusted to 
incorporate qualifying operational risk mitigants; and
    (2) The [bank]'s methodology for incorporating the effects of 
insurance, if the [bank] uses insurance as an operational risk 
mitigant, captures through appropriate discounts to the amount of risk 
mitigation:
    (i) The residual term of the policy, where less than one year;
    (ii) The cancellation terms of the policy, where less than one 
year;
    (iii) The policy's timeliness of payment;
    (iv) The uncertainty of payment by the provider of the policy; and
    (v) Mismatches in coverage between the policy and the hedged 
operational loss event.
    (b) Qualifying operational risk mitigants. Qualifying operational 
risk mitigants are:
    (1) Insurance that:
    (i) Is provided by an unaffiliated company that has a claims 
payment ability that is rated in one of the three highest rating 
categories by a NRSRO;
    (ii) Has an initial term of at least one year and a residual term 
of more than 90 days;
    (iii) Has a minimum notice period for cancellation by the provider 
of 90 days;
    (iv) Has no exclusions or limitations based upon regulatory action 
or for the receiver or liquidator of a failed depository institution; 
and
    (v) Is explicitly mapped to a potential operational loss event; and

[[Page 55947]]

    (2) Operational risk mitigants other than insurance for which the 
[AGENCY] has given prior written approval. In evaluating an operational 
risk mitigant other than insurance, [AGENCY] will consider whether the 
operational risk mitigant covers potential operational losses in a 
manner equivalent to holding regulatory capital.

Section 62. Mechanics of Risk-Weighted Asset Calculation

    (a) If a [bank] does not qualify to use or does not have qualifying 
operational risk mitigants, the [bank]'s dollar risk-based capital 
requirement for operational risk is its operational risk exposure minus 
eligible operational risk offsets (if any).
    (b) If a [bank] qualifies to use operational risk mitigants and has 
qualifying operational risk mitigants, the [bank]'s dollar risk-based 
capital requirement for operational risk is the greater of:
    (1) The [bank]'s operational risk exposure adjusted for qualifying 
operational risk mitigants minus eligible operational risk offsets (if 
any); or
    (2) 0.8 multiplied by the difference between:
    (i) The [bank]'s operational risk exposure; and
    (ii) Eligible operational risk offsets (if any).
    (c) The [bank]'s risk-weighted asset amount for operational risk 
equals the [bank]'s dollar risk-based capital requirement for 
operational risk determined under paragraph (a) or (b) of this section 
multiplied by 12.5.

Part VIII. Disclosure

Section 71. Disclosure Requirements

    (a) Each [bank] must publicly disclose each quarter its total and 
tier 1 risk-based capital ratios and their components (that is, tier 1 
capital, tier 2 capital, total qualifying capital, and total risk-
weighted assets).\11\
---------------------------------------------------------------------------

    \11\ Other public disclosure requirements continue to apply--for 
example, Federal securities law and regulatory reporting 
requirements.
---------------------------------------------------------------------------

    [Disclosure paragraph (b)]
    [Disclosure paragraph (c)]
    End of common rule.
    [End of common text]

List of Subjects

12 CFR Part 3

    Administrative practices and procedure, Capital, National banks, 
Reporting and recordkeeping requirements, Risk.

12 CFR Part 208

    Confidential business information, Crime, Currency, Federal Reserve 
System, Mortgages, reporting and recordkeeping requirements, 
Securities.

12 CFR Part 225

    Administrative practice and procedure, Banks, banking, Federal 
Reserve System, Holding companies, Reporting and recordkeeping 
requirements, Securities.

12 CFR Part 325

    Administrative practice and procedure, Banks, banking, Capital 
Adequacy, Reporting and recordkeeping requirements, Savings 
associations, State nonmember banks.

12 CFR Part 566

    Capital, reporting and recordkeeping requirements, Savings 
associations.

Authority and Issuance

Adoption of Common Appendix

    The adoption of the proposed common rules by the agencies, as 
modified by agency-specific text, is set forth below:

Department of the Treasury

Office of the Comptroller of the Currency

12 CFR Chapter I

Authority and Issuance

    For the reasons stated in the common preamble, the Office of the 
Comptroller of the Currency proposes to amend Part 3 of chapter I of 
Title 12, Code of Federal Regulations as follows:

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

    1. The authority citation for part 3 continues to read as follows:

    Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n 
note, 1835, 3907, and 3909.

    2. New Appendix C to part 3 is added as set forth at the end of the 
common preamble.
    3. Appendix C to part 3 is amended as set forth below:
    a. Remove ``[AGENCY]'' and add ``OCC'' in its place wherever it 
appears.
    b. Remove ``[bank]'' and add ``bank'' in its place wherever it 
appears, and remove ``[Bank]'' and add ``Bank'' in its place wherever 
it appears.
    c. Remove ``[Appendix -- to Part -- ]'' and add ``Appendix C to 
Part 3'' in its place wherever it appears.
    d. Remove ``[the general risk-based capital rules]'' and add ``12 
CFR part 3, Appendix A'' in its place wherever it appears.
    e. Remove ``[the market risk rule]'' and add ``12 CFR part 3, 
Appendix B'' in its place wherever it appears.
    f. Remove ``[Disclosure paragraph (b)]'' and add in its place ``(b) 
A bank must comply with paragraph (c) of section 71 of appendix F to 
the Federal Reserve Board's Regulation Y (12 CFR part 225, appendix F) 
unless it is a consolidated subsidiary of a bank holding company or 
depository institution that is subject to these requirements.''
    g. Remove ``[Disclosure paragraph (c)].''

Board of Governors of the Federal Reserve System

12 CFR Chapter II

Authority and Issuance

    For the reasons stated in the common preamble, the Board of 
Governors of the Federal Reserve System proposes to amend parts 208 and 
225 of chapter II of title 12 of the Code of Federal Regulations as 
follows:

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

    1. The authority citation for part 208 continues to read as 
follows:

    Authority: 12 U.S.C. 24, 36, 92a, 93a, 248(a), 248(c), 321-338a, 
371d, 461, 481-486, 601, 611, 1814, 1816, 1818, 1820(d)(9), 1823(j), 
1828(o), 1831, 1831o, 1831p-1, 1831r-1, 1835a, 1882, 2901-2907, 
3105, 3310, 3331-3351, and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g), 
78l(i), 78o-4(c)(5), 78q, 78q-1, and 78w, 6801, and 6805; 31 U.S.C. 
5318; 42 U.S.C. 4012a, 4104a, 4104b, 4106, and 4128.

    2. New Appendix F to part 208 is added as set forth at the end of 
the common preamble.
    3. Appendix F to part 208 is amended as set forth below:
    a. Remove ``[AGENCY]'' and add ``Board'' in its place wherever it 
appears.
    b. Remove ``[bank]'' and add ``bank'' in its place wherever it 
appears, and remove ``[Bank]'' and add ``Bank'' in its place wherever 
it appears.
    c. Remove ``[Appendix -- to Part --]'' and add ``Appendix F to Part 
208'' in its place wherever it appears.
    d. Remove ``[the general risk-based capital rules]'' and add ``12 
CFR part 208, Appendix A'' in its place wherever it appears.
    e. Remove ``[the market risk rule]'' and add ``12 CFR part 208, 
Appendix E'' in its place wherever it appears.
    f. Remove ``[Disclosure paragraph (b)]'' and add in its place ``(b) 
A bank must comply with paragraph (c) of section 71 of appendix F to 
the Federal Reserve Board's Regulation Y (12 CFR part 225, appendix F) 
unless it is a

[[Page 55948]]

consolidated subsidiary of a bank holding company or depository 
institution that is subject to these requirements.''
    g. Remove ``[Disclosure paragraph (c)].''

PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL 
(REGULATION Y)

    1. The authority citation for part 225 continues to read as 
follows:

    Authority: 12 U.S.C. 1817(j)(13), 1818, 1828(o), 1831i, 1831p-1, 
1843(c)(8), 1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 3907, and 
3909; 15 U.S.C. 6801 and 6805.

    2. New Appendix G to part 225 is added as set forth at the end of 
the common preamble.
    3. Appendix G to part 225 is amended as set forth below:
    a. Remove ``[AGENCY]'' and add ``Board'' in its place wherever it 
appears.
    b. Remove ``[bank]'' and add in its place ``bank holding company'' 
wherever it appears, and remove ``[Bank]'' and add ``Bank holding 
company'' in its place wherever it appears.
    c. Remove ``[Appendix -- to Part --]'' and add ``Appendix G to Part 
225'' in its place wherever it appears.
    d. Remove ``[the general risk-based capital rules]'' and add ``12 
CFR part 225, Appendix A'' in its place wherever it appears.
    e. Remove ``[the market risk rule]'' and add ``12 CFR part 225, 
Appendix E'' in its place wherever it appears.
    f. Remove the text of section 1(b)(1)(i) and add in its place: ``Is 
a U.S.-based bank holding company that has total consolidated assets 
(excluding assets held by an insurance underwriting subsidiary), as 
reported on the most recent year-end FR Y-9C, equal to $250 billion or 
more;''.
    g. Remove the text of section 1(b)(1)(iii) and add in its place: 
``Has a subsidiary depository institution (as defined in 12 U.S.C. 
1813) that is required, or has elected, to use 12 CFR part 3, Appendix 
C, 12 CFR part 208, Appendix F, 12 CFR part 325, Appendix F, or 12 CFR 
556 to calculate its risk-based capital requirements;''.
    h. At the end of section 11(b)(1) add the following sentence: ``A 
bank holding company also must deduct an amount equal to the minimum 
regulatory capital requirement established by the regulator of any 
insurance underwriting subsidiary of the holding company. For U.S.-
based insurance underwriting subsidiaries, this amount generally would 
be 200 percent of the subsidiary's Authorized Control Level as 
established by the appropriate state regulator of the insurance 
company.''
    i. Remove section 22(h)(3)(ii).
    j. In section 31(e)(3), remove ``A bank may assign a risk-weighted 
asset amount of zero to cash owned and held in all offices of the bank 
or in transit and for gold bullion held in the bank's own vaults, or 
held in another bank's vaults on an allocated basis, to the extent it 
is offset by gold bullion liabilities'' and add in its place ``A bank 
holding company may assign a risk-weighted asset amount of zero to cash 
owned and held in all offices of subsidiary depository institutions or 
in transit and for gold bullion held in either a subsidiary depository 
institution's own vaults, or held in another's vaults on an allocated 
basis, to the extent it is offset by gold bullion liabilities.''
    k. Remove ``[Disclosure paragraph (b)].''
    l. Remove ``[Disclosure paragraph (c)].''
    m. In section 71, add new paragraph (b) to read as follows:
    Section 71. * * *
* * * * *
    (b)(1) Each consolidated bank holding company that has successfully 
completed its parallel run must provide timely public disclosures each 
calendar quarter of the information in tables 11.1-11.11 below. If a 
significant change occurs, such that the most recent reported amounts 
are no longer reflective of the bank holding company's capital adequacy 
and risk profile, then a brief discussion of this change and its likely 
impact must be provided as soon as practicable thereafter. Qualitative 
disclosures that typically do not change each quarter (for example, a 
general summary of the bank holding company's risk management 
objectives and policies, reporting system, and definitions) may be 
disclosed annually, provided any significant changes to these are 
disclosed in the interim. Management is encouraged to provide all of 
the disclosures required by this appendix in one place on the bank 
holding company's public Web site.\12\ The bank holding company must 
make these disclosures publicly available for each of the last three 
years (that is, twelve quarters) or such shorter period since it began 
its first floor period.
---------------------------------------------------------------------------

    \12\ Alternatively, a bank holding company may provide the 
disclosures in more than one place, as some of them may be included 
in public financial reports (for example, in Management's Discussion 
and Analysis included in SEC filings) or other regulatory reports. 
The bank holding company must provide a summary table on its public 
Web site that specifically indicates where all the disclosures may 
be found (for example, regulatory report schedules, page numbers in 
annual reports).
---------------------------------------------------------------------------

    (2) Each bank holding company is required to have a formal 
disclosure policy approved by the board of directors that addresses its 
approach for determining the disclosures it makes. The policy must 
address the associated internal controls and disclosure controls and 
procedures. The board of directors and senior management must ensure 
that appropriate verification of the disclosures takes place and that 
effective internal controls and disclosure controls and procedures are 
maintained. The chief financial officer of the bank holding company 
must certify that the disclosures required by this appendix are 
appropriate, and the board of directors and senior management are 
responsible for establishing and maintaining an effective internal 
control structure over financial reporting, including the disclosures 
required by this appendix.
---------------------------------------------------------------------------

    \13\ Entities include securities, insurance and other financial 
subsidiaries, commercial subsidiaries (where permitted), significant 
minority equity investments in insurance, financial and commercial 
entities.
    \14\ A capital deficiency is the amount by which actual 
regulatory capital is less than the minimum regulatory capital 
requirement.

                    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.
------------------------------------------------------------------------


[[Page 55949]]


                     Table 11.2.--Capital Structure
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Qualitative Disclosures...........  (a) Summary information on the terms
                                     and conditions of the main features
                                     of all capital instruments,
                                     especially 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
                                     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;
                                          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 Requirement
---------------------------------------------------------------------------

    \15\ Representing 50% of the amount, if any, by which total 
expected credit losses as calculated within the IRB framework exceed 
eligible credit reserves, which must be deducted from Tier 1 
capital.
    \16\ Including 50% of the amount, if any, by which total 
expected credit losses as calculated within the IRB framework exceed 
eligible credit reserves, which must be deducted from Tier 2 
capital.
---------------------------------------------------------------------------

    For each separate risk area described in tables 11.4 through 11.11, 
the bank holding company must describe its risk management objectives 
and policies, including:
     Strategies and processes;
     The structure and organization of the relevant risk 
management function;
     The scope and nature of risk reporting and/or measurement 
systems;
     Policies for hedging and/or mitigating risk and strategies 
and processes for monitoring the continuing effectiveness of hedges/
mitigants.
---------------------------------------------------------------------------

    \17\ Risk-weighted assets determined under [the market risk 
rule] are to be disclosed only for the approaches used.
    \18\ Total risk-weighted assets should also be disclosed.

            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 exposure.
                                    (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,
                                     broken 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\
------------------------------------------------------------------------


[[Page 55950]]

     
---------------------------------------------------------------------------

    \19\ Table 4 does not include equity exposures.
    \20\ That is, after accounting offsets in accordance with U.S. 
GAAP (for example, FASB Interpretations 39 and 41) and without 
taking into account the effects of credit risk mitigation 
techniques, for example collateral and netting.
    \21\ For example, banks could apply a breakdown similar to that 
used for accounting purposes. Such a breakdown might, for instance, 
be (a) loans, off-balance sheet commitments, and other non-
derivative off-balance sheet exposures, (b) debt securities, and (c) 
OTC derivatives.
    \22\ Geographical areas may comprise individual countries, 
groups of countries or regions within countries. A bank holding 
company might choose to define the geographical areas based on the 
way the company's portfolio is geographically managed. The criteria 
used to allocate the loans to geographical areas must be specified.
    \23\ A bank holding company is encouraged also to provide an 
analysis of the aging of past-due loans.
    \24\ The portion of general allowance that is not allocated to a 
geographical area should be disclosed separately.
    \25\ The reconciliation should include the following: A 
description of the allowance; the opening balance of the allowance; 
charge-offs taken against the allowance during the period; amounts 
provided (or reversed) for estimated probable loan losses during the 
period; any other adjustments (for example, exchange rate 
differences, business combinations, acquisitions and disposals of 
subsidiaries), including transfers between allowances; and the 
closing balance of the allowance. Charge-offs and recoveries that 
have been recorded directly to the income statement should be 
disclosed separately.

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      (c) For wholesale exposures, present
 assessment.                         the following information across a
                                     sufficient number of PD grades
                                     (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
                                     segments to allow for a meaningful
                                     differentiation of credit risk.
Quantitative disclosures:           (d) Actual losses in the preceding
 historical results.                 period for each category and
                                     subcategory and how this differs
                                     from past 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
                                     minimum, this should include
                                     information on estimates of losses
                                     against actual losses in the
                                     wholesale category and each retail
                                     subcategory over a period
                                     sufficient to allow for a
                                     meaningful assessment of the
                                     performance of the internal rating
                                     processes for each category/
                                     subcategory.\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\
------------------------------------------------------------------------

     
---------------------------------------------------------------------------

    \26\ This disclosure does not require a detailed description of 
the model in full--it should provide the reader with a broad 
overview of the model approach, describing definitions of the 
variables, and methods for estimating and validating those variables 
set out in the quantitative risk disclosures below. This should be 
done for each of the four category/subcategories. The bank holding 
company should disclose any significant differences in approach to 
estimating these variables within each category/subcategories.
    \27\ The PD, ELGD, LGD and EAD disclosures in Table 11.5(c) 
should reflect the effects of collateral, qualifying master netting 
agreements, eligible guarantees and eligible credit derivatives as 
defined in Part 1. Disclosure of each PD grade should include the 
exposure weighted-average PD for each grade. Where a bank holding 
company aggregates PD grades for the purposes of disclosure, this 
should be a representative breakdown of the distribution of PD 
grades used for regulatory capital purposes.
    \28\ Outstanding loans and EAD on undrawn commitments can be 
presented on a combined basis for these disclosures.
    \29\ These disclosures are a way of further informing the reader 
about the reliability of the information provided in the 
``quantitative disclosures: Risk assessment'' over the long run. The 
disclosures are requirements from year-end 2010; in the meantime, 
early adoption is encouraged. The phased implementation is to allow 
a bank holding company sufficient time to build up a longer run of 
data that will make these disclosures meaningful.
    \30\ This regulation is not prescriptive about the period used 
for this assessment. Upon implementation, it might be expected that 
a bank holding company would provide these disclosures for as long 
run of data as possible--for example, if a bank holding company has 
10 years of data, it might choose to disclose the average default 
rates for each PD grade over that 10-year period. Annual amounts 
need not be disclosed.
    \31\ A bank holding company should provide this further 
decomposition where it will allow users greater insight into the 
reliability of the estimates provided in the ``quantitative 
disclosures: Risk assessment.'' In particular, it should provide 
this information where there are material differences between is 
estimates of PD, ELGD, LGD or EAD compared to actual outcomes over 
the long run. The bank holding company should also provide 
explanations for such differences.

[[Page 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 (including type, for example,
                                     cash, government securities), and
                                     net unsecured credit exposure.\32\
                                     Also report measures for EAD used
                                     for regulatory capital for these
                                     transactions, the notional value of
                                     credit derivative hedges purchased
                                     for counterparty credit risk
                                     protection, and the distribution of
                                     current credit exposure 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 derivative products used,
                                     broken down further by protection
                                     bought and sold within each product
                                     group.
                                    (d) The estimate of alpha if the
                                     bank holding company has received
                                     supervisory approval to estimate
                                     alpha.
------------------------------------------------------------------------

     
---------------------------------------------------------------------------

    \32\ Net unsecured credit exposure is the credit exposure after 
considering both the benefits from legally enforceable netting 
agreements and collateral arrangements without taking into account 
haircuts for price volatility, liquidity, etc.
    \33\ This may include interest rate derivative contracts, 
foreign exchange derivative contracts, equity derivative contracts, 
credit derivatives, commodity or other derivative contracts, repo-
style transactions, and eligible margin loans.

            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 associated with that
                                     exposure.
------------------------------------------------------------------------

     
---------------------------------------------------------------------------

    \34\ At a minimum, a bank holding company must give the 
disclosures in Table 11.7 in relation to credit risk mitigation that 
has been recognized for the purposes of reducing capital 
requirements under this Appendix. Where relevant, bank holding 
companies are encouraged to give further information about mitigants 
that have not been recognized for that purpose.
    \35\ Credit derivatives that are treated, for the purposes of 
this Appendix, as synthetic securitization exposures should be 
excluded from the credit risk mitigation disclosures and included 
within those relating to securitization.
    \36\ Counterparty credit risk-related exposures disclosed 
pursuant to Table 11.6 should be excluded from the credit risk 
mitigation disclosures in Table 11.7.

                       Table 11.8.--Securitization
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Qualitative disclosures...........  (a) The general qualitative
                                     disclosure requirement disclosures
                                     with respect to securitization
                                     (including synthetics), 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.

[[Page 55952]]

 
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 criteria 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 exposures 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 exposure type), and recognised
                                     gain or loss on sale by asset type.
------------------------------------------------------------------------

     
---------------------------------------------------------------------------

    \37\ For example: originator, investor, servicer, provider of 
credit enhancement, sponsor of asset backed commercial paper 
facility, liquidity provider, swap provider.
    \38\ Underlying exposure types may include, for example, 1-4 
family residential loans, home equity lines, credit card 
receivables, and auto loans.
    \39\ Securitization transactions in which the originating bank 
holding company does not retain any securitization exposure should 
be shown separately but need only be reported for the year of 
inception.
    \40\ Where relevant, a bank holding company is encouraged to 
differentiate between exposures resulting from activities in which 
they act only as sponsors, and exposures that result from all other 
bank holding company securitization activities.
    \41\ For example, charge-offs/allowances (if the assets remain 
on the bank holding company's balance sheet) or write-downs of I/O 
strips and other residual interests.

                      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 objectives 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 different 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\
------------------------------------------------------------------------

     
---------------------------------------------------------------------------

    \42\ Unrealized gains (losses) recognized in the balance sheet 
but not through earnings.
    \43\ Unrealized gains (losses) not recognized either in the 
balance sheet or through earnings.
    \44\ This disclosure should include a breakdown of equities that 
are subject to the 0%, 20%, 100%, 300%, and 400% risk weights, as 
applicable.

       Table 11.11.--Interest Rate Risk for Non-Trading Activities
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Qualitative disclosures...........  (a) The general qualitative
                                     disclosure requirement, including
                                     the nature of interest rate risk
                                     for non-trading activities and key
                                     assumptions, including assumptions
                                     regarding loan prepayments and
                                     behavior of non-maturity deposits,
                                     and frequency of measurement of
                                     interest rate risk for non-trading
                                     activities.

[[Page 55953]]

 
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).
------------------------------------------------------------------------

* * * * *

Federal Deposit Insurance Corporation

12 CFR Chapter III

Authority and Issuance

    For the reasons stated in the common preamble, the Federal Deposit 
Insurance Corporation proposes to amend part 325 of chapter III of 
title 12 of the Code of Federal Regulations as follows:

PART 325--CAPITAL MAINTENANCE

    1. The authority citation for part 325 continues to read as 
follows:

    Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b), 
1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n), 
1828(o), 1831o, 1835, 3907, 3909, 4808; Pub. L. 102-233, 105 Stat. 
1761, 1789, 1790 (12 U.S.C. 1831n note); Pub. L. 102-242, 105 Stat. 
2236, 2355, 2386 (12 U.S.C. 1828 note).

    2. New Appendix D to part 325 is added as set forth at the end of 
the common preamble.
    3. Appendix D to part 325 is amended as set forth below:
    a. Remove ``[AGENCY]'' and add ``FDIC'' in its place wherever it 
appears.
    b. Remove ``[bank]'' and add ``bank'' in its place wherever it 
appears, and remove ``[Bank]'' and add ``Bank'' in its place wherever 
it appears.
    c. Remove ``[Appendix ---- to Part ----]'' and add ``Appendix D to 
Part 325'' in its place wherever it appears.
    d. Remove ``[the general risk-based capital rules]'' and add ``12 
CFR part 325, Appendix A'' in its place wherever it appears.
    e. Remove ``[the market risk rule]'' and add ``12 CFR part 325, 
Appendix C'' in its place wherever it appears.
    f. Remove ``[Disclosure paragraph (b)]'' and add in its place ``(b) 
A bank must comply with paragraph (c) of section 71 of appendix F to 
the Federal Reserve Board's Regulation Y (12 CFR part 225, appendix F) 
unless it is a consolidated subsidiary of a bank holding company or 
depository institution that is subject to these requirements.''
    g. Remove ``Disclosure paragraph (c)].''

Department of the Treasury

Office of Thrift Supervision

12 CFR Chapter V

Authority and Issuance

    For the reasons stated in the common preamble, the Office of Thrift 
Supervision proposes to amend part 566 of chapter V of title 12 of the 
Code of Federal Regulations as follows:
    1. Add a new part 566 to read as follows:

PART 566--ADVANCED CAPITAL ADEQUACY FRAMEWORK AND MARKET RISK 
ADJUSTMENT

Sec.
566.1 Purpose

    Authority: 12 U.S.C. 1462, 1462a, 1463, 1464, 1467a, 1828(note).


Sec.  566.1  Purpose.

    (a) Advanced Capital Framework. Appendix A of this part 
establishes: minimum qualifying criteria for savings associations using 
internal risk measurement and management processes for calculating risk 
based capital requirements, methodologies for these savings 
associations to calculate their risk-based capital requirement, and 
public disclosure requirements for these savings associations.
    (b) [Reserved]
    2. Appendix A to part 566 is added to read as set forth at the end 
of the common preamble.
    3. Appendix A to part 566 is amended as set forth below:
    a. Remove ``[AGENCY]'' and add ``OTS'' in its place wherever it 
appears.
    b. Remove ``[bank]'' and add ``savings association'' in its place 
wherever it appears, and remove ``[Bank]'' and add ``Savings 
association'' in its place wherever it appears.
    c. Remove ``[Appendix----to Part----]'' and add ``Appendix A to 
Part 566'' in its place wherever it appears.
    d. Remove ``[the general risk-based capital rules]'' and add ``12 
CFR part 567'' in its place wherever it appears.
    e. Remove ``[the market risk rule]'' and add ``12 CFR part 566, 
Subpart B'' in its place wherever it appears.
    f. Remove the text of section 12(b) and add in its place: ``A 
savings association is not required to deduct equity securities from 
capital under 12 CFR 567.5(c)(2)(ii). However, it must continue to 
deduct equity investments in real estate under that section. See 12 CFR 
567.1, which defines equity investments, including equity securities 
and equity investments in real estate.''
    g. Remove the text of section 52(b)(3)(i) and add in its place: 
``An equity exposure that is designed primarily to promote community 
welfare, including the welfare of low- and moderate-income communities 
or families, such as by providing services or jobs, excluding equity 
exposures to an unconsolidated small business investment company and 
equity exposures held through a consolidated small business investment 
company described in section 302 of the Small Business Investment Act 
of 1958 (15 U.S.C. 682).''
    h. Remove ``[Disclosure paragraph (b)]'' and add in its place ``(b) 
A savings association must comply with paragraph (c) of section 71 
unless it is a consolidated subsidiary of a depository institution or 
bank holding company that is subject to these requirements.''
    i. Remove ``[Disclosure paragraph (c)].''
    j. In section 71, add new paragraph (c) to read as follows:
    Section 71 * * *
* * * * *
    (c)(1) Each consolidated savings association described in paragraph 
(b) of this section that has successfully completed its parallel run 
must provide timely public disclosures each calendar quarter of the 
information in tables 11.1-11.11 below. If a significant change occurs, 
such that the most recent reported amounts are no longer reflective of 
the savings association's capital adequacy and risk profile, then a 
brief discussion of this change and its likely impact must be provided 
as soon as practicable thereafter. Qualitative disclosures that 
typically do not change each quarter (for example, a general summary of 
the savings association's risk management objectives and policies, 
reporting system, and definitions) may be disclosed annually, provided 
any significant changes to these are disclosed in the interim. 
Management is encouraged to provide all of the disclosures required by 
this appendix in one place on the savings association's public Web 
site.\45\ The

[[Page 55954]]

savings association must make these disclosures publicly available for 
each of the last three years (that is, twelve quarters) or such shorter 
period since it began its first floor period.
---------------------------------------------------------------------------

    \45\ Alternatively, a savings association may provide the 
disclosures in more than one place, as some of them may be included 
in public financial reports (for example, in Management's Discussion 
and Analysis included in SEC filings) or other regulatory reports. 
The savings association must provide a summary table on its public 
Website that specifically indicates where all the disclosures may be 
found (for example, regulatory report schedules, page numbers in 
annual reports).
---------------------------------------------------------------------------

    (2) Each savings association is required to have a formal 
disclosure policy approved by the board of directors that addresses its 
approach for determining the disclosures it makes. The policy must 
address the associated internal controls and disclosure controls and 
procedures. The board of directors and senior management must ensure 
that appropriate verification of the disclosures takes place and that 
effective internal controls and disclosure controls and procedures are 
maintained. The chief financial officer of the savings association must 
certify that the disclosures required by this appendix are appropriate, 
and the board of directors and senior management are responsible for 
establishing and maintaining an effective internal control structure 
over financial reporting, including the 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 \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.
------------------------------------------------------------------------

     
---------------------------------------------------------------------------

    \46\ Entities include securities, insurance and other financial 
subsidiaries, commercial subsidiaries (where permitted), significant 
minority equity investments in insurance, financial and commercial 
entities.
    \47\ A capital deficiency is the amount by which actual 
regulatory capital is less than the minimum regulatory capital 
requirements.

                     Table 11.2.--Capital Structure
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Qualitative disclosures...........  (a) Summary information on the terms
                                     and conditions of the main features
                                     of all capital instruments,
                                     especially 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.
------------------------------------------------------------------------

     
---------------------------------------------------------------------------

    \48\ Representing 50% of the amount, if any, by which total 
expected credit losses as calculated within the IRB framework exceed 
eligible credit reserves, which must be deducted from Tier 1 
capital.
    \49\ Including 50% of the amount, if any, by which total 
expected credit losses as calculated within the IRB framework exceed 
eligible credit reserves, which must be deducted from Tier 2 
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\

[[Page 55955]]

 
                                       For the top consolidated
                                       group; and
                                       For each DI subsidiary.
------------------------------------------------------------------------

General Qualitative Disclosure Requirement
---------------------------------------------------------------------------

    \50\ Risk-weighted assets determined under [the market risk 
rule] are to be disclosed only for the approaches used.
    \51\ Total risk-weighted assets should also be disclosed.
---------------------------------------------------------------------------

    For each separate risk area described in tables 11.4 through 11.11, 
the savings association must describe its risk management objectives 
and policies, including:
     Strategies and processes;
     The structure and organization of the relevant risk 
management function;
     The scope and nature of risk reporting and/or measurement 
systems;
     Policies for hedging and/or mitigating risk and strategies 
and processes for monitoring the continuing 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 exposure.
                                    (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,
                                     broken 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\
------------------------------------------------------------------------

     
---------------------------------------------------------------------------

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

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      (c) For wholesale exposures, present
 Assessment.                         the following information across a
                                     sufficient number of PD grades
                                     (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

[[Page 55956]]

 
                                          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
                                     segments to allow for a meaningful
                                     differentiation of credit risk.
Quantitative disclosures:           (d) Actual losses in the preceding
 historical results.                 period for each category and
                                     subcategory and how this differs
                                     from past 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
                                     minimum, this should include
                                     information on estimates of losses
                                     against actual losses in the
                                     wholesale category and each retail
                                     subcategory over a period
                                     sufficient to allow for a
                                     meaningful assessment of the
                                     performance of the internal rating
                                     processes for each category/
                                     subcategory.\63\ Where appropriate,
                                     the savings association should
                                     further decompose this to provide
                                     analysis of PD, ELGD, LGD, and EAD
                                     outcomes against estimates provided
                                     in the quantitative risk assessment
                                     disclosures above.\64\
------------------------------------------------------------------------

     
---------------------------------------------------------------------------

    \59\ This disclosure does not require a detailed description of 
the model in full--it should provide the reader with a broad 
overview of the model approach, describing definitions of the 
variables, and methods for estimating and validating those variables 
set out in the quantitative risk disclosures below. This should be 
done for each of the four category/subcategories. The savings 
association should disclose any significant differences in approach 
to estimating these variables within each category/subcategories.
    \60\ The PD, ELGD, LGD and EAD disclosures in Table 11.5(c) 
should reflect the effects of collateral, qualifying master netting 
agreements, eligible guarantees and eligible credit derivatives as 
defined in Part 1. Disclosure of each PD grade should include the 
exposure weighted-average PD for each grade. Where a savings 
association aggregates PD grades PD for the purposes of disclosure, 
this should be a representative breakdown of the distribution of PD 
grades used for regulatory capital purposes.
    \61\ Outstanding loans and EAD on undrawn commitments can be 
presented on a combined basis for these disclosures.
    \62\ These disclosures are a way of further informing the reader 
about the reliability of the information provided in the 
``quantitative disclosures: risk assessment'' over the long run. The 
disclosures are requirements from year-end 2010; in the meantime, 
early adoption is encouraged. The phased implementation is to allow 
a savings association sufficient time to build up a longer run of 
data that will make these disclosures meaningful.
    \63\ This regulation is not prescriptive about the period used 
for this assessment. Upon implementation, it might be expected that 
a savings association would provide these disclosures for as long 
run of data as possible--for example, if a savings association has 
10 years of data, it might choose to disclose the average default 
rates
    \64\ A savings association should provide this further 
decomposition where it will allow users greater insight into the 
reliability of the estimates provided in the ``quantitative 
disclosures: risk assessment.'' In particular, it should provide 
this information where there are material differences between its 
estimates of PD, ELGD, LGD or EAD compared to actual outcomes over 
the long run. The savings association should also provide 
explanations for such differences.

  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 (including type, for example,
                                     cash, government securities), and
                                     net unsecured credit exposure.\65\
                                     Also report measures for EAD used
                                     for regulatory capital for these
                                     transactions, the notional value of
                                     credit derivative hedges purchased
                                     for counterparty credit risk
                                     protection, and the distribution of
                                     current credit exposure 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 derivative products used,
                                     broken down further by protection
                                     bought and sold within each product
                                     group.
                                    (d) The estimate of alpha if the
                                     savings association has received
                                     supervisory approval to estimate
                                     alpha.
------------------------------------------------------------------------

     
---------------------------------------------------------------------------

    \65\ Net unsecured credit exposure is the cedit exposure after 
considering both the benefits from legally enforceable netting 
agreements and collateral arrangements without taking into account 
haircuts for price volatility, liquidity, etc.
    \66\ This may include interest rate derivative contracts, 
foreign exchange derivative contracts, equity derivative contracts, 
credit derivatives, commodity or other derivative contracts, repo-
style transactions, and eligible margin loans.

               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.

[[Page 55957]]

 
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 associated with that
                                     exposure.
------------------------------------------------------------------------

     
---------------------------------------------------------------------------

    \67\ At a minimum, a savings association must give the 
disclosures in Table 11.7 in relation to credit risk mitigation that 
has been recognized for the purposes of reducing capital 
requirements under this Appendix. Where relevant, savings 
associations are encouraged to give further information about 
mitigants that have not been recognized for that purpose.
    \68\ Credit derivatives that are treated, for the purposes of 
this Appendix, as synthetic securitization exposures should be 
excluded from the credit risk mitigation disclosures and included 
within those relating to securitization.
    \69\ Counterparty credit risk-related exposures disclosed 
pursuant to Table 11.6 should be excluded from the credit risk 
mitgation disclosures in Table 11.7.

                       Table 11.8.--Securitization
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Qualitative Disclosures...........  (a) The general qualitative
                                     disclosure requirement with respect
                                     to securitization (including
                                     synthetics), including 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 follows 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 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.
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 exposures 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 exposure type), and recognised
                                     gain or loss on sale by asset type.
------------------------------------------------------------------------

     
---------------------------------------------------------------------------

    \70\ For example: Originator, investor, servicer, provider of 
credit enhancement, sponsor of asset backed commercial paper 
facility, liquidity provider, swap provider.
    \71\ Underlying exposure types may include, for example, 1-4 
family residential loans, from equity lines, credit card 
receivables, and auto loans.
    \72\ Securitization transactions in which the originating 
savings association does not retain any securitization exposure 
should be shown separately but need only be reported for the year of 
inception.
    \73\ Where relevant, a savings association is encouraged to 
differentiate between exposures resulting from activities in which 
they act only as sponsors, and exposures that result from all other 
savings association securitization activities.
    \74\ For example, charge-offs/allowances (if the assets remain 
on the savings association's balance sheet) or write-downs of I/O 
strips and other residual interests.

                      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.
------------------------------------------------------------------------


[[Page 55958]]


         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 objectives 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 different 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
                                     association'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
                                     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).
------------------------------------------------------------------------

* * * * *

    Dated: September 5, 2006.
John C. Dugan,
Comptroller of the Currency.

    By order of the Board of Governors of the Federal Reserve 
System, September 11, 2006.
Jennifer J. Johnson,
Secretary of the Board.

    Dated at Washington, DC, this 5th day of September, 2006.

    By order of the Board of Directors.
    Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.

    Dated: September 5, 2006.

    By the Office of Thrift Supervision.
John M. Reich,
Director.
[FR Doc. 06-7656 Filed 9-22-06]
BILLING CODES 4810-33-P, 6210-01-P, 6714-01-P, 6720-01-P